Article

Fundamental Optimism:
Aperture’s 2024 Outlook

Among the many questions coming into 2023 were how persistent inflation would be, and how high (and for how long) the Federal Reserve would (“Fed”) keep interest rates elevated. The Fed maintained its hawkish rhetoric throughout most of the year though made a dovish shift and significant change in its monetary stance during the recent December Federal Open Market Committee (“FOMC”) meeting. Since peaking above 6%, the Core Consumer Price Index (CPI) remains elevated at 4% and only halfway to the Fed’s 2% inflation target. The longer it takes the Fed to restore inflation to reasonable levels, the harder it is to tame. The objective of the Fed’s recent, and very aggressive, monetary policy was to avoid price inflation from becoming systemic whereby consumers expect and, more importantly, accept higher prices. The Fed’s latest economic projections revealed a more optimistic outlook for inflation and sent a wave of elation through global markets.

Market participants have priced a “soft landing” with interest rate cuts in the first half of next year following signs of inflationary pressures abating. We have maintained our view that it would take three to four years to tame inflation (similar to the previous cycle length) since its multi-decade high in 2022. Drastic decreases in U.S. Treasury yields indicate investors expect inflation will get to ~2% and view the Fed following through on its “higher for longer” monetary policy stance as a low probability outcome. While we do expect the Fed to moderate rates in the second half of next year, we don’t expect they will fall precipitously. After more than a decade of unprecedented quantitative easing following the “Great Financial Crisis” (GFC) and the global pandemic, we expect that the Fed will look to normalize real rates back to the historical long-term averages (~2.5%) and not reintroduce “ZIRP” (zero-interest rate policy). 

We predicted a recession and poor equity performance in 2023, but the markets have a long history of humbling investors. The combination of easing monetary policy by the Fed, coupled with extreme fiscal spending in response to the global pandemic, made the long and lagged variable effects usually associated the higher interest rates of restrictive monetary policy more digestible for U.S. consumers and has done little to slow economic growth to this point. If not for the introduction of ChatGPT and resultant exuberance for “artificial intelligence” (AI) concentrated in a few stocks, along with GLP-1 phenomenon, it’s likely our prediction for lower U.S. equities would have held. Year to date through the first two weeks of November, the Dow was up 2% and the Russell 2000 was -2%, while the S&P500 was up 16% and NASDAQ was up 42%. Throughout the year, it has remained unclear whether earnings growth could outpace economic deceleration from monetary tightening. With consumers showing some fatigue and pricing power fading for many firms, the answer so far appears to be that it can’t, at least not for much longer.  Equity markets anticipated this, which is why through mid-November, Non-AI and GLP-1 stock indices were lackluster.

Nominal gains are moderating, and defaults are increasing (especially for overleveraged companies facing refinancing headwinds in the new year). If you strip out inflationary pricing, then we’re actually in negative territory for most companies. While the Fed’s tightening has engineered a soft landing so far, it’s not clear whether this equilibrium will endure. The market has so far digested the chip wars, trade wars, and real wars, yet a material change (positive or negative) in any of these conflicts will almost certainly affect the tenuous stability across markets. Change seems inevitable as countries around the world are gearing up for elections. In 2024, 80% of the countries in the MSCI World Index will have a significant election including India, Indonesia, Mexico, South Africa, Australia, and the United States.

MSCI World Index returns in the past 20 years have been very different under different interest rate regimes. From 2000-2015 annualized returns were 2.9%. In the last five years, ending 2020, returns were 12% annualized. The best five-year period from 2000-2005, 2005-2010, and 2010-2015 was the latter with 7.8% annualized. The most recent period paid significant dividends to levered (at low-interest cost) debt and equity. Alpha in liquid portfolios was less valuable given the high-level beta. Markets persistently mean revert. Beta in the next five years is far less likely to rival the past five (2015-2020). Alpha from concentrated, high tracking error, and capacity-constrained managers, will be sought out by allocators.

While it’s always a challenge to predict exactly how a new year will play out, I have asked Aperture Investors’ portfolio managers to share their insights and outlooks for the following markets. 


