A special live episode from the Morningstar Investment Conference. Two of Morningstar Wealth’s investment leaders—Matt Wacher and Ricky Williamson—joined the show to help us dig into what’s already happened this year and where we may be headed. The topics covered included: • The Fed and where rates may be headed • Further discussion on fixed-income • US stocks are off to another hot start this year. Can outperformance continue? • Every business is thinking about AI. How is it impacting markets? • And how should investors be preparing for a presidential election? And as always, we address the implications on client portfolios and help consider action items.
Nicholas VanDerSchie: All right. Welcome to the Morningstar Investment Conference at Navy Pier for today's special edition of Simple But Not Easy. We're coming to you live from Theater 2, and we have an exciting agenda lined up and this will serve as a mid-year outlook for investors as well as advisors.
I'm Nick VanDerSchie, Head of Strategy and Execution for Morningstar Wealth. I'm delighted to be joined by two of Morningstar Wealth's investment leaders, Matt Wacher and Ricky Williamson, who will help us dig into what's already happened this year as well as where we may be headed. We've got a packed agenda and plan to cover a host of topics, including the Fed and where interest rates may be headed, fixed income pricing, U.S. and international equity performance and valuations, AI and its impact on markets, and everyone's favorite topic, the presidential election. As always, we'll be sure to address implications on client portfolios and help guide any actionable insights for your practices.
Before we get into the conversation, if you'd like to know more about how we support advisors, we welcome you to email us at simple@morningstar.com or me personally at Nicholas.VanDerSchie@morningstar.com.
Now, let's get started. Matt, Ricky, welcome to our special live edition of the Simple But Not Easy podcast from the 2024 Morningstar Investment Conference.
Wacher: Thanks, Nick. Thanks everyone for listening.
Williamson: Thanks for having us.
VanDerSchie: Let's start with introductions. Matt, you joined Morningstar Investment Management in 2019 and serve as our Asia Pacific Chief Investment Officer. You're responsible for leading the investment management teams in APAC and overseeing the multi-asset and equity managed funds and managed account capabilities. Matt, how was the trip over from Sydney?
Wacher: It was long as you'd expect. I think that's why they put me on the couch for the jet lag. But…yeah.
VanDerSchie: You can lounge out if you want, Matt.
Wacher: Thank you.
VanDerSchie: Ricky is based out of Chicago and serves as Head of investments for Morningstar Mutual Funds. He is focused on portfolio construction, asset allocation, and manager due diligence. He is a member of Morningstar Investment Management's global asset allocation team and helps lead America's fixed income research. Despite being an 11-year Morningstar veteran, this is Ricky's first appearance on Simple But Not Easy. Ricky, thanks for joining us.
Williamson: Thank you. About time.
VanDerSchie: So, I want to start by talking about where we sit year-to-date. We're about at the halfway point of the year. Ricky, if you had to provide a quick recap of the year so far, what would you want advisors to know?
Williamson: Yeah. I mean, I think a lot of it's relatively obvious to everyone. I think there's been two dominant themes within the U.S. It's been AI and its impact on market performance in the U.S., particularly within the technology sector as well as the communication services sector. But even what we would call AI tangential sectors like utilities, people are starting to see how other sectors are going to feed and drive AI and those valuations are evolving as well. And then on the other side of the ballot is really what's happened in fixed income. This push and pull between inflation, the Fed, and bond markets. And so, interest rates have continued to be volatile as it had been for really the last three-plus years. And so that's driving a lot of short-term volatility, both within fixed income as well as equity.
VanDerSchie: Matt, same question for you. How would you summarize what's happening outside of the U.S.?
Wacher: Well, I think there's been pockets of excellent performance from global markets. Japan has kind of petered out a little bit. Some of the emerging markets – China had a period there where the equities were up 30%. Australia has done reasonably well for the first quarter. And Europe did really well. But really everything in the last couple of months has been overshadowed by the U.S., again taking market leadership. And similar globally on the bond perspective, there's been lots of volatility there. And we'll probably get to this, but there's been interesting interest rate divergence. So, there's rate cuts already arriving in some areas and bond yields have been increasing after the big rally we saw in the fourth quarter last year.
VanDerSchie: Surprisingly, neither of you guys updated us on GameStop's price target. Matt, what's your prediction here?
