Market Rotation Anticipated as Fed Rate Cut Looms: Investors Eye Shift from Tech Giants to Undervalued Sectors

Investors bet a Fed rate cut to spur rotation from crowded stocks to neglected as bull market continues

In the current financial cycle, there's a bull market in superlatives. The pileup of "first time ever" and "unprecedented extremes" over the past couple of years amounts to a case that this bull is leaving truly unique hoofprints. Last Thursday, 87% of S & P 500 stocks outperformed the index itself, which Goldman Sachs called "the most in the history of our data set." This came after six months in which the fewest stocks in the benchmark had managed to beat the S & P 500 of any half-year period on record. Similarly, Strategas Research says it was by far the most positive advance-decline ratio among New York Stock Exchange issues in any day in which the S & P 500 posted a loss. That loss, a mere 0.8% yet the biggest daily drop since April, came of course after a squishy CPI report opened a clearer line of sight to a Federal Reserve rate cut in September. The most profound action was in the gear-melting reversal in the Big Tech-vs.-small-cap domination, which had grown torqued to an extreme. The Russell 2000 jumped 5.5% while the Nasdaq 100 fell more than 1%. More broadly, Renaissance Macro says the one-day surge in the Russell 2000 against the large-cap Russell 1000 was one of the four largest since 1980. And of the three prior episodes, all occurred near a climactic broad-market low - in 1987, 2009 and 2020 - rather than with the big-cap indexes half a year into clocking fresh all-time highs. All of these rare or unprecedented features of last week's action tie back to the key characteristic investors have been fixated on for months: the profound concentration of market value in a tight cluster of the largest stocks. This configuration is the easiest way, mathematically, for the mass of stocks to diverge in such unusual fashion from the S & P 500. Recall, the market got this way in part because the highest financial-quality stocks - those with the most attractive earnings profile and sexiest secular dynamics - are also among the most expensive and most defensive in a time of macro unease and scarcity of reliable earnings growth. Plausible but untested conventional wisdom has held that an idealized "broadening out" of the market should coincide with a Fed rate cut and resulting democratization of profit growth. It seems a bit too neat and tidy, and history isn't clear on such a sudden change in market preference. But these days conventional wisdom gets converted into preset automated trading tactics juiced by exaggerated rotational mechanics. And so we get days like Thursday, which seem both logical and possibly overdone. Bull market 21 months old Still, it's not merely the internal to-and-from of the latest phase of this advance that has made this cycle unique. The ongoing bull market, which dates to October 2022, is now 21 months old, which is exactly half the median length of all bull markets since 1877, according to Fidelity Investments. Its total gain of 57%, measured by the S & P 500, is almost exactly half the post-1929 average too. And it's the only (at least in the past 70 years) to have started with the Federal Reserve in the middle of a tightening campaign. (Perhaps this fits, given that the preceding bear market got rolling even before the first rate hike in March 2022, defying decades of precedent under which stocks tended to rally through the initial months of a tightening program.) For good measure, this year the S & P 500 has posted the best-ever start to a presidential election year. Certain macroeconomic "rules" are also failing: The 2/10-year Treasury yield curve has now been inverted (with short yields exceeding long-term yields) for two years, the longest such stretch without a recession arriving. We can plausibly surmise why the interplay of market rhythms and macro forces have so often exceeded the bounds of historical norms over the past few years. A forced flash recession and multi-week market crash was met with a spring-loaded recovery helped by massive stimulus, leaving household finances stronger at the end of the economic shock than at the start. The tendency of the largest tech platforms to dominate and perpetuate their network advantages has been a factor for a decade, allowing the winning stocks to consume a greater share of capital. And, of course, the eruption of a runaway AI capital-investment boom almost the moment stocks bottomed and inflation peaked in late 2022 has engorged the big-cap growth segment of the market, compensating for an abundance of weakness elsewhere. It also argues for some humility in handicapping the market's next act, given its recent tendency for breaking patterns. What we can say for sure is that this is a bull market, and no recent extremes or anomalies can repeal the wisdom of respecting a sturdy uptrend. It's also sensible to observe that very strong first halves of a year tend to be followed by above-average second halves, and that the average positive year for the market (as opposed to the average of all years) sees a gain above 20%. Working against these comforting facts, at least tactically, is the fact that the historically strong first half of July has ended, with seasonal inputs growing a bit less friendly from here. And while the seasonal election-year cadence hasn't really been relevant so far this year, most such years do undergo some churn and weakness after midsummer. Rotation have legs? Whether last week's radical reversal of fortune in favor of the abject losers at the partial expense of the acclaimed winners is less clear. For sure, the kind of violent, broad momentum burst by most smaller stocks is unlikely to be a pure fluke. Such things tend to have some legs at least over a matter of weeks, according to multiple technical studies making the rounds. As the chart below of the Russell 2000 relative to the Nasdaq 100 shows, the rubber band was stretched pretty far, and the forces of mean-reversion alone could remain a tailwind behind the little laggards. But it also suggests those calling for a lasting shift in market character face a high burden of proof. As noted above, the most similar one-day outbreaks of small-cap outperformance to last Thursday's happened as broad, damaging selloffs were culminating, and not in a calm bull market looking toward a Fed rate cut to keep things humming. The best type of initial rate cut is an "optional" one in a healthy economy that is aimed at normalizing policy slowly to preserve and extend an expansion. Slower and shallower easing cycles historically are more bullish than rapid and deep ones. This scenario certainly remains in play. Arguably something close to it is already priced in to a considerable degree, with the S & P 500 pushing 22-times forward earnings again. Though the market can typically hold a full valuation when earnings are indeed growing, as they are now, and the Fed is not in tightening mode. Bottom line, the S & P 500 is strong but a bit overbought, with sentiment getting a bit lopsidedly optimistic and an economic deceleration of unknown extent underway. The elevated sentiment backdrop is par for the course for a bull market, but sometimes associated with pauses or pullbacks. (The resolute ascent in 2021 is a notable exception in virtually ignoring stretched sentiment readings.) It's fair, too, to question whether the narrow leadership and uneven internals of the market will be addressed in a painless rotation from large to small, growth to value, crowded to neglected stocks, just as a Fed rate cut is getting fully priced in. This would seem somewhat too cute, and perhaps too pleasing to a majority of investors frustrated by a split market and hard-to-beat S & P 500. Then again, anything can happen, as we've seen over and over again lately.

Wall Street Exclusive: A Story Of Two Different Markets (NYSEARCA:IWM)

Technology, Energy, Communication Services, Financials, and Healthcare are expected to lead the Q2 earnings parade. "Don't give up at half time. Concentrate on winning the second half." - Despite the most aggressive tightening cycle in four decades, the economy has been riding the wave of consumer strength since the post-COVID recovery. But with the consumer showing signs of fatigue (e.g., rising delinquencies, slower discretionary spending, fewer splurges), the labor market starting to slow, and inflation taking its toll (particularly for lower-income consumers), mainstream analysts and economists are pounding the table for the Fed to start dialing back some of its policy restraint to keep the recovery going. Of course, one might argue that the lumpy economic data, which sometimes indicates slowing and then some areas with resilience, suggests that Fed policy isn't restrictive. The Fed's trick will be to cut interest rates in time to avoid an economic wipeout (aka recession) without further stoking inflation pressures. Consensus calls for this year's end and some additional easing in 2025. The idea is to keep GDP growth near the trend of 2.1% in 2024 and 2.0% in 2025. Just like the first couple of 25 basis point hikes didn't make any difference for months, one or even two 25 basis point rate cuts won't move the needle on the economy. The Fed is also looking over its shoulder at the cost of paying for America's national debt, which crossed the 1 trillion dollar mark in 2023, driven by high interest rates and a record $34 trillion mountain of debt. One has to wonder if that will also factor into their decisions, leaving inflation a secondary concern and opening the door for round two of inflation. Suffice it to say the Fed is in a VERY difficult situation now. Growth initiatives and maintaining the present competitive tax rate structure will be necessary to keep corporate America resilient. In turn, the economy can remain in decent condition as we head into 2025. The strong correlation between a strong corporate scene and a strong economic scene is indisputable. The bond market is guided by two key dynamics -- growth and inflation- and faces the challenges of record government debt issuance, the Fed's balance sheet, and demand unease. If the gurus are correct, inflation and the economy will cool for the remainder of the year, and that should keep a lid on the 10-year yield. We may have seen the highs for the year when the 4.7% level was struck in April. Cash remains an attractive alternative, with short-term (3-month CD) yields still hovering above 5.0%. While rates won't rocket higher, it's doubtful they will crash. Therefore, if you believe inflation is dead, it is prudent to slowly lock in a longer duration ahead of the Fed's easing cycle. Equities Should Keep 'Climbing' - but not without volatility. The S&P 500 has scaled to new heights in 2024 (34 record highs YTD/ 3 this week), despite climbing a wall of worry -- successfully navigating recession fears, elevated valuations and higher-for-longer interest rates. The AI revolution has trumped all of those concerns, leading to what has turned out to be the tale of two markets. Stocks may encounter more volatility in the months ahead, particularly as growth slows, earnings enter a more challenging environment, and as the Presidential election nears. Volatility will also be heightened with the expectation of "normalization." A scene where mega caps slowdown and other market areas begin to perform. That analysis is based on the earnings picture. A composite of mega-cap tech stocks (MAGMAN) has strongly outperformed the overall market YTD, but earnings growth for the rest of the market will catch up and even outpace MAGMAN's earnings later this year. Performance MUST broaden beyond just tech as the rest of the index and smaller company earnings accelerate. If that occurs, the primary trend can stay in control. Sectors that should remain on our radar lists include Technology, Industrials, Energy, and Health Care. The unanswered question is how much has already been priced in based on the expectation that artificial intelligence will ramp up earnings for the entire corporate scene. A Tale of Two Markets It is no secret now that the "average diversified" portfolio has underperformed this year as investors have flocked to "anything AI." While we can't dismiss the performance of the AI-related MAG 7, the picture below shows what everyone has been referring to. That has made for a more difficult backdrop for investors and, to some degree, has ramped up investor anxiety. The opening quote states that the game isn't over after the first half. That confirms the strategy that avoids making major portfolio changes. Quality will always be in demand. While the Magnificent Seven ETF (MAGS) stocks possess many quality attributes (low/no debt, above-average cash flow, etc.), other sectors will join the uptrend as the MAG trade slows. That is based on earnings improvement spreading to different sectors, in turn, broadening the market as the year unfolds. At some point, a simple reversion to the mean always occurs. The rush to get into anything AI continued. The week ended with AMZN, AAPL, GOOGL, META, etc., making new all-time highs and NFLX reaching a 52-week high. That pushed the S&P to finish the week with three consecutive days at all-time highs and four straight days of new highs for the NASDAQ. Meanwhile, the average stock remains in a sideways pattern. On Monday, the S&P 500 flipped between gains and losses, but a rally in the day's final minutes left the index 5 points higher. That was enough to mark the fourth straight day with a new high. The Nasdaq outperformed with a 0.28% gain leaving it at its fifth straight day at an all-time high. The small-cap Russell 2000 (IWM) finally got some attention and recorded a 0.59% gain. Breadth was mixed with five sectors higher and the other six falling. Tech was the best performer, with a 0.72% gain, while Communication Services fell over 1%. It was more of the same on Tuesday. Another day, another record high. Six straight days of gains and five straight days with a new high being recorded for the S&P 500 (#36). The Nasdaq rose 0.14%, extending the index's new high streak to six straight days. Financials outperformed with a 0.65% rally, while Materials was the worst performer with a 1% decline. Small caps keep running in place, with the Russell 2000 dropping 0.45%, offsetting Monday's gain. We are at a point where an analyst can write the same daily script and simply change the numbers. Another day, another record high (#37). Seven straight days of gains and six straight days with a new high being recorded for the S&P 500. Instead of a modest gain of four points on Tuesday, the index added 56 points, closing at 5633 today. The NASDAQ gained 1.1%, extending the index's new high streak to seven straight days. The DJIA broke its two-day losing streak, adding 1%, while the small caps bounced and kept up with the other indices, adding 1%. Breadth improved on Wednesday, with all eleven sectors rallying -- Technology (XLK), Materials (XLB), Consumer Discretionary (XLY), Communications Services (XLC), and Utilities (XLU) were the leaders. Thursday brought about a noticeable reversal. The Russell 2000 small caps (IWM) were the focus, rallying 3.5%. The S&P gave back 0.88% of its recent 7-day rally, closing at 5584. Its new high streak was snapped at six. The (MAGS) momentum trade took a well-deserved breather and took the NASDAQ Composite down 1.9%, breaking its seven-day new high streak. The magnificent seven ETF lost 4.3%, as AMZN, AAPL, GOOGL, MSFT, META, NVDA, NFLX, etc., were down between 2 and 5%. The 10-year dropped to the early June lows at 4.19%, while Gold, Silver, and Uranium rallied. The final trading day of the week produced a strong across-the-board rally, with every index and sector participating. The S&P has now recorded weekly back-to-back gains. It has been positive in four of the last six weeks and eleven of the last thirteen. Meanwhile, the NASDAQ Composite made it six straight weeks with a gain and has produced positive results in eleven of the last twelve weeks. Inflation The big report on Thursday was CPI, which came in lower than expected at a negative 0.1% month-over-month level. That's the lowest print since May 2020. On a core basis, CPI increased 0.1%, the lowest level since February 2021. What has been interesting lately is that we've witnessed multiple instances of a positive inflation report preceded by positive price action with seemingly no catalyst. Thinking back to the surge into yesterday's close, did somebody know something (again)? The late afternoon buyers who pushed the S&P and NASDAQ up to new highs on Wednesday didn't get the desired result this time around. The indices sold off sharply after the report, giving back all of the previous day's gains and more. Friday's PPI report didn't confirm the CPI data when it overshot estimates in June with gains of 0.2% for the headline and 0.4% for the core after upward May revisions. The mixed June inflation reports still leave a net moderation in inflation risks into the back half of 2024. Sentiment The NFIB's small business sentiment report came in higher than expected. At 91.5, it was the year's highest reading in June, a one-point increase from last month. NFIB Chief Economist Bill Dunkelberg; Main Street remains pessimistic about the economy for the balance of the year. Increasing compensation costs has led to higher prices all around. Meanwhile, no relief from inflation is in sight for small business owners as they prepare for the uncertain months ahead." Four years later, small business optimism remains near pandemic lows and just above the GFC recession lows. Over the past three months, Michigan sentiment has fallen below the early pandemic bottom of 71.8 in April 2020 after a four-month stint above that level. Current conditions fell to a 19-month low, while expectations fell to an 8-month low. The data doesn't lie; the average consumer isn't thrilled with the current economic backdrop. This section presents a series of issues that may not necessarily impact the market today but can pose problems for the MACRO scene. Inflation remains a key topic. While the media is focused on the .01%-0.2% month-over-month data that rolls in, the point that most everyone is missing is the cumulative effects of inflation that are embedded in prices. People aren't celebrating the month-over-month changes or, for that matter, the headlines that inflation is coming down. Consumer confidence has been at near record lows for months because prices are still much higher than in early '21. That is illustrated by reports such as the "Chapwood Index," which uses the actual costs of the "top 150 items that Americans buy in the 50 largest cities," which was up between 7.8% and 13.6% over the past year. That seems more in line with anecdotal experience than the CPI or PCE indicate. It also better reflects the risk of the Fed cutting rates too soon and keeping such year-over-year price increases as a rule rather than the exception. Regardless of how that plays into the entire rate discussion, it is a moot point; it plays into consumers' pocketbooks, which are the heart of the US economy. In addition to other issues currently playing out in the US, this is the main reason consumer sentiment is near historic lows. The Courts start to bring equilibrium and reinforce a BALANCE of POWER. Two recent rulings by federal judges have dealt a significant near-term blow to the administration's SAVE income-driven student loan repayment program, impacting millions of borrowers ahead of the scheduled July implementation. The decisions temporarily block the Education Department from implementing key provisions of the program, including the further reduction in monthly payments for millions of borrowers and canceling additional debt under the program. From a market perspective, the SAVE income-driven repayment program (which has already enrolled over 8 million borrowers) is the most impactful dimension of President Biden's student loan agenda. The SAVE plan is designed to be an affordable federal student loan repayment option, with provisions for lower monthly payments and faster debt forgiveness. The program had already canceled $5.5 billion of debt for 414,000 borrowers, with more cancellations planned. The Supreme Court has already ruled that only legislation passed by Congress can forgive any debt. That confirms the adage outlined in the Constitution that Congress (and only Congress) has the "power of the purse." In another recent ruling that didn't get much coverage, the Supreme Court overturned the 1984 Chevron precedent in a monumental decision that is set to shake up the federal regulatory landscape across all industries. This ruling could have massive implications, particularly for highly regulated industries like healthcare, energy, and technology. The ruling curtails the power of federal agencies to interpret the laws they regulate when a dispute arises. In essence, an "agency " proposed and then administered regulations. They were the governing body that ruled on any dispute on the same regulations they imposed. Cutting through the legal jargon - this means that future legal challenges against federal regulations will be more likely to succeed. This autocratic nightmare was first struck down in the West Virginia clean air case, in which the Supreme Court ruled against the EPA, citing that it overstepped its bounds and did not have the authority to regulate greenhouse gas emissions. This shift will slowly strip unauthorized power from unelected bureaucratic agencies and bring it back to Congress where it was intended. That's a win for Corporate America. Finally, the war on fossil fuels was dealt another blow when a court ruled that the administration did not have the authority to halt liquefied natural gas projects. The initial ban was controversial, as it allowed Russia to overtake the US in shipping Nat Gas to Europe. During the week, Germany released two very rough reports on factory orders and industrial production. The chart below shows that both continue to fall off their post-COVID peaks. Excluding the COVID shock, factory order volumes were the lowest since November of 2012, while industrial production (extraction, utilities, manufacturing, and construction) was the weakest since 2006, excluding the two major global shocks over that period. The German economy remains fundamentally very, very weak. The cool CPI report has investors pricing at a 90% chance of a rate cut in September. I'll continue to play devil's advocate and say, "Be careful what you wish for." History shows that the FED typically cuts rates at the start of an economic decline -- NOT at what is now believed to be a SOFT landing. Is this time different? Maybe so. Nothing has followed the economic script for the last four-plus years. I'm in the camp that says the initial and perhaps subsequent rate cuts won't do much, just like they didn't do much when they were raised. Onerous regulatory conditions and an anti-business stance at the current FTC hamper the economy more than a 25 -- or 50 basis point change in rates. High energy costs slow the economy down more than the current 4.5% Fed funds rate, which is BELOW the historical norm. If we want to see rate cuts spur the economy, then we'll also have to see changes take place that is geared to strengthen corporate America. As much as investors want to avoid this political backdrop, the ramifications of what has developed are unprecedented, hard to ignore, and may already be impacting the markets. We are on a collision course in DC between President Biden and Congressional Democrats over each of their desire to stay in power, with an uncertain future. President Biden's performance at the June debate with President Trump has created a crisis for the Democratic Party, with a growing concern that if President Biden stays in the race as the Democratic nominee, former President Trump is increasingly likely to win and increases the probability of a Republican sweep. President Biden issued a letter to Congress indicating his intentions to remain in the race, as growing pressure from Congress and Democratic allies advised him to withdraw. If Biden steps aside, Vice President Harris appears to be best positioned for the nomination (especially as she can inherit the Biden-Harris fundraising haul). However, questions over her viability as a candidate also loom large. When she dropped out of the presidential race in 2020, she garnered only 1% of the DEMOCRATIC vote. Her high water mark was 3%. Getting back to the market implications, most analysts see a Trump victory ushering in a period of lower regulations and, at the very least, keeping the low tax backdrop in place. Concerns over a more aggressive stance on tariffs are also being surfaced. From a market perspective, no one envisions a significant variance between the current high regulatory/higher taxes Biden policies and a Harris candidacy. The extension of the 2017 tax cuts and former President Trump's potential deregulatory agenda are starting to get priced into the market. That's why we have seen renewed interest in financials, as JP Morgan hit a new all-time high on July 3rd. After the 2016 election, financials (XLF) staged a 52% rally in 2017. In addition, there will be an expectation of more M&A approval in a Trump presidency. Many conversations have been had regarding the potential for more inflationary policies from a Trump presidency. Tariff policies (10% worldwide and 60% in China) have been the source of near-term angst. However, I'll remind everyone that the initial round of Tariffs imposed by Trump in 2018 did NOT result in an inflationary spiral. PLEASE remember that the PRIMARY factor in performance in any stock/ sector or the market itself ALWAYS depends on the individual fundamental picture. Specifically what the Earnings scene and overall economic backdrop look like. These are only suggestions or ideas, and with 3+ months to go before the election, anything can still happen. Therefore, there is NO reason to start getting positioned for any outcome. Furthermore, what happens with Congress will be of the utmost importance and will set the tone for the first two years after the election. The earnings season officially started on Friday, with a few large central money banks reporting. Savvy investors get competitive daily updates on EPS reports, including companies that are not only beating estimates but, more importantly, raising guidance. That report is a MUST for all looking for opportunities that can produce outsized results. On Thursday, the streak of six straight sessions with new all-time highs for the S&P 500 was broken. A rebound on Friday followed the one-day dip, leading to the index hitting a new intraday high at 5655. The strong, pristine BULL trend remains in place, and the good news is that the overall market has broadened. On Thursday, the ratios of advancers to decliners and up-to-down volume increased to nearly 5-to-1 on the NYSE. On Friday, all indices and sectors participated in the rally. Investors should look higher, not lower, until there is a definitive break in the first support trendline. THANKS to all the readers who contribute to this forum to make these articles a better experience. These FREE articles help support the SA platform. They provide information that speaks to Both the MACRO and the short-term situation. With a diverse audience, there is no way for any author to get specific unless they're simply highlighting ONE stock, ETF, etc. Therefore, detailed analysis, advice, and recommendations are reserved for members of my service offering on the platform. SA verifies the information provided here; in most cases, links are provided as supporting documentation. If anyone can point out a comment in any article I put forth and demonstrate that it is factually INCORRECT - I will REMOVE it.

