Happy New Year, everyone! And welcome to our “Top 10 Investment Themes for 2024.”

As you may recall, our overall macro theme for 2023 was “Better Days Ahead.” The theme proved to be relatively accurate, at least as it relates to the stock market. Although the better days were enjoyed primarily by just seven large-cap technology stocks – the “Magnificent 7” stocks, if you will, belonging to Apple, Amazon, Alphabet, Nvidia, Meta, Microsoft, and Tesla.

2024 should see a widening of the rally’s breadth for stocks (although the stock market will likely not experience the heights of the overall gains that took place in 2023) and bonds, provided that the Federal Reserve shifts from tightening to accommodation as inflation continues to moderate and the economy slows.

Regarding the economy, a recent GDPNow estimate from the Federal Reserve Bank of Atlanta shows a real gross domestic product (GDP) growth (seasonally adjusted annual rate) in the fourth quarter of 2023 of 1.2%, slowing significantly from the revised GDP growth rate of 5.3% in the third quarter.

Further, on the slowing economic growth front, the Summary of Economic Projections released by the Federal Reserve after their FOMC meeting on December 13, 2023, forecasts a real GDP growth rate of below 2% through the end of 2026. Despite this economic slowdown, we believe the economy can still achieve a relatively soft landing if the Fed refrains from raising interest rates further and begins cutting them when signs of duress emerge, likely during the second half of 2024.

As it stands now, according to Fed’s December 2023 Dot Plot Chart, the Fed is forecasting 75 Bp (0.75%) in rate cuts in 2024, another potential 100 Bp (1.00%) in rate cuts in 2025, and yet another 75 Bp (0.75%) in potential rate cuts in 2026 – this equates to 250 Bp in possible rate cuts over the next three years!

As a result, we see the theme for 2024 as “An Expansion of the Rally.” This theme does not imply that inflation will drop to the Fed’s 2% target in the new year because it likely will not. It also does not mean the economy will not slow because it likely will. Finally, it does not imply that periods of short-term bouts of volatility are behind us. Given that it is an election year and due to the many existing geopolitical uncertainties, because they are not.

What it does suggest, however, is that we have reached the end of this rate hike cycle, and rate cuts are likely coming next year to help prevent the intended economic slowdown from becoming a recession. Once the Fed starts cutting interest rates and the economy shows signs of stabilization, the rally in stocks and bonds, which was largely limited in 2023, should broaden in 2024. Investors should position their portfolios accordingly.

Below are our “Top 10 Investment Themes for 2024” for your review and consideration.

1. Preparing for an Economic Slowdown

As stated earlier, real GDP growth is forecasted to slow to 1.2% in the 4th quarter of 2023 from 5.3% in the 3rd quarter. The Federal Reserve also projects real GDP growth to slow to 1.4% in 2024. This slowdown is an intended consequence of all the aggressive rate hikes that the Fed has implemented since March 2022 to help curb record-setting levels of sticky inflation by putting pressure on an increasingly leveraged consumer who accounts for approximately 70% of GDP growth in the U.S.

We believe that a relatively soft landing of the economy can still be realized if the Fed refrains from any further rate hikes and does not keep rates too high for too long. However, this does not negate the likelihood of a long-awaited, highly anticipated economic slowdown in 2024, and investors would be wise to position their portfolios accordingly. Historically, stocks within sectors such as Health Care, Consumer Staples, Industrials, Utilities, and investment-grade fixed-income investments have fared relatively well during economic slowdowns leading up to and even through recessionary periods.

2. Where to Invest as Interest Rates Decline

The Federal Open Market Committee (FOMC) meets eight times each year, and they have four scheduled meetings during the 1st half of 2024: January 30 – January 31, March 19 – March 20, April 30 – May 1, and June 11 – June 12. We contend that the Fed may keep interest rates at their current elevated levels through the 1st half of 2024 and then start cutting interest rates in the second half of 2024 through 2026. According to a recent Dot Plot Chart released by the Federal Reserve, as noted above, the Fed is forecasting 75 Bp (0.75%) in rate cuts in 2024, 100 Bp (1.00%) in rate cuts in 2025, and 75 Bp (0.75%) in potential rate cuts in 2026.

We don’t necessarily disagree with the total percentage of cuts over the next three years. Still, we do believe, at this time, that the Fed may pull forward some of the projected cuts into 2024, resulting in a total of 100 Bp (1.00%) in rate cuts next year, potentially in four 25 Bp (0.25%) increments over the second half of the year. Of course, we do not have a crystal ball, nor does the Fed, for that matter, to help predict future interest rates with any degree of certainty, but it does appear all but certain that we are now heading into a declining interest rate environment.

