2024 Multi-Asset Strategies Outlook
Third Quarter
Key Takeaways
The risk/reward trade-off for stocks is not compelling with Treasury bill yields above 5%.
Among stocks, we prefer U.S. over non-U.S. equities due to stronger economic and profit growth.
A Nuanced View of Global Equities
We’re marginally underweight stocks relative to bonds, and to explain why, we’re going to appeal to the Oracle of Omaha, Warren Buffett. He said interest rates are to asset values as gravity is to an apple.
This is the case because investments are valued based on future cash flows. Future cash flows are great in theory. But you must account for the fact that they 1) are subject to the effects of inflation and 2) must reflect the opportunity cost of not being able to invest and compound returns today. As a result, the net present value of future cash flows is determined by discounting at today’s interest rates.
Think of the old maxim, better a bird in hand than two in the bush, where yield today is the bird in hand, and potential future earnings are the two in the bush. And with Treasury bill yields above 5%, we have to discount future cash flows aggressively. In our view, U.S. stocks aren’t offering a compelling risk/reward tradeoff vis-à-vis cash with rates at these levels.
Another lens to examine the same issue is the equity risk premium, or ERP. The ERP compares stock earnings yields against bond yields. The aim of the ERP is to gauge whether investors are adequately compensated for the additional risk (price volatility) that stocks carry relative to bonds. When the risk premium is high, equities offer greater potential rewards relative to bonds. But when the premium is low, it makes less sense to take on stock risk.
Today, the ERP is negative for stocks versus both short-term Treasury bills and long-term bonds. The last time the ERP relative to the 10-year Treasury yield was this low was 15 years ago during the Great Financial Crisis. The ERP relative to Treasury bills hasn’t been this low in more than 20 years.1
With U.S. stocks at record highs and cash yielding more than 5%, we don’t see any reason to move off our underweight in stocks and overweight to cash.
Within Equities, U.S. Over Non-U.S. and Large Over Small
On the one hand, we find domestic equities unattractive relative to cash and short-term fixed income in the U.S. But within our overall equity allocation, we see U.S. stocks as more attractive than those in other developed markets. Within the U.S. equity market, we prefer large over small-company stocks for now.
This is largely explained by corporate earnings growth. Despite our prior skepticism, the reality is that earnings for the biggest companies in the U.S. have come in better than we and many Wall Street analysts expected. We theorize that this is explained by solid productivity growth that is enabling revenue, profit and margin improvement for large-cap companies.
In contrast, an apples-to-apples comparison of small-company stocks shows revenue declines and only slight profit growth.2 Given the current level of interest rates, economic growth and strong price and earnings momentum in large-caps, we prefer these stocks to smaller-cap firms over a three- to six-month horizon. This makes intuitive sense — small companies tend to be earlier in their life cycles, meaning their best earnings growth is likely far in the future. Similarly, many rely on debt financing. Higher rates then present a “double whammy” of sorts for small companies — increasing financing costs and discounting the value of their future earnings. Our three- to -five-year capital market assumptions are much more constructive on small stocks, but our short-term tactical model isn’t there yet.
The country story is similar. The U.S. continued to produce solid economic growth, while developed market economies outside the U.S. were relatively weak. As a result of these pronounced differences, earnings expectations for European and Japanese companies are significantly below those of U.S. corporations.
Earnings are the “E” in the “P/E” or price/earnings ratio. This is a key valuation metric that measures how much investors pay for each dollar of earnings. Valuations are historically high in both the U.S. and the eurozone, but more rapid earnings growth means U.S. valuations have improved in recent months. This improvement is one reason why we’re more inclined toward U.S. equities.
Additional dimensions of our model also favor the U.S. over other developed markets. These include both the stock market and the U.S. dollar/foreign currency momentum. Both of these technical momentum-based measures support a U.S. overweight. We express this positioning in our portfolios by underweighting large-cap non-U.S. investments and reallocating that capital to U.S. large company stocks.