Equities Outlook: Fundamental Optimism

Uncertainty around inflation, monetary policy, and global growth lingers at a time when geopolitical tension rests on a razor’s edge. “We are sanguine about next year, despite what appears to be a tightening consumer. The government spending backdrop, despite the budget impasse, will continue to be a boon to the U.S. economy. I think parts of Europe are in a recession right now, and that could continue for another quarter or so. But I feel the U.S. can avoid a recession,” said Aperture’s International Equity Portfolio Manager, Bill Kornitzer. Aperture Equity Portfolio Managers are optimistic that corporate earnings and consumer strength should provide ballast for equities in 2024.

Looking at the earnings progression for U.S. large-cap stocks over the course of the past twelve months, an upward bias in earnings and estimates emerges. But most of it can be narrowly attributed to the so-called “Magnificent 7” (Alphabet, Nvidia, Tesla, Microsoft, Amazon, Meta, and Apple). These same stocks led last year’s stock market significantly lower and entered the year more attractively priced while hoarding billions of dollars in cash on their balance sheets. The latter of which also made them an attractive investment as investors flocked to safety during the regional bank crisis in March 2023. Cynics will point out that four out of the seven didn’t survive in the original film “Magnificent 7” after which this phrase was coined. That’s the market equivalent of not believing these names can continue to support current valuations. Earnings revisions for these companies (which have been robust) are likely to be softer going forward, putting pressure on the stock’ performance. When excluding these names from the S&P 500, there was little performance dispersion amongst large cap and small cap companies. We feel the stage is set for active management to benefit from the increased dispersion in fundamentals next year.

Investors are optimistic that inflation will continue its downward progression towards 2% without higher interest rates causing a recession culminating in the so-called “soft landing”. It’s a challenging feat for the Fed to manufacture a soft landing, and one has not been accomplished since the mid-1990s. Optimism for its potential has grown, and the market now anticipates the Fed cutting rates in the first half, if not the first quarter of next year. This will lower the cost of capital and improve corporations’ profitability. “My view is that ’we have experienced a rolling recession for some time as certain industry sub-sectors  experienced persistently weak demand, but we are not believers that we’re going to see a classic recession for the economy as a whole,” said Aperture’s U.S. Small Cap Equity Portfolio Manager, Brad McGill. “There’s so much focus on the health of the U.S. consumer right now,  but with historic levels of 30 year fixed rate mortgages and still healthy employment by most measures, the consumer is holding up.  That said when looking at corporate earnings progressions, there are many companies that have already seen massive declines in their bottom line. We’re actually in a bottoming process now and as rates and prices come down, we think we’re more likely to be in a recovery phase than a consumer malaise next year.”

Investors have redirected their focus to tangible sales, earnings, and cash flows. In this context, we consider small caps offer exceptional value vs. large caps, but selectivity is key. All in, interest level in the asset class is building. Brad McGill said, “There’s a recognition of the embedded value in this small cap asset class, and we believe it won’t take a lot to generate some truly outstanding absolute performance if you’re selective – prioritizing healthy balance sheets, competitive positionings, and pricing power.” When participation wanes in down markets, correlations tend to break down across the investable universe. During the recovery phase, we see true differentiation in terms of the haves and have nots within the constituents of an index such as the Russell 2000.

The proliferation of AI and machine learning is likely to expedite a digital transformation that has been underway for over a decade, creating what we believe to be a wealth of investment opportunities. With divergences growing between winners and losers, astute stock picking can drive investment alpha. This is salient in small caps as Brad McGill said, “We see small cap companies deploying Research & Development dollars to find AI-driven solutions. While there’s been hype around the large cap beneficiaries, what is interesting in the small cap space is how AI may level the playing field and create efficiencies in business operations and revenue opportunities. We’re just at the nascent stages of AI enhancing small cap companies and their opportunity sets.”  

