Part 1: Review

Branstad: Hi, everyone. Thank you for joining us today for Thrivent Asset Management's Capital Markets Perspective on the third quarter of 2024. I'm Jeff Branstad, portfolio manager for Thrivent’s Model Portfolios. Joining me today is Steve Lowe, chief investment strategist; David Spangler, director of mixed asset markets strategies; and Kent White, our head of fixed income.

Not too hot or cold

Branstad: So, gentlemen, before we turn to our outlook, let's review a little bit of what happened over the past quarter. Equities had a mixed but generally positive quarter. Fixed income was a little more subdued. What did you see as some of the key trends and key themes over the last quarter?

Lowe: Yeah, sure. I think one of the key themes is Goldilocks. So, markets want the economy not too hot and not too cold. Too hot risks higher inflation and higher rates, which could slow the economy and cause a recession. Too cold hurts growth and you're not getting earnings, and markets do not like that either. I think the economy remains solid overall, but it's a bit of a two-speed economy.

Sticky inflation

Lowe: Inflation is slowing, but it's far from dead. The year started off with hot inflation, meaning that it was beating expectations coming in hot. That trend has flipped recently and inflation is now decelerating, coming under expectations. Goods prices remain in deflation, which they have been for a bit now. But we're starting to see encouraging signs in parts of services, particularly core services, which is a focus of the Federal Reserve, or Fed.

But there are still sticky areas, like what we call shelter, which is rent and the imputed cost of owning a home. And wages are still somewhat sticky. We expect progress, but like we've talked about before, it's going to be a bumpy path. And getting down to the Fed's 2% goal is going to be hard, that so-called last mile.

Markets remain hyper focused on inflation because inflation is driving the Fed, and the Fed has a large influence over markets and the economy.

Part 2: Outlook

Signs of a soft landing

Branstad: When we are looking forward into the next quarter and the rest of the year, what are you feeling is supporting the economy and leading more people to be comfortable predicting a soft landing?

Lowe: Overall, the economy is solid. The data is a little bit more mixed, but still strong. You can look at gross domestic product (GDP), which is a broad measure of economic growth—that slowed in the first quarter. But, underlying that, really good domestic demand, which really drives the economy, was very strong. Real-time measurements of the second quarter, such as the Atlanta Fed's GDP, is very strong.

I think the crux of it is that the job market is strong. If you have a strong job market, people have income. And if people have income, they can spend. The service sector is about two-thirds of the economy, and the consumer overall is holding up well, particularly upper income sectors. Manufacturing is soft, but you also have a strong investment cycle in technology, particularly artificial intelligence.

The other thing to remember is that we're running deficits, meaning that the government is borrowing and spending more because of that. So, they're adding to economic growth through deficit spending.

Is a recession still possible?

Branstad: Is there still a possibility for a significant slowdown or even a recession?

Lowe: Yeah, absolutely there is. There are numerous signs of slowing. The jobs data overall is good, but it's a little more mixed. Payrolls are solid. But, if you look at unemployment, that's starting to rise. There are fewer job openings. Retail sales have been somewhat weaker recently. In particular, consumer confidence is not great. It depends what you ask them about, but they're very concerned about high prices. Inflation is slowing, but the price level is still super high, and that has an impact.

The other item is that economies are non-linear, meaning that a slowdown can snowball very quickly into a recession. You know what happens when one company cuts back? Well, the suppliers for that then in turn can cut back, and it kind of daisy-chains down. Historically, job markets hold up very well. There are other economic metrics until just before or a few months before recession, or even toward the start of it, and then they fall off quickly.

Global perspectives

Branstad: What if we zoom out our view a little bit, David, and look at the global economy, particularly Europe and China? What do you see there?

Spangler: Europe has been improving. In fact, they were showing some improvement in corporate profits, and in general, it was doing as well or even somewhat better than the S&P 500 on a year-to-date basis, despite not having anywhere close to the same type of tech representation. It's a little more value and cyclically oriented, and that was being reflected in the fact that they were beginning to show little signs of improvement.

However, more recently, we've had some issues with elections, which is to say that both the far right and the far left have gained on the centrists within Europe in general and within France, and this is causing some significant sentiment deterioration. So, more recently, Europe has really underperformed the S&P 500 domestic equities. One could say that it's a bit of an overreaction, or it could be. But it is a concern at this point. The U.S., though, is overall a more resilient, more innovative economy.

From an emerging markets (EM) standpoint, what we are seeing is that there's EM economies that are beginning to, or have been, reducing rates in advance of the U.S. That is also true with the European Central Bank (ECB) in Europe, and that causes some rate differentials, and rate differentials can be reflected in a stronger dollar. A stronger dollar is not great for EM economies that are especially sensitive to dollar-denominated debt. So, overall, we're not constructive on EM on a relative basis to domestic equity. But China has structural issues itself: very high debt, demographics, and other areas.

