Adding to Equities on Increased Optimism

If one had to pick a word to describe the investing world in 2023, “resilient” would be a good choice. Through the course of the year, the U.S. consumer, labor market, corporate profit engine, and stock market have all delivered stronger performances than expected at the start of the year. Despite concerns that a too-hot economy could stoke the flames of inflation, price pressures have steadily abated, giving the Fed cover to log their last rate hike of the cycle in July and begin prepping the markets for rate cuts in 2024. We have increased our conviction in the soft-landing scenario and are taking the opportunity to increase equity risk in portfolios—bringing our equity exposure from an underweight to neutral versus our strategic asset allocation benchmark by adding to U.S. small cap. This is being funded by a reduction in cash and investment-grade fixed income.

Gliding to a soft landing

The single most important piece of economic data this year has been inflation. The Core PCE has fallen from 4.9% y/y in December of 2023 to 3.5% as of October (the latest data point available). While not yet at the Fed’s target on a year-over-year basis, inflation as measured using a 3- and 6-month annualized rate is at 2.5% on both measures (Figure 1). Inflation has evaporated from nearly every major category except for housing and based on real-time measures of home and rental prices, we expect this to drag inflation lower in coming months. Encouragingly, disinflation has occurred with the labor market slowing but showing no signs of cracking, and the consumer has behaved similarly. This progress toward the “goldilocks” economy (not too hot, not too cold, and inflation receding) has contributed to our increased conviction in the soft-landing scenario for the U.S. economy. We recently increased the odds of the U.S. escaping recession to 65-70%; we see a 25% probability of a recession.

Figure 1: Disinflation is now well entrenched

Core PCE Infation at 3 months, 6 months, and 12 months annualized rates through October 2023

As of October 31, 2023. Source: Bloomberg, WTIA.

We have a slightly above-consensus forecast of 1.2% GDP growth in 2024, which should support ongoing disinflation. Importantly, our expectation that headline inflation will finish 2024 around 2% means the Fed will need to begin cutting their policy rate by midyear, or they will run the risk of keeping monetary policy too tight and tipping the U.S. economy into recession. The Fed Chair’s comments at last week’s FOMC meeting give us a higher level of confidence that necessary rate cuts will occur, which should support returns of equities and fixed income alike.

Adding to small cap

The last two months of the year have delivered stellar returns for a diversified portfolio, as a sharp decline in interest rates benefited both stocks and bonds. The 10-year Treasury yield peaked at 5% in mid-October and sits below 4% at the time of this writing. Global equities, as measured by the MSCI ACWI, returned nearly 11% over that period[1], with the U.S. aggregate bond index[2] delivering total returns in excess of 8%.

This year we have positioned portfolios with a slightly conservative asset allocation, choosing to underweight U.S. small-cap and international developed equities versus our benchmark but retaining a full allocation to U.S. large cap (the best-performing equity asset class in 2023). Recession fears were elevated throughout the year, and luckily no recession has materialized. At this stage, we see sufficient evidence in the soft landing that we are closing our equity underweight. We are doing so by adding to U.S. small cap, which takes our overall U.S. equity position to slightly overweight versus our benchmark while maintaining a slight underweight in international developed equities (Figure 2).

Core narrative

As discussed in our Capital Markets Forecast, the U.S. remains in prime position to continue its reign of economic exceptionalism. Despite risks around the U.S.’s fiscal state, we expect U.S. economic strength to continue to support outperformance of U.S. equities. When it comes to international developed equities, Europe continues to be mired in war and recessionary economic conditions, and Japan is starting the year by raising interest rates—running counter to most major central banks. Frankly, the 15% total return year to date for the MSCI EAFE index seems overdone, and that asset class is more subject to a pullback in 2024 than U.S. equities.  

The first three quarters of the year were dominated by the “Magnificent 7” stocks,[3] but the fourth quarter has seen improved market breadth, meaning a larger share of stocks are participating in the market gains. Since the start of the fourth quarter, the S&P 500 equal weighted index has kept pace with the market-cap weighted index, and the Russell 2000 Small Cap Index has bested both by approximately 2%[4]. We expect 2024 to be a year of broader leadership, which would include U.S. small-cap equities. Smaller companies source a larger share of their revenues domestically, so superior U.S. economic performance would provide a greater advantage to small cap. U.S. small cap is also still more than 17% off its 2021 highs and attractively valued when compared to U.S. large-cap equities, with valuations[5] in the 16^th percentile relative to the last 10 years of history. Financials, in particular small- and mid-sized regional banks, had a very challenging year but are expected to perform better in a year of moderating interest rates and an expanding economy. Financials have a 17% weight in the Russell 2000, compared to 13.5% in the Russell 1000,[6] So recovery of financials stocks would likely benefit small cap more than large cap. In terms of positioning, though it has been the smaller, lower quality companies that have surged at the close of this year, we continue to favor larger, higher quality companies within the small- cap asset class, as the interest rate environment and slowing growth should reward those companies with earnings and healthy balance sheets.