Global Market Perspectives Q3 2024: Losing Some Of The Shine

The inflation scare of 1Q24 is now waning, but a few more months of soft inflation data are required to validate that disinflation is proceeding as necessary. By Seema Shah, Chief Global Strategist, Brian Skocypec, CIMA, Director, Global Insights & Content Strategy, Ben Brandsgard, Insights Strategist U.S. growth is softening as lower-income households feel the bite of higher interest rates. Other developed markets are now enjoying cyclical upturns, yet the limited nature of their recoveries suggests that U.S. economic dominance still holds. The inflation scare of 1Q24 is now waning, but a few more months of soft inflation data are required to validate that disinflation is proceeding as necessary. Without a sharp labor market slowdown, global inflation will unlikely reach central bank targets until late 2025, if not 2026. A first Fed rate cut could occur in September, provided inflation continues to decelerate and economic activity does not reaccelerate. Other central banks have started easing, but their next moves will fall back in line with the Fed's actions. After having weathered the post-COVID environment exceptionally well, the U.S. economy is now seeing a slight softening in growth. By contrast, while the Euro area, the UK, and several other developed nations experienced a meaningfully weaker growth outcome post-COVID, they have been enjoying a slight cyclical economic upturn. Yet, U.S. economic dominance still holds. Europe's recovery has a limited upside, being held back by lackluster credit demand and signs that upside economic surprises are already losing momentum. Similarly, although China's growth has also improved, it is being upheld almost solely by net exports. With the property sector showing no clear signs of bottoming and credit growth still weak, China's recovery is unlikely to gain further traction. Meanwhile, the underlying resilience of the U.S. economy implies that any slowdown will be modest. The upshot is that even as segments of the global economy enjoy upturns, the limited nature of their recoveries means that the U.S. will likely remain the strongest performer. With so many elections taking place around the world this year, the global economy is vulnerable to the threat of increased trade tariffs and geopolitical tensions. Given the significant increase in government deficits, debates around fiscal discipline are also likely to dominate market focus. That same economic strength that has delayed Fed cuts should support a positive backdrop for corporate earnings, ensuring that the set-up for U.S. equities remains reasonably constructive. Yet, the concentration of gains does pose a risk. Macro resilience should ensure a gradual rise in defaults rather than a sudden spike, meaning credit spreads are unlikely to widen significantly from their current levels. Fixed income yields are markedly higher than a few years ago. Assets in money market funds have ballooned to a record $6 trillion, with investors attracted by elevated yields. Now, this cash represents a potential tailwind to risk assets. U.S., Europe, and China economic surprises Citi Economic Surprise Index level, weekly, 2023-present After having weathered the post-COVID environment exceptionally well, the U.S. economy is now seeing a slight softening in growth. By contrast, while the Euro area, the UK, and several other developed nations experienced a meaningfully weaker growth outcome post-COVID, they have been enjoying a slight cyclical economic upturn. Yet U.S. economic dominance still holds. Europe's recovery has a limited upside, being held back by lackluster credit demand and signs that upside economic surprises are already losing momentum. Similarly, although China's growth has also improved, it is being upheld almost solely by net exports. With the property sector showing no clear signs of bottoming and credit growth still weak, China's recovery is unlikely to gain further traction. Meanwhile, the underlying resilience of the U.S. economy implies that any slowdown will be modest. The upshot is that even as segments of the global economy enjoy upturns, the limited nature of their recoveries means that the U.S. will likely remain the strongest performer. With so many elections taking place around the world this year, the global economy is vulnerable to the threat of increased trade tariffs and geopolitical tensions. Given the significant increase in government deficits, debates around fiscal discipline are also likely to dominate market focus. U.S. 30yr fixed mortgage rate, effective mortgage rate, and effective Fed funds rate 2010-present Personal interest payments, mortgage and non-mortgage Percent of disposable income, January 2010-present, Rebased to 100 at 1Q 2010 It is important not to exaggerate the impact of pockets of U.S. economic weakness. While lower-income households are showing strains, middle- and higher-income households, who are responsible for most consumer spending, remain in good shape. Coupled with gains from property and equity market exposure, household balance sheets have broadly remained strong. Total U.S. household net worth as a percentage of disposable income sits close to an all-time high. Similarly, there is a divergence within the corporate sector, with small business confidence struggling with their limited pricing power and shrinking margins. In contrast, large business confidence remains very robust. Broad corporate balance sheets are too in good shape, thanks to the fact that many companies chose to issue/refinance their debt when rates were low in 2020/21. Interest payments, as a percentage of profits, are at the lowest levels since 1957. However, rising numbers of corporate bonds are now maturing, requiring refinancing at higher rates than the existing loans. The solid economic backdrop implies that most corporates should be able to climb the maturity wall relatively unscathed - but will have to offset higher refinancing costs by reducing expenses elsewhere. One key strategy is to reduce labor costs, in turn, contributing to a weaker labor market. Corporate interest payments versus Federal funds rate Quarterly, January 1970-present On the surface, the labor market appears to be in good health. Overall, non-farm payrolls have averaged 177,000 in the past three months, meaningfully above the 150,000 level which would be considered consistent with a strong economy. Yet, under the surface, companies are already re-evaluating labor costs. Job openings have declined meaningfully, and hiring plans have been pulled back, particularly among smaller businesses where high input and wage costs have made it more difficult to expand headcount. Quits rates have fallen as employees' job security has deteriorated, with a recent New York Fed survey showing that, outside of the pandemic period, employees' perception of finding a new job within three months is the lowest in over a decade. Weekly jobless claims, typically a very timely labor market indicator, are low but trending higher. The U.S. unemployment rate also remains historically low, but at 4%, it too has been nudging higher. Labor market surveys suggest a further weakening in labor demand should soon appear in the data, likely pushing jobless claims and unemployment slightly higher. Yet, provided the underlying economy remains fundamentally robust and company profit margins remain healthy, mass job losses and an income decline spiral should be avoided. Yet, it is still a pertinent risk on the Fed's radar. Labor market tightness: various measures NFIB hiring plans, JOLTS quits rate, job openings Global inflation progress continues to grab market attention. Although there has been significant improvement, the "last mile" in inflation is proving to be sticky and frustrating across most economies. Most central banks have responded by raising their 2024 inflation projections. Economic strength has not come without costs. After a series of hotter than expected inflation prints, more recent data suggest that U.S. inflation may have returned to its more disinflationary trend. The two key contributors to U.S. inflation remain shelter services, which various indicators, including primary rents, new lease signings, and median home prices, all indicate it should see significant improvement over the coming year, and core services ex-housing -- the segment of the consumer basket most closely related to wage growth. If the labor demand/supply balance continues to improve, a further softening in wage growth is likely, and, therefore, core services ex-housing inflation should wane. It is doubtful that, without further cracks in the labor market, there will be enough softening to bring inflation all the way down to the Fed's 2% target. But the improvement should be enough to assuage fears around renewed inflation pressures and a second inflation wave. Global inflation rates Principal Asset Allocation GDP-weighted inflation, 2015-present Fed rate cut cycles typically play out against a backdrop of falling inflation, mass job layoffs and rising recession risk. Instead, in the current cycle, the Fed is playing a balancing act: perfectly time rate cuts to cultivate a soft landing without reigniting inflation pressures. Indeed, the uncertainty around the last mile of progress for stubborn and sticky inflation undoubtedly complicates the Fed's decision making. History clearly warns against cutting rates before inflation is on a sustainable path to target. There are striking similarities between U.S. inflation developments today and those of the early 1970s. During that period, the Fed had also responded with steep interest rate hikes. After some time, it was anxious to ease monetary policy, cutting interest rates before inflation had fallen back to levels consistent with price stability. The result was a resurgence in price pressures. While it is not obvious that the economy requires policy easing, the very minimal of successful soft landings following a Fed hiking cycle demonstrates the dangers of waiting too long before cutting rates. Indeed, there are already signs that consumers are starting to show fatigue and that companies are considering labor costs, suggesting that the Fed risks throwing away prospects of achieving a soft landing if it waits too long. Market rate expectations have shifted significantly over the past six months as inflation projections have risen. In fact, the timing of the first Fed rate cut remains a difficult question to answer, given that the Fed's policy decision is highly dependent on incoming releases. Evidence of moderating economic activity and a rebalanced labor market suggest that inflation pressures should subside over the coming months. We expect the first cut to come in September, followed by December - but it will certainly take additional positive inflation readings to cement the timing. Investors can derive three key insights for the Fed's outlook: While inflation is likely to decelerate, the economy's underlying strength, geopolitical tensions, and several structural drivers argue against a meaningful drop in inflation. This is shaping up to be a short and shallow cutting cycle. Evolution of market 4Q 2024 inflation and Fed rate forecasts U.S. CPI 4Q 2024 and market implied Fed rate for December 2024, June 2023-present Federal Reserve policy rate pathFed funds rate and projections, 2021-present Typically, central banks wait for the Fed to reduce rates before they move. In fact, until June, the ECB had never cut rates ahead of the Fed. However, given the Euro area's lackluster growth backdrop and headline inflation having plunged sharply, the ECB had strong reason not to wait for the Fed. However, the ECB will be wary of its diverging policy path. A widening gap between U.S. and Euro area policy rates risks putting downward pressure on the euro, in turn adding to inflationary pressures. Although the Euro area's inflation has fallen, recent data have surprised to the upside, so the ECB cannot risk further significant euro depreciation. Some global policy coordination is required. The next ECB rate reductions are likely in September and December -- the same months the Fed is likely to cut. However, if the Fed delays the start of its easing cycle until early 2025, the ECB's next move may be equally delayed. The Bank of England (BOE) will likely begin rate cuts in August and then move at a pace similar to the Fed. For the Bank of Japan, a slow move towards hikes has weighed heavily on the yen. With the Fed's cutting cycle likely to be short and shallow, the Bank of Japan will need to embrace tighter policy to avoid further yen weakness. Prospects for significant interest rate cuts were an important driver of the market rally in the first half of 2024. Yet that same economic strength that has delayed Fed cuts should support a positive backdrop for corporate earnings, ensuring that the setup for equities remains constructive, even if gains are not as strong as earlier in the year. Historically, long Fed pauses have been positive for stocks. In fact, the 1995-1996 Fed pause was against a similar backdrop to the present day, with strong economic growth giving the Fed little reason to lower rates. During that period, the Fed kept policy rates on hold, the S&P 500 rose 19.2%. The narrowness of market gains remains a concern, with the equity rally hostage to the performance of Magnificent 7 technology stocks. Yet, the AI craze and delivery of strong earnings means that investors are still willing to pay higher multiples for those companies. Stretched valuations and very concentrated positioning may imply the Magnificent 7 only grind higher from here, but the secular trend upwards should persist over the long run. Furthermore, solid economic growth should support a broadening out of risk appetite and earnings growth across a variety of other companies, sectors, and markets which are meaningfully less stretched and, therefore, offer the potential for strong returns. Magnificent 7 performance Simple equal-weighted performance versus the S&P 500 and Nasdaq composite, indexed to 100 at January 1, 2020 The stock market and earnings S&P 500 Index price and trailing earnings-per-share, 1990-present Equities lost some momentum in 2Q as several risks confronted the global outlook, including inflation surprises, election shocks, and geopolitical risk. The S&P 500 hit a new record high, largely thanks to a 17% gain in the Magnificent 7. By contrast, the equal-weighted S&P 500 fell 2.6% in 2Q, Europe posted only marginal gains and Japan posted a loss. The U.S., along with India, are the most stretched markets. Large-cap U.S. stocks have rarely been more expensive, while small-caps are historically attractive. Yet, their relatively high share of floating rate debt implies that small- caps cannot stage a sustained recovery unless rate cuts materialize promptly and economic growth strengthens. In Europe, Germany remains meaningfully less stretched than the U.S. market and is enjoying a cyclical upturn. Yet, exposure to political risk and limited potential for a meaningful growth upgrade suggests that further gains could be lackluster. Japan's valuations are clearly flagging as expensive, but momentum in corporate governance reforms presents opportunities for unlocking value. Segments of the Latin America and Asia EM complex are historically cheap and have strong fundamentals. However, China continues to be pressured by its weak macro outlook. Global equity returns and valuations Last twelve months returns and % times cheaper, MSCI indices The second quarter of 2024 proved to be volatile for sovereign bonds as markets debated central bank policy paths. With investors pricing in a more gradual cycle of rate cuts in most economies, sovereign yields rose through 2Q, and 10-year U.S. Treasury yields ended the quarter 20 basis points higher than they started. Election risk has also played its part. Markets have focused on the risks of looser fiscal stances, putting upward pressure on longer-end bond yields, steepening the yield curve. With the Fed likely to start cutting rates later this year, Treasury yields should skew lower. However, the likely short and shallow Fed cutting cycle, coupled with elevated market scrutiny on fiscal sustainability, suggests that yields are unlikely to revert to the ultra-low levels of recent years. Despite the significant repricing in rate expectations so far in 2024, fixed income has continued to deliver positive performance, predominantly because the macro resilience narrative remains intact. More pertinently, the total yield generated from fixed income today is markedly higher than a few years ago, and credit is offering important additional carry to U.S. Treasurys. Fed funds rate and U.S. 10y Treasury bond yield Recessions are shaded, 1985-present Credit spreads for both investment grade and high yield are currently near historic lows and are unlikely to narrow further. Yet attractive yields are helping to offset unappealing credit spread entry points. What's more, provided recession is avoided, a gradual rise in defaults is more probable than a sudden spike, meaning spreads are unlikely to widen significantly from their current levels. Additionally, it is noteworthy that despite recent macro volatility, spreads have remained within a relatively tight range. This suggests an attractive "stability" element to credit which should continue even amidst ongoing debates about interest rates. In an environment of solid economic growth and higher for longer rates, the short duration and cyclical exposure of high yield is attractive. A much-flagged risk for high yield is that the wall of maturing debt will face significantly higher refinancing costs, potentially triggering a spike in defaults. However, the resilient, albeit slowing, macro backdrop and strong balance sheets suggest that companies should scale the wall relatively unscathed. In addition, the maturity wall leans towards high-quality, so most companies will be able to digest the interest rate costs without too much strain. U.S. high yield and investment grade spreads Option-adjusted-spread, 1998-present As investors have pared back their expectations for the timing and pace of rate cuts, assets in money market funds have continued to increase. Yet, with the Fed set to reduce rates later this year, the attractiveness of cash is set to decline, and reinvestment risk is elevated. The U.S. economy is cooling, but is not heading for recession. Inflation is sticky, but is not heading into a second wave. The Fed is cautious, but the next policy move will be a cut, not a hike. This backdrop, while not as convincingly positive as at the start of the year, is still constructive for markets -- and a $6 trillion mountain of cash is ready to fuel risk assets. Equities not only offer exposure to important secular themes that show little sign of fading, such as AI and technology but also harness the positive growth environment. Bonds can offer important income stability and a hedge against downside risk. Alternatives such as real assets offer insulation in case inflation remains sticky or starts to trend higher again. With the potential for gains across the asset class spectrum, the main risk for investors is staying in cash. This year will likely be beset by election volatility and political risk. Investors will need to keep cool heads, focus on the fundamentals, and resist the temptation to revert to cash. Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Q3 2024 Equity Market Outlook