3. Embracing Artificial Intelligence and Other Transformative Technologies

A July 12, 2023, CNBC article entitled, “Bill Gates explains why we shouldn’t be afraid of A.I.” stated that Microsoft co-founder Bill Gates believes artificial intelligence (A.I.) models like the one at the heart of ChatGPT are the most important advancement in technology since the personal computer. We tend to agree with the transformative nature of A.I. across multiple industries and society altogether. According to IDC, a leading technology media, data, and marketing services company, the ongoing incorporation of A.I. into a wide range of products will result in a compound annual growth rate (CAGR) of 27.0% over the 2022-2026 forecast, with spending on A.I.-centric systems expected to surpass $300 billion in 2026.

Furthermore, a study by management consultant Gartner found that “55% of organizations reported increasing investment in generative A.I. since it surged into the public domain ten months ago. Generative A.I. is now on CEOs’ and corporate boards’ agendas as they seek to take advantage of the transformative potential of this technology.” However, A.I. is still at the very start of its evolution and adoption, so investors would be wise to conduct their own due diligence before investing in companies that purport to be developers or users of A.I. Investors should also appreciate that there are other types of transformative technologies, including, but not limited to, robotics, blockchain, and cybersecurity, that could be incorporated alongside A.I.-oriented companies within a diversified portfolio of growing companies that use or develop revolutionary technologies.

The importance of cybersecurity, the glue that holds the technologies (both traditional and transformative) puzzle together, cannot be underestimated, as Gartner predicts that 45% of all organizations will experience attacks on their software supply chains by 2025.

4. Munis Continue to Build on End of 2023 Momentum

Goldman Sachs Asset Management stated in their October 2023 Municipal Fixed Income Update, “We believe investment grade municipals could continue to benefit over the near term due to a trifecta of factors: solid credit fundamentals (even when accounting for a potential decline in the broader economy), a more stable interest rate environment due to an expected deceleration in Federal Reserve Rate hikes, and pent-up demand coupled with lower supply expectations that should keep municipal valuations on the lower end of their historic ranges.”

This forecast proved accurate as municipal bonds enjoyed their best month of returns since July 1986 during the month of November 2023. We believe that this momentum can carry into 2024 as the current prices of investment-grade municipal bonds, notwithstanding their rebound in November 2023, and municipal bond closed-end funds (CEFs), which continue to trade at significant discounts to their net asset values (NAVs), create attractive entry points for investors to consider for potential total return opportunities in the months and years ahead. It’s also important to remember that the leverage employed by most municipal CEFs should benefit fund strategies in the years ahead as interest rates decline.

5. Biotech M&A Activity Ramps Up Again

Innovations in healthcare are of paramount importance to society and many interested investors. Society desperately needs new healthcare solutions for rare, chronic diseases that still do not have any effective treatments, much less cures. These solutions increasingly come from smaller-cap biotechnology firms instead of large-cap pharmaceutical companies. Now, here is where investors come into the equation.

Given the trifecta of drug price controls, patent expirations, and generic competition, serving as headwinds to large-cap pharmaceutical companies, big pharma will likely need to become more acquisitive to help replace revenues lost to the trifecta mentioned above. According to a LeeRink Partners article entitled, “Biopharma M&A Market Update and 2024 Outlook,” biopharma M&A deal activity has declined modestly in 2023 thus far (as has all of Healthcare M&A) with the announcement of 44 deals, down 11% on an annualized basis from 58 in 2022, but they expect biopharma M&A activity to remain elevated in 2024 as large pharmaceutical companies attempt to fill revenue and pipeline gaps via acquisitions of late- or commercial-stage companies, though not necessarily involving mega-cap deals.

Investors thus need to find those smaller-cap biotech companies with existing breakthroughs or innovative drugs in the FDA approval pipeline that large-cap pharmaceutical companies desire to add to their platforms and thus have the greatest chance of being acquired. Selecting these securities is no easy task for any investor and is better handled through a diversified portfolio of carefully selected biotech companies.

6. Preferreds Poised for a Rebound

In a rising rate environment, income-focused investors may worry about the impact on their portfolios, especially with traditional fixed-income investments like corporate or government bonds, which carry interest rate risk. To address this, some opt to shorten their portfolio’s duration, but this move often reduces yield, potentially eroded by inflation. However, for more aggressive investors, it’s worth considering preferred securities, which experienced a market correction in 2022 and may stand to benefit from the anticipated declining rate environment over the next two years.

Regarding the latter, it is noteworthy that investment-grade U.S. dollar preferred securities have performed relatively well following the end of Federal Reserve rate-hiking cycles, producing an average 12-month return of 14.2% and an 8.2% average two-year annualized total. Preferred securities have also outperformed other fixed-income classes, on average, coming out of rate-hiking cycles since 1990.

