Within equities, continue to favor domestic large-cap growth stocks

U.S. large-cap growth stocks have been the market leaders for much of the past year, and while our optimism about a soft landing could tempt investors to broaden their exposure within the S&P 500^® Index or rotate more of their portfolio to mid-cap, small-cap or value stocks, we believe it is still early to make significant strategic commitments.

To be sure, returns within the sectors of the S&P 500 Index are already broadening. The S&P 500 equally weighted index has recently performed better than the benchmark capitalization-weighted index, and we are seeing mid- and small-cap stocks performing a bit better than they did in early 2024 or 2023. As such, we are increasingly more positive on the outlook for mid-cap stocks, and continue to monitor small-cap stocks. Both may benefit from a resurgence in the willingness to take risk if geopolitical tensions subside, the U.S. election is less chaotic than the market fears, and most importantly the economy continues to grow at a solid pace. But as small-cap stocks, in particular, are notoriously volatile (for better or worse) as sentiment shifts, we favor taking longer-term views and waiting for more sustainable fundamental factors that can create durable rallies before we overweight small caps.

Broadly speaking, small-cap company fundamentals are weak relative to the asset classes’ history, with relatively high debt levels and a large number of which are unprofitable. While a stronger economy will help for the more cyclical companies, and lower interest rates will help the more indebted companies, we believe these effects will be on the margin and take time to fundamentally alter their long-term outlook. Additionally, the growth path for small-cap stocks has been changing. A decade ago, a small-cap company would grow into a large-cap company through public stock issuances. But today, these companies are increasingly staying private, supported by the now huge private equity markets. And, large (particularly technology) companies have been very aggressive in buying promising small-cap companies. Microsoft Corporation, for example, has taken a large stake in OpenAI—arguably one of the more interesting smaller market capitalization companies in America.

Finally, both small-cap stocks and value stocks have indeed historically performed better as economies transition out of recession, but it is important to remember that the U.S. economy is not in a recession. In the past, recessions have created more damage to the real economy, depressed market valuations and eliminated some of the weaker companies. But in today’s world of less dramatic business cycles, and our forecast for a soft landing, there isn’t such a dramatic bottom from which these stocks could rebound in a strong cyclical upturn.

Remain underweight international stocks

Our primary reluctance to increase allocations to international markets is our continued concerns about the European economy. Compared to the dynamism of the U.S. economy, the European economy is relatively static. Not that Europe is lacking on an absolute basis, but that the U.S.’s financial ecosystem—its spirit of entrepreneurship and the resulting volume of startup companies, together with more developed capital, private equity and venture capital markets—is unparalleled.

On a more tactical basis, consumption in the eurozone has been weak, while China’s increasing reliance on competitive exports and Europe’s likely embrace of import tariffs will only weigh on the economy. As such, relative to the U.S., we continue to maintain our recommendation to be strategically underweight Europe, the largest of the international economies. To be clear, this is not a tactical recommendation based on short-term factors in either the U.S. or Europe, but a bias over the long term to favor the more dynamic U.S. economy.

Within the emerging markets, we remain more positive and are positioned roughly neutral, but caution that China’s lackluster growth and worrying structural problems remains a drag on the outlook for emerging-market economic growth. China has recently announced additional monetary stimulus (including supporting mortgages, equity markets and lowering borrowing rates), which should help, but doesn’t fully address the substantial problems within its real estate market and its extremely low levels of consumer confidence. If China were to address these issues more aggressively, with massive fiscal stimulus (in addition to monetary stimulus), the Chinese stock market could more sustainably rebound and have significant spillover effects throughout the rest of the emerging-market economies. Thus, the situation warrants monitoring, but it is too early to make assumptions about the longer-term outcome.

What to watch: The labor market, geopolitics and the election

U.S. unemployment has been rising and is near the level at which—in normal times—it could continue to rise and possibly accelerate in a vicious spiral. However, these are not normal times, and we are not seeing significant layoffs that could hurt consumer sentiment (slowing consumption), in turn hurting corporate sentiment. Instead, companies have been reluctant to fire or lay off employees, choosing to bet on a recovery given the costs of hiring and training new employees when demand for its goods or services increases.

Meanwhile, geopolitics and domestic politics remain a source of significant uncertainty. Whether it is the ambitions of Russia, its growing alliance with China, the fate of Taiwan, Iran joining the Middle East conflict, democracies failing in Latin America or coups and wars in Africa, the world has not seen such a breadth of places in conflict that could erupt into something big enough to disrupt the global economy in a long time. 

While the risks of a sudden change in the geopolitical landscape does concern us, it is important to keep in mind that all or most of these concerns have been present to some degree throughout the year and yet the U.S. stock market is still setting record highs. That is, to the extent tensions can remain relatively contained, disruption can be minimal. But should something somewhere boil over or result in a significant disruption to commodity supplies (recall the effect food shortages had on inflation soon after Ukraine was invaded), equity volatility will likely spike.  

While the original source is debated, there is a phrase increasingly paraphrased in the recent press which goes something like this: “There are decades in which nothing happens, and there are days where decades happen.” We suspect it has gained popularity because any of the current global disputes we’ve mentioned could confirm its point, and the U.S. presidential election is no exception. Historically, markets are generally indifferent (over the long term) to which party wins the presidency or takes control of Congress. But in the short term, markets do not like uncertainty. It raises volatility and thus risk premiums, prompting greater caution from investors and thus lower prices. Insofar as consumer confidence surveys already show the election to be a key concern, confirmation of a contested outcome could heighten concern, raise volatility and dampen economic activity.

There are decades in which nothing happens

There may be a risk that inflation rises, the U.S. economy weakens more than we expect or global or domestic politics boil over. But in our approach to investment management, we believe the prudent response to these concerns is not to withdraw from the markets, but to remember the importance of having a diversified, actively managed portfolio.

With a longer-term view, we remain constructive on the outlook for the U.S. economy, the stability of the country’s political system and the ability of the global economy to weather a multitude of surprises. Consider the sudden emergence of COVID-19: It threatened to devastate the global economy, but the S&P 500 Index set a new high just six months later. Investors, in our view, should maintain their exposure to stocks and bonds, continue to favor equities with a long-term view, consider the opportunity to lock-in long-term yields in U.S. government and corporate bonds, maintain a diversified portfolio and work with an active manager who is vigilantly monitoring the risks and looking for potential investment opportunities.