Episode 19 – Headwinds And Tailwinds for the Year Ahead

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Welcome to Market Perspectives, a Mercer Advisors podcast. Today’s episode is headwinds and tailwinds for the year ahead. And we’re going to be taking stock of where financial markets are in this moment and where we think they’re going. We’re a month into the year, and it’s a good time to look at what might be in store for the year ahead. I’m Josh Zumbrun. I’m the Director of External Communications here at Mercer Advisors, and I’m joined by Don Calcagni, our Chief Investment Officer. Don, thanks for being here.

Josh, it’s great to be here. Thank you.

So we’re going to take a minute to catch our breath, put the current market in context. As investors, we’re often so caught up in whatever the latest change was that we lose track of where things are. So first, let’s just take a look at the stock market. The S&P 500 is a little bit over 6,000 right now.

Don put these numbers in context for us–

the run up we’ve seen over the past year in equity markets.

Yeah, I mean, Josh, we’ve seen–

really over the past several years, we’ve seen some really amazing blockbuster returns in US equities. Last year, the S&P 500 index was up 25%. The year before that, it was up significantly as well. In fact, if you look at the S&P over the last four years, it was positive in three of the past four years, delivering an average annualized return of 13.6%

over the past four years. So we’ve really seen explosive growth. A lot of that is attributable to what we call the Magnificent Seven. These AI technology-oriented stocks like NVIDIA that I’m sure all of our listeners have heard of at this point. So yeah, it’s really been an AI-fueled boom here over the past couple of years.

When we look at the sectors driving the market, is that what we see, that it’s been disproportionately the tech companies and the companies that are in this space?

Certainly very disproportionately. In fact, if we just step back for a moment, Josh, and we look at the S&P 500 index in terms of its capitalization, about 40% of the entire S&P 500 index consists only of about seven companies. These Magnificent Seven–

your Microsofts, your Teslas, your NVIDIA’s, companies like that, Alphabet. And when we look at the actual returns that have been generated within the S&P 500 index, just looking at last year, for example, about 55% of the entire gain of the S&P 500 index was attributable to just those seven stocks.

In fact, the Magnificent Seven, those companies were actually positive 48% last year. The rest of the S&P 500 index, the other 493 companies, let’s call them, were positive about 10%. So we still saw great returns. It’s just that those seven companies, given their profit margins, given their growth prospects, given the CapEx investments that they’re making in AI, have really pulled the market substantially higher. But those are really the heroes of the market at the moment.

That’s remarkable. 493 companies, or only 60% of the index. Have we ever seen that degree of concentration in the S&P 500?

Frankly, no. Last time we saw concentration this high, you really have to go back to the early 1900s. The days of Standard Oil Company and all of the trust busting that had to occur back then to demonopolize the market. So it has been a very long time, probably well over 100 years since we’ve seen this level of concentration.

One of the big questions, whenever a small group of companies is up this high is like, are valuations getting stretched? What should we be watching for whether this is a little too much too fast?

Valuations are certainly stretched. And it’s one of the things that–

the entire investment team here, we spend a lot of time fixated on valuations.

The higher the valuation, the more we’re paying to enter a position. It’s harder for those companies to deliver outsized returns to investors. When we look at the Magnificent Seven, for example, or just the growthiest stocks in the S&P 500, they’re trading at about two times the same valuation of value stocks. Think of your energy companies, your financials. Those companies generally are trading at somewhere around 14, 15 times earnings, whereas these high-growth, tech-oriented companies are trading at 30, 35, or 40 times earnings. That’s very, very high. And so that is a concern.

Now to be fair, putting aside those high valuations for a moment, those high valuations may be justified when you look at the earnings growth that these companies have been delivering. When you look at their profit margins that they are delivering to shareholders, those companies I think legitimately, you could argue, should be priced at a premium relative to other companies in the market that have humbler prospects. But valuation is always something you have to pay attention to, Josh.

The way I think about this is markets always have what I call headwinds and tailwinds. A headwind heading into 2025 is that valuations are far above their historical average, which has been about 16 times earnings for the S&P. The S&P currently trades at 22 times earnings. So certainly a premium relative to its history. So that’s going to be a headwind. That’s going to be tough. Investors markets are going to have to overcome those high valuations.

The tailwind that’s pushing markets higher is the earnings growth the prospect for lower interest rates heading into the year. There’s also some big policy changes coming out of Washington, perhaps deregulation, perhaps lower taxes, lower corporate taxes. All of those things are a tailwind that could help push equity prices higher in the year ahead.