When global production picks up, we observe goods prices tend to follow, thereby bolstering margins within industrially sensitive sectors. Financial headlines suggest that vigorous debate has returned to equity markets. In our 3Q Equity Market Outlook, we highlight key aspects of this shift and discuss what they might portend for markets over the next six to 12 months. Specifically: We remain constructive on equities based on three general observations: 1) investors' renewed focus on corporate earnings; 2) the gradual broadening of the stock market; and 3) the continuing global industrial rebound. Renewed Focus on Earnings While an increase in price-to-earnings (P/E) multiples drove much of the stock market's rise in 2023, fundamentals have made a strong comeback in the first half of 2024. As figure 1 shows, 70% of the S&P 500's total return in 2023 came from expanding P/E multiples, and just 24% from earnings growth; thus far in 2024, that split is much more even, 50% to 45%. Figure 1: Earnings have contributed more to equity returns in 2024 than in 2023 Why might a renewed focus on earnings be good news for stocks? We find that earnings-driven markets tend to be anchored by improving economic and corporate fundamentals, whereas P/E multiple-driven markets are often led by sentiment and liquidity. Furthermore, we notice that earnings-driven markets tend to be less volatile and engage more investors who have longer investment horizons, which can add to a bull market's longevity. Solid Earnings Are Underpinning a Broadening Stock Market Another reason for optimism, in our view, is that we saw positive earnings revisions spread across many sectors during the first half of 2024. As shown in figure 2, the net percentage of companies within the Russell 1000 with positive earnings revisions has been rising rapidly since the beginning of the year. Furthermore, by the end of May, nine out of 11 sectors within the S&P 500 had seen net positive earnings revisions, versus just one-Technology-at the end of 2023. Figure 2: The breadth of positive earnings revisions has risen dramatically In the near future, we expect further corporate earnings growth across sectors, fueled by rising household net worth, a supportive labor market, positive fiscal impulse and reviving global industrial production (more on that below). Notably, rising earnings breadth across the stock market has narrowed the growth gap between the Magnificent 7 (Microsoft, Amazon, Meta, Apple, Alphabet, Nvidia and Tesla) and the other 493 stocks in the S&P 500. As of 4Q 2023, the Mag 7's growth has been moderating while the rest have picked up. As shown in figure 3, the earnings growth gap between the Mag 7 and the rest peaked at 64% in 4Q 2023 and has begun trending in favor of the S&P 493, which is much more reasonably valued in our view. For most of 2023, the Mag 7 were valued at a growth-scarcity premium, which we expect will be chipped away as growth broadens. Figure 3: Broader growth means the Mag 7 is no longer the "only game in town" Should this transition continue, we believe it could reduce the appeal of the Mag 7 (and the valuation premium they command), thereby increasing the relative attraction of the broader market. From an investment style perspective, we think another shift appears in progress: While growth has been outpacing value at the index level, a closer look leads us to believe that growth stocks could be starting to cede market leadership to value stocks. In figure 4, the teal line shows that, among the stocks in the top momentum quintile of the Russell 1000 at the end of June, the representation of growth stocks relative to value stocks had grown a lot thinner than at the start of the year. Additionally, policy easing has historically coincided with the outperformance of value versus growth over the following 24 months, and we believe a rate cut later this year or next could accelerate that transition. Figure 4: Growth Stocks Appear to be in the Late Stages of Outperformance Global Industrial Production Continues to Rebound Yet, a third reason we are optimistic is that manufacturing is humming across much of the globe: PMIs are expanding in most countries for the first time in two years (see figure 5); OECD industrial confidence has been soaring; and global new orders are now outpacing the growth in global inventories. This suggests to us that global industrial production could continue to strengthen for the rest of the year. Figure 5: An Industrial Rebound Is Strengthening and Broadening Across the Globe When global production picks up, we observe goods prices tend to follow, thereby bolstering margins within industrially sensitive sectors. We believe much of this potential margin improvement is not yet priced into these sectors, which is why we recommend overweighting them within portfolios in the near term. At the same time, we find that goods inflation can be a headwind for consumer discretionary stocks, hence our underweight recommendation. In our 2Q Equity Market Outlook, we explored the extreme distortions within and across U.S. equity markets wrought by the Mag 7's recent run-up. We find that many of those distortions not only remain, they have intensified, presenting an even greater potential threat when they unwind. Mag 7 Valuations Have Moved Even Higher The artificial intelligence (AI) revolution continues to shine a halo on the Mag 7, which picked up even more steam during May and June. From the start of 2024 through mid-June, this vaunted group advanced 33% versus 10% for the rest of the S&P 500, as shown on the left side of figure 6. Furthermore (as shown on the right), the Mag 7 recently traded at a 44% premium to its theoretically justifiable valuation based on the next-12-month return on equity; at the end of March, that figure stood at a more modest 26%. Figure 6: The Mag 7 Continued to Outperform and Grow Increasingly Expensive Source: Neuberger Berman Research and FactSet. Data as of June 28, 2024. Past performance is not indicative of future results. To us, such a rich valuation implies the need for substantial earnings gains in coming quarters-an impressive feat for a sector already more profitable than any in the S&P 500. Tech Carries Even More Weight in the S&P 500 Last quarter, the Tech & Communication Services sector accounted for 38.7% of the S&P 500 by market cap-a level temporarily breached on only three other occasions over the past 60 years. At the end of June, tech's concentration had ticked up even further, to 41.8%. We believe such extreme sector concentrations argue for continued caution, given that history has shown they are not only rare, but also relatively short-lived. Short Selling Remains Subdued We find that tech investors remain remarkably complacent relative to those in other sectors. As of mid-June, total short interest in the Communication Services and Technology sectors was the lowest among all 11 sectors in the S&P 500, and short interest across the tech-heavy NASDAQ continued to make all-time lows. We believe this trend demonstrates a lack of caution and debate-neither signs of fundamentally driven price appreciation. In our experience, healthy debate and skepticism tend to accompany sustainable bull runs rather than a combination of rich valuations, aggressive sentiment and historically stretched earnings expectations. While the equity market is ever rife with sector subplots (see The Equity Breakdown: Parsing the Key Debate in Five Sectors), we think investors should keep an eye on two broader themes in the second half of the year: 1) higher volatility in the wake of the U.S. presidential election, and 2) weaker consumer spending due to potential further deterioration of real disposable personal incomes. Expect Higher Volatility as November's Election Draws Closer During the fall of an election year, tight races tend to be accompanied by lower returns (see the left side of figure 7) and roughly 10% higher stock market volatility (see the right side) than the same period during a non-election year. We believe higher risk premiums reflect greater uncertainty over contrasting policies and their potential economic impacts. Figure 7: Expect Higher Volatility Leading Up to And Beyond the November Election Source: Neuberger Berman Research and FactSet. Data as of June 10, 2024. Close election years include 1952, 1960, 1968, 1976, 1980, 2000, 2004, 2008, 2016 and 2020. Non-election years include all years starting in 1952. Past performance is not indicative of future results. No matter who wins the contest, we find the stock market tends to mark a post-election rally as the risk premium eases and valuations catch up to the accumulated earnings improvement. As in the past, we expect the market to exhibit more volatility in the fourth quarter, but eventually tether back to earnings fundamentals, which we see improving during the rest of the year. More Important Than Ever: The Connections Among Inflation, Income and Stocks Real disposable personal income (RDPI) is what consumers have after paying taxes, adjusted for inflation. RDPI growth has slowed to an anemic 1% year-over-year. At 75% of GDP, RDPI is a key driver of the U.S. economy. But it becomes even more important when consumer financing, the second most significant source of consumer spending (20% of GDP), is unlikely to come to the rescue. In response to rising financial stress, non-revolving consumer credit growth has stalled and credit card usage-even in the face of higher interest rates-has surged: In a potential sign of simmering desperation, credit card debt has been growing at nearly twice the pace of nominal disposable personal income over the past year. Meanwhile, delinquencies have been rising across credit utilization cohorts, and consumers have been tightening their belts by forgoing non-essential purchases in favor of essentials such as housing, health care and food-a shift that has historically been a harbinger of recession (see figure 9). Figure 8: Slowing Growth in Real Disposal Income Could Dampen the U.S. Economy, Unless Inflation Eases If inflation subsides more slowly than income growth in the coming months, RDPI growth could fall closer to zero, potentially curbing consumer spending, slowing the U.S. economy, and ultimately threatening the stock market. Conversely, if inflation were to ebb faster than income growth, we expect that would boost RDPI, potentially stimulate spending, reaccelerate the economy and be a tailwind for the stock market. The impact of this stimulus would be in addition to, and arrive sooner than, the impact of the Fed's anticipated interest rate cuts, which usually take four to eight quarters to take hold in the economy. Figure 9: U.S. Consumers Have Been Tightening Belts And Focusing On Essentials Against this backdrop, we believe investors would be wise to focus on upcoming inflation prints and closely monitor the forward trajectory of RDPI as a meaningful gauge for economic growth. If RDPI continues to deteriorate, consumption growth could suffer; if it improves, economic growth would accelerate and likely embolden the equity market. Mindful of these risks, we remain optimistic given the broadening of growth within the S&P 500 and the incipient global industrial recovery. In light of these considerations and in line with our evolving equity return/risk ratio cycle analysis (for more on this framework, see our 2Q Equity Market Outlook), we maintain our stances on the following U.S. sectors and styles, and highlight key changes to suggested weightings in various international markets. Sectors (U.S.) Overweight: Energy, Materials, Industrials, Financials, Consumer Staples, Health Care and Utilities. Underweight: Information Technology, Communication Services and Consumer Discretionary. Japan (Overweight to Market Weight): A weakened Yen has driven much of this export-driven market's stellar outperformance since 2021. Now, rising inflation has begun to hurt growth, which is pressuring the BoJ to consider hiking interest rates. This could put upward pressure on Japan's currency and potentially dampen its equity markets. China (Underweight to Overweight): While China's economy has shown few sustainable signs of strength, the ongoing revival in global industrial production could be a welcome catalyst for a stock market that has been trading at historically low valuation levels. We suspect that low valuations imply that much of the bad economic news coming out of China may already be priced in. Furthermore, we think Chinese policymakers are more likely to become incrementally supportive of growth to quicken the pace of recovery and buoy consumer confidence. Notably, some Chinese stocks have taken leadership within the MSCI ACWI index, suggesting to us that a transition could be starting to unfold. Europe (Maintaining Underweight, but anticipating an upgrade): Europe is more leveraged to the revival in the global industrial production cycle and has begun easing monetary policy sooner than the U.S. Because European companies tend to be more dependent on bank financing than their U.S. counterparts, we believe interest rate cuts by the ECB could stimulate lending and accelerate growth, likely causing the Euro to weaken against the U.S. dollar. In our view, stronger growth and a weaker Euro could boost both European exports and earnings, thereby supporting Europe's relative performance in a global equity portfolio-but we don't think we are there yet. The targeted investment horizon for these recommendations is 12 months, but we expect more frequent changes at the sub-index level in response to changing market dynamics. For detailed recommendations across sectors, factors, style and geographies, see the section titled "Investment Themes and Views." Neuberger Berman Research and Mill Street Research. Data as of May 31, 2024. Source: Neuberger Berman Research and FactSet. Data as of May 31, 2024. Source: Neuberger Berman Research and FactSet. Data as of June 28, 2024. Ibid. Source: Neuberger Berman Research and FactSet. Data as of June 12, 2024. Source: J.P. Morgan. Data as of June 19, 2024. Neuberger Berman Research and FactSet. Data as of March 31, 2024. Source: TransUnion US Consumer Credit Database. Data as of March 31, 2024. Source: Neuberger Berman Research and FactSet. Data as of April 30, 2024. This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice. This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Investment decisions and the appropriateness of this material should be made based on an investor's individual objectives and circumstances and in consultation with his or her advisors. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. The information in this material may contain projections, market outlooks or other forward-looking statements regarding future events, including economic, asset class and market outlooks or expectations, and is only current as of the date indicated. There is no assurance that such events, outlook and expectations will be achieved, and actual results may be significantly different than that shown here. The duration and characteristics of past market/ economic cycles and market behavior, including any bull/bear markets, is no indication of the duration and characteristics of any current or future be market/economic cycles or behavior. Information on historical observations about asset or sub-asset classes is not intended to represent or predict future events. Historical trends do not imply, forecast or guarantee future results. Information is based on current views and market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Index Definitions The S&P 500 Index consists of 500 U.S. stocks chosen for market size, liquidity and industry group representation. It is a market value-weighted index (stock price times number of shares outstanding), with each stock's weight in the Index proportionate to its market value. The Russell 1000® Index measures the performance of the large-cap segment of the US equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium term (2 year) growth and higher sales per share historical growth (5 years). The MSCI ACWI Index captures large and mid-cap representation across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. DM countries include: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the UK and the U.S. EM countries include: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Kuwait, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates. With 2,837 constituents, the index covers approximately 85% of the global investable equity opportunity set. The views expressed herein may include those of the Neuberger Berman Equity Research team. The views of the Equity Research team may not reflect the views of the firm as a whole, and Neuberger Berman advisers and portfolio managers may take contrary positions to the views of the Equity Research team. The Equity Research team's leading indicators and research models are based upon a variety of inputs, including markets surveys, market prices and government and economic data. The Equity Research team's views do not constitute a prediction or projection of future events or future market behavior. Discussions of any specific sectors and companies are for informational purposes only. This material is not intended as a formal research report and should not be relied upon as a basis for making an investment decision. The firm, its employees and advisory accounts may hold positions of any companies discussed. Specific securities identified and described do not represent all of the securities purchased, sold or recommended for advisory clients. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. This material is being issued on a limited basis through various global subsidiaries and affiliates of Neuberger Berman Group LLC. Please visit www.nb.com/disclosure-global-communications for the specific entities and jurisdictional limitations and restrictions. The "Neuberger Berman" name and logo are registered service marks of Neuberger Berman Group LLC. Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

