To present Parametric’s views on the investing environment in 2024, I canvassed my colleagues for their insights on topics of particular interest to institutions. Here’s what we think matters most to institutional investors this year.
Interest rates may be higher for longer than investors think
With the market pricing in several Federal Reserve rate cuts over the course of 2024, it’s not a stretch to state that we believe short-term rates have peaked. Over the past several decades, the 12-month period following the final Fed rate hike has produced attractive corporate and municipal bond returns for opportunistic investors—with the greatest benefit typically going to those who have acted early.
Yet the most recent consumer price index (CPI) print remained stubbornly above the Fed’s 2% target, suggesting a potential moderation of cuts. That means the now ubiquitous phrase “higher-for-longer” may be around for longer than investors think.
When investors plan to increase overall allocations to fixed income, we’ve seen several lean into the Treasury market for this exposure while credit spreads remain tight. We’ve encouraged investors seeking additional credit exposure to consider investments in intermediate duration and laddering strategies, given the current shape of the interest rate curve in light of the market’s rate cut expectations this year.
Expectations of upcoming rate cuts, combined with increased fixed income allocations, have increased investors’ sensitivity to potential underweights to their benchmark duration. That may lead some investors to employ duration extension and completion overlays, which are designed to help offset or mitigate any potential shortfall to the target.
Equity diversification is still a prudent approach for patient investors
No one needs to be reminded how significantly the “Magnificent Seven” stocks contributed to overall equity index returns in 2023. Those who were underexposed to these names paid a potentially heavy penalty in the game of active management.
Five of these seven are in just two GICS sectors—Apple, Microsoft and Nvidia in Information Technology, Amazon and Tesla in Consumer Discretionary—that now carry sector P/E ratios relative to the S&P 500®’s P/E in the top quartile of the historical 30-year relative P/E distribution. Meanwhile, six of the 11 GICS sectors have relative P/E ratios in the bottom quartile—with two in the bottom 5%—and the other three are near their long-term averages.
We highlight the disparity in relative sector P/E valuation to underscore the importance of diversification. We’re fielding more investor questions about equity index concentration at both individual stock and sector levels. After periods like this when just a few stocks have driven strong benchmark returns, we’ve often observed a convergence of those names with the rest of the pack. Parametric’s methodology views diversification as a prudent, time-tested approach, with the potential to reward patient investors.
For more evidence of the lack of diversification, consider that the historically low to negative correlation between stocks and bonds has steadily increased over the past two years, with the correlation between monthly returns of the S&P 500® and the Bloomberg Aggregate Index up sharply from basically 0 to nearly 0.70 in late 2023. Allocating to traditional fixed income hasn’t been providing the “free lunch” investors used to enjoy, further underscoring the need to seek diversification within equities.
Volatility could increase if both rate and equity markets surprise to the downside
Amid a surprisingly tepid volatility environment, market expectations of future short-term volatility decreased steadily in 2023, with the VIX Index reaching levels not seen since before the Covid pandemic. As inflation cooled and the Fed neared its peak policy rate, investors may have become more comfortable about the relative direction of rates. At the same time, correlations across individual equities dropped, lowering overall index volatility.
Two significant contributors of uncertainty were thus muted, leaving expected volatility at multi-year lows. With hindsight as clear as ever, we’re not surprised at where the general level of equity risk ended the year.
But investors don’t care about what happened yesterday. It could be argued that on a go-forward basis, the consensus in both rate and equity markets is more apt to surprise to the downside. After all, inflation breakevens are pricing close to the Fed’s 2% target, while overall equity market valuations remain elevated.
For those who believe that the general level of risk is priced too low, the current environment presents historically attractive levels for equity market hedges. Elevated short-term interest rates translate to higher forward prices, which in turn increase the relative pricing differential between similar tenor equity calls and puts. And that leads to historically “cheap” pricing for option-based protection structures like put-spread collars.
Systematic, rules-based strategies to enhance institutional portfolios
Commodities belong in a well-diversified portfolio
We expect investors to remain constructive on real assets, given that inflation continues to run stubbornly above 2%. The healthy labor market, resilient consumer demand and volatile geopolitical forces are likely to keep prices elevated. Investors may wish to consider adding broad exposure to commodities, which are known for their sensitivity to inflation. And thanks to their low correlation with traditional marketable asset classes, commodities may also serve as a source of portfolio diversification in the wake of converging stock-bond movements.