We are funding the additional equity exposure via cash and investment-grade fixed income. This will take our cash positioning to below benchmark, and we will retain an overweight to fixed income, where we still see compelling risk versus reward given interest rates and our economic views.

The recent stretch of strong market performance can make it tempting to wait for a more attractive entry point. However, timing the market is incredibly difficult. Did 2023 “borrow” some equity returns from 2024? Most likely. Will volatility increase from current levels at some point in the first quarter? Almost certainly. But absent a recession, any pullback should be relatively short, shallow, and par for the investment course. We expect the equity market to deliver returns next year that are more in line with historical averages (mid-to-high-single digits), and in this environment, a neutral allocation to equities is appropriate. Should the stock market correct in early 2024 and our conviction in the health of the U.S. economy remain, we could opportunistically add further to equities.

Figure 2: Moving to a neutral allocation to equities, underweight to cash

High-net-worth Portfolios with Private Markets*

^{Data as of December 18, 2023. Positioning reflects our monthly tactical asset allocation (TAA) versus the long-term strategic asset allocation (SAA) benchmark. For an overview of our asset allocation strategies, please see the disclosures.}

^{*Private markets are only available to investors that meet Securities and Exchange Commission standards and are qualified and accredited. We recommend a strategic allocation to private markets we do not tactically adjust this asset class.}

^{[1] October 19, 2023-December 19, 2023, total returns.}

^{[2] Bloomberg U.S. Aggregate Total Return Index.}

^{[3] A reference to Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla.}

^{[4] Through December 19, 2023; source: Bloomberg.}

^{[5] 12-month forward price-to-earnings multiple of the Russell 2000 divided by that of the Russell 1000.}

^{[6] As of December 19, 2023; source: Bloomberg.}

Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other business areas of Wilmington Trust or M&T Bank who may provide or seek to provide financial services to entities referred to in this report. M&T Bank and Wilmington Trust have established information barriers between their various business groups. As a result, M&T Bank and Wilmington Trust do not disclose certain client relationships with, or compensation received from, such entities in their reports.

The information on Wilmington Wire has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor’s objectives, financial situation, and particular needs. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will succeed.

Past performance cannot guarantee future results. Investing involves risk and you may incur a profit or a loss.

Indexes are not available for direct investment. Investment in a security or strategy designed to replicate the performance of an index will incur expenses such as management fees and transaction costs which will reduce returns.

Reference to the company names mentioned in this blog is merely for explaining the market view and should not be construed as investment advice or investment recommendations of those companies. Third party trademarks and brands are the property of their respective owners.

Any investment products discussed in this commentary are not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or guaranteed by M&T Bank, Wilmington Trust, or any other bank or entity, and are subject to risks, including a possible loss of the principal amount invested.

Some investment products may be available only to certain “qualified investors”—that is, investors who meet certain income and/or investable assets thresholds.

Alternative assets, such as strategies that invest in hedge funds, can present greater risk and are not suitable for all investors.

Any positioning information provided does not include all positions that were taken in client accounts and may not be representative of current positioning. It should not be assumed that the positions described are or will be profitable or that positions taken in the future will be profitable or will equal the performance of those described.

Wilmington Trust offers seven asset allocation models for taxable (high-net-worth) and tax-exempt (institutional) investors across five strategies reflecting a range of investment objectives and risk tolerances: Aggressive, Growth, Growth & Income, Income & Growth, and Conservative. The seven models are High-Net- Worth (HNW), HNW with Liquid Alternatives, HNW with Private Markets, HNW Tax Advantaged, Institutional, Institutional with Hedge LP, and Institutional with Private Markets. As the names imply, the strategies vary with the type and degree of exposure to hedge strategies and private market exposure, as well as with the focus on taxable or tax-exempt income.

Model Strategies may include exposure to the following asset classes: U.S. large-capitalization stocks, U.S. small-cap stocks, developed international stocks, emerging market stocks, U.S. and international real asset securities (including inflation-linked bonds and commodity-related and real estate-related securities), U.S. and international investment-grade bonds (corporate for Institutional or Tax Advantaged, municipal for other HNW), U.S. and international speculative grade (high-yield) corporate bonds and floating-rate notes, emerging markets debt, and cash equivalents. Model Strategies employing nontraditional hedge and private market investments will, naturally, carry those exposures as well. Each asset class carries a distinct set of risks, which should be reviewed and understood prior to investing.

Allocations: Each strategy group is constructed with target policy weights for each asset class. Wilmington Trust periodically adjusts the policy weights’ target allocations and may shift from the target allocations within certain ranges. Such tactical allocation adjustments are generally considered on a monthly basis in response to market conditions.