We’ve been talking about US equities there really. But what’s the outlook internationally for most investors? We’ve got a little bit of our portfolio in US. But we’ve also got a little bit international equity. What are you watching on that side?

When you look at the valuation of non-US companies, they’re trading at about 13 times earnings. Compare that to the S&P 500, which trades at 22 times earnings. You can see that they trade at a substantial discount relative to their US counterparts. Now there’s reasons for that.

Non-US markets have their own headwinds that they’re contending with–

the war in Europe, challenges in China which have had a ripple effect throughout the emerging markets. So there’s certainly headwinds that non-US markets are dealing with at the moment.

There’s story, Josh, of the past year with non-US equities has really been currency. It’s been a currency effect that has really hurt non-u.s. returns. The US dollar has risen dramatically relative to non-US currencies, and that acts as a headwind for earning returns in those markets. Now, Josh, if we just look at the past month, the truth is European stocks have significantly outperformed US stocks, so these things could change very quickly.

We’ve seen European stocks outperform US stocks by about 5% just in the first month of this year. So we think there’s opportunity in non-US markets. We do think investors have to be prudent. We think it’s still important to be slightly overweight US stocks relative to non-US stocks. But in the year ahead those low valuations I do think are pretty attractive given where we’re at in US equity markets.

Some people have soured a little bit on international stocks over the past 20 years or so. International stocks had a few good years, but US stocks have really outperformed pretty good in recent years. We shouldn’t expect that to necessarily continue forever. It’s not the case that we really want to go too overweight US and ignore international.

Diversification is about owning things that you hate.

That’s just part of the reality of the game. If you’re always chasing yesterdays winners when you build a portfolio, you’re going to be pretty disappointed when you just look at market history, so you don’t want to avoid these companies that are out of favor. I’ll just give you some real world market data, Josh. I mean, if we just look at the first two decades of the 2000s. From 2000 to 2010, non-US equities significantly outperformed US stocks. At the end of 2009, if we were having this conversation, you would be saying, people Don have really soured on US stocks. Why should we own US stocks?

Let’s go all international.

Let’s go all non-US. And so over the past decade, 12, 13 years, we’ve seen the opposite. These are just long cycles in my view. And so I think for long-term investors that’s what we need to look at.

We need to look at the long-term return patterns that we observe in markets. We think that valuations matter. For income-oriented investors, non-US equities pay substantially higher dividends than non-US equities. So I think it depends on the investor profile in terms of who really should be owning those non-US equities, but valuation is always important, and I think that’s something that there will come a time when US valuations will probably correct a bit and we will see more capital flow back into those non-US assets at some point.

The other story here, Josh, that I would just highlight, is that one of the reasons we’ve seen the US market outperform so dramatically relative to non-US markets is that the US market is more heavily overweight technology. We have more of the world’s technology companies. So a lot of this outperformance starts to go away after you adjust for the heavy technology concentration that we see in US markets.

Now, we’re thinking through the components of our portfolio. So we’ve talked about our equities. The next building block of a lot of portfolios is going to be our fixed income. What do you see going on with interest rates right now?

It’s been an interesting moment. The Federal Reserve started cutting short-term interest rates in the fall. They’ve cut a percentage point and longer term yields have actually gone up over this same time period, in fact, up almost a percentage point on the 10-year treasury. What should we know about the state of fixed income markets right now.

And this pattern we’re seeing of lower short-term rates but higher long-term rates?

I mean, I’d say a couple of things. I mean, first off, I always like to begin with the Fed. The Fed is–

the US Central Bank ultimately–

if not directly, certainly indirectly–

influences interest rates and really the cost of capital the world over. The US Central Bank is currently on a downward trajectory in terms of cutting interest rates. Like you said, we saw some pretty outsized rate cuts last fall. The Federal Reserve is actually forecasting that they themselves will cut interest rates here in the year ahead.

They’re not in a rush to do that. They’re taking their time. They’re paying close attention to the data, paying close attention to inflation.

Naturally, we have a pretty significant policy regime change in Washington. I think the Federal Reserve has to pay close attention to that to see how those changes are going to influence interest rates and the economy as a whole. But to be just high level directionally, it looks like the trend going forward for interest rates is down. Now, why is that important?