It's Rotation Time (Or Not) Again

One day does not a trend make. But yesterday was a doozy of a reversal in the fortunes of large cap growth stocks and their long-suffering compatriots in large value and small caps. That, necessarily, begat a flood of chatter about one of the most beloved themes among financial talking heads - The Rotation. We have seen this movie before, and more often than not it proves to be a head fake rather than a sustained development. But given how long growth's outperformance has been going on, and how expensive many of these stocks have become, it's worth at least delving into the whys and the wherefores. As the chart below shows, the small cap frenzy in particular is continuing unabated in the early hours of trading this morning. Yesterday's big move was not without a catalyst. The June Consumer Price Index (CPI) report came out an hour before trading commenced and delivered the pleasant surprise of lower than expected price gains for the month of June. The all-items headline number actually fell by -0.1 percent, thanks largely to a decline in gasoline prices. The more Fed-relevant core CPI gained 0.1 percent, lower than the 0.2 percent predicted by economists, bringing year-on-year core CPI down to 3.3 percent. This marks the third month in a row for a reasonably benign CPI, after the unexpectedly high readings earlier in the year. All well and good, but why should lower inflation have an outsize impact on small-cap stocks? The easiest and probably most relevant answer to that question is that lower inflation increases the likelihood that the Fed will start cutting interest rates in September. The market promptly priced in a 95 percent probability of that following release of the CPI report. Lower interest rates can be particularly beneficial for smaller companies which are more sensitive to changes in operating leverage - interest is a fixed expense you have to pay regardless of whether your revenue is going up or down, so it can eat into profit margins, which is especially important when economic conditions are slowing, as they have been recently. As long as the slowdown stays within the parameters of "soft landing" and doesn't turn into something worse, lower interest rates will help smaller companies keep their profit margins from turning dramatically lower. Of course, 3.3 percent core inflation is still not 2.0 percent core inflation, and all it would take would be another sticky CPI report showing monthly gains of 0.4 percent, like the January and February readings, to throw a wet blanket over yesterday's good cheer. So we will watch and wait before forming any deep convictions about the durability of this rotation. But there is another question as well, and that pertains to the large cap growth stocks that got dumped yesterday. Was it just some reflexive tactical reallocating of portfolio weights, or are there reasons to be more skeptical of this asset class's recent run of good times? We will have a more in-depth look at this question next week, when we revisit a theme we brought up several weeks ago about the business case for generative artificial intelligence. In the storied annals of stock market history, there are a handful of variations around the theme of "X looked great, until it didn't" where "X" at different times has been railroads, industrial chemicals, automobiles, oil production, e-commerce... you get the picture. At some point, many of today's darlings are likely to become part of this colorful history. But (to give a little preview of next week's topic) that day of reckoning may still be some ways away. See you next Friday! Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

ClearBridge Appreciation Strategy Q2 2024 Commentary

We do not expect the top-heavy market of the second quarter to continue and believe a diversified portfolio with investments focused on durable growth at attractive valuations is best positioned in this transitioning interest rate regime. By Scott Glasser, Michael Kagan, & Stephen Rigo, CFA Diversification Best for Transitioning Interest Rate Regime Market Overview The soft landing rally that gained traction in November 2023 continued through 2024's second quarter, driven by virtually ideal disinflation data and continued fervor around AI. The S&P 500 Index (SP500, SPX) has now advanced in six of the past seven quarters (including seven of the past eight months). The second quarter's 4.3% advance left the S&P 500 up 15.3% year to date and an eye-popping 34% off the November 2023 low. Market performance narrowed from the broad base of the early stages of the current rally. Information technology ('IT') and communication services shares rose 13.8% and 9.4%, contributing 115%, or more than all, of the S&P 500's return. Apple (AAPL) and Nvidia (NVDA) alone accounted for 76% of the benchmark's return in the quarter. Narrow markets, especially after a large rise, have historically been risky markets. This has us on alert for a correction should the AI frenzy cool. "Narrow markets, especially after a large rise, have historically been risky markets." On the flip side, six of the 11 GICS sectors declined in absolute terms in the quarter, including the shares of materials, industrials, energy and financials stocks, which are key barometers of economic activity. Materials, the worst-performing sector, declined 4.5%, underperforming the benchmark by 878 bps, the sector's worst relative performance quarter in nearly nine years. Industrials, the second-worst-performing sector, underperformed the S&P 500 by 717 bps, its worst showing since the first quarter of 2020. Financial, energy, health care and real estate shares underperformed the benchmark by more than 500 bps. We also follow measures of liquidity to assess the environment for risky assets. Although we have been concerned that sustained high interest rates and the withdrawal of liquidity from a shrinking Fed balance sheet would tighten financial conditions, the impact of this dynamic has yet to impact key measures of liquidity: corporate credit spreads still look benign; bank deposits are expanding for the first time since 2022; and capital markets activity showed robust debt issuance. Clearly, we underestimated the degree to which enormous fiscal spend would help offset tightening monetary conditions. Although we are concerned a quantitative tightening liquidity drain is a matter of when and not if, we expect the Fed to ensure ample liquidity exists through the presidential election. Outlook We are at a key inflection point for the economy and investors, in our view. After hovering near expansion territory, the ISM Manufacturing Index has slipped back into contractionary territory. Leading indicators of consumer expectations have deteriorated. More specifically, transport volumes are anemic with railroad car loads flattish and trucking and logistics mired in contraction. Higher delinquency rates on credit cards and mortgages indicate that consumer credit has started to deteriorate. Housing starts and new home sales, which had held up surprisingly well given sticky mortgage rates, are finally showing signs of fatigue. Finally, the employment picture bears watching as late spring job openings declined while the unemployment and underemployment rates ticked higher. Although we believe investors underestimate the risk of a U.S. recession, we do not foresee a severe or protracted downturn. We would likely use a growth scare as opportunity to methodically add incremental risk to the portfolio. This is not all bad for investors. An economic slowdown combined with continued disinflationary data would compel the Fed to begin an interest rate cutting campaign, bolstering the chances of a Fed engineered soft landing. We are at the last mile to determine whether disinflation will reach the Fed's 2% target, which we view largely as a wage question, since services inflation remains sticky. Today, wage growth at 4.7% remains too high to reach the last mile target, but the trend is favorable, having declined consistently over the past year. Most economists circle 3.5% wage growth as the level that would support a 2% core PCE (3.5% wage growth + 1.5% productivity = 2% core inflation). To us, wage growth will be the key moving forward to determine whether the Fed can cut rates before the economy loses too much momentum to accomplish a soft landing (Exhibit 1). We remain in wait-and-see mode on this topic. History has shown tackling the last mile has proved challenging, with elevated risk that easing too soon could spur a renewed bout of inflationary pressures. Exhibit 1: Wage Growth Pointing in Right Direction to Reduce Core Inflation In sum, near-immaculate inflation data has further cemented the soft landing narrative as consensus, while animal spirits are betting that AI will revolutionize the global economy. We believe this dynamic has heightened the risk to the investment landscape should there be any stall in the disinflationary trend or disappointment in AI-driven capex. Our focus is, first, can corporate America monetize its investment in AI enough to justify capital spending levels that support the valuations of AI-related stocks? And second, will a weaker jobs market and the deflationary force of technological advancement deliver disinflation supportive of Fed rate cuts this fall? Longer term, we worry about the sustainability of government debt and the increasing burden of higher interest rates on the budget deficit. At some point the U.S. will need to increase taxes or cut spending to prevent debt costs from spiraling out of control. Neither will happen in an election year, but the next Congress faces stark choices. By no means is the U.S. dollar's status as reserve currency our birthright. While we are optimistic about the long-term benefits generative AI will have on workplace productivity, aggressive assumptions need to be made to justify current valuations for the direct hardware vendors. Software stocks have lagged this year, creating opportunities in companies that can successfully monetize generative AI. We admire the business models of the largest technology companies, but we are mindful of their regulatory risks and also the concentration risk they create for our portfolio. We are positive on much of the health care sector as market expectations for medical device and life science/tool companies have come in markedly, while we find the non-cyclical nature and modest valuation of pharmaceutical companies appealing. We are positive on select cyclicals such as rails where expectations are low and sustained economic growth would create upside. We believe stable financial conditions and the potential for rate cuts and a steeper yield curve will benefit select financial companies such as banks. We do not expect the top-heavy market of the second quarter to continue and believe a diversified portfolio with investments focused on durable growth at attractive valuations is best positioned in this transitioning interest rate regime. Conclusion Although we remain constructive on the medium-term outlook, we believe narrow market performance and the upcoming presidential election pose risks to today's placid environment. We believe investors should anchor return expectations closer to longer-term trends (high-single digits annually) versus the current ebullient backdrop. There is value in many non-AI corners of the market, especially should the Fed ease financial conditions. We are long-term investors focused on the risk-adjusted returns a diversified portfolio can deliver through a market cycle. Rather than trying to bet on near-term earnings trends, we believe it is better to look out two to three years and make investment decisions based upon our assessment of a company's longer-term, sustainable growth rate relative to what is implied in today's share price. Portfolio Highlights The ClearBridge Appreciation Strategy underperformed the benchmark S&P 500 Index in the second quarter. On an absolute basis, the Strategy had positive contributions from seven of 11 sectors. The IT sector was the main positive contributor to performance, while the financials sector was the main detractor. In relative terms, stock selection contributed positively while sector allocation detracted. Specifically, stock selection in the consumer discretionary and energy sectors contributed the most, while stock selection in the communication services, financials and materials sectors detracted, along with an IT underweight and overweights to the materials, financials and industrials sectors. On an individual stock basis, the biggest contributors to absolute performance during the quarter were Nvidia, Apple, Microsoft (MSFT), Alphabet (GOOG),(GOOGL) and Eli Lilly (LLY). The biggest detractors were Walt Disney (DIS), Travelers (TRV), U.S. Bancorp (USB), Visa (V) and PPG Industries (PPG). During the quarter, we initiated a new position in ConocoPhillips (COP) in the energy sector and closed positions in Intel (INTC) in the IT sector and Hartford Financial Services (HIG) in the financials sector. Portfolio holding Pioneer Natural Resources was acquired by holding Exxon Mobil (XOM) in the energy sector whose shares we retained. Scott Glasser, Chief Investment Officer, Portfolio Manager Michael Kagan, Managing Director, Portfolio Manager Stephen Rigo, CFA, Director, Portfolio Manager Past performance is no guarantee of future results. Copyright © 2024 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance source: Internal. Benchmark source: Standard & Poor's. Click to enlarge Original Post Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors. ClearBridge is a leading global asset manager committed to active management. Research-based stock selection guides our investment approach, with our strategies reflecting the highest-conviction ideas of our portfolio managers. We convey these ideas to investors on a frequent basis through investment commentaries and thought leadership and look forward to sharing the latest insights from our white papers, blog posts as well as videos and podcasts.

