Pursuing an Active Approach Amid Economic Uncertainty

While the first half of 2024 has seen promising economic growth and increased activity in the financial markets, economists believe there’s still room for volatility through the second half. In his midyear economic outlook below, Richard de Chazal, CFA, William Blair’s London-based macro analyst, emphasizes that investors should maintain optimism while remaining active and nimble in their approach to portfolio management and construction.

Client Focus (CF): What are your thoughts on the broader macroeconomic landscape as we look back at the start of 2024? Has it played out as you anticipated thus far?

Richard de Chazal (RDC): Fortunately, so far, growth in 2024 has been much better than anticipated, following what has been the sharpest Fed tightening cycle since the 1970s. There’s been a strong possibility the lagged effects from those rate increases would constrict growth throughout the year, but up to now, the impact from the tightening has remained more muted. Conversely, it’s worth remembering that rate cuts also act with a lag, and the Fed will need to start easing soon to raise the chances of effecting a soft landing.

The more muted impact has been due to a combination of factors, including both the consumer and corporate sectors having locked in lower rate debt for several years in advance, desensitizing them to higher interest rates. Meanwhile, consumer balance sheets are in excellent shape (with consumers deleveraging them for the last decade), the labor market is very tight, and the government has been running exceptionally large fiscal deficits. We are also in the middle of another great innovation wave—this one focusing on generative artificial intelligence. The rapid adoption and diffusion of this technology across the economy should help businesses and consumers raise productivity and efficiency.

CF: You mentioned in one of your recent notes that the market is “seemingly obsessed with the start of rate cuts.” What do you think it will take for the Fed to act?

RDC: Currently, the market seems to have a one-track mind, with its sight set on the start of the Fed rate-cutting cycle. More recently, it’s also been the case that the more the market has attempted to preempt rate cuts and ease financial conditions on its own (through a weaker dollar, tighter credit spending, lower longer-term interest rates, and a stronger stock market), the more the Fed was likely to conclude that the market was doing the Fed’s work for it, that liquidity was abundant, thereby easing any near-term pressure to start cutting. Ultimately, however, the Fed will have to deliver on those cuts.

With ongoing fears about sticky inflation, some suggest the Fed’s next move could even be to hike rates. We believe that’s very unlikely. There are already emerging signs the economy is softening around the edges, and the Fed is increasingly aware that it needs to get ahead of that weakening.

The Fed has also been clear that it doesn’t want to start lowering rates until it sees ample evidence that inflation is firmly on the path to its 2% target rate. According to Chair Jerome Powell, that roughly translates to several good inflation reports before it can feel confident enough to move. The most recent data on inflation has been encouraging, and there is also evidence that some of the heat is starting to come out of the labor market. Therefore, we believe that the Fed should feel more comfortable moving later this year, possibly as early as September.

CF: How would you describe the resiliency of the U.S. consumer so far this year? Do you think the spending behaviors are sustainable?

RDC: It’s worth remembering two old maxims about the U.S. consumer. The first is, “Where the consumer goes, so goes the economy,” especially given that the U.S. consumer accounts for 68% of aggregate GDP. The other is, “Never underestimate the power of the U.S. consumer.”

Consumer balance sheets are in good shape, with levels of debt to net worth still hovering around their lowest since the early 1980s. Second, the labor market is extremely tight. While there may be some cyclical choppiness, and we may see the unemployment rate rise in the coming quarters, on a secular basis, companies will continue to have a harder time finding labor than they have in decades. On the supply side, this shortage is largely from a combination of adverse demographics across Western nations, as a result of retiring baby boomers and lower birth rates. On the demand side, we’re seeing elevated demand for workers related to the effects of reshoring and deglobalization.

In the near term though, we’re seeing some cyclical pressures emerge around the consumer. This is primarily felt in the lower-income cohort, where inflation has been the most painful, wage growth has been decelerated, and job openings have diminished. We have also already seen consumers trading down, shifting to white-label brands, and an increase in pushback against retail price increases. In aggregate, however, looking across all cohorts, the consumer remains in a good place and incredibly resilient.

CF: What can you say about capital markets, especially as it relates to the IPO backlog of assets that may have accumulated over the last two years?

RDC: When interest rates dropped to the zero lower bound following the pandemic, companies took the opportunity to load up on cheap debt—whether they needed it or not. There was still a tremendous amount of uncertainty about what would happen to the global economy, but the capital markets were open. Therefore, it made sense to seize the opportunity while they could. Following the sharp increase in rates, resulting in several bank failures, fears about systemic issues in the banking system, and the possibility of a recession, activity dried up.

What we’ve seen in 2024, however, has been more encouraging. Interest rates have peaked, and rate cuts are now a matter of "when," not "if." We’ve also seen more buoyant equity market returns as companies have been increasingly willing to approach the equity market to finance the next leg of their growth. When liquidity in the private equity space gets tighter, it raises the attractiveness of public markets. Perhaps surprisingly, the upcoming U.S. elections also act as an accelerator for this activity. Companies have been telling us that they want funding rounds achieved as soon as possible in the event of potential market volatility after the election.

Looking forward, we believe that this is an environment in which investors should be optimistic but, given the uncertainty, continue to pursue a nimble and active approach to portfolio management and construction.

RICHARD DE CHAZAL

CF: Do you think the current U.S. economic backdrop bodes well for small- and mid-cap stocks?

RDC: Again, perhaps surprisingly, we believe it does bode well for these stocks. Small- and mid-cap stocks have struggled over the last few years. But that’s not unusual in the face of the sharp run-up in interest rates, uncertainty over economic growth, and the shift to passive portfolio management. These stocks typically outperform from around the midpoint of a recession once the worst of the downturn has been reached and the market can get its arms around the scale of the downturn. This cycle, these stocks have struggled in the face of both fewer listings due to the growth of private equity and the surge in demand for the big global mega-cap technology stocks.

Now, valuations are historically extremely attractive, suggesting that a recession has likely already been fully priced in. From this perspective, the margin of safety has widened, making it an attractive area for investors to start chipping away. Meanwhile, several structural growth drivers, such as deglobalization and reshoring, coupled with a new industry growth policy, are spurring a greater domestic focus on economic activity. This could be beneficial to the more locally oriented small- and mid-cap stocks.

CF: Given the variety of mixed economic signals today, what factors should be considered when assessing the months ahead, and what is your outlook for the remainder of 2024?

RDC: It’s still a balancing act between what’s happening in the real economy (growth, inflation, and employment) and what’s taking place in the financial markets, with the Fed acting as the fulcrum between the two.

While the first half of the year has been good for economic growth and financial markets, there’s still room for volatility through the second half. Stronger economic performance and slower-than-hoped-for progress on inflation have raised doubts for some about the potential for rate cuts this year.

Meanwhile, geopolitical tensions remain elevated and could be exacerbated by the results of another contentious set of U.S. elections in November and other major elections around the globe, now including ones in both the U.K. and France in July.

We continue to see a soft landing as the base-case scenario, with the unemployment rate starting to inch higher and inflation still heading back toward 2.5% through the first half of 2025, and both by enough to give the Fed the confidence it needs to start lowering rates in September or November. Looking forward, we believe that this is an environment in which investors should be optimistic but, given the uncertainty, continue to pursue a nimble and active approach to portfolio management and construction.