Midyear Outlook 2024

The sticky U.S. inflation rate probably will end 2024 higher than anticipated when the year began. A strong labor market and higher oil prices support higher U.S. inflation, while a stronger U.S. dollar could help offset some of the upward pressure via lower import costs. With the Fed now holding past June, higher interest rates should keep inflation uncertainty low for the rest of 2024.

Internationally, we expect much faster progress toward inflation targets. With headline inflation of about 2.4%, the eurozone is already quite close. The U.K., though, has some work to do with inflation still considerably above the target level of 2%. We expect to see more improvement toward the target soon. China is already undershooting on the prices side, and its consumer price indicators will likely turn negative again this summer. This will lead to monetary policy divergence (differing monetary policies adopted by the world’s most systemically important central banks) for 2024’s second half.

The first half provided a precursor of what the second half will likely bring. While U.S. and international growth should slow, the speed of adjustment will be much faster in international markets. In the U.S., company earnings, retail sales, and jobs have remained strong, supporting the economy, but tightening financial conditions—partly due to higher real rates and weakening external demand—could lead real U.S. growth to stabilize between 1.5–2.5%. Outside the U.S., weakness will be the trend. Cautious consumers are spending less and saving more. Manufacturing and labor have been weakening. The lack of fiscal and monetary stimuli will keep Europe’s real growth rate close to 0%. Regarding China, we’ve observed that underneath the country’s growth data, domestic weakness is being offset by cheap exports.

We see two main risks markets face in the second half

While the macro outlook looks conducive for asset prices over the coming months, there’s always a risk of uncertainties— unplanned events that might take a meaningful toll on markets. From our perspective, two main concerns in this category are the uncertain impact of November’s U.S. elections on markets and the potential for increasing geopolitical risk primarily in the Middle East.

The U.S. presidential election is almost certain to be a pivotal event for markets. Irrespective of the outcome, equities and commodities historically have struggled with higher political uncertainty while higher-quality bonds, like government bonds and corporate bonds, have fared better (Figure 2). This is true for both U.S. and global asset prices as the significance of this U.S. event has the potential to affect global sentiment.

Geopolitical risk in the Middle East rose markedly in the first half of 2024, raising the prospect that Iran could engage militarily with Israel or another country at the same time that Russia continues its war in Ukraine. We expect this risk to remain high throughout 2024—we see no signs that the rising tensions will abate soon. While the potential for any negative impact is highest in commodity markets, it’s also possible the Western world could experience higher inflation as a result.

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Can income still drive outcomes?

GEORGE BORY, CFA
Chief Investment Strategist, Fixed Income

Bond investors can continue managing risk by using the three basic principles we identified at the start of 2024:

1. Diversify Spread duration across different yield curves in an effort to maximize income and capture return potential.
2. Prioritize Diversify across sectors and securities to remain nimble.
3. Be intentional with Use high nominal and real yields to pursue durable, inflation-beating cash flows over multiple years.

These principles are just as relevant in June as they were six months ago, and they’re likely to remain so over the rest of 2024 and into 2025. The global macroeconomic backdrop as of mid-2024 is a mix of diverging front-end interest rates, uneven growth, and sticky inflation across many jurisdictions (Figure 1). Elevated yields and tight credit spreads should persist in these conditions (Figure 2). Big policy shifts in the second half will likely include broader central bank inflation targets and political volatility.

Fixed income investors should expect further progress in 2024 along the path of interest rate normalization as policymakers worldwide navigate the shifting landscape. Prudently financed public- and private-sector borrowers possess considerable advantages in this environment. Highly indebted entities will face real pressure—or even solvency issues—due to higher borrowing costs and tighter financial conditions. Identifying the winners and losers will be paramount to capture attractive absolute and relative returns in bond portfolios over the coming years.

In this environment, consider the following actions we believe will benefit fixed income portfolios over the coming months:

1. FOCUS ON THE FRONT END

Adding duration at the front end of yield curves will likely steepen and/or “twist” as yield curves normalize in the second half of 2024.

We favor duration in Europe and emerging economies, neutral positioning in the U.S., and underweighting Japan.

Ultrashort and short-duration strategies coupled with a high-income yield advantage should perform for taxable, tax-exempt, and global bond investors.

