In the wake of an increasingly uncertain economic backdrop, narrowing earnings growth, and heightened market risk, market discussions have pivoted to a renewed focus on active management.
Indeed, with its emphasis on identifying companies with resilient fundamentals, such as competitive position and pricing power, it’s an attractive approach in today’s rapidly evolving macro environment.
‘Higher for Longer’ Emerges
For much of the first quarter, equity markets rode to new highs on a positive narrative grounded in resilient consumer demand, positive conviction on inflation, and favorable earnings surprises. Notably, rallies exhibited broadening participation, with nearly half of the S&P 500 sectors outperforming the index return of 10.6% for the quarter.
That said, a subsequent stall in disinflation has complicated an otherwise buoyant mood. April's Core Personal Consumption Expenditures Price Index (the Core PCE Price Index), which excludes volatile food and energy data, has remained unchanged since February at 2.8%一well above the Fed’s target rate of 2.0%. Consequently, this has deferred the timing and number of rate cuts in 2024, ushering in a ‘higher for longer’ phase, at least for now.
In a worst-case scenario, this could hamstring the Fed’s ability to prevent a decelerating economy from sliding into recession. As the impact of 18 months of restrictive monetary policy moves through the economy一slowing growth and softening labor markets一any stopgap rate cuts deployed to slow an accelerating fallout could further exacerbate an already elevated inflation level.
Said Hilton Co-Chief Investment Officer Alex Oxenham:
”A long period of disinflation has enabled the Fed to price in several cuts through 2024. Now it appears there may be only one cut for 2024.”
“If inflation remains sticky and recessionary pressures increase, the Fed’s ability to manage the situation could be hindered,” he added.
Positive Sentiment, For Now
For the moment, however, optimism remains in the air. Markets continue to climb amid rising earnings, robust consumer demand, and low volatility. However, this could be only part of the story. Other observable factors suggest a more nuanced situation:
Narrowing Market Returns
AI exuberance continues to drive returns, led by a small group of tech giants, including Alphabet (Google’s parent company), Amazon, Apple, Meta, Microsoft, and Nvidia, among others. In recent days, the 10 largest stocks in the S&P 500 comprised almost 37% of the index’s total value, the highest since September 2000.
A concentrated rally can increase market risk if the megacaps fail to deliver on the elevated earnings expectations already priced in. Apple, for one, is facing increased scrutiny after experiencing its steepest quarterly decline in iPhone sales since the onset of the pandemic.
Elevated Valuations
Equity market valuations are also on the higher side. The S&P 500 is trading at 21.0x 12-month forward earnings, meaningfully above its 10-year average of 17.9x. A similar expansion is apparent in the tech-heavy Nasdaq at 30.8x. Again, the risk lies not in the absolute values themselves but in whether corporate profits materialize to support the higher multiples.
On balance, the markets appear to be banking on a steady stream of positive news, with an anticipated rate cut likely to boost tailwinds supporting earnings expectations.
However, the potential for increased vulnerability underscores the importance of companies fortifying underlying fundamentals. For investors, identifying the names that can successfully navigate this increasingly intricate environment will be key.
Oxenham adds, “The ongoing resilience of consumer demand and labor, and how companies respond to these dynamics, will be a key focus going forward.”
Potential Benefits of Active Management
Not surprisingly, then, a renewed emphasis on active management has emerged. By actively monitoring and adjusting portfolios in line with specific investment mandates, managers may be able to better respond to market fluctuations, identify emerging opportunities, and, importantly, mitigate risks.
Conversely, passive management is generally designed to mirror a market index, such as the S&P 500, with the goal of matching performance.
Potential advantages of active management relative to passive investment strategies include the following:
- Selective Outperformance: Active managers may be able to identify better-performing sectors, industries, and securities, and weight portfolios accordingly.
- Risk Management: Exposure to overvalued sectors and assets may be able to be better controlled, and avoiding ‘herd mentality’ tactics and financial bubbles can also help protect investors from sharp declines.
- Stock Picking: While crucial to all portfolios, this is especially relevant for dividend and income strategies, where identifying consistent and higher-yielding securities is essential across all market conditions.
- Agility: Active managers may be able to adapt more quickly to changing market conditions and indicators by rebalancing portfolios to leverage nascent opportunities or mitigate exposure.
- Leveraging Inefficiencies: Active managers may be able to exploit mispricing opportunities where available and appropriate to their respective mandates.
In short, an active approach with the right manager may be preferable for navigating the increasing complexities of the current economic climate and helping deliver better long-term returns.
Hilton’s Approach to Active Management
While we currently observe inflation slowing, albeit with pauses along the way, resilient economic growth, and a stable labor market, the markets could be questioning how long this favorable situation can persist.
At Hilton, we deploy a data-driven methodology to active management grounded in a comprehensive view of global macroeconomic signals, asset allocation, and principled security selection.
Our focus is on pinpointing businesses with solid foundations and durable competitive advantages that best position them to steer through ambiguities and leverage attractive growth opportunities.
This disciplined approach seeks to mitigate portfolio volatility, safeguard existing assets, and capitalize on attractive prospects一regardless of market conditions. We believe it is an especially relevant and prudent approach to navigating the potential for greater uncertainty in the weeks and months to come.