That’s important because if indeed that comes to pass all things equal, that pushes up bond prices. And so if you’re a bond investor, you have an allocation to bonds in your portfolio, declining interest rates should push up the overall value of the bond part of your portfolio. So that’s a good thing. We’re starting at a place today, Josh, where interest rates are, even though they’ve come down a bit from where they were last year, they’re still significantly higher than where they were really over the past decade prior to the Fed rate increases that began in March of 2022.

And so today, nowadays, investors are still earning something on their fixed income. That’s good. The two-year treasury is paying about 4 and 1/4. Investment grade is paying about 5.3,

when I say investment grade, I mean, investment grade corporate bonds paying about 5.3. And when you look at high-yield bonds, depending on your duration, you’re going to get somewhere between 6.5 and 7 and quarter. So these are good positive yields.

I mean for mean, for those of us who’ve been in the market a long time, it’s been a long time since we’ve seen some healthy positive interest rates.

But having healthy positive interest rates is an important starting point when you’re heading into what we expect to be a declining rate environment. And if indeed the Fed delivers on that, that should be a nice tailwind for the bond side of our portfolio. Now, what could be a headwind for the bond side of the portfolio? Well, we’re seeing pretty significant regime change in Washington that could have an influence on interest rates, tariffs, the ballooning federal deficit. I think right about 36 trillion now in federal debt. These are serious challenges that we have to pay very close attention to as bond investors.

And new administration has certainly made it a priority to try to bring down the ballooning deficit. That would be good for bond investors as a whole. But whether or not they can actually bridge that gap, I think really remains to be seen. So that could be a headwind for bond markets depending on what happens in Washington.

Yeah, a lot of focus on cutting expenses, but whether or not it translates into lower deficits also depends on the revenue side of the equation. So the deficit is really a big question still.

It certainly is. And while I think we should always aggressively try to cut any wasteful spending or anything like that, I think the reality is when you look at the federal budget, Josh, it’s going to be really hard to bring the deficit down meaningfully without touching entitlements and defense spending. Those are the biggest parts of the federal budget. Certainly, many of our citizens hold those up as sacred and certainly do not want to touch those very cherished programs.

And I totally understand that. So bridging that gap will be a challenge, especially if it’s our intent to bring down corporate and individual income taxes. That’s only going to make bridging that deficit that much more difficult. Which my point is tying this back to bond investing, that’s going to be a headwind for bond investors going forward if we cannot get our debt under control.

Now let’s talk about for many investors, we’re believers that there’s a big benefit to having an allocation to private markets. It’s the third big building block in terms of asset allocation. You’ve got your public equities, you’ve got fixed income, and then you have a private market allocation. What have been the big picture trends in private markets the last couple of years that we ought to keep in mind?

I think the reality is over the past several years, if we go back to before the Fed began raising interest rates, we really saw really a record of capital being allocated to private markets. And so a lot of that capital was raised. A lot of that capital has been deployed. A lot of that was deployed when rates were close to zero. And what that means is they were actually paying premium valuations for a lot of the portfolio companies in those funds. And so I do think your 2020, your 2021, early 2022 vintage funds for private equity for venture are not going to be very good. They actually paid very, very high valuations for the companies in their portfolios.

Because rates were so low, naturally in March of 2022 and throughout 2022 and into 2023, the Fed raised interest rates quite substantially that really forced a reset for company valuations. The days of cheap leverage, the days of basically free money were over and are over. And so that’s forcing a lot of companies to be more judicious with allocating capital. They’re getting better prices, better entry points naturally because valuations have come down.

But what it also means is that those earlier vintage funds that are holding on to portfolio companies. It’s harder for them to exit. They paid premium valuations. They certainly don’t want to exit those companies today at lower valuations. And so for that reason, we’re not seeing the distributions out of those earlier vintage-year vehicles to limited partners. And so there’s been a lot of frustration in the LP community because they’re not seeing that return of capital that they would have expected at this point in their respective fund life cycles.

Now, does that mean that we should not be considering private markets going forward? No, we absolutely should. In fact, I would argue now is a better time to consider allocating to private markets than it was several years ago when valuations were pretty high. Look, anyone allocating to private markets really need to have a very long-term horizon. You’re not day-trading ETFs when you’re investing in private equity or venture capital.

These are 10 to 15-year investment cycles for those investors who are in search of higher expected returns. We do see in the real world, when you look at the actual data, significant outperformance for private equity, just as an asset class. I’m not even talking about specific managers top quartile versus bottom quartile. I’m just talking about the asset class broadly has significantly outperformed public markets to the tune of 400 to 600 basis points on a per year basis. So that’s pretty significant. So I think the investment thesis is really solid for long-term investors.