So, on an overall basis, we're still much more constructive on the U.S. economy and domestic equity.

Part 3: Equity perspective

Valuation in mega caps

Branstad: If we turn back to stocks, David, what's your outlook there? What do you see leading the way?

Spangler: It’s likely to be more of the same, which is to say, momentum. And momentum now is characterized as large-cap tech. It’s large companies, mega-cap tech, which have very strong earnings growth and margin growth. On a relative basis, their margins are actually not overly valued. Their earnings are so strong, or margins are so strong, that they're not necessarily overvalued for what they're producing.

Lowe: If you look at price-to-earnings, maybe a little bit, but if you look at price-to-cashflow, they're actually very attractively priced because these companies kick off so much cash.

Spangler: Yeah, indeed. So, we do have risks, of course, with concentration and crowding into these areas. But until there's a reason why they don't work, we believe that they will continue to work.

Branstad: So, we still like growth, essentially?

Spangler: We are still overweighted to growth and still expect growth to continue to outperform value. If we do have a softer inflation-type of a scenario, and we do see Fed rate cuts, in that situation, we could see a bit of a rotation more to the cyclical side and you could see value outperforming growth. But, until we have that change, we do believe that we're still going to continue to see growth outperforming value.

Underperforming small caps

Branstad: How about small caps, David? They've been continuing to underperform for quite some time.

Spangler: Yeah, by a significant amount, for a significant period of time as well. We believe that we're still going to continue to see large caps outperform small caps and mid caps as well. Small caps typically aren't going to perform until you see a troughing of the economic data or troughing of the economy overall, and then a catalyst for resurgence of growth. So, whatever they might gain in a shorter period of time, if we were to see a Fed rate-cutting cycle, they're going to give back, we would expect. And, over a longer or intermediate period of time, we would expect large caps to outperform small caps.

Lowe: Yeah. As we've talked about a lot in our strategy meetings, small cap in a lot of ways is a different asset class than it used to be. And in general, small caps are just lower quality than they used to be. I think, of the Russell 2000 Small Cap index, about 40% are unprofitable.

Spangler: Yeah, exactly. It is a lower-quality section of the market; it always has been. But it's even more so now than it used to be. So, as we get into that troughing of the economy, if we get rate cuts, you could see the lower quality outperform higher quality. And, since there's a very small float so to speak, it doesn't take very much for small caps to actually outperform. Not very much money has to come into small caps to really cause them to outperform. But, over the longer period of time, we think that they’ll underperform.

Lowe: Yeah, because the whole index is equal to roughly one or two mega-cap tech names in market capitalization.

Part 4: Fixed income perspective

Federal Reserve policy & rate cuts

Branstad: Let's shift gears again back to fixed income. Kent, what do you see happening with interest rates and the Treasury market for this next quarter and for the rest of the year?

White: Well, as David just alluded to, the market is looking for some rate cuts from the Fed. That’d be pretty supportive for the market overall and certain asset classes. But one thing we have to be careful about is why the Fed is cutting and how much they are cutting. Too many rate cuts could send a signal that the economy is really falling off a cliff or weakening more than we would like it to. We like the economy to be supportive and the Fed just going in and doing some fine tuning with their policy rate. But our expectation is that the Fed will eventually begin making some adjustments to its policy rate.

However, they’re very data dependent at the moment, as we talked about, and the timing of these rate cuts is a little uncertain. I think the Fed would like to begin cutting rates sooner rather than later. We believe that their policy rate is quite restrictive at these levels. The current Fed policy rate is the highest it's been in 23 years, which is a really long time. Before they get started, they're going to need to see some more good inflation data—we had one good month, just your base CPI report—to be convinced that inflation is on a sustainable path towards their 2% target.

Until we see a few more months of supportive inflation data, the Treasury markets are likely to remain somewhat volatile, like we've seen it pick up here again. Our more intermediate-term view remains that yields are likely to move lower.

Inflation is slowing, but it's still above target, and the labor market has shown some signs of loosening, so I believe that should give the Fed some room to begin cutting rates before the end of the year. Whether it's 1 or 2 cuts, you know, it depends on how the data comes in.

Lowe: So, that's where you'd be? One to two rate cuts, most likely?

White: I think so. I think the Fed just—you can see in language from Chair Powell—he would like to begin cutting and just needs more [data], especially on the inflation front. I'd rather see some good inflation prints as opposed to the labor market. If they begin to cut rates because the labor market is loosening, I don't think that’d be taken as positively as if—

Branstad: —as if they did it [because of] inflation.

White: Exactly, yeah.

Credit outlook

Branstad: What about the credit side?

