What should asset allocations look like going forward?

Equities keep breaking records. Perhaps that’s US equities in particular, but the somewhat improbable run by the S&P 500 and the Dow Jones has maintained its pace through recent months. That rise has given investors an attractive level of return, but left them wondering what to do when equities are expensive and fixed income markets seem tied to the cloudy course of interest rate policy.

Som Priestley spends his days managing this exact quandary for investors. The head of multi-asset solutions for North America at T. Rowe Price oversees broad asset allocation strategies. He explained some of his team’s outlook going into 2024 and how that outlook has shifted over the course of the year so far. He explained where he sees opportunity in the face of an expensive equity market and an unclear fixed income environment. He drove home that as asset managers look at their broad 60/40 allocations, current circumstances dictate certain underweights and overweights.

“We came into the year overweight equities and we remained there,” Priestley says. “A lot of that has been based on the idea of a fading recession risk [in the US] and the incremental benefit of AI. I think that AI benefit and spend can be underappreciated unless you’re living in the market. We’ve had sort of a slow, modest growth environment but on the other side we’ve had some to the biggest companies in the world continuing to spend on AI, not just to defend their businesses, but also to continue to grow and win.

“You’ve had an economic environment tell you modest growth, modest recovery, small caps and value stocks. And then growth stocks have been telling you that things are incredible.”

That contrast, and the shocking runs of mega-cap stocks, informs Priestley’s overweight to equities. While he is underweight fixed income, within that broad category he says that his team is underweight duration and overweight credit. That’s because he sees persistent inflation as a greater risk than recession. Where a recession would impact corporate debt in the credit market, continued inflation would keep bond prices low and the yield curve may well stay inverted.

Can AI keep driving equity returns?

The AI story in equities, Priestley says, is more a question of AI spend than AI progress as of now. While some AI software stocks have been hit by disappointing rollouts or launches, there’s a reason that Nvidia — a semiconductor company — has been the darling of this AI boom in equities. AI infrastructure, the technological roads and bridges that software companies need to spend on, is the first winner of this boom. Priestley notes that other areas like copper prices and utilities stocks have risen as investors digest the energy demands all this computational power will put on grids.

Even as equities make their remarkable runs, in large part powered by AI-related stocks, Priestley says he is seeing some growing differentiation. Where in past quarters the macro story lifted markets broadly, and certainly lifted AI-related stocks in unison, Priestley says that now asset managers can benefit from stock-specific selections.

In addition to AI, Priestley sees some tailwinds coming from GLP-1 drugs and the healthcare companies with these drugs in their portfolios. He continues to be bullish on energy as well as some recovery in the Chinese economy.

The great risk in equities, as Priestley sees it, is if growth doesn’t start to broaden out beyond the select mega-cap stocks that have been beneficiaries of the AI trend, GLP-1 drugs, or other major narratives. He expects, however, that those growth names will start to see tougher comps while value stocks will get more favourable treatment from investors.

Fixed income at a crossroads

While the story for equities has been largely rosy, fixed income has come with more challenges. Priestley says, somewhat tongue in cheek, that the lack of US Federal Reserve rate cuts in line with expectations has complicated the picture for fixed income investors. As US inflation and GDP growth remain higher than expected, the predicted schedule for rate cuts has been revised downwards, adding volatility to the bond market. Priestley doesn’t expect normalization to come until we have greater clarity into when and how deeply the Fed will cut.

Inflation, Priestley says, is now a greater risk than a recession. That outlook is less positive for bonds, but more positive for credit or corporate debt. He advocates for an overweight to credit for two reasons. One is to hedge against that inflation risk. The second is because he sees greater opportunities. Spreads may be tight in credit, but he sees a nice carry on trade in credit products with higher yields on floating rates.

Overall, Priestley’s view is informed by an outlook on the US economy as a whole. He believes that in current circumstances, the asset mix outlook favours equities over fixed income.

“I think what really matters is whether you view the biggest risk as economic weakness or inflation,” Priestley says. “In a situation where you have elevated inflation, that benefits equities because nominal earnings tend to go up. Whereas for bonds, inflation is your enemy. On the other side, if you see economic weakness as your bigger risk then fixed income is where you want to position yourself. But I think we’ve seen the market struggle over the last year as recession risks have come off the table and equity markets have stayed resilient and benefitted from sticky inflation.”