For those who are looking at something like private credit or direct lending, I think there’s an opportunity there to earn higher yields. Those funds deploy leverage. You can get somewhere between 8, 9, 10, 11% in private markets in private credit that I think is pretty attractive for investors. So I think the long-term investment thesis still very much intact for investors who are allocating to those asset classes.

There’s two big reasons that you think about a private market allocation. One is that potential for higher returns and the other is just like the diversification benefit of it. It’s a way to get access much closer to what’s going on in the economy. How would you say these investments have held up from the standpoint of diversification?

Measuring diversification in private markets is admittedly always a little challenging using traditional metrics. Here’s what I would say. The reality remains that most investors do not require full liquidity in their investment portfolios. They certainly need some and perhaps even a lot. But it’s rare that an investor is going to consume their entire portfolio over a 10 to 15-year time horizon. So just from a liquidity perspective, it makes sense to take part of the portfolio and invest it in illiquid, longer term assets that have much higher expected returns. That could really help fuel the growth in the broader balance sheet over time and really help investors outperform inflation.

But, Josh, when we actually look at more traditional metrics that asset managers use, things like sharpe ratios and correlations, what we observe is that private markets are a powerful diversifier to portfolios that consist exclusively of publicly traded stocks and bonds. And for example, if you look at private credit as an asset class has a correlation to the broad market of only about 0.6. So that’s very powerful. That tells you that’s a very powerful diversifier for portfolios consisting exclusively of just publicly traded stocks and bonds.

To take it a few steps further, when you think of private equity, when you think of venture, what you’re actually doing, and you said it best, you’re actually investing now in the total economy. You’re getting away from markets that tend to be very dominated by these top seven or 10 companies that we were referencing earlier. And now you’re investing in really the innovation that’s driving the global economy forward. And so I think investing in private equity and venture is giving you exposure to some of the best thinking that’s happening in the marketplace in terms of technology and innovation, and so on, and so forth. So having a small slice of that in a more broadly diversified portfolio. We think makes just good sense.

So to sum this up, I mean, the reason we take stock of what’s happening in all these different markets is to stress test the way designed our portfolios. We’re continually asking, do we have the right approach? Does it still make sense to have these allocations? And so when you look at the current environment with what we just discussed about equities, fixed income, private markets, what do you see as the takeaway for investors? Are there strategies that we shift here, or where do our strategies stay the same as they’ve always been?

I think the takeaways for investors are several. Number one, when you look at markets, it’s very easy to quickly become fixated with what has done well in the recent past. We’re human. We get excited about these things.

But there’s a lot of danger in that. We need to keep our emotions in check. That fear of missing out on the next NVIDIA or Microsoft or Alphabet or whatever it is, that’s very dangerous. That could lead us down a path where we’re buying companies at very high valuations.

So I think number one is just take stock of the market and understand that every single asset class has its own combination of headwinds and tailwinds. There’s no such thing as an asset class or a company. That is a sure bet. Anyone who tells you it’s a sure bet doesn’t know what they’re talking about. So all of these asset classes, when you go through them and you look at what’s pushing them higher, what’s trying to push them lower, and you understand those forces, I think it’s humbling. It forces us to recognize that, OK, given the reality of the market, we should probably spread our bets across multiple asset classes, knowing full well that in the year ahead, we’re going to have some that don’t do well. And we’re going to have some that do amazingly well.

The challenge is knowing those in advance. If there’s anything we’ve observed about markets, Josh, in the 120 years of actual real-world market data that we have, it’s that trying to predict tomorrow’s winners and losers is exceptionally difficult. I would just argue it’s flat out impossible. And so for those reasons, you really want to diversify. And that’s my second point, is diversify broadly across markets across asset classes, but also within those asset classes.

Owning 5, 10, or even 25 stocks is not a diversified portfolio. We want to diversify globally across asset classes and within asset classes, and that really is the best way that financial science has identified for helping us to keep our capital. The return of our capital, I would argue, is typically more important than the return on our capital. Best way to ensure that is to diversify broadly.

Don, thanks so much for this discussion. It’s always great to walk through this with you.

Great, Josh. Thank you. It was great to be here.

If you’re already a Mercer advisors client, feel free to reach out to your advisor with any questions about your portfolio. And if you’re not a client but would like to learn more, visit our website, merceradvisors.com, set up a phone call with our team. Until next time, this is Market Perspectives.

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