In Asia, the People’s Bank of China is facing a very different set of circumstances. After the government announced an end to their Zero Covid policy, investors were very optimistic about its re-opening and what it would mean for global growth. Similar to the U.S. and other developed economies that shutdown during the height of the pandemic, upon re-opening, China’s pent up consumer spending focused on goods and services. Initial excitement has waned, and future growth expectations have reached some of their lowest levels in decades following its real estate collapse. Real estate has been one of the country’s largest economic drivers over the last 20 years. But now with more than sixty million empty apartments, that trend has reversed, and the economy looks over-levered.

“In China, we are finding opportunities from its market’s continued weakness, making stocks look downright cheap,” said Bill Kornitzer. “What’s changed from 20 years ago is that corporations, local governments, and the Chinese people have taken on a ton of debt to buy all this property. As the world spins and we go through near-shoring of manufacturing, China needs to push internal consumer consumption and encourage a paradigm shift from real estate to the local economy to drive the equity markets.”

Aperture’s Global Equity Portfolio Manager, Tom Tully, echoed much of this sentiment, “We believe it has good upside for next year, but its (China’s) economy will be in transition and take some time to get moving in the right direction.” He feels China has been slow and measured with deploying stimulus. Should it accelerate, it may work out quite well for the country and its investors. “If they don’t, I think it’s going to be a tough year given the U.S. market is likely to continue its rally and so much of what happens is driven by the U.S. market. At the end of the day, China will be a unique and interesting bright spot.”

In Japan, where inflation remains high and interest rates low, the long-term stability of the economy seems unsustainable, and yet we believe there are amazing pockets of opportunity as well. The market is expecting the Bank of Japan (BoJ), the country’s central bank, to end its negative rates policy in the near term. Speculation on the timing has been a topic of much debate throughout 2023, particularly as the BoJ’s yield curve control program has been deemphasized. Tom Tully said, “We have been excited about Japan with its economy exiting years of deflation and finally seeing foreign inflows for the first time in years. The country has been a bright spot on the back of improved flows due to governance (and trend-following momentum flows), and it continues to be intriguing from the single stock perspective.”

Somewhere in between the optimism for the US and the potential upside of Asia lies Europe. “In Europe, we are seeing an active recovery in the retail, media, construction, and banking sectors while the worst-performing sectors – food, beverage, and tobacco – are only slightly negative,” said Anis Lahlou, Aperture’s European Equities Portfolio Manager.  “And that’s the elephant in the room. We’ve been talking about a recession all year long, anticipating a hard landing, and worried about the cost of living with inflation and interest rates going up. Yet, it is retail that’s leading the charge in Europe. So, we must focus on the opportunities ahead of us.” The current environment has created a divide between companies who are resilient and those who are not. Heading into 2024, we’re looking for opportunities based on fundamentals.

Companies with strong balance sheets and the ability to generate free cash flow are attractive. There’s less single-stock performance dispersion relative to fundamental progression. “We’re prioritizing healthy balance sheets, competitive position, and pricing power during a period in which other market participants may not be doing so, and we believe we’ll ultimately be rewarded for it,” said Anis Lahlou. Areas where we see attractive opportunities include those related to the transition towards electric vehicles (EV), generative AI, and Life Longevity. In Mobility, the age of software defined Evs has arrived, and penetration is accelerating. We view Generative AI and multi-modal Chat GPT as a multi-year opportunity to act as a super-agent for change. Anti-obesity drugs will change the weight/age correlation paradigm and offers the potential for a longer, healthier life. These opportunities are going to accelerate this transformation.


Fixed Income: The End to the New Normal and Return to the Old Normal

For more than a decade and since the Fed took its unprecedented and extraordinary measures at the height of the “GFC, investors have experienced zero returns on cash, historically low yields on bonds, and have been forced to look further out the risk spectrum in pursuit of yield. Beyond publicly traded equities, it was often a choice between liquidity and the marginally higher returns (on an unlevered basis) in the multiple-year lock-up offered by the private markets. The confluence of aggressive fiscal spending and easing monetary policy in response to the global pandemic had the unintended consequence of causing inflation rates not experienced since the 1970s. Believing the inflation was transitory because of the supply chain, the Fed was late to act but eventually responded with one of the most aggressive interest rate hiking cycles in its history. As we look ahead over the next year, we expect inflation to make a bumpy progression towards the 2% target, increasing the probability that the Fed will either reduce interest rates because the economy has slowed too much or declared victory over inflation. The period between 2008-2021 marked one of ultra-low interest rates and a deviation from historical norms to which the Fed is unlikely to ever want to return. The new normal (2008-2021) is – hopefully – dead; and the old normal, with healthy interest rates that reward savers and retirees, will ideally be returning.

