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

Part 1: U.S. Economy

Let's start today by discussing the U.S. economy, which has actually been holding up better than forecasted.

Lowe: The economy has been very resilient. A lot of economists had forecasted a recession by now. That hasn’t happened. Growth has actually been very solid—not too hot or not too cold. Inflation is lower. The rate of change is lower. But the prices are still very, very high.

The lower to middle tiers are struggling a little bit, particularly with debt, and income, and inflation and the rising delinquencies. But the top 20%, or the top part of the consumer market, is doing very, very well. The top 20% accounts for more than half of overall spending. So, overall, I would say it feels like we’re at this tipping point right now where the economy is clearly slowing.

I think we probably have a soft landing. But it could tip over—there’s still this recession risk. Economies tend to be non-linear, meaning that they can fall apart very, very quickly, even if they're humming along for a while.

Spangler: We're beginning a rate cutting cycle here with a large, first 50 basis point rate cut into an environment where we’re not in recession, but rather, we still have economic strength. GDP is still growing; the consumer is still spending. We're seeing that that cycle is being extended.

Lowe: Normally when the Fed is cutting 50 basis points or larger, you’re already in a recession. In this case, it’s purely preventative. So, it's a little bit different.

Spangler: The U.S. stock market is also at record highs, and the money supply is beginning to grow after having contracted for some period of time with rising rates. We’re also seeing the velocity of money begin to rise a bit, too. The decline in interest rates, that will support areas of the market that were hurt with rising interest rates. So, more cyclical areas would be supported with a reduction of interest rates.

Jobless claims are reasonably firm at this point—they’re pretty low. So, in total, the consumer is well supported, both from the wealth effect and having capacity to continue to spend, but from this aspect of having jobs as well because, while we've seen an increase in the unemployment rate, that’s more to do with the rise in the supply of labor, but not as much with companies laying off. So, if the consumer is not concerned about losing jobs and has the capacity to spend, the consumer will continue to spend and support the U.S. economy.

Branstad: What are you guys most concerned about for the U.S. economy?

Lowe: I'm most concerned about the labor market. Unemployment is rising and it’s at a level where typically it would keep rising. The definition of a recession really, or the hallmark of it, is high unemployment and job losses. The job market, sort of like the economy, could deteriorate very, very quickly. In other words, we're still adding payrolls, but then if you look at history, you can fall off a cliff very fast.

So far, as David mentioned, we’re not seeing that many layoffs. It’s really that companies have pulled back on hiring. They’re very, very reluctant to let workers go because they had a bad experience during Covid, and it costs a lot of money to hire, and it costs a lot of money to train people.

Branstad: David, what are some of your concerns?

Spangler: My concerns are similar to Steve’s, but also, geopolitical events. These are things, of course, that we can’t predict what's going to happen. But an example is within the Middle East. If that grows into a wider conflict, it could cause some disruption and volatility in the markets. However, history has shown that, while the market can pull back with wars, it actually ends up being more of a buying opportunity, intermediate and longer term.

Branstad: Kent, what are some things that you’re keeping an eye out on?

White: Well, there's always no shortage of things to worry about. I think one of the risks that we're kind of looking at and maybe isn’t really priced in the market right now is an environment where the labor market continues to gradually weaken, and inflation remains elevated or even begins to accelerate. The Fed likely won't be able to cut rates in this environment, and the markets would probably react really negatively to that scenario.

Part 2: Federal Reserve Outlook

Branstad: Obviously, the concerns over inflation have been driving what the Fed has been doing, which has in turn kind of been driving markets to a large extent. So, now that inflation has kind of moderated and lowered a little bit, how has that changed the Fed’s outlook?

Lowe: The Fed appears very confident that they have inflation in the bank, that it’s sustainably lower. But it’s going to be a little bit uneven. I think we’re going to have periods where it goes up, particularly rent and what's called shelter inflation, which is the cost of owning a home—it’s very sticky.

White: There’s also some seasonality with inflation we’ve seen in the last few years. Early in 2024, we had this inflation scare in the first three months of the year and we could absolutely see that again in the beginning of 2025. Just to kind of put that in a little bit of perspective.

Branstad: Now that the Fed has started cutting rates, Kent, what are your expectations for the Fed for the rest of this year and going into next year, too?

White: The Fed just began their cutting cycle with a 50-basis point cut, as Steve mentioned earlier. That’s the first reduction in the Fed funds rate in over four years. So, they’ve started cutting rates, though, from what the Fed viewed as a very restrictive level. The Fed funds rate is still above where anyone believes the neutral rate really is.

From that perspective, there's still a lot of room for the Fed to continue recalibrating rates to lower levels. We’re likely to see probably two more 25 basis point cuts this year, possibly a 50 in November, depending on what the labor market looks like. Then in 2025, the Fed’s dot plot right now is showing four cuts or 100 basis points of easing into 2025.

Branstad: That’s what the Fed is saying. What about the market? Is the market in alignment with those views?