Fixed income perspectives: Looking ahead at Q3 2024

While H1 2024 has felt like a perpetual state of "hurry up and wait," a pivotal US presidential election and the potential for elusive rate cuts begin to make the second half of the year a more interesting story for fixed income investors. Despite policy rate cuts remaining elusive, several tailwinds are boosting a resilient U.S. economy. And while the Federal Reserve (Fed) continues to navigate a potential soft landing, global central banks are actively transitioning onto a path of easing policy. Going into 3Q, there is less uniformity in the path forward among central banks; the European Central Bank and the Bank of England are guiding for more rate cuts this year, while rate cuts in the U.S. continue to be delayed and decreased. A healthy labor market and resilient consumer have been the most significant part of the U.S. economy propping up growth and prices. However, those components are starting to show signs of cooling, a potential indicator of a more substantial slowdown. Ahead of likely election-related volatility, many fixed income asset classes are poised for potential outperformance heading into the second half of the year. Today's economic backdrop offers everything that a fixed income investor could traditionally ask for: positive but moderating economic growth, easing inflation pressures, and a Federal Reserve on the verge of a new rate cutting cycle. Of course, prospects for the asset class were more attractive earlier this year when the market was pricing in multiple rate cuts, and potential duration gains looked significant. However, fixed income has handled the significant repricing in rate expectations well, helped by continued macro resilience and yields sitting near the top end of their range over the past two decades. Perhaps the main concern for the asset class is the narrowness of credit spreads. Sitting near the tight end of their long-term range, and confronting an economy that is no longer accelerating, spread narrowing is unlikely to provide a further tailwind to returns. Yet, the benign economic outlook, supported by strong balance sheets, implies that solid corporate fundamentals can remain intact, so a widespread rise in defaults is unlikely, and significant widening in spreads is not in the cards. With that in mind, carry continues to be king. In investment grade credit, the compelling yields continue to attract demand. Consider that, after nearly $800B in issuance in the first five months of 2024 - including a record first quarter - investor receptivity has remained strong for new bond deals as buyers, 60% of whom are yield-focused, seek out the higher yields of IG. At the same time, the higher credit quality of IG continues to be a strong pull factor, particularly as economic activity is showing clearer signs of moderation. In high yield credit, too, it is yield that matters. Indeed, even though spread levels are important, a crucial stat that investors should keep in mind is that when charting the asset class's starting yield against its corresponding five- year forward annualized returns, it produces a correlation of 0.87 - higher than the correlation between the starting spread and corresponding five-year forward annualized returns. In other words, the starting yield, not the starting spread, is the more powerful gauge of HY's attractiveness. The asset class continues to be positioned to deliver long-term returns at these yield levels. And while the looming maturity wall still startles some investors, it to be very manageable for most issuers, helped by the higher quality tilt of the asset class and the prospect of lower rates as the Fed starts to ease monetary policy. There remain many other income-focused opportunities across the credit spectrum. Munis offer longer, attractive, tax-free yields, while their defensive attributes and longer-duration profiles are set to benefit from the macro environment of slowing growth and rate cuts. Emerging markets, although challenged of late by more hawkish Fed pricing, continue to draw interest due to their elevated yields, while recent political volatility is presenting interesting opportunities for investors. That is not to say risks are absent in today's fixed income market. A sharp deterioration in the labor market or a meaningful slowdown in consumer spending would negatively impact the asset class. Yet, our outlook for the remainder of 2024 is for a sanguine U.S. economy that offers attractive yields and the potential for duration gains as the Fed normalizes rates. U.S. outlook The combination of a resilient U.S. economy, improving inflation, attractive starting yields, and the potential for Federal Reserve rate cuts presents a healthy backdrop for fixed income. After suffering two years of severe headwinds due to low starting yields and aggressive Fed hiking, the Bloomberg Aggregate Bond Index now offers yields near the top end of its range from the past two decades. Spreads, however, are not as attractive from a historical perspective; in most fixed income sectors, spreads are near the tight end of their long-term range. Market environment Year-to-date performance, spread, and yield for various fixed income indices With consumer spending accounting for ~70% of the economy, robust and consistent expenditures have been a key driver of economic resilience. Several factors have been tailwinds for the consumer, including fiscal stimulus/deficit spending, excess savings from the pandemic, Social Security cost of living adjustments, positive real wages, stock market gains, and a strong labor market. However, there are increasingly signs of bifurcation within the consumer, specifically symptoms of stress appearing for lower income households. While still positive, real wages are moderating, and excess savings are largely depleted. Household non- mortgage interest payments have increased dramatically, while consumer delinquencies are also on the rise. This suggests that overall spending may moderate through the rest of the year but does not necessarily portend dramatic spread widening in credit sectors. A modest pullback in consumer spending would be beneficial for the demand side of the inflation equation, which would increase the probability of Fed rate cuts and may even support credit spreads. A more pronounced deterioration in the labor market is a key risk. While additional slowing in the labor market is anticipated, unemployment claims to date remain historically low, and payroll gains remain robust. Absent a more severe downturn in the labor market, our outlook for fixed income is positive given attractive yields and the potential for duration gains as the Fed normalizes rates. Global outlook Benign growth expectations meet cooling job markets The theme of higher-for-longer policy rates continued to dominate market expectations in much of the second quarter, as growth data remained resilient and inflation data stayed sticky. The data swayed Federal Open Market Committee members to turn more cautious toward policy easing, leading to a very strong market reaction in April reminiscent of the 3Q 2023 move. To rein in market concerns, the Fed implemented the planned tapering of quantitative tightening to forestall a repeat of the liquidity shock experienced in 2019. At the same time, Fed Chairman Jerome Powell also pushed back on concerns that the Fed would need to hike again, noting considerable progress made in inflation and signs of a cooling labor market. On the other side of the Atlantic, both the European Central Bank (ECB) and the Bank of England (BoE) declared the independence of their respective monetary policies from the Fed-the ECB has already started cutting rates, and the BoE is likely to follow suit in the coming months. Our global policy outlook, which called for the commencement of the rate cutting cycle by major central banks, remains intact, though with fewer cuts than initially expected. Given the lagged nature of policy transmission, last year's rate hikes are still working their way through the U.S. economy and will likely continue to do so even as rate cuts commence. However, the market has been more positive about the global growth outlook since 3Q 2022, when policy rates were deemed to have exited neutral territory and moved into a restrictive zone. This presents a remarkable divergence from the typical path of growth over the policy cycle. As is the case in the U.S., the most significant part of many global economies, holding up growth and prices, is the labor market. Looking across the major global economies, five out of 11 major industrialized countries have seen unemployment rates rising more than 0.5% above the cycle low, a recession indicator commonly known as the Sahm Rule. While the reliability of this indicator on a global scale remains to be seen, it illustrates a broad cooling in labor markets to levels last witnessed just before the pandemic. Given the stickier post-COVID labor market, there is good reason to believe that this may be the beginning of a more prolonged, albeit tempered, rise in the unemployment rate. Accordingly, there is significant scope for the market to re-align growth expectations toward the cooling labor market. Finally, investors should be preparing for the potential market implications of the November U.S. presidential election. Historically, U.S. elections tend to focus on domestic issues, limiting U.S. attention and participation in new geopolitical hotspots. As such, the market may be more desensitized toward geopolitics leading up to the election compared to last year. In terms of monetary policy, the Fed has declared neutrality over the election. However, their window for policy adjustment may be narrowed to manage public perception. If polls swing strongly in favor of either candidate, the market may price in the anticipated winner's fiscal policy impact on growth and inflation for 2025. Labor market vs. growth forecasts May 2012 - present Summary of investment implications Investment Grade Credit Amid delayed monetary policy easing, investment-grade credit should continue to benefit from an attractive yield and a strong technical tailwind. Investors seeking to add yield without taking on undue risk should continue to favor high-grade corporate bonds. High Yield Credit In an environment of higher-for-longer policy rates, the argument for taking a longer-term approach to investing in the high yield asset class is amplified. Historically attractive starting yields help to more than offset unappealing credit spread entry points--particularly considering the strong fundamental picture and muted default expectations underlying the sector today. Securitized Debt Commercial mortgage-backed securities (CMBS): The positive news for the CMBS market is that there is not an immediate maturity wall, and loan maturities are quite balanced over the next two years. With AAA bonds more fairly priced, there is value in lower-rated bonds, especially in single-asset-single-borrower (SASB) deals. Municipals Whether inflation stays sticky, or a recession surfaces, high yield municipals should prosper due to their defensive attributes and longer-duration profiles. Investors can still today lock in longer, attractive tax-free yields. Emerging Market Debt A combination of positive fundamentals and technical factors has strengthened the emerging market debt sector. Developed market economic strength and expectations of U.S. rate cuts have provided a positive backdrop, while relatively benign emerging market sovereign fundamentals have lowered idiosyncratic macroeconomic risks. Private Credit Direct lending: Continued economic uncertainty and higher rates contribute to several supportive trends for middle market direct lending and an opportunity to enhance risk-adjusted returns relative to historic loan vintages. Investment grade: Following an exceptionally busy June for investment-grade private placements, the market is likely to slow into the typically sluggish August issuance schedule before picking up in 4Q. Click to enlarge Investment grade credit While monetary policy easing may be pushed back for now, recent dovish remarks by Fed Chairman Powell and softening pricing data form a firm macro environment for investment grade (IG) credit. Although the Fed is waiting for inflation to reach a sufficiently low level before cutting policy rates, the IG market appears content knowing that rate cuts are coming and are less concerned with the exact timing of the cuts. Meanwhile, the consumer-charged U.S. economy keeps growing in a way where neither inflation nor economic growth is too strong (or too weak) to alter the Fed's course. As inflation diminishes from recent levels and the labor market continues to balance, the favorable window for IG should hold. Despite tight valuations, IG's compelling yield continues to attract demand. This strong technical factor, combined with the Fed outlook, serves to underpin IG credit. Furthermore, as demand remains robust, supply has responded. After nearly $800B in issuance in the first five months of 2024 - including a record first quarter - the pace of supply should start to moderate following frontloaded volume. Remarkably, investor receptivity has remained strong for new bond deals as buyers, 60% of whom are yield-focused, seek out the higher yields of IG. Amid this backdrop, IG credit should benefit from attractive yields and a duration tailwind. With rates 500 basis points (bps) higher than at their trough, the income bonds provide is substantially higher now than a few years ago, while the Fed's impending pivot promotes smooth sailing for duration-sensitive securities. As the Treasury yield curve normalizes, investors will look to extend duration, while some of the $1 trillion that poured into money market funds will find a home "out the curve" in corporate bonds, supporting incumbent investors. As this transpires, shorter and intermediate-duration corporate bonds should be the first logical landing spot for demand as the market sets up for forthcoming Fed cuts. As the easing path becomes evident, investors will likely extend further on the yield curve, seeking longer-duration bonds. Another factor supporting corporate bond demand centers on ratings quality, which has been slowly improving for the past five years with BBBs now almost half of the corporate bond index. While that portion is higher today than a decade ago, the positive trending upgrade/downgrade ratio and the surge in higher-rated issuance over the past two years have given the index a higher quality tilt. Credit quality of investment grade corporate bond index J.P. Morgan U.S. Liquid Investment Grade Corporate Index, 2015-present Of the three factors we consider (fundamentals, technicals, and valuations), technicals remain the strongest driver of the IG market; it's all about yield and moderating supply. Despite starting from a strong place, fundamentals have recently shown slight degradation. With record debt issued in 1Q, leverage ticked up on a gross and net basis as debt increased and companies spent cash faster. Still, fundamentals remain on strong footing, and solid 1Q earnings growth blunted some of that impact. To that end, earnings growth from the first quarter surprised to the upside, coming in at 9.8% year-on-year. With valuations pinned at tight levels, credit picking and curve positioning remain key. Additionally, as strong technical factors remain in place, investors yearning for yield should continue to favor high-grade corporate bonds. High yield credit Never mind spread; it's yield that matters. Many investors look at credit spreads (the difference in yield between a security relative to a risk-free security with the same maturity) as the hallmark indicator for when to enter or exit credit markets. However, history suggests that tactically timing spread movements can be incredibly challenging, especially in high yield (HY) credit markets. Though spread levels are important, we believe yield is a more powerful gauge of HY's attractiveness. When charting the asset class's starting yield against its corresponding five-year forward annualized returns, it produces a correlation of 0.87 - higher than the correlation between the starting spread and corresponding five-year forward annualized returns. The substantial income produced by the yield should continue to deliver attractive returns in the asset class for investors. High yield index yield and 5-year forward return comparison Bloomberg U.S. Corporate High Yield Bond Index The shrinking default rate of high yield offers confidence that starting yields should translate into attractive returns. Conventional wisdom is that HY returns equal yield minus defaults, so the aim is to maximize the former while avoiding the latter. With high yield today in a historically higher-yielding environment, and defaults projected to be below historical averages (Moody's 12-month forecast of 2.95% vs. historical average of ~4%), investors may be in the midst of a particularly strong high yield market. Despite concerns about inflation and slowing economic growth, a widespread rise in defaults is unlikely from here: Businesses have runway: The maturity wall is very manageable and has been proactively addressed by corporates, as shown by the lower amount of debt outstanding versus the amount issued. Survival of the fittest: The COVID-19 pandemic already brought a short, but painful, a wave of corporate defaults. Most of the remaining businesses are better capitalized and have clear shareholder support. High yield debt outstanding Bloomberg U.S. Corporate High Yield Bond Index In looking at the current state of the market, CCCs make up a smaller portion of the market than they did in the