Wacher: Well, I don't think it's going to zero. It's not something that we're following all that closely. I think the main reason I don't think it's going to zero is because they have a subsidiary in Australia and my kids spend a lot of time there, a lot of my money. So, there's some value there, maybe not too much as the price indicates at the moment.
VanDerSchie: Fair enough. Okay, let's start digging into some of the big questions everyone is trying to answer. Starting with the Fed. Last November, the Chicago Mercantile Exchange Fed Funds futures were expecting six rate cuts in 2024. Sitting here in late June, we've had zero and the market now only expects one to two between now and the end of the year. So, Ricky, what's happened?
Williamson: Yeah. Well, I think in Q4 last year, the market may have gotten a bit ahead of itself, but also, Powell was kind of encouraging that message and he was certainly dovish. But as we sat towards the end of 2023, there was still this divergence between what the Fed was messaging officially and their dot plots versus what the market was pricing in. So, there was like a four to five cut difference there. And then you had inflation come in relatively hot to start out the year. And the convergence ended up happening with market pricing moving closer to what kind of the Fed dots have been.
So, inflation continues to be volatile. I think the message has always been sort of this last mile can sometimes be the hardest. And that's what we've seen. And also, the economies remain resilient. And so, higher interest rates haven't necessarily had this impact on the economy that many people were expecting. And that gives the Fed more time to push out rate cuts. And that's so far what we've seen.
VanDerSchie: And Matt, you alluded to this a minute ago, but we're not observing similar monetary policy in all parts of the world. In fact, as you mentioned, other countries are actually cutting interest rates. What are you seeing and what's driving these decisions?
Wacher: Well, I mean, I think if we look it, Europe made an interest rate cut a couple of weeks ago. That's really on the back – they had a very shallow recession last year. So that's a different framework to here in the U.S. where growth has been very strong or much stronger than expected, at least. Japan, their bond yields have remained very low. They still had negative interest rates much later than everyone else. And they're potentially on a rate hiking cycle, albeit very incrementally, that that could play out over time. That will probably have a lot of effect on the valuation of the yen, which is very cheap at the moment, according to us anyway. And I think that other areas, Australia, my home country, interest rates are still a borderline decision whether they're going to go up again in Australia. And I think one of the big elephants in the room is what happens to U.S. interest rates and bond yields here is going to have a big effect on China. They've already been easing monetary policy there, but they can't go too much further until the U.S. join the party because that will have too much effect on the yuan, their currency there. So that could be a huge driver of returns once the interest rates in the U.S. start to come down.
VanDerSchie: So, I want to talk about what all that means for fixed income. And to set the backdrop, stocks have hit more than 30 all-time highs so far this year, whereas bonds have not hit a new high since July of 2020, almost four years. And I just want to ask, how should advisors be talking to clients about the role of fixed income in their portfolios in this environment? Ricky, we'll start with you.
Williamson: Yeah. So obviously, as everyone knows, fixed income yields are coming off all-time lows in 2021. And so, it's not surprising that we've lifted off that. But now you're seeing yield levels we haven't seen in decades, and that provides cushion not only for additional potential price loss from interest rate volatility, but also just expected returns. We all know expected returns in fixed income is largely going to be dependent on your starting yield, and that high level is going to be constructive for fixed income returns moving forward. It also is going to allow for more potential price appreciation if we do hit some sort of deflationary recession. We're not saying that's our base case, but it allows you for more diversification offset for your equity portfolio in case that comes to fruition. So, we're pretty constructive on fixed income. We're not wanting to stretch too much for incremental yield in spread assets, just given how historically tight spreads are right now. But we do see a lot of value at various parts of the curve in high-quality fixed income right now.
VanDerSchie: And Matt, it's fair to say the cousin of fixed income is cash, and we're observing investors holding cash and money market funds as a fixed income substitute. Do you think now is the right time for advisors and their clients to be keeping powder dry?