Several key macroeconomic indicators, including commodity prices and wage growth, point to peak hawkishness globally and give fixed income investors a reason to be optimistic. But the same backdrop also warrants that they exercise caution as uncertainties persist around inflation and central bank policies. Across the yield curve, short-dated bonds should offer stability and yield while the Fed maintains higher interest rates for the time being. We believe the tentative normalization of yields will set the stage for divergent outcomes between resilient and vulnerable areas of fixed income markets. “Credit has outperformed most people’s expectations in 2023. Growth has been more robust, especially in the US, and inflation has fallen in a timely manner.’,” said Aperture’s Chief Investment Office (CIO) of Global Credit, Simon Thorp. “Looking forward, we think that the most likely outcome is for macro-economic weakness that we see currently in China and Europe to spread to the US. This will mean that whilst credit as measured by yield will look enticing, spreads will likely widen as markets price in rising default risk. This scenario will likely be exacerbated by the very real maturity walls due in high yield and leveraged loans, which require re-financing. We would expect a high degree of bifurcation as investors try to distinguish between the wheat and the chaff, leading to considerable volatility in Q2 & Q3 before the settling effect of lower rates is felt. If, however, central banks are lucky, economies will experience a soft-landing coupled with lower inflation. Interest rates will be cut in time, allowing for all but the weakest re-financing candidates to be successful. ” Our expectation for next year is increased dispersion based on fundamentals like debt burdens and cash flows. The dispersion will be evidenced as corporate debt matures over the next 12+ months and must be refinanced. Most investment grade companies seized upon the Fed’s return to ZIRP at the onset of the pandemic to issue more debt at incredibly low interest rates later and should weather quite well any volatility in the credit markets. Though spread widening could occur, it’s likely to be economic and sector-specific. Those companies barely able to service their debt at historically low rates will struggle to generate the necessary cash flow to support the same amount of leverage at higher rates. The U.S. High Yield bond market, which has decreased in size over the past decade as more borrowers went to the leveraged loan or private credit market for financing, is the highest credit quality in its history and should weather the upcoming maturity wall better than the past. Nonetheless, we still expect credit spreads to widen meaningfully versus current levels. The global high yield market looks more attractive amid wider spreads as higher rates pressure investment grade valuations. Struggling names may face existential refinancing hurdles, and it will be the job of astute credit pickers to bifurcate the opportunities in yields. “In such an uncertain environment, we feel confident in predicting that the opportunity set for credit stock pickers will remain enticing, and flexibility in portfolio construction and instrument selection will be critical in optimizing these possibilities.,” said Simon Thorp.

In a “Tale of Two Economies”, the U.S. and Europe are moving into the next chapter from two very different perspectives, but likely to converge some. In the third quarter, U.S. GDP grew at an annualized 5.2% rate while the Eurozone contracted. Both the Fed and European Central Bank (ECB) have publicly maintained a hawkish rhetoric and expressed their commitment to fight any threats to price instability. Despite these overtures, the market views both central banks as being at the end of their tightening cycles. The implied probabilities of both cutting interest rates in the next three to twelve months have recently increased. Optimists see the Fed lowering interest rates from current levels because they are no longer necessary to tame inflation. Pessimists will say the cuts are needed to stimulate the economy and shift their focus to the other side of their mandate, full employment. We expect the ECB, with its singular mandate for price stability, to ease its monetary policy and its action to lag its American counterpart’s actions by six months. But unlike the U.S., we see lower rates as necessary to stimulate the struggling Eurozone economy. It’s likely we’ll see some convergence between economies as the U.S. slows from its strong third quarter number and the Eurozone narrowly avoids economic contraction with both offering a variety of investment opportunities.