2. EMPLOY MULTI-SECTOR STRATEGIES

Multi-sector debt strategies that include the plus parts of the bond market should allow investors to capture positive real yield while also layering in some protection against unexpected bouts of volatility and/or an economic hard landing.

Incremental yield at the front end of yield curves—by going down the rating spectrum, up to and including high yield, coupled with high-quality duration at the long end and structured products and mortgage-backed securities (MBS) in the intermediate part of the curve—provides an attractive blend of diversified duration.

3. MAINTAIN A HIGH-QUALITY BIAS

Bond strategies tracking the core of the taxable and tax-exempt bond markets offer a high-quality bias and mid-market duration that should provide stable cash flows and protection against an economic hard landing.

Structured cash flows in asset-backed securities, MBS, and other structured products can help investors diversify cyclical risk that’s inherent in single-issuer corporate credit and provide precise risk exposure.

Tax-exempt municipal debt in the U.S. also allows bond investors to move up in quality and de-emphasize cyclical exposure.

Global climate transition strategies could also perform well while pursuing carbon-reduction strategies at the same time.

Income can drive desirable outcomes

With nominal yields still close to multidecade highs, bonds have continued to deliver value. Further, breakeven inflation rates imply attractive real yields across several jurisdictions and sectors.

Within sectors, price/yield/spread dispersions across sectors, issuers, and securities remain wide, which we believe should benefit investors who can monetize security selection and reduce dependence on large macro or directional positions.

What are the major risks to this bond-friendly environment? We’ve identified the following: possible central bank policy errors, U.S. elections in November 2024, and potential military escalations in the Middle East and/or Eastern Europe.

In today’s market, most bonds are doing exactly what they’re designed to do: generating consistent, predictable cash flows that we believe should beat inflation over time. These cash flows can anchor a well-diversified investment portfolio. Furthermore, the prospect of political upheaval only strengthens the argument. Opportunities to “ride the curve” and capture these investments can be built into a wide array of fixed income portfolios across different maturities, sectors, regions, tax statuses, and currencies.

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Are you taking stock of quality and valuations?

ANN MILETTI
Head of Active Equity & Chief Diversity Officer

At the start of 2024, we said investors should consider owning quality stocks given the ongoing paradigm shift of monetary policy and lack of tailwinds supporting lower-quality businesses. So far, the market has largely agreed, and we remain steadfast in supporting this approach for the balance of 2024.

However, let’s step outside the shadow of an intangible concept—quality—and bring some sunshine in by providing several concrete examples of how quality can be perceived and applied in this industry.

A company’s value is based on the cash flow it produces, and the stock market represents investors’ expectations for the company’s future cash flows. These seem irrefutable, but what an investor believes affects these future cash flows has a material impact on how that investor defines what to look for in a quality business. The definition may change as investors move through an economic cycle, digest different regional opportunities, or reflect on the characteristics of the specific investable universe(s) in which they’ve focused their investments.

Importantly, as asset owners, investors should make the effort to learn what different investment teams specifically mean when they say they own quality businesses. To illustrate this concept, we’ve compiled the table below, which shows how three Allspring teams that invest in different equity categories define what a quality business means to their team.

Look for quality and attractive pricing in small and mid caps

Notice that none of the teams’ quality criteria mention a business’s size, as there’s no need to sacrifice quality when moving down in market cap. That’s especially beneficial in an environment like today’s, where, relative to large caps, small caps and mid caps are undervalued. Their attractive valuations mean investors are being compensated to move down in market cap.

While it’s challenging to predict when small and mid caps could revert back toward their average longer-term prices, we think the fading exuberance around the large-cap artificial intelligence theme is as good a catalyst as any to point out the current valuation dispersion, as seen in Figure 1.

The rewards of deciding to invest more in small- or mid-cap stocks could likely be amplified by choosing active managers who’ve proven themselves adept at exploiting the inefficiencies of the small-/mid-cap universe. But for over 15 years, many investors have chosen instead to buy broad market exposure through passive indexes. Passive indexes, though, hold the good, the bad, and the ugly—which means significant portions of those purchases were in low-quality stocks.

In a perfect investing world—where all economies regularly fire on all cylinders and central banks consistently pump just the right amount of liquidity into their systems—passive investing could be a winning approach. But we know this isn’t the case at all times, and certainly not today.