White: In credit, we're likely to be in a pretty tight trading range for the next few months, through the summer. Maybe we see some volatility pick up, as Steve referred to, as we get closer to the election. But credit spreads should be supported by solid second-quarter earnings. We've got really good credit fundamentals in the market right now, stronger balance sheets. So much of our new issued supply was front-loaded this year to get in front of the election and any other volatility that might arise. So, in the second half of the year, we should see lower supply, too, which will be a positive impact on technicals.

But like we referred to earlier, credit spreads are already pretty tight. So, there's limited opportunity for price performance from spread compression going forward. Fixed income, whether it’s investment grade credit or high-yield credit, remains attractive for the total yield and less so for the spread pick up. So, it's just, it’s mostly carry at this time—

Branstad: —the carry trade that we talked about earlier.

White: Yep.

Part 5: Areas of focus

Overall markets

Branstad: As we're getting close to wrapping up our time here today, let's talk a little bit about where you're focusing your attentions on going forward. David, what are some things that you're keeping an eye out for?

Spangler: As we talked about, we do expect and hope for the soft landing. But what we're looking for is weakening employment. What we need to see is a weakening employment but not too much weakening, so that what we can have is the Fed feeling comfortable that inflation will come down, that the sticky parts of inflation will moderate and that they can begin a rate cutting cycle. However, if unemployment accelerates, then we could go past a soft landing towards recession.

But really, for me, the main thing that we're looking at is employment, because that's going to affect so many different sticky parts of inflation, and we want to see a moderation, but not too much.

Branstad: Steve, where else are you focused?

Lowe: We’re very focused on the consumer which is related to employment very significantly. But we want to make sure that they hold up because there are signs that there's weakness in certain areas. So, we’re watching that.

And [we’re also watching] broadly what I've called geopolitical risk. There’s a lot of turmoil in Europe right now, war and elections.

And, as you reference, we do have this election coming up in the U.S.

Branstad: Yeah, don't forget! There’s plenty of things to be paying attention to and be focusing on.

Mixed-asset portfolio positioning

Branstad: To wrap this up, let's go through our mixed-asset positioning. Steve, why don't you start? Give us kind of the broad view of how we're positioned: aggressive, cautious, however you want to say it.

Lowe: Broadly, in our mixed-asset portfolios—so, fixed income and equities—we’re modestly overweight risk, overweight equities versus fixed income. Our long-term strategy is to overweight equities, but we dialed it back a little bit recently because there's more mixed economic signals. As we've talked about, to get more aggressive, we want to see some re-acceleration in growth and kind of an upward turn of the cycle to get cyclicals going.

Equity positioning

Spangler: As Steve mentioned, we're somewhat overweight risk to assets, somewhat overweight equity. We’re not all the way to our strategic long-term overweight in equity, but we have capacity to add if we were to see market weakness. But, overall, generally a little bit overweight public equity.

Within equity, we're overweight large caps, we’re overweight growth. We're most overweight domestic over international.

If we were to have the soft landing, we believe that we would continue to see support to the equity markets, but we are taking a little bit of caution at this point, giving ourselves the opportunity to increase risk if the opportunity presents itself, but a little bit more cautionary overall.

Lowe: The threshold for us to get underweight equities is pretty high. We would have to have strong conviction that things are going to be quite negative.

Spangler: Yeah. If we do see ourselves moving towards a recession, that's the point at which we would reduce risk; we would go underweight equities. We don't believe that that's where we're going to go, but we are definitely keeping our eyes out to ensure that we're not overweight risk at—

Branstad: —at the wrong time.

Spangler: —at a point where the economy is weakening more than expected.

Fixed income positioning

Branstad: Alright, Kent, why don't you bring us home? Why don’t you tell us where you're overweight and underweight on the fixed income side?

White: Sure. Because spreads are so tight right now, valuations aren’t particularly attractive. We're picking our spots in fixed income. Specifically, we're a little bit more up in quality and taking more of our duration from the right place, the Treasury market. So, rather than buying 30-year corporates, we've been taking on duration in the Treasury market, 30-year Treasuries as opposed to 30-year corporates to get most of our exposure to longer-dated maturities.

There's some other pockets of value that we found, one of them—moving down the capital structure—is the preferred and hybrid debt markets. We usually do that in really high-rated quality issuers, like banks and utilities. We've seen a little bit more issuance there, and we've got yields anywhere from 7 to 8% in the preferreds space, which is pretty close to where the high-yield market is right now.

So, away from that, we're also modestly long duration, waiting for the right time to get a little bit longer duration, just waiting for more signs that the Fed is ready to pivot a little bit more and begin to fine tune their policy rate.

In high yield, we remain underweight the lowest-quality segments. That’s one tricky part of the high-yield market that is populated with a lot of distressed issuers and stressed balance sheets. So, we've been avoiding that spot, that space. And we're overweight the more mid-quality segments of high yield.

Branstad: Kent, David, Steve, thank you all for sharing your insights and perspectives with everyone here today. And on behalf of my colleagues, thank you all for joining us and we hope to see you again soon.