As the Fed has likely completed the rate hiking cycle, the US dollar may lose a key pillar of support in 2024. Then global buyers would pay less in local currencies to acquire the same raw inputs, which could prove a tailwind to commodity prices and further stoke potential demand.
The need for rare earth elements and other metals to support the global transition to renewable energy has been well documented. Yet the International Atomic Energy Agency (IAEA) continues to forecast increasing demand for fossil fuels. Ongoing turmoil in oil-rich regions has the potential to trigger short-term upward price shocks. Though many investors have sought to reduce their exposure to fossil fuels, we think it might make sense to maintain exposure given possible volatility within the global energy complex.
Pension risk management strategies can help to preserve funded status
Exceptionally strong equity market returns and somewhat stable interest rates in 2023 pushed pension funded status higher. For the second year in a row, the Milliman 100 Pension Funding Index finished above 100%, with 2022 and 2023 being two of only four years since 2000 that has happened. We would point out, however, that after 2000 and 2007, the other two years with funding above 100%, markets were not kind to the average pension plan.
While we are neither market prognosticators nor fortune tellers, we strongly believe that pension investors should consider increasing risk management strategies, if they aren’t already in place. If equity markets become challenged and rates fall dramatically, the result could be a double whammy for the typical pension. We feel that a better approach could be shoring up a liability hedging strategy and considering an explicit or implicit equity protection scheme.
Most pensions are closed—despite IBM’s recent announcement to reopen its pension—so pension management is increasingly a game of preserving and protecting what’s already there. In our experience, structuring and implementing risk management strategies during times of relative market calm has typically offered advantages in helping to meet that goal.
Liquidity and leverage strategies need to take prevailing rates and risk premia into account
Our institutional clients are increasingly seeking ways to boost returns on cash. The typical custodial short-term investment fund (STIF) vehicle tracks three-month Treasury Bills closely. But now that fees waived for years in the wake of the Fed’s Zero Interest Rate Policy have been re-instituted, investors are paying 10 to 15 basis points on average for money market returns, which isn’t overly attractive.
Expanding the toolkit and structure of cash holdings has the potential to offer opportunities to increase the expected return. Among the interesting strategies remaining in place for the next year, we expect to see US Treasury Bill ladders, repo facilities, equity funding trades and even option box spreads—all strategies that could possibly allow investors to add meaningful incremental return to their cash allocations.
While some investors have the luxury of worrying about where to park excess cash, others are struggling with how to increase overall portfolio liquidity given growing private market allocations. One approach to consider is replacing physical public market allocations with equivalent synthetic exposure. This strategy immediately improves fund liquidity, while giving investors the ability to employ leverage either explicitly—for example, a 10% total portfolio leverage target—or implicitly via strategies like portable alpha.
Speaking of leverage, we’ve also been fielding questions about the cost of using derivatives to gain market exposure. Synthetic instruments like futures and swaps carry an embedded financing cost approximately equal to short-term risk-free rates. When investors seek to add marketable exposure in excess of the cash or cash-like assets in their funds, they bear this financing cost. If short-term rates are so high, does using derivatives to gain market exposure make sense?
To answer that question, from an economic perspective, we can think of any investment as combining two return streams: the risk-free rate and the risk premium associated with it. Whenever an investor considers adding levered exposure to a specific asset class, that risk premium should determine the relative attractiveness of the investment. When viewed through this lens, it may make sense to consider using leverage, even in the context of higher rates.
The bottom line
Whatever the investing environment turns out to be this year, we believe institutions can always benefit from professional guidance to help them choose and implement solutions for fixed income, equity, commodity, liability, liquidity and leverage management that offer an appropriate balance of return and risk. We look forward to working with our institutional clients to enhance the value of their portfolios in 2024.
With contributions from Brian Barney and Dane Fickel on interest rates, Perry Li on equities and volatility, Greg Liebl and Adam Swinney on commodities, Dane Fickel and Ben Hood on liquidity and leverage.