Emerging markets offer opportunities for discerning investors

Looking outside the U.S., there’s an additional level of complexity (and thus opportunity) for investors. The emerging market category has long underperformed developed markets, resulting in some investor fatigue for the category. However, perhaps the tide is beginning to turn—and those who consider investing in emerging markets will see that the category currently is significantly discounted relative to developed markets, as shown in Figure 2. Also, they’ll likely find that having to grapple with the geopolitical, economic, currency, and fiscal variables within emerging markets underscores the value a quality investment manager can deliver through constant monitoring and risk management.

We understand that uncertainty and volatility frequently appear—and critical investment decisions must be made with the goal of maximizing risk-adjusted returns in the face of shifting environments.

This is today’s environment. In the U.S., for example, the Federal Reserve has been confronting a lukewarm economy and stubbornly high inflation. Consumers have shown tremendous resilience, but their stamina has been fading. This type of fluctuation is the norm, and it’s why active investment managers recognize the need to dig into the fundamentals of each business they’re considering. Active managers want to understand where each company resides within their team’s definition of quality and how the company may successfully navigate today’s environment and the possible shifts ahead.

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CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

The “Magnificent 7” is a group composed of these seven market-leading, mega-cap stocks in the S&P 500 Index: Nvidia Corp.; Meta Platforms, Inc.; Tesla, Inc.; Amazon.com, Inc.; Alphabet Inc.; Microsoft Corp.; and Apple Inc.

The Bloomberg Global Aggregate Bond Index is a measure of global investment-grade debt performance. This multicurrency benchmark includes Treasury, government-related, corporate, and securitized fixed-rate bonds from both developed and emerging market issuers. You cannot invest directly in an index.

The Bloomberg Commodity Total Return Index is an index that tracks the performance of futures contracts on commodities and adds the returns from investing in U.S. Treasury Bills. You cannot invest directly in an index.

The MSCI World ex USA Index captures large- and mid-cap representation across 22 of 23 developed markets countries—excluding the United States. With 1,022 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. You cannot invest directly in an index.

The Bloomberg U.S. Large Cap Total Return Index is a float market-cap-weighted benchmark of the 500 most highly capitalized U.S. companies. You cannot invest directly in an index.

The Bloomberg Global Aggregate Bond ex-U.S. Dollar Total Return Index is a measure of investment grade debt from 24 local currency markets. This multi-currency benchmark includes treasury, government- related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. You cannot invest directly in an index.

The Bloomberg U.S. Corporate High Yield Total Return Index measures the U.S. dollar-denominated, HY, fixed-rate corporate bond market. You cannot invest directly in an index.

The Bloomberg 10-Year U.S. Treasury Bellwethers Index is a universe of Treasury bonds and used as a benchmark against the market for long-term maturity fixed-income securities. The index assumes reinvestment of all distributions and interest payments. You cannot invest directly in an index.

The Bloomberg U.S. Corporate Bond Total Return Index measures the investment grade, fixed-rate, taxable corporate bond market. You cannot invest directly in an index. The MSCI Emerging Markets Investable Market Index (IMI) captures large, mid and small cap representation across 24 Emerging Markets (EM) countries. With 2,669 constituents, the index covers approximately 99% of the free float-adjusted market capitalization in each country. You cannot invest directly in an index.

The MSCI World Index captures large and mid-cap representation across 23 Developed Markets countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country. You cannot invest directly in an index.

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. You cannot invest directly in an index.

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index. You cannot invest directly in an index.

The Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000® Index, which represent approximately 25% of the total market capitalization of the Russell 1000 Index. You cannot invest directly in an index.

Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. Allspring Global InvestmentsTM is the trade name for the asset management firms of Allspring Global Investments Holdings, LLC, a holding company indirectly owned by certain private funds of GTCR LLC and Reverence Capital Partners, L.P. These firms include but are not limited to Allspring Global Investments, LLC, and Allspring Funds Management, LLC. Certain products managed by Allspring entities are distributed by Allspring Funds Distributor, LLC (a broker-dealer and Member FINRA/SIPC).

This material is for general informational and educational purposes only and is NOT intended to provide investment advice or a recommendation of any kind—including a recommendation for any specific investment, strategy, or plan.

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