past. With that, tighter spreads have prevailed-and deservedly so. This shift toward higher credit quality makes it more challenging for investors to sit on the sidelines and await a magic spread number to signal an attractive entry point. It likely won't materialize, and even if it does, investors will miss out in the meantime. It is important to remember that coupons aren't dividends. They aren't discretionary; they're contractual. The income component of the asset class makes up the bulk of the return, so maximizing this is crucial to long-term outperformance. What remains of HY is a higher-quality asset class that is increasingly fundamental and income driven. Investors' ability to maximize their portfolios' income generation will be the key driver of forward-looking investment returns. The asset class continues to be positioned to deliver long-term returns at these yield levels. Commercial mortgage-backed securities Demand for CMBS has kept pace with a larger-than-anticipated supply of new issuance in the first half of 2024. Spreads tightened and the credit curve flattened, with BBB "on the run" conduit bonds rallying 213 bps compared to AAA bonds tightening by 21 bps. We now see AAA bonds as fairly priced, while still believe there is value in lower-rated bonds, especially in single asset single borrower (SASB) deals. Given the expectation for a wide dispersion of credit performance across deals, security selection remains vital to any SASB investment strategy. From here, a broad move tighter will be challenged by headwinds related to refinance risk and office performance. Conduit refinance success rates have remained in line with longer-term trends. However, there has been seen a significant deterioration in on-time pay-off rates for SASB transactions, while commercial real estate collateralized loan obligations (CRE CLO), as underlying loans with historically low interest coupons, struggle to refinance into a higher-rate environment. This is especially true for office loans that are only registering a 36% refinance success rate. We anticipate that borrowers willing to commit to their encumbered assets will be more likely to negotiate extension options on maturing loans. Refinance success rate By loan type, 2015-present The positive news for the overall CMBS market is that there is no immediate maturity wall, and loan maturities are quite balanced over the next two years. Fully extended office loans within conduit and SASB account for $22 billion, only 4% of the total outstanding private credit CMBS market. CMBS maturities Forecasted through 2032 Over the coming years, we expect ultimate loan resolutions to significantly vary in outcome, impacted by location, leasing demand, sponsor commitment, and interest rates. The ability to effectively underwrite and forecast areas of risk and opportunity will be critical to discerning between deals. Municipals The end of 2023 illustrated a municipals market where beta was rewarded. After a disastrous October in 2023, the last two months of the year witnessed record returns across all sectors/subsectors as the market anticipated upwards of six rate cuts in 2024. However, most of the gains in the municipal market were due to an expected parallel fall in interest rates across the curve. By early January, it didn't take long for the market to turn hawkish. Although the Fed conveyed confidence that rate increases were unlikely, the idea of a multitude of cuts in 2024 was eliminated. Inconsistent economic data illustrated stubborn inflation metrics. As a result, Treasury rates continued to rise throughout 2024, coupled with municipal benchmark rates. Bloomberg fixed income indices total return U.S. Municipal Index -1.91% U.S. Corporate Index -1.11% U.S. Treasury Index -1.85% U.S. Corporate High Yield +1.62% Municipal High Yield +1.65% Click to enlarge Source: Bloomberg, Principal Asset Management. Data as of May 31, 2024. Last year's jump in rates has either hurt municipal bond returns or left them at a stalemate year-to-date, exerting pressure on high yield municipals. However, weakness was mitigated by high average coupons, which dampened volatility, and tightening credit spreads, which augmented prices. Active management remains important for navigating the complexities of the credit market and helping investors benefit from opportunities in the speculative portion of the tax-exempt market. In fact, there are still chances for additional spread compression in the municipal high yield market during the second half of the year. Furthermore, the term structure and back-end steepness of the exempt market (with a 10y-30y spread of 85 basis points) offers return potential that is not available in Treasury tenors (where the 10y-30y spread is 15 basis points). As a result, some investors are moving away from money markets to take advantage of these potential opportunities. Whether inflation stays sticky or a recession surfaces, high yield municipals should prosper due to their defensive attributes and longer-duration profiles. Investors can still lock in longer, attractive, tax-free yields. Year to date, high yield and non-rated municipals have represented a wide breadth of sectors, allowing for diversification benefits, and, while speculative municipals have not been as frequent, there has been greater depth to the market, facilitating greater liquidity and bondholders. Emerging market debt (EMD) Emerging market (EM) credit has outperformed amid a shifting backdrop of surprising U.S. economic strength that has pushed back the Fed's easing cycle. Overall EM credit is 44 bps tighter year-to-date, with EM investment-grade 17 bps tighter and EM HY spreads leading the way at 94 bps tighter. The strength in the EM debt sector has been driven by a combination of positive fundamentals and technical factors. Developed market economic strength and expectations of U.S. rate cuts have provided a positive backdrop, while relatively benign EM sovereign fundamentals have lowered idiosyncratic macroeconomic risks. Investors' underweight positions in the asset class have helped offset receding Fed rate cut expectations and periodic volatility in U.S. Treasury markets. After starting the year quickly, new issuance has also slowed, with greater cross-over interest from other sectors and the market retaining an appetite to fund new issuance. Emerging market economies have benefited from a relatively strong commodity cycle in 2024. Metals such as aluminum, copper, and nickel have benefited from CapEx spending related to green energy and artificial intelligence (AI) investments, along with constraints in global supply. Despite a backdrop of strong production and growing evidence of slowing consumer demand, crude oil has benefited from continued geopolitical tensions and strong demand. Continued discipline from OPEC+ should continue to support crude oil prices without incentivizing further production growth. Unfortunately, the likelihood of higher-for-longer U.S. rates has put EM central banks in a more difficult situation. Early expectations of EM central bankers leading developed markets in the rate-cutting cycle have been put on hold. China, another key driver for EM, surprised with a growth upside of 5.3% year-over-year during 1Q 2024. Strong performance from exports, particularly in the electric vehicles segment, helped drive growth higher. In addition, the Chinese Communist Party's Politburo shifted its focus toward its embattled property sector to better handle existing housing inventory. It announced its strongest policy support package for the sector, easing mortgage terms to a historically easy level and launching a RMB300B relending facility by the People's Bank of China to help local governments buy completed but unsold apartments from developers. These are significant positive signals with the potential to clear 25% of China's completed unsold housing inventory. While a program of this size is subject to implementation risks, it is a crucial step in rebuilding buyers' confidence and driving a sustainable turnaround in the housing sector. Against this backdrop, EM debt investors continue to balance an investment outlook focused on continued spread compression and excessive carry, as the asset class has successfully navigated numerous risks in recent years. Although spreads have reached the tighter end of the range for many performing issuers and have normalized for distressed issuers, EM's elevated yields remain the dominant investment theme. Idiosyncratic opportunities continue to exist in select corporate issuers and lower-rated countries that have benefited from continued orthodox economic policies and renewed engagement with the IMF. Recent volatility surrounding election outcomes in Mexico, South Africa, and India will likely present opportunities for investors. Emerging market bond index spread and yield June 2014-present Private credit Direct lending Deal activity in the private equity and private credit markets has picked up in 2024. Tightening credit conditions, an uncertain economic environment, and declining enterprise value multiples slowed merger & acquisition and leveraged buyout (LBO) activity in 2023, thus reducing loan volume in direct lending. Despite this, middle market direct lending has continued to fill the void left by commercial banks and the continued decline in syndicated loan market issuance. Middle market LBO volume and percent syndicated $US billions, 2014-2023 While volume is up more significantly in the syndicated loan market compared to last year, much of this is refinancing and repricing of existing loans. Though new loan volume origination for private middle market direct lending started the year much like 2023, the volume is beginning to increase to more typical levels. Notably, the volume is primarily financing new opportunities for LBOs and M&A, with modest refinancing activity and very little repricing activity, especially for direct lenders focused on the lower and core middle markets (companies generating $5 million to $50 million EBITDA). This refinancing is typically associated with companies at the upper end of the middle market (borrower EBITDA of $50 to $100 million) and beyond. Lenders that focus on these larger deals are making attractive proposals to borrowers/sponsor owners while still achieving value in pricing and terms compared to the public broadly syndicated loan market. Based on our observations, deals that are getting done in the lower and core middle markets continue to reflect strong value. In addition to the relative value of new private loans compared to public markets, investors are more assured of maintaining attractive economics from transactions completed over the past 12-18 months. This ability to continue to harvest the favorable economics from 2022 and 2023 vintage loans is driven by call protection and attractive original issue discounts (OID) in the direct lending market. Relative to the size of the debt capital structure, frictional costs to refinance are a deterrent for borrowers and sponsors considering refinancing. Attractive spreads, OID, and all-in yield continue to drive desired performance for investors who have allocated to the private loan middle market. The public and private credit markets continue to display easing credit conditions, with spreads considerably tighter over the past year in the public market along with more modest spread tightening in the private middle market. Though spreads have tightened approximately 75 bps from the widest levels of 2023, the relative value of middle market private credit is up, given the spread compression has been much less than realized in public high yield and bank loans. OID remains relatively attractive, typically two bps for lower and core middle market loans. Driven by lenders requiring sufficient debt service coverage in a higher rate environment and with favorable economics and reasonable leverage levels, the current vintage represents an attractive opportunity for investors. Easing credit conditions may contribute to the economy's resiliency and borrower performance through the cycle. As the market may be getting ahead of itself in anticipating a soft landing, lenders must remain focused on underwriting through a potentially challenging cyclical downturn. Continued economic uncertainty and higher rates contribute to several supportive trends for middle market direct lending and an opportunity to enhance risk-adjusted returns relative to historic loan vintages. Increased focus on economically resilient business models: PE sponsor and lender focus will remain on the more cyclically resilient industries and borrowers that can generate steady financial performance through a cyclical downturn. More conservative leverage profile: Leverage expectations for sponsors and borrowers are considerably lower than levels targeted just a couple of years ago in a much lower rate environment. Focusing on the less competitive lower middle market borrower segment can allow for leverage levels below the broader middle market industry. Compelling valuation: Valuations remain attractive with the base secured overnight financing rate (SOFR) remaining at a relatively high level and the spread premium to public high-yield loans moving even higher, as spread tightening of the public market outpaces lower and core middle market loans. Average first-lien sponsored middle market term loan spend Basis points, 2016-present More lender-friendly transaction terms: The structure of transactions should remain sound, with reasonable original issue discount, improved call protection, tighter financial covenants, and more conservative EBITDA adjustments. Manageable default rates: Despite annual default rates potentially moving higher and approaching 2-3% for the private middle market, credit losses should remain in the 75-125 bps range. In this scenario, the return to investors will be quite compelling, as the typical yield for performing first-lien, floating-rate lower and core middle market direct loans remains over 12%. Intentional industry exposure, a disciplined credit structure, and a highly selective process to identify companies that exhibit steady performance through a down cycle should result in more favorable risk-adjusted returns. Investment grade Following an exceptionally busy June for IG private placements, the market will likely slow into the typically sluggish August issuance schedule before picking up in 4Q. That said, the current pipeline is robust, with a heavy flow of deals coming from infrastructure, particularly anchored in energy, renewables, and technology. Data center deals have also been popular, and more are expected in 2024. It is the hot sector in infrastructure debt and real estate assets, and the complexities of the structures are ushering the deals into the investment grade private credit market. Relative value to public comparables has finally started to compress from very attractive levels, and we expect that to continue in 3Q, albeit while still offering value above historical long-term averages. The bid side of the market is very strong, and most deals in 3Q are likely to be well oversubscribed by investors looking for long-tenor IG private fixed income opportunities. Given the global investment incentives, the need for renewable projects, the mandate for additional LNG, and the strong demand in the private market, infrastructure will still represent a larger-than-historical portion of the deals in the IG private market in 3Q. Issuers have pushed to issue heavier in the 10-year-and-under tenors, while investors are strongly bidding 15-year-and-longer notes -- a dynamic that we expect to continue in 3Q given current rates. Forward-looking sector views Conclusion While the first half of 2024 has felt like a perpetual state of "hurry up and wait," a pivotal U.S. presidential election and the potential for elusive rate cuts begin to make the second half of the year a more interesting story for fixed income investors. Heading into 3Q, a strong and resilient economy presents numerous opportunities across fixed income asset classes. We will be keeping a close eye on the labor market, but absent a severe downturn in the labor market, we remain optimistic about fixed income given attractive yields and the potential for duration gains as the Fed normalizes rates. Original Post Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors. The Principal Financial Group (The Principal®) is a global investment management leader offering retirement services, insurance solutions and asset management. The Principal offers businesses, individuals and institutional clients a wide range of financial products and services, including retirement, asset management and insurance through its diverse family of financial services companies. Founded in 1879 and a member of the FORTUNE 500®, the Principal Financial Group has $519.3 billion in assets under management1 and serves some 19.7 million customers worldwide from offices in Asia, Australia, Europe, Latin America and the United States. Principal Financial Group, Inc. is traded on the New York Stock Exchange under the ticker symbol PFG. For more information, visit www.principal.com. Insurance products issued by Principal National Life Insurance Co (except in NY) and Principal Life Insurance Co. Plan administrative services offered by Principal Life. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities offered through Princor Financial Services Corp., 800/247-1737, Member SIPC and/or independent broker/dealers. Principal National, Principal Life, Principal Funds Distributor, Inc. and Princor® are members of the Principal Financial Group®, Des Moines, IA 50392. Investing involves market risk, including possible loss of principal.