Wacher: Look, I think that cash does obviously play that role, Nick. It's got optionality to it. But I think that as Ricky was alluding to, if you're holding fixed income assets as opposed to cash, you're really going to get a much better diversification benefit. If something does – if we do see some hiccups in the economy and maybe even push closer towards a recession, something along those lines, you're really going to get diversification. And what that means is that you can actually hold more growth assets. And while cash is giving you reasonable returns and you have that optionality, we're holding less cash in the portfolios that we run than we were, say, in 2020. That all-time high that you spoke of in 2020, it could be the all-time high for all-time. I heard someone else describe it as a 5,000-year low in interest rates. So, the negative interest rates and where 10-year bond yields got to a little while ago, you may never ever see those levels again.
VanDerSchie: So, we've covered fixed income. We've covered cash. I want to turn now to equities. And Matt, I'll start with you. Morningstar prides itself on being an independent research organization. And if you look at the data from the past 50 years of global equity markets, international stocks have had many periods of sustained outperformance. But we've been living through this very unique period over the past decade where U.S. stocks seemingly cannot be knocked off the podium. How should advisors be thinking about U.S. versus international equity
Wacher: Look, I think U.S. equities, they are exceptional. There are some amazing companies that are based in the U.S. We know them all. The Magnificent Seven are very magnificent. But they're kind of at this stage priced to perfection. And you used the word podium, Nick. But the Olympics are coming up. So maybe I'll use an Olympic analogy. If you think about the high jump, as the bar gets higher, it's going to get knocked off at some stage. And so, we think that at this stage, U.S. equities are reasonably, or certain pockets of U.S. equities are reasonably expensive. Ricky can potentially go into more on that. Whereas parts of the, say, the emerging markets or even other parts of the world, the bar is much lower. It's much easier to get over for that high jumper when the bars are lower. And that's the way that we're seeing things at the moment. We want to make sure that we have some exposure to those really high-quality tech companies and the high-quality market like the U.S. But we want to be able to generate our returns in other parts of the world at this point in time, just because the risk-reward is a better opportunity there the way we see it.
VanDerSchie: Thanks, Matt. And Ricky, if you told me in December that we would have zero rate cuts and the market was up 15%, I wouldn't have believed you at all. How have the U.S. stocks been able to maintain this upward trajectory for so long?
Williamson: Yeah, I think it's a few things. One, obviously, AI, the momentum around that, and it's not just hype. We are seeing that in earnings. They are delivering on certain degrees of expectations. But it has been concentrated, right? So, there has been a large portion of the U.S. equity market that is not also rallying along with the big quality names that have relation to AI. So that's been part of it. Also, despite this kind of rate volatility and despite inflation being higher, inflation expectations, long-term inflation expectations have been anchored. And so, while the bond market is experiencing a lot of volatility, people are still comfortable with where inflation will be in two, three, four, five years, and people are pretty comfortable with where the Fed is going. It's just a matter of when. And so, while the Treasury market is kind of having that day-to-day and extrapolating every data point, the equity market is kind of looking more long-term and that has been able to look through the noise in the short term. And that's certainly been bullish for risk assets.
VanDerSchie: Ricky, you mentioned AI, and one interesting data point that I read recently is that while U.S. stocks are up 15%, the equal-weighted index is actually only up about 5%, so on par with the rest of the world. And it seems that most of the stocks driving the U.S. performance, as you mentioned, are AI beneficiaries. Would you expect this trend to continue?
Williamson: Yeah, I think I would go back to Matt's comment on the hurdle is higher than it has been. And you actually saw that last night, a company called Micron Technology put out its forecast. It was about what expectations were, but somehow that wasn't good enough for the market and it's down 7%, 8% this morning. And so, expectations are really high and any disappointment in those names can lead to a pretty severe valuation correction. So, we need to be aware of that. The good news as U.S. equity investors with the concentrated market is a lot of the market isn't as expensive. And so, there are a lot of opportunities that we're seeing within the U.S. equity that are just more outside of that AI. So, consumer staples we see value in. We still see some value in utilities, REITs look attractive, small caps look decent. So, there are a lot of opportunities we think. We're just trying to be cautious on those big names that have drove the rally.
VanDerSchie: So, AI is interesting because it does lead us to a broader investment question around growth versus value in the sense that most of the AI companies sit within the growth quadrants of the Morningstar style equity box. And while AI's impact is usually linked to technology businesses, it arguably can have an impact on any business. In fact, NVIDIA CEO, Jensen Huang recently quoted as saying AI will bring significant productivity gains to nearly every industry. And so, Matt, the question for me is, could the benefits of AI accrue to value stocks as well?