7. Defense Spending Forecasted to Increase Significantly

Despite the setbacks and operational challenges brought on by the pandemic and ongoing turbulence in global economies, analysts are very optimistic about the aerospace and defense (A&D) industry, expecting annual earnings growth of 12% over the next five years, likely fueled by much-needed increases in defense spending given all the military conflicts across the world, including, but not limited to, Ukraine and Israel, that may, unfortunately, only escalate further.

On March 9, 2023, the Biden-Harris Administration submitted to Congress a proposed Fiscal Year (F.Y.) 2024 Budget request of $842 billion for the Department of Defense (DoD), an increase of $26 billion over F.Y. 2023 levels and $100 billion more than F.Y. 2022, to help address much-needed defense expenditures. In addition, according to Statista, defense spending in the United States currently amounts to approximately $746 billion U.S. dollars and is expected to increase by over 47% to $1.1 trillion U.S. dollars over the next decade. Certain companies that operate within the aerospace and defense industry stand to benefit from increases in defense spending.

8. Value Stocks will Cut into the Significant Outperformance of Growth Stocks

The Russell 1000 Growth Index significantly outperformed the Russell 1000 Value in 2023, reflecting a current investor preference for high-growth stocks. However, given the belief that we have reached the end of this rate hike cycle, along with evolving economic conditions, there is increasing speculation about a potential shift towards value stocks, possibly prompting a market rotation as investors reassess strategies and explore opportunities in value-oriented sectors.

Historical data from the last three Federal Reserve rate hike cycles consistently shows value stocks outperforming growth across market caps in the 12 months following the end of the rate hikes. Mid Cap Value averaged an impressive 22.26% return in the Mid Cap segment, surpassing the 10.61% average of Mid Cap Growth. Similarly, Small Cap Value averaged a robust 23.73% return in the small-cap category, outperforming the 15.99% average of Small Cap Growth. Large Cap Value also demonstrated a noteworthy average return of 18.31%, surpassing the 8.61% average of Large Cap Growth. These averages highlight the historical tendency for value stocks to deliver stronger returns compared to their growth counterparts after Federal Reserve rate hike cycles.

9. 60/40 is Still Alive

Is the 60/40 portfolio alive again? Was it ever really dead? The well-known asset allocation strategy of 60% equities and 40% fixed income has come under much scrutiny in recent years, particularly in 2022, when both stocks and bonds fell due to the aggressive interest rate hiking campaign employed by the Federal Reserve. In fact, according to the Wall Street Journal, 2022 was the worst year for the typical 60/40 portfolio since at least 1937, with a loss of approximately 17% based on data from the Leuthold Group.

Historically, stocks and bonds do not exhibit high correlation and therefore do not necessarily move in the same direction as economic or market conditions change.  This relationship makes them worthy candidates for a diversified portfolio strategy, such as 60/40, which should, of course, consider an investor’s tolerance for risk, investment timeframe, and financial objectives. As interest rates decline and inflation moderates, signs of new life may emerge in the age-old 60/40 portfolio construct.

Look no further than November 2023 for an example of this rebound potential as the average 60/40 portfolio had its best month since January 1991 during the month, according to Bank of America Global Research as published by Reuters, as investors came to believe that we were at the end of this rate hike cycle. These signs of new life will only intensify as interest rates start to decline later in 2024.

10. What if the Fed Stays “Too High for Too Long?”

Risks to the economy and the markets do exist in 2024 if the Fed stays “Too High for Too Long.” Keeping interest rates at their current levels (or potentially even higher) for too long could substantially impact over-leveraged companies and consumers facing short-term rate challenges. This possibility, along with the uncertainty that may accompany a Presidential election year and the potential escalation of certain military conflicts across the globe, creates the potential for more market volatility in 2024.

The potential for more volatility in 2024, which was largely absent in 2023 when compared to 2022, does not mean that investors should try to time the market, as timing the market is often an exercise in futility, and “staying on the sidelines” for too long can have a negative impact on achieving longer-term financial goals. Rather, a more balanced approach towards positioning in the stock market, perhaps through equal-weighting strategies, covered calls, or more defensive stocks, may be worthy of consideration for certain investors and/or portions of their overall portfolios.
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Disclosures: Hennion & Walsh Asset Management currently has allocations within its managed money program, and Hennion & Walsh currently has allocations within certain SmartTrust® Unit Investment Trusts (UITs) consistent with several of the portfolio management ideas for consideration cited above.

This commentary is not a recommendation to buy or sell a specific security. Investing involves risk including possible loss of principal.Past performance is no guarantee of future results.