Likewise, Emerging Market (EM) debt offers renewal potential after years scourged by rising global rates. Emerging economies often face higher inflation sooner and often respond quicker than their developed counterparts. With the Fed and ECB rate hiking cycles both on pause, EM central banks may pre-emptively cut their interest rates as global inflation progresses towards a sustainable level. The post-pandemic on-shoring, near-shoring, or “friend-shoring” trend, paired with moderating U.S. dollar strength, could steady Emerging Market currencies and ease financial strains to unlock local growth engines. This would provide some much-needed relief for distressed dollar-denominated bonds across sovereign and corporate assets in these countries. “For 2024, the prospect of synchronized cuts across various EM countries could present ample opportunities across all EM asset classes including credit, local rates, and FX,” said Peter Marber, Aperture’s CIO of Emerging Markets Debt. “Some EMs are also benefitting from the “friend-shoring” or diversification away from China, which could also spur positive momentum in some countries. Mexico, for example, attracted more than $50 billion in foreign direct investment (FDI) in 2023 (its highest levels in several years). India is also attracting more FDI, and it is expected to grow by more than 6.3% in 2024 according to the IMF, its fastest level in several years. At this stage, any normalization of, or improved, trade relations between the US and China, also could inject optimism and fuel growth in EMs further. The recent meetings between President Biden and Chairman Xi might even give a boost to world trade, which has slowed in the last decade. It has been a tough decade for EM assets with strong US dollar headwinds, with the last two being among the most difficult and volatile in the 21st century. It appears that the worst is behind us, hopefully ushering a new period of above-market returns from Africa, Asia, the Middle East, Latin America, and Eastern Europe.”


Playing the Long Game

As we complete our fourth full year of investing, we continue to focus on the incentives that drive us to align our performance with our clients’ interests. We are looking forward to expanding our product offerings in the new year as we launch new strategies and new vehicles. Above all, we understand that preserving capital during periods of uncertainty solidifies the foundation for achieving long-term performance objectives. As we navigate the markets, which we expect to remain complex - and at times - turbulent in 2024, our risk management strategy will continue prioritizing capital preservation in periods of distress.  Employing strategies such as tactical hedging, maintaining cash buffers and portfolio diversification can allow portfolios to endure short-term volatility while sticking with long-term winners.

Ultimately, our alignment with our clients’ success is an underlying driver of our investment and risk decisions. We take this responsibility seriously through fee structures tied to performance, accountability for downside protection, and transparent communication even in difficult markets. This shared mission will persist regardless of any changes in the markets over the next year.

We remain dedicated to earning your trust and appreciate the opportunity to act as stewards of your capital. We wish you a peaceful holiday season and a prosperous New Year. Please feel free to schedule a call with our team at any time to discuss personal outlooks, portfolio positioning, or risk management philosophies in more detail.

Here’s to a great 2024,

PK


Peter Kraus
Aperture Investors, Founder and CEO

 


IMPORTANT INFORMATION

This letter is for information purposes only and does not provide any professional investment, legal, accounting nor tax advice. All information and opinions contained in this note represent the judgment of Aperture Investors, LLC (“Aperture”) at the time of publication and are subject to change without notice. For more information about costs, risks and conditions in relation to an investment or a service, please always read the relevant legal documents. This note may not be reproduced (in whole or in part), transmitted, modified, or used for any public or commercial purpose without the prior written permission of Aperture. Recipients of this information are deemed to be investment professionals and/or qualified investors that have employed appropriately qualified individuals to manage their financial assets and/or are appropriately informed and experienced as to understand the associated risks of investment. To the extent that any opinions or forecasts are provided, they are as of the dates indicated, are subject to change without notice and may not be revised, may not be accurate and do not represent a recommendation or offer of any investment. Although all reasonable care and attention has been given to the data provided, no liability is accepted for any omissions or errors. Data contained herein should not be relied upon as the basis for any investment decision.