2024 Midyear Global Outlook: Waves Of Transformation

We stay dynamic and ready to overhaul asset allocations when outcomes can be starkly different. The world could be undergoing a transformation on par with the Industrial Revolution - thanks to a potential surge in investment in artificial intelligence (AI), the low-carbon transition and a rewiring of global supply chains. But the speed, size and impact of that investment is highly uncertain. And it comes against an unusual economic backdrop post-pandemic: sticky inflation, higher interest rates, weaker trend growth and high public debt. We think taking risk by leaning into the transformation and adapting as the outlook changes will be key. The new regime of greater macro and market volatility has taken hold, shaped by supply constraints like shrinking working-age populations. The result? Higher inflation and interest rates amid weaker growth relative to the pre-pandemic era - and elevated public debt. But now investment opportunities transcend the macro backdrop. We see waves of transformation on the horizon, driven by five mega forces - or structural shifts. We see three of them spurring major capital spending: the race to build out AI, the low-carbon transition and the rewiring of supply chains. The size, speed and impact of that investment is highly uncertain, but we think it could transform economies and markets like past technological revolutions. Together with BlackRock's portfolio managers, we designed five starkly different scenarios to assess the near- term outlook, recognizing it could quickly change. Before the pandemic, low inflation allowed central banks to slash interest rates and make massive asset purchases to buoy the economy. That boosted the financial economy - and helped drive gains across bonds and stocks. In this new regime, the real economy matters more. Our first theme is Getting real. We see the biggest opportunities in the real economy as investment flows into infrastructure, energy systems and technology - and the people driving them. We think companies may need to revamp business models and invest to stay competitive. For investors, it means company fundamentals will matter even more. The gap between winners and losers could be wider than ever, in our view. That dispersion creates opportunities and is why our second theme is Leaning into risk. The answer to a highly uncertain outlook is not simply reducing risk. We look for investments that can do well across scenarios and lean into the current most likely one. For us, that's a concentrated AI scenario where a handful of AI winners can keep driving stocks. We stand ready to adapt as and when another scenario - potentially suddenly - becomes more likely as the transformation unfolds. So our third theme is Spotting the next wave. This is about being dynamic and ready to overhaul asset allocations when outcomes - and investment opportunities - can be vastly different. Investment implications: We stay overweight U.S. stocks and the AI theme on a six- to 12- month view. Our overweight to Japanese stocks is one of our highest-conviction views. We like income in short-term bonds and credit. And we see private markets as a way to tap into the early winners and the infrastructure needed for the investment boom ahead. We think the world could be undergoing waves of transformation on a scale rarely seen in history. Mega forces are driving this transformation and are starting to unleash massive investment into the real economy: infrastructure, energy systems, advanced technology - and people. We think the volume of investment could be on a par with past technological revolutions - reshaping markets and economies. See the chart. Yet, the speed and scale of that investment, and its potential impact on economy-wide productivity, are highly uncertain. Consider AI. The race to scale up AI capabilities is already spurring major capital spending. A range of estimates see investment in AI data centers rising by 60-100% annually in coming years. Yet, it is difficult to pin down exact amounts, even in the first phase of the AI buildout. It will depend on any resource constraints - like difficulty meeting AI's energy needs on top of already growing demand, including for electrification. Innovations in computing and energy could ease those constraints. In a second phase, we think investment will broaden out to firms seeking to harness AI - with the amount depending on AI's buildout and adoption. It is possible that this all results in a third phase of broad productivity gains. See pages 8-9. The low-carbon transition is also spurring major investment. Our BlackRock Investment Institute Transition Scenario estimates energy system investment will hit $3.5 trillion per year this decade. Rising geopolitical fragmentation also implies investment: countries are prioritizing national security over economic efficiency. Reconfiguring supply chains requires investment. Uncertainty around the speed and scale of coming investment, plus an unusual economic backdrop marked by supply constraints, make it tough to gauge exactly where the world is heading longer term. But we see the transformation evolving through distinct phases, like advances in the AI buildout first and broad adoption later. This progression can help provide direction - enabling us to evolve asset allocations on the way. We see a possible investment boom ahead that could transform economies and markets. But the speed, scale and impact of that investment is unclear. We use scenarios to help identify where economies and markets may be headed on a six- to 12-month horizon. They help put parameters around very different states of the world - even if they don't capture the many potential outcomes beyond that horizon. We worked with portfolio managers across BlackRock to develop five, distinct scenarios for the near-term outlook. We see two scenarios where equities can do well: one with a concentrated group of winners in AI, even with a tough macro backdrop, and another where AI-driven growth becomes more broad-based, leading to productivity gains and sharp rate cuts. The two hard economic landing scenarios differ on whether central banks can come to the rescue with rate cuts. The fifth is one of subdued growth and stubborn inflation, where inflation proves sticky, keeping central bank policy rates higher. The arrows on the right show how the assumed market impact can diverge sharply across these scenarios. We lean into the concentrated AI case, reflecting our view that AI valuations are rooted in solid earnings. Yet, we stand ready to pivot - and our approach gives us a roadmap to gauge when another scenario becomes more likely. We think expertise in identifying these scenario shifts could help investors deliver outsized returns. We see much of the potential large investment flowing into the pipes and people of the economy. Think new data centers powering AI models, computer chips, solar farms, super batteries, factories, logistics centers - and roads, bridges, schools and hospitals in countries with growing populations. It's a new wave of investment into the real economy transforming economies and markets. It's a world where company fundamentals will matter even more, we think. This is a big change from the pre- 2020 dominance of the financial economy. Steadily expanding global production capacity and growing workforces kept macro volatility at bay: whenever growth faltered, central banks could come to the rescue without fearing an inflation flare-up. This stability reduced uncertainty and allowed central banks to signal their intentions well in advance. Such a favorable backdrop buoyed most companies, leaving little room for differentiation among businesses and stock pickers. We think that era is over. As the real economy takes over from the financial economy, we think investors should actively position for waves of transformation like we have rarely seen before, we think. We see widespread opportunities for companies that innovate and position themselves to take advantage of this transformation. That includes building capabilities to harness AI, for example. Spotting winners will require deep insights on the technology being developed, its applications and the potential disruption it entails. We are seeing that play out now with companies building strong cash flows from the real economy thanks to their dominant positions. Nvidia's (NVDA, NVDA:CA) price surge shows how fast winners can emerge - and be rewarded. Companies who fall behind are likely to struggle in this environment - partly because central banks won't be able to respond easily with lower rates if growth weakens, in our view. We are not going back to a time of cheap and plentiful capital. Nvidia and the AI momentYears to go from $10 billion to current market capitalization The transformation could take any of several very different paths: it could lead to a broad productivity boom or to AI winners becoming overvalued, for example. Investors may feel tempted to sit on the sidelines and await clarity - especially given the attractive returns from holding cash. Yet we see bigger rewards for leaning into risk in this environment. We think markets are likely to keep rewarding perceived AI winners in the next six to 12 months - regardless of where the transformation leads longer term. We think investors should take risk more deliberately now, across multiple dimensions. First, consider the time horizon. We have most conviction about the near term. We think large technology companies investing heavily in the AI buildout, chip producers and firms supplying key inputs like energy and utilities can keep doing well. That's why we lean into the concentrated AI scenario. See pages 8-9. Beyond tech, we like sectors such as industrials and materials that are also set to benefit in the near term. Second, be deliberate in choosing the type of risk exposure. A few winner-takes-all companies have driven U.S. equity gains this year. We don't see the concentration of equity performance as a problem as mega caps have delivered on earnings. Yet we actively choose to lean more heavily into AI than benchmark index weights. Two big U.S. tech firms each have a market capitalization larger than the entire UK or German benchmark stock indexes. See the chart. Third, be deliberate about blending different sources of return across public and private markets. We think both active strategies and private markets play a bigger role now - and see private markets as a way to gain access to the early journeys of firms set to win in a potentially rapid transformation. We also see broader opportunities in private markets than public ones. That's especially true in a world where elevated debt limits the ability of government to invest in infrastructure. Still, private markets are complex and not suitable for all investors. Companies larger than country stock marketsMarket capitalization of select U.S. companies and stock indexes, 2005-24 We are in a world where multiple, starkly different - or "polyfurcated" - outcomes are possible. This means we can no longer view the outlook in terms of slight deviations around a central outcome. We need to look at whole new ways of how the waves of transformation could reshape the economy and asset returns ahead. Distributions are a useful way to think about this. A central base case meant a single distribution was sufficient in the past for describing potential outcomes. We think looking at the world in multiple distributions - with very little overlap between them - is a better way of characterizing the possible scale of the waves of transformation ahead. We show two distinct branches for U.S. GDP with distributions around them to illustrate this. See the chart. Diverging growth pictures are just one example of the very different ways in which the economy could reconfigure. A transformation potentially on a par with past technological revolutions could see entire sectors revamped. It could mean a world that looks very different from the low growth, low inflation environment that dominated in the decade after the global financial crisis. Such profound changes could make it necessary to rethink what a long- term anchor for asset allocation looks like. What does this mean in practice? Investors should look for where the next wave of investment opportunity may come - and be ready to overhaul portfolio allocations to capture it. This is not only about the next six months or year, but about recognizing the possibility of very different future states of the world. On the next page we lay out three phases of AI evolution to help track the path of global transformation. We believe an active approach is key as we face very different states of the world. - Helen Jewell Chief Investment Officer EMEA, Fundamental Equities - BlackRock Starkly different outcomesStylized view of two different U.S. GDP outcomes The AI juggernaut - still largely a U.S. story - has powered the S&P 500 (SPX) this year. We think AI is central to the transformation - and could make up a large part of the coming investment wave. We believe AI can keep driving returns across most outcomes. We don't see a tech bubble: earnings and fundamentals support current valuations. Case in point: Nvidia's forward earnings have kept pace with its rocketing share price so far. We think an understanding of how AI could evolve from here is key. We see three distinct phases. AI relies on vast computing power, so some large technology firms are racing to invest in data centers to secure that power. We're at the start of this phase. Early winners are already emerging, including those tech firms, chip producers and firms supplying key inputs like energy, utilities, materials and real estate. Yet the buildout faces challenges, notably whether the power grid can grow fast enough. AI's power needs are expected to grow in coming years, even with further energy efficiency. See the chart. Policy and regulation could put the brakes on buildout, too. For example, policymakers may step in if data center growth pushes up local energy prices. And rules on the use of AI could impact adoption. Supply bottlenecks could also slow progress as demand grows for metals and minerals like copper, aluminum and lithium - already in high demand as inputs for the low-carbon transition. Here we see investment broadening to firms looking to harness AI. We see some of that already, especially in healthcare. It and other sectors like financials and communication services could benefit, potentially lifting economic growth. Yet both phases 1 and 2 could be inflationary: building AI and retooling creates extra demand before any supply- side or productivity benefits arise. We don't think markets or central banks appreciate that yet. Massive energy and investment needsData center power demand as a share of total U.S. demand, 2022-2030 In this very uncertain phase, AI could enable economies to produce more with the same amount of capital, labor - and energy as AI-enabled innovation potentially balances out AI's power needs. Technological innovations have done that before. The chart shows broad computer adoption drove up average output per hour by over 1 percentage point for nearly a decade. AI could eventually help economies grow faster and ease inflation pressure, in our view. The size and spread of productivity gains from AI are uncertain. Capital could be misallocated in the AI race. Estimates of AI's boost to annual U.S. growth range from 0.1 to 1.5 percentage points. We find the lower end more realistic - it will depend on sector adoption and cost savings. Yet these gains can only come after AI capabilities are fully deployed. That could take years, followed by the typical lag. It took nearly a century for the steam engine to boost productivity. And it was decades before the 1970- 80s computer and tech revolution paid off. It's not impossible this phase starts within a year, but we think several years is more likely. The potential winners in this phase are less clear-cut than in the earlier phases. It could be just a subset of companies that own the key tech. Or certain parts of society: For example, if AI enhances worker productivity, wages could rise - with benefits felt widely across the economy. In all events, AI is likely to spur a broad reallocation of workers across sectors. Even with this uncertainty, the potential for big future rewards supports the case for investing now and our AI overweight. AI could eventually deliver broad productivity gains - yet the path is uncertain. - Simona Paravani-Mellinghoff, Co-Head of Multi-Asset Strategies & Solutions - BlackRock As countries representing over half of the global population go to the polls this year, voters are focused on economic issues including the surge in the cost of living. Yet record or elevated government debt levels limit leaders' ability to address these concerns. See the chart. Neither candidate or major party in the U.S. presidential election has made debt and deficits a key campaign issue - or shied away from advocating more sizable spending. These ongoing budget deficits reinforce persistent inflation pressures and our view the Federal Reserve will keep rates higher for longer. That's why we see investors demanding more compensation for the risk of holding long-term U.S. bonds - and favor shorter-term bonds. We think France's unprecedented political stalemate after its parliamentary election and weak fiscal outlook will draw greater investor scrutiny. This contrasts with perceived policy stability in the UK after its election. Global elections add to the geopolitical volatility we see. This is a challenging time for incumbents. We see a structural shift toward geopolitical fragmentation, exacerbated by ongoing competition with China and protectionist measures in areas like advanced technology and electric vehicles - both in the U.S. and EU. Global supply chains are rewiring in response - and that will involve new infrastructure needs. See the next page. Countries like India and Mexico stand to benefit over the long term as intermediate trade partners between economic and geopolitical blocs. That's one reason we get granular with our country preferences. Globalization has proved resilient - but it is also more expensive. - Tom Donilon Chairman, BlackRock Investment Institute Infrastructure is at the intersection of the mega forces driving the waves of transformation. AI is a key aspect of economic competition among countries, while the investment in data centers is starting to impact the low-carbon transition as well. Net-zero emissions targets of the companies investing the most in the AI buildout could drive up demand for renewable energy. AI's energy needs could magnify the already massive investment expected, as noted earlier. Infrastructure investment is key to funding the low-carbon transition: By the 2040s, we estimate that low-carbon investment will account for up to 80% of energy spending, up from 64% now. We see geopolitical fragmentation reinforcing energy pragmatism as countries seek to balance the transition with energy security and affordability. The rewiring of supply chains is driving infrastructure demand globally and we favor the emerging markets set to benefit. Across markets, demographic divergence is shaping investment needs. Typically, the faster a population grows, the faster capital investment grows to support growing populations. See the chart. And developed markets will need to invest to adapt to aging populations. See the next page. A huge gap exists between the total amount of infrastructure investment needed globally and the amount governments can spend given high debt levels in many countries. We see private markets bridging the gap - though private markets are complex and not suitable for all investors. We are seeing the AI buildout boost demand for renewable energy. -David Giordano, Global Head of Climate Infrastructure - BlackRock Demographic trends tend to be seen as long term in nature and not impacting returns now. We disagree. Rising life expectancy and falling birth rates mean the working-age population - usually defined as 15-64 years old - is shrinking in many developed markets and China. That means those economies will not be able to produce as much and grow as quickly as in the past. These developments impact labor markets and sector-level demand now. Aging could be inflationary: retirees stop producing economic output but don't typically spend less. Governments are likely to spend more on healthcare. We think that's another reason why Governments can respond by trying to boost the workforce and/or productivity by investing in automation and AI. These strategies can provide some offset, but it's unlikely to be enough. We see opportunities in countries that better adapt to aging. By contrast, working-age populations in many EMs are still growing. We see opportunities in those that best capitalize on their demographic advantage, such as by improving workforce participation and investing in infrastructure. Countries with higher investment demand - India, Mexico and Saudi Arabia - may offer higher returns. Across countries, we think investors need to assess what markets have priced in. Research finds markets can be slow to price in the impact of even predictable demographic shifts. See the chart. That looks to be the case in the U.S. and Europe, like Japan before - and is why we favor the healthcare sector in both. Aging populations underpin our favorable outlook for the healthcare sector. - Carrie King, Chief Investment Officer of U.S. and Developed Markets, Fundamental Equities - BlackRock Slow to price in agingJapan healthcare outperformance vs. dependency ratio, 1970-2024 Japan is at the forefront of major economies grappling with an aging population. Yet its economic revival - and return of long-missing inflation - makes its equity market one of our strongest convictions on both on tactical and strategic horizons. In the near term, a benign macro backdrop and brightening corporate fundamentals - including ongoing reforms to improve profitability - prompted us to go further overweight Japanese equities. At the same time, the Bank of Japan is being patient in normalizing policy after raising policy rates for the first time in nearly two decades. Japan's stable macro outlook - with mild inflation feeding higher wages and corporate pricing power - has also reinforced our upbeat outlook for equity returns on strategic horizons of five years or longer. In our view, that means Japanese stocks warrant a higher allocation on such horizons of five years or longer than the benchmark would suggest. We hold an above-benchmark allocation, or overweight, to Japanese equities in our strategic views - with a preference for an unhedged exposure vs. currency hedged. See the chart on the right. We see a medium-term improvement in corporate earnings as the return of inflation and worker wage gains gives companies greater pricing power. We are watching for signs of a structural inflows into local stocks from households after an overhaul to the country's tax- exempt investment vehicles. Finally, we see mega forces creating compelling sectoral opportunities in Japan - such as in healthcare - and favoring a more active approach. Japan's economic revival has strong roots, creating long-term opportunities. - Yuichi Chiguchi, Japan Chief Investment Strategist and Head of Japan Multi-Asset Strategies & Solutions - BlackRock Japan for the long termHypothetical strategic allocation to Japan equities Our scenarios framework helps ground our views on a tactical horizon. Yet we could change our stance quickly if a different scenario were to look more likely. This is one reason why we may need to think about strategic asset allocation differently in the future - building on our long-held view that strategic views should be dynamic in this new environment. It is no longer possible to base strategic views on just one central view of the future state of the world with some deviation around it, in our view. We have seen the AI theme drive broader equity returns in the first half of the year - and we stick with our overweight. Beyond the U.S., we like emerging market countries like India and Saudi Arabia that are positioned to benefit from mega forces. We like Japanese stocks across horizons - and recommend strategic allocations larger than what index benchmarks would suggest. We also still like earning quality income in short-term government bonds and credit on both tactical and strategic horizons. Sticky inflation makes us prefer inflation-linked over nominal long-term bonds on a strategic horizon. We stick to our long-term preference for private credit even as spreads have tightened and we make cautious default assumptions. Why? We see private credit stepping up to play a bigger role in lending. Big callsOur highest conviction views on tactical (6-12 month) and strategic (long-term) horizons, July 2024 Six- to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, July 2024 Our approach is to first determine asset allocations based on our macro outlook - and what's in the price. The table below reflects this and, importantly, leaves aside the opportunity for alpha, or the potential to generate above-benchmark returns. We don't think this environment is conducive to static exposures to broad asset classes but creates more space for alpha. The BlackRock Investment Institute (BII) leverages the firm's expertise and generates proprietary research to provide insights on macroeconomics, sustainable investing, geopolitics and portfolio construction to help Blackrock's portfolio managers and clients navigate financial markets. 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ClearBridge Canadian Equity Strategy Q2 2024 Commentary