The asset classes and their current proxies are: • Large–cap U.S. stocks: Russell 1000® Index • Small–cap U.S. stocks: Russell 2000® Index • Developed international stocks: MSCI EAFE® (Net) Index • Emerging market stocks: MSCI Emerging Markets Index • U.S. inflation-linked bonds: Bloomberg US Treasury Inflation Notes TR Index Value Unhedged* • International inflation-linked bonds: Bloomberg World ex US ILB (Hedged) Index • Commodity-related securities: Bloomberg Commodity Index • U.S. REITs: S&P US REIT Index • International REITs: Dow Jones Global ex US Select RESI Index • Private markets: S&P Listed Private Equity Index • Hedge funds: HFRX Global Hedge Fund Index • U.S. taxable, investment-grade bonds: Bloomberg U.S. Aggregate Index • U.S. high-yield corporate bonds: Bloomberg U.S. Corporate High Yield Index • U.S. municipal, investment-grade bonds: S&P Municipal Bond Index • U.S. municipal high-yield bonds: 60% Bloomberg High Yield Municipal Bond Index / 40% Municipal Bond Index • International taxable, investment-grade bonds: Bloomberg Global Aggregate ex US • Emerging bond markets: Bloomberg EM USD Aggregate • Cash equivalent: 30-day U.S. Treasury bill rate.

Index Descriptions

The Bloomberg U.S. Aggregate Index measures the performance of the entire U.S. market of taxable, fixed-rate, investment-grade bonds. Each issue in the index has at least one year left until maturity and an outstanding par value of at least $250 million.

The Bloomberg U.S. High Yield Corporate Index, formerly known as Lehman Brothers U.S. High Yield Corporate Index, measures the performance of taxable, fixed-rate bonds issued by industrial, utility, and financial companies and rated below investment grade. Each issue in the index has at least one year left until maturity and an outstanding par value of at least $150 million.

The Bloomberg World Government Inflation-Linked Bond (WGILB) Index measures the performance of investment grade, government inflation-linked debt from 12 different developed market countries.

Bloomberg Commodity Index measures the performance of 19 futures contracts on physical commodities.  As of the annual reweighting of the components, no related group of commodities (for example, energy, precious metals, livestock, and grains) may constitute more than 33% of the index and no single commodity may constitute less than 2% or more than 15% of the index.

The Dow Jones Global ex-U.S. Index is an equal-weighted stock index composed of the stocks of 150 top companies from around the world (excluding the U.S.) as selected by Dow Jones editors and based on the companies' long history of success and popularity among investors. The Global Dow is designed to reflect the global stock market and gives preferences to companies with global reach.

The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is composed of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage. The strategies are asset weighted based on the distribution of assets in the hedge fund industry.

The MSCI All-Country World Index ex USA measures the performance of large- and mid-capitalization stocks in approximately 50 developed and emerging equity markets, excluding the United States.

The MSCI EAFE^® (net) Index measures the performance of approximately 20 developed equity markets, excluding those of the United States and Canada. The total returns of the index are net of the maximum tax withholding rates that apply in many countries to dividends paid to nonresident investors. 

The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 emerging markets countries. With 1,198 constituents, the index covers approximately 85% of the free-float-adjusted market capitalization in each country.

Russell 1000^® Growth Index measures the performance of those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth values.

Russell 1000^® Value Index measures the performance of those Russell 1000 Index companies with lower price-to-book ratios and lower forecasted growth values.

The Russell 2000^® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. As of its latest reconstitution, the index had a total market capitalization range of approximately $128 million to $1.3 billion.

The Russell 3000^® Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market. As of its latest reconstitution, the index had a total market capitalization range of approximately $128 million to $309 billion.

The S&P 500 Index measures the performance of approximately 500 widely held common stocks listed on U.S. exchanges. Most of the stocks in the index are large-capitalization U.S. issues. The index accounts for roughly 75% of the total market capitalization of all U.S. equities.

The S&P Composite Stock Price Index (noted on slide 8) refers to the data series made popular in recent years by Yale Professor Robert Shiller, not to be confused with the S&P Composite 1500, an index that combines the S&P 500, the S&P Mid Cap 400, and the S&P Small Cap 600. Investing involves risks and you may incur a profit or a loss.

The S&P Developed Property defines and measures the investable universe of publicly traded property companies domiciled in developed markets.

The S&P Municipal Bond High-Yield Index consists of bonds in the S&P Municipal Bond Index that are not rated or are rated below investment grade.

The S&P Municipal Bond Index is a broad, market value-weighted index that seeks to measure the performance of the U.S. municipal bond market.

The S&P United States REIT Index measures the investable U.S. real estate investment trust market and maintains a constituency that reflects the market’s overall composition.