Wacher: I think definitely. I mean, it's like the tech stocks out there, the AI stocks that we're calling them at the moment, certainly they provide the tools for all of those, we'll call them value companies or more traditional companies, banks, consultancies. All of these companies are going to potentially be able to carve out a huge amount of costs from their business and improve their bottom lines. These are all value companies that really want to focus on generating much better earnings. And to do that, they can focus on the bottom line rather than having to grow revenues significantly. They still want to grow revenues significantly. But if they can take out their cost base, maybe not good for employees, but we won't go there, but certainly good for balance sheets. And once that does start to flow through, you'll start to see some excellent returns from traditional value stocks, we'd expect. Hard to know who the winners are going to be, though.
VanDerSchie: Thanks, Matt. So, we've covered a lot of the big topics. One that I do want to come back to, and that's important on people's minds, is the U.S. presidential election. It was touched on a little bit this morning on the main stage. And I want to caveat this, that this is the furthest thing from a political podcast. But with that in mind, Ricky, can you speak to the election's influence on markets?
Williamson: Yeah. Obviously, elections have consequences. And that comes to fruition within policy decisions, right? But the most extreme outcomes are really if you have kind of a sweep. So, you have the House, the Senate, and the White House all under one party. And that seems relatively unlikely, but we still need to be prepared for that. So, the way we prepare for these, again, we don't try to predict what's going to happen. We don't pretend to have any type of edge on what's going to happen in the U.S. election. But we need to prepare for a wide range of outcomes. And so, what we do is kind of go through our overweights and underweights and make sure we're not overexposed to one outcome or another. So, we like U.S. banks, for example. That would benefit from a Republican sweep, would have a detrimental outcome if there was a Democratic sweep. You think about China, a Republican sweep would probably be detrimental to Chinese equity positions and so on. And so, we kind of go by position-by-position and make sure that we're not overexposed.
At the same time, we also want to be prepared for volatility because what you saw in something like 2016, a relatively surprising outcome. You saw interest rates spike. You saw emerging market assets really get crushed. You saw municipal bonds go crazy. And so that type of volatility is where we think we can add value and where we look for opportunities. So, we want to be prepared for those market reactions and be able to make sure that we're prepared to deploy capital in those assets that we think are selling off more than the fundamentals would suggest. And so that's how we think about preparing for something like this.
VanDerSchie: And Matt, beyond the U.S. presidential election, actually 50% of the world will be going to the polls this year. What impact will those elections have outside of the U.S.?
Wacher: Well, I think, I mean, obviously, localized impacts certainly. But I think the key thing with elections is that it creates uncertainty. Markets hate uncertainty. And I think what we know – just to cover off the U.S. election very quickly, we kind of know what's going to happen there. Trump or Biden? Every four years, there's an election, et cetera, et cetera. What we've seen globally is France recently announcing an unexpected election. That's created a huge amount of volatility in France and Europe. We've seen those markets sell off after having a significant run of good performance early in the year. We saw Modi in India get reelected but with a much-reduced majority, had to find coalition partners to actually form a government. So that was quite unexpected. That created some volatility in Indian markets. The U.K., although the election was brought forward, we know the outcome there hasn't been as volatile.
What we try to do, as Ricky said, is look through that noise and focus on the fundamentals of each of those economies and the stocks within them and say, okay, well, where we're going to get to? Things aren't going to change too much structurally. Let's look at where things are priced and look through this noise. And I think what elections do is create opportunities for investment. The markets are going to rally significantly or sell off based on that noise and potentially can use that as an opportunity.
I think that some of the noise around elections and the work that we've done previously is not necessarily informed by the elections themselves. If you think back to 2008, you'd think, well, markets are going to sell off significantly after an election of a Democrat, just for example, when Obama got in. But that was obviously in the middle of the financial crisis. If you think to when Biden got elected, you might go, well, markets are going to rally on a Democrat coming in. But actually, if you think back to the 2020, that was really – the vaccine was released in that COVID period. So, markets rallied. Not necessarily – there's lots of coincidental things that might happen that create noise around what people expect of elections and things like that. So, we tend to look through all of that noise and focus on the longer term and what's going to happen at the company level or the asset level.