Trading activity was robust with five new holdings and additions to attractively priced defensive/interest-rate-sensitive positions as well as out-of-favor cyclical and growth names. With myriad risks to the economic outlook, overall positioning remained more defensive than usual. Following a strong first quarter and new all-time highs reached in the middle of the second, the S&P/TSX Composite Total Return Index ('TRI') slipped in June to finish the period down 0.5%. Canadian equity performance continues to pale in comparison to the U.S., underperforming the S&P 500 TRI's advance of 4.3% (5.3% in Canadian dollars). For context, the U.S. equity juggernaut, driven by mega cap information technology ('IT') and related growth stocks, has now outpaced the S&P/TSX Composite TRI in the past six consecutive quarters. Benchmark 10-year interest rates in Canada and the U.S. ended the second quarter roughly flat at 3.50% and 4.40%, respectively, remaining at highs not seen since the Global Financial Crisis. Consensus expectations for Fed rate cuts in 2024 tempered further in the second quarter - with futures now pushing out most cuts to late 2024/2025, as opposed to the six cuts expected at the beginning of this year. In contrast, the Bank of Canada ('BOC') cut rates at its June 5 meeting for the first time this cycle, lowering the headline overnight rate to 4.75% from 5.00%. For the BoC, a less robust economy in Canada relative to the U.S. and a more highly indebted homeowner facing pending mortgage rate renewals over the next couple years contributed to its more dovish policy stance. "Lacking meaningful AI enablers, Canadian equity performance continues to pale in comparison to the U.S." Second-quarter returns in Canadian equities were divergent across sectors, but generally weak with seven of 11 sectors in negative territory. The health care sector, lacking in relevance due to its sub-1% weighting in the benchmark, was the worst performer. Interest-rate-sensitives remained under pressure, contributing to the material weakness in real estate and communication services. Meanwhile, the Canadian IT sector returns were anemic, absent meaningful generative artificial intelligence (Gen AI) enablers seen in the U.S. equity market - and therefore any leverage to the panic corporate spending on cutting-edge semiconductor chips. In addition, Canadian sector heavyweight Shopify, introduced to the Strategy during the quarter, came under considerable pressure following underwhelming first-quarter results and a disappointing outlook. In contrast, with rising gold and copper prices, the materials sector was strong. Gold bullion advanced 5.5% for the quarter to US$2,340/oz (COMEX) and hit a new all-time high of US$2,439/oz in late May, and copper advanced 9.6% to finish at US$4.39/lb (COMEX). Meanwhile, the resilient consumer staples sector also contained some of the strongest contributors in a softer market environment, including sector heavyweights and Strategy holdings Alimentation Couche-Tard (OTCPK:ANCTF) and Loblaw (OTCPK:LBLCF). In energy, crude oil prices recovered from a steep decline mid-quarter to end down 2.0% at US$81.54/bbl (West Texas Intermediate). There was significant bifurcation in North American natural gas prices with NYMEX natural gas prices increasing 47.5% to US$2.60/mmbtu (NYMEX) while local Alberta (AECO) prices languished. Noteworthy for the Canadian energy sector, the long-awaited Trans Mountain Pipeline expansion is now online, and with LNG Canada expected to start exporting liquefied natural gas in 2025, prospects have improved for regional crude oil and natural gas prices in Western Canada. The ClearBridge Canadian Equity Strategy performed in line with the S&P/TSX Composite TRI benchmark in the second quarter, with slightly negative absolute returns. The most significant positive relative contributors to performance included our underweight position in the underperforming Shopify (SHOP), as well as meaningful weights in the outperforming Agnico Eagle Mines (AEM) and Saputo (OTCPK:SAPIF). In materials, Agnico Eagle shares benefited from strong operational execution and robust gold prices. The company recently hosted a site visit at its long-life Detour property in Northeastern Ontario. Detour is the largest gold-producing mine in Canada with production expected to increase to one million ounces annually by 2030 from a current run rate of approximately 700k ounces. Across all its operations in Canada, Australia, Finland and Mexico, with solid production guidance, project and reserve updates, and better than expected cost control, the company has performed well. In consumer staples, dairy products provider Saputo rebounded following its well-received fiscal fourth-quarter results (fiscal year ending March) and outlook for fiscal 2025. Following years of struggles, management is confident in the pending benefits from its recent network optimization initiatives and reduction in capital expenditures. Furthermore, U.S. supply-demand dynamics are better balanced in a region that has been challenged by unfavorable commodity price trends. While its international business remains more of a wildcard, Saputo remains focused on improved free cash flow generation and balance sheet management to put the business back on a better track. Meaningful detractors in the second quarter included Open Text (OTEX) in IT, and Telus International (TIXT) in industrials. Open Text shares declined following its fiscal third-quarter results, largely due to increased investments in AI capabilities within its software solutions, further marketing spend to grow the cloud business, as well as a change in acquisition strategy. Alongside recent divestitures, near-term margin and operating leverage improvements have been pushed out. That said, the base business is still showing areas of fundamental improvement, with continued increases in cloud bookings, ongoing deleveraging, stabilization of its recent Micro Focus acquisition and overall organic growth. In the case of Telus International, demand weakness within the broader IT services ecosystem continues to plague its core digital customer experience business, with majority shareholder Telus, as well as Google (GOOG,GOOGL), the only growing segments. Management's guidance incorporates a back-half recovery in 2024. However, with limited visibility and multiple missteps in the company's short public history, credibility is an issue. While AI remains a potential eventual tailwind for the business, macro headwinds are stiff in the near term, with tech and telecom clients reining in IT budgets. Telus will remain a "show me" story until management can prove out consistent revenue growth and profitability. Trading activity in the quarter included an uncharacteristically high five new holdings: Parex Resources (OTCPK:PARXF) in energy, Franco-Nevada (FNV) and Wheaton Precious Metals (WPM) in materials, Shopify in IT and Brookfield Infrastructure Corporation (BIPC) in utilities. We also broadly added to more attractively priced defensive/interest-rate-sensitives as well as out-of-favor cyclical and growth names, while selectively taking profit in several defensive/less interest-rate-sensitive holdings. Interest-rate-sensitive holdings in communication services and utilities continued to grow in prominence in the portfolio, with the higher interest rate environment weighing on sentiment to the point that we believe the risk/reward is excellent - hence the second quarter additions to BCE, Brookfield Renewable (BEP), Canadian Utilities (OTCPK:CDUAF). Shopify was added to the Strategy on weakness for the first time since its IPO in 2015. While typically a volatile security, an 18.7% decline following the company's recent quarterly report represented its worst single trading day since the IPO. Shopify is undoubtedly a great Canadian success story and we've been consistent in this view over time. However, the success of a business and the attractiveness of an investment can be two completely different things, with calibration of price and value often a sticking point. The company has posted incredible historical growth, and we believe it can continue on an expanding trajectory - and profitably so. Market share gains are ongoing, and Shopify has successfully tested the price elasticity of its subscription business while abandoning its disastrous past fulfillment ambitions, providing a sign of improved capital allocation priorities and a level of maturity where we now have better visibility into the business model and prioritization of sustainable profitability. "Shopify is providing signs of improved capital allocation and a level of maturity that provide better visibility into the business model and prioritization of sustainable profitability." In materials, we trimmed our position in Agnico Eagle and initiated positions in two royalty/streaming businesses, Wheaton Precious Metals and Franco-Nevada. In the precious metals subsector, we have tended to favor the royalty/streaming business model when valuations align. Once a novel business model, over past decades they have become a conventional source of financing for miners, complementing the traditional capital structure. Wheaton has demonstrated constructive portfolio growth over the past couple of years, while challenges at Franco-Nevada and related share price weakness present an attractive opportunity. In energy, we initiated a position in Parex, a Canadian company with oil and gas assets in Colombia and a key partner of the Colombian state oil company Ecopetrol (EC), holding a number of production sharing agreements. It has an established track record of generating excess free cash flow, from which it has pursued a multiyear share buyback program as well as, more recently, instituted an attractive dividend. Reporting first production at the company's Arauca exploration well should provide more confidence around its ability to add to its reserve base, as well as re-ignite production growth. In utilities, the seemingly higher-for-longer interest rate environment has weighed on interest-rate-sensitive equities, with names such as Brookfield Infrastructure (BIPC) coming under considerable pressure. The company owns and operates a globally diversified portfolio of high-quality, long-life infrastructure assets spanning utilities, transport, energy and data infrastructure, which are poised to prosper from secular tailwinds of decarbonization, deglobalization and digitization. The scarcity and strategic positioning of these assets provides valuable protective moats. BIPC operates under a Master Service Agreement with Brookfield Asset Management (BAM), which allows the company to leverage BAM's global reach, deep expertise and strong capabilities across key areas of operation and allows BIPC to co-invest in compelling, high-quality assets of significant size and scale alongside BAM and its institutional partners. At quarter end, the Strategy's largest sector exposures were financials, industrials, energy and consumer staples. Relative to the benchmark, the Strategy is overweight consumer staples, utilities and industrials, and is most underweight financials, energy and materials. While corporate earnings have largely delivered to date in 2024, equity market valuations mostly remain heightened. This is particularly true in the higher-growth and less interest-rate-sensitive portions of the equity market. With meaningful risks to the economic outlook remaining, including the lagged potential impacts of tightened monetary policy, residual inflationary concerns, geopolitical risks and uncertainty surrounding upcoming U.S. elections, and something close to an ideal scenario already priced in for those favored equities, the Strategy continued to drive toward more defensive positioning than has been the case in many years. Despite the BoC's divergent rate cut in the second quarter, with tempered U.S. rate cut expectations in the short run and the overall gravity of a structurally higher interest rate environment in North America, we remain mindful of the inherent risks in equities as investors continue to re-acclimatize to a non-ZIRP (zero interest rate policy) and non-TINA (there is no alternative) environment. While the differences in the Canadian and U.S. equity markets have undoubtedly led to significant divergence in performance in recent years, the resulting fear of missing out (FOMO), capital flows and market concentration can often lead to overlooked opportunities elsewhere. Our bottom-up approach is designed to seek out such opportunities, with a particular focus on visibility to high full-cycle profitability, secular growth, effective capital allocation and a discerning approach to valuation. With superior predictability and downside protection available at a reasonable price, we continue to appreciate and emphasize the more defensive posturing of the Strategy. We believe our positioning can provide ballast in more challenging equity market environments, which will allow the Strategy to power ahead with predictable growth, and serve as dry powder when better risk/reward opportunities arise. We will continue to target a trailing beta of 0.8 to 0.9 for the Strategy, limiting the systematic risk and volatility relative to the benchmark. During the second quarter, the ClearBridge Canadian Equity Strategy performed in line with its S&P/TSX benchmark. On an absolute basis, the Strategy generated gains in five of the 10 sectors in which it was invested (out of 11 total). The primary contributors were the consumer staples, materials, consumer discretionary and utilities sectors, while the main detractors were the industrials and IT sectors. Relative to the benchmark, negative security selection offset positive sector allocation. In particular, a sector overweight in the strongly performing consumer staples sector, as well as an underweight to the underperforming IT sector, as well as stock selection in consumer discretionary and utilities contributed to performance. Stock selection in industrials and IT as well as an underweight to materials detracted from relative performance. On an individual stock basis, leading absolute contributors included Royal Bank of Canada (RY), Dollarama (OTCPK:DLMAF), Agnico Eagle Mines, Saputo and Brookfield Renewable. Top absolute detractors included Open Text, Canadian Pacific Kansas City (CP), Canadian National Railway (CNI), Toronto-Dominion Bank (TD) and Bank of Nova Scotia (BNS). Timothy W. Caulfield, CFA, Dir. Canadian Eq. Research Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.