Of course, while we are speaking at the asset class level, we rely on our management teams to identify the most attractive individual stocks in their markets, regardless of capitalization or geography. For example, our developed market exposures outside the U.S. are focused on companies with a global presence. Examples include firms providing products and services addressing opportunities like semiconductor manufacturing or the commercialization of treatments for diabetes and obesity.
¹MacroMicro, “S&P Equity Risk Premium & Earnings Yield (w U.S. 10Y & 3M Treasury Yield),”accessed June 6, 2024.
²Tajinder Dhillon, “Russell 2000 Earnings Dashboard 24Q1,” LSEG, May 9, 2024.
Asset Class
U.S. Equity vs. U.S. Fixed Income & Cash Equivalents
The calculus here is fairly simple. High cash yields look compelling at a time when inflation has moderated, with little risk of price volatility compared with stocks and long-term bonds. At longer investment horizons, this overweight is less compelling. But for now, unless or until the Federal Reserve (Fed) begins to cut interest rates, we prefer cash.
Equity Region
U.S. vs. Developed Markets
We’ve been writing for some time about how both fundamental and technical indicators were moving in the direction of the U.S. over other developed market equities. Now, stronger economic and corporate earnings growth combined with foreign currency effects call for a U.S. stock overweight.
U.S. vs. Emerging Markets
This is an excellent example of the benefits of an actively managed approach to each underlying allocation. At a high level, we’re neutral on emerging markets for now, though the expectation of strong future earnings growth and additional rate cuts mean we’ll watch this space carefully. But at an individual security level, our managers see tremendous opportunities across diverse geographies and companies.
U.S. Equity Size & Style
Large Cap vs. Small Cap
Fama and French, the undisputed godfathers of factor investing, decades ago identified a “size premium” wherein small company stocks outperform large over time. The problem is that “over time” can sometimes take a long time to manifest. And small is arguably cheap for a reason — rates are high and large companies are enjoying better profit growth. As a result, we favor large over small for now. Longer term, lower rates and a more normal economic environment could well prove Fama and French right, but we’re not there yet.
Growth vs. Value
At present, we see greater distinctions and opportunities at the asset class level in large/small U.S. stocks and in U.S. versus non-U.S. than we see in deciding between growth and value stocks. Each group faces unique challenges and opportunities that make asset class decisions less useful, opening up space for individual security selection. Examples of growth are opportunities beyond the Magnificent Seven, and in value, it’s about finding companies that can thrive amid high interest rates.
Fixed Income
U.S. vs. Non-U.S.
Given stronger growth, persistent inflation and higher-for-longer rates, U.S. bonds likely have less upside. Therefore, we prefer shorter-term, higher-yielding bonds in the U.S. In contrast, rate cuts are already a reality in developed non-U.S. markets. In the eurozone, the European Central Bank cut rates for the first time in eight years in June. Similarly, emerging market central banks have also begun cutting. They can’t get too aggressive and get too far ahead of the Fed, but the implication is clear that rates outside the U.S. are set to come down faster than here at home.
Alternatives
REITs vs. Core Assets
The setup for real estate investment trusts (REITs) continues to improve. Interest rates have leveled off, valuations are better after a difficult few years, and the earnings outlook for 2024 and 2025 is improving. In addition, some sectors in the space are attractive. For example, data center REITs benefit from the insatiable demand for computing power to underpin the cloud and the artificial intelligence revolution. Similarly, senior housing REITs are supported by the long-term trend of an aging population. To us, this seems like an excellent opportunity to remain neutral at the asset class level while allowing our REIT management team to identify compelling opportunities.
Capital market assumptions are not meant to reflect any projection or promise of performance. No guarantee or representation is being made that any account will or is likely to achieve the assumptions shown.
References to specific securities are for illustrative purposes only and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Historically, small- and/or mid-cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.
Diversification does not assure a profit nor does it protect against loss of principal.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.