VanDerSchie: Great. So, as we love to do on the Simple But Not Easy podcast, we want to bring today's conversation back to practical application for financial advisors and specifically from a portfolio management perspective, where are some areas of opportunity. And I want to start with stocks. And maybe the first question for you, Ricky, is how has what's happened in the U.S. market shifted our expectations moving forward? And are there any sectors that you still find attractive?
Williamson: Yeah, I think it goes back a little bit to how concentrated this market has been to your point on equal weight versus market weight. You've really just seen these top names drive market performance year-to-date. And what that means, again, is that a lot of names have been left behind because the exuberance has all been caught up with AI. People have had FOMO. People have just been diving into NVIDIA and AI tangential names. And so, what we've found is that there's a lot of sectors that have not seen that type of exuberance that are now reasonably attractively priced. And so, we still like some of the names. As Matt alluded to, we still have some communication service overweights that we find attractive. But mostly, it's been the sort of either defensive equity names or interest rates-sensitive names. So, consumer staples, again, we find attractive. REITs and small caps have been hurt by the interest rate environment and they're showing some value there. Healthcare. So, a lot of these names that just aren't as sexy, aren't as talked about in the news that have just been left behind is where we're seeing value within the U.S. equity market.
VanDerSchie: And Ricky, you touched on small cap stocks there briefly. Can you go into a little more detail?
Williamson: Yeah. I mean, we're basically at a historic level of valuation divergence between large cap and small cap. I don't think that necessarily should mean we should be overly excited because a lot of that's just been driven by overvaluation or expensive large cap names, not necessarily absolute value in the small cap names. That being said, we do find them reasonably attractive and certainly relative to large cap. They do get hurt by higher interest rates. They have floating rate debt. They tend to have more debt. But as we forecast forward where we think rates are moving over the intermediate to long term, some of those problems should be worked out. And so, we do find value there, particularly in the profitable, higher-quality names where we can actually project cash flows. And so, we're trying to avoid the unprofitable names that are more based on speculation. But yeah, certainly the quality portion of the U.S. small cap universe is where we're seeing value. We have to be conscientious because there's financials there. So regional banks that we already think attractive on their own, real estate that we already think attractive on their own. They have bigger portions in the small cap. So, we don't want to be overexposed. But as a conglomerate, we do see value.
VanDerSchie: And Matt, from your perspective, where are you seeing the most opportunities internationally?
Wacher: Yeah. Maybe I'll speak more at the country level. But I think emerging markets in aggregate, real opportunity at this point in time. I think people have been saying that for 10 years. So, take that with a grain of salt. But that's where we really see the hurdle is much lower. There's that concept of geopolitical risk out there. And if I talk specifically about China, obviously, there's a huge amount of noise around China. We think it's a great opportunity. But we want to control for that geopolitical risk by the sizing of our positions. We're not going to have too much too many eggs in the one basket there. But China is a great opportunity at this point in time from a contrarian perspective.
The way that we're playing that in portfolios and managing risk is that we don't want to – there's some very high-quality companies in China. We don't want to own the real estate sector or anything along those lines where there's huge amount of unknowns or even in financial services. But what we do want to do is own some of those big tech names – the Alibaba's, the Tencent's, et cetera. And we do own those in our portfolios. Very high-quality tech companies, very similar tech companies to the U.S. tech companies and also focus very much on the domestic economy in China, as opposed to the international economy. So, these companies are still growing. There's still a lot of potential there. They're very cheap and there's potentially a huge amount of tailwinds behind some of those companies. As I said, there could be more stimulus coming from the Chinese government as soon as there's a bit of relief globally, as soon as interest rates start to come down in more parts of the world, particularly the U.S., there's potential for the Bank of China to add more to the stimulus that they've provided. So, there's a few catalysts that can take wind in some of these tech companies. And we think that they're very good, solid companies. You understand the ownership structures there as well. And so that's kind of one way that we're playing China. I think more broadly, there's other emerging markets, areas like Brazil and Mexico, reasonable opportunities that we hold in our portfolios. But I think looking for those pockets of value is becoming harder to do as markets in general have rallied globally as well.
VanDerSchie: Thanks, guys. So, flipping over to fixed income, Ricky, starting with you, where do we see value in the credit markets?
Williamson: Not much. I think spread sectors have looked through any of the short-term volatility. Fundamentals are clearly strong, and that's fully priced in. And so, there's not a ton of value that we're seeing. And especially when you can achieve 80% to 90% of your income by just owning treasuries, we want to be very selective on where we take excess risk within fixed income markets. Where we do see some relative value is within agency mortgage-backed securities. They obviously have been volatile given the interest rate volatility. And we think they're reasonably priced. And then I think the other credit sector where we're seeing some value is hard currency emerging market debt. That is not quite as expensive. It's very diversified and they were a lot of hurt by the tighter financial conditions, by inflation, currency weakness. And so, they were sold off. They've rallied back some, but we still see more value there than we do within U.S. corporate credit markets, for example.
VanDerSchie: And I noticed that we're actually underweight U.S. corporate bonds right now. Could you explain?
Williamson: Yeah, it's mostly because they're just at historically tight levels, maybe lowest decile on spread levels between U.S. investment grade corporate as well as U.S. high yield corporate spreads. And again, when you can achieve a majority of your income through just owning treasuries, we want to be selective there. And just the fact that U.S. high yield spreads, for example, are around maybe 300 right now in an event like COVID, we're not obviously not predicting like that could happen, but spreads can get up to 1100, 1200. And so, the excess return asymmetry that's priced in right now does not look that appealing. And so, we're not completely out of it because fundamentals do appear very strong. But we want to be quite cautious on how exposed we are there.
VanDerSchie: And maybe just the last question for you, Ricky. Are there any areas within fixed income where you're preferring an active management approach versus an index?
Williamson: I would say largely we're almost always constructive on active management within fixed income markets. There's a lot of issuers, credit work can go a long way. And so, outside of basically nominal treasuries or TIPS, we tend to look for active management because we do think through time that they can add a lot of value, especially in something like corporate high yield or emerging market debt where there's a lot of dispersion and things aren't moving altogether, we think they can add a lot of value through time.
VanDerSchie: Matt, what's your take on fixed income right now?
Wacher: Well, I think Ricky has said a lot. Similar positioning in Australia and our portfolios. But maybe I'll focus on emerging market debt. I think it's an interesting opportunity at this point in time. Again, spreads relative to developed market and U.S. government bonds, for example, are very tight from a historical perspective. But if you'd look deep into fixed income, emerging market debt, you can see that a lot of the return – there's still a reasonable opportunity there. A lot of return is being driven by currency. And one thing we haven't discussed today is the strength of the U.S. dollar. And relative to many, many currencies and emerging currencies, the yen, et cetera, et cetera, it's almost at all-time highs. And it's been that way for a very long time that dollar has been driving things. So, I think if that ever starts to unwind, I'd expect it will at some stage, then there could be huge tailwinds for some currencies globally, and that can change market dynamics quite significantly. But emerging market bonds, a lot of the value there is being driven by currency at this point in time, and that's an interesting dynamic.
VanDerSchie: Great. Fantastic discussion today, guys. Before we wrap, if you want to leave our listeners with one idea that you want them to take away from today's discussion, what would that be? Matt, we'll start with you.
Wacher: Well, if they're brave, I think some of those China tech stocks are probably worth having a look at.
VanDerSchie: Ricky?
Williamson: Yeah, I think it's a good time to be a multi-asset investor. We haven't seen prospective fixed income returns like this in quite some time. Equity valuations look reasonable. So, we're just generally constructive.
Wacher: I'd leave GameStop alone, though.
VanDerSchie: GameStop for sure. And there you have it. Another episode of Simple But Not Easy. As always, we thank Ricky and Matt for their time and their engagement, and also to you, our audience today, at the Morningstar Investment Conference. And once again, if you'd like to know more about how Morningstar can support you, please drop us a note at simple@morningstar.com or me personally at Nicholas.VanDerSchie@Morningstar.com. That wraps up this week's episode. Before we depart, if you enjoy hearing the insights on our podcast, please consider leaving a 5-Star review on Apple Podcasts. Until next time, thanks for listening, and we hope you had an excellent Morningstar Conference.