Lowe: Relatively aligned, but it’s still pricing in more cuts than the projections that the Fed put out. The Fed is looking for four cuts in 2024, followed by four more in 2025. The market is closer to five this year, and five more in 2025. I think if the Fed does cut less than expected, you could see rate markets react to that, maybe push up short-term rates a little bit. The broader market could have some indigestion. I think, either way, the actual path is unlikely to be what the market thinks and unlikely to be what the Fed thinks.

Part 3: Global Economy

Branstad: If we’re to broaden our viewpoint a little bit, David, what do you see? How do you kind of see the global economy reacting? Particularly Europe, China?

Spangler: Internationally, it’s an interesting question because, with the Fed lowering interest rates, it allows other international countries to lower rates as well. But overall, we're still underweight international, particularly in developed markets, and having a lot to do with Europe and slow growth within Europe. We’re moderately underweight emerging markets.

Within the emerging markets, just today, this week, the Chinese government has come out with a whole series of monetary stimulus to the markets—supporting mortgages, supporting the equity markets and lowering borrowing rates, among other things. But it's really just, I think, a small step because it’s not addressing the substantial overhang of their housing market, real estate markets and extremely low consumer confidence and sentiment within China. So, without much larger stimulative measures within China, we still would remain underweight China or emerging markets by some modest degree. If we did see the proverbial big bazooka on the fiscal side within China, that would follow through to the rest of emerging markets as well.

But within the developed areas of international, we still are not constructive there. Mainly because, within Europe, productivity is still extremely poor.  Europe has tremendous structural problems as well, from demographics, very intractable employment and much, much higher regulation. So, the innovations and growth are not going to come from Europe, it’s going to come from the United States.

We remain overweight within the domestic markets. Principally, as I said, the main underweight is within developed markets, internationally.

Part 4: Treasury Rates & Curve

Branstad: Kent, we've talked a bit about the Fed cutting the Fed funds rate. What's your outlook more broadly on Treasury rates?

White: With a soft landing as our base case, our expectation is that it will take longer for inflation to reach the Fed's 2% target. As a result, the curve is likely to continue to steepen, meaning that long rates are going to decline less than short rates. We think that the ten-year Treasury yield is likely to remain in a range from 3.5 to 4%.

It’s interesting—after the Fed cut, long rates actually went up, which is probably telling you the market's a little more worried about inflation. Maybe they think that might catalyze growth somewhat.

Branstad: Steve, could you tell us a little bit more about what's happening with the shape of the yield curve?

Lowe: Yeah. The curve has been steepening, as Kent mentioned. It's un-inverted after the longest inversion ever, which was more than two years. That's where short rates are higher than long rates, and usually it's the other way around. The catalyst for the curve steepening was the Fed cutting shorter rates and that impacts particularly—the Fed funds rate is what they cut, and it impacts two-year rates significantly.

White: Yeah, another factor behind our view for a steeper Treasury curve, besides inflation not going away as easily, is that the fiscal backdrop will likely keep a floor on kind of rates out the curve, ten years and 30 years especially. We've also had some periodic weak Treasury auctions throughout the last year, and those are likely to happen again periodically over the next 12 months.

Part 5: Equity Perspective

Branstad: Let's talk about equities for a little bit. They have been noticeably more volatile recently. But there have actually also been signs of them broadening out from that extreme concentration. David, what do you expect going forward? Is that broadening sustainable?

Spangler: Well, as you have mentioned, there has been some broadening more recently. But year to date, the Mag Seven—or the Big Six, however we want to say it—is still the market leader, but we are seeing a broadening out within the S&P 500. The S&P 500 equal-weighted index over the last month and more has been performing better than the capitalization-weighted index.

We are seeing mid caps and small caps also performing a little bit better than they have throughout the early part of the year and last year as well. So, the question then is: what is broadening out? So, is broadening out into mid caps and small caps and from growth to value, or is it really just within the S&P 500? I think that I'm a little bit more in the camp of broadening out within the S&P 500, and not as much into mid caps and small caps and value from growth. It's a little bit more of a near-term phenomenon with the more recent decrease in interest rates. The thing about small caps as well is that it doesn't take a lot of money to move from large into small to really push the price of small caps.

Lowe: So, you might see bouts of investors seeking value or rotating in, but not sustainable?

Spangler: Yeah, I think that that's how I would characterize it. The reason that we would view it that way is that just, structurally, now, small caps are disadvantaged relative to large caps in a wide number of ways. Small caps are very much lower quality nowadays than they were in the past, but also, companies that used to IPO or have an initial public offering into small cap and then grow into a large cap—think of, let's say, Microsoft, over the course of several decades, right—but we're not seeing that now. The private equity markets are so, so large now. Companies are staying private for much longer. If they even do go public, they do so as a large-cap company. So, the benefits of a small cap now accrue to private investors more than they do to public investors.

The large-cap tech companies are really venture capitalists as much as they are pursuing their own business. Microsoft has taken a very big position into OpenAI, which is private, and now is maybe worth as much as $100 billion, right? So, that's a lot of the structural reasons why small caps are disadvantaged relative to large caps.

Now, in the intermediate or shorter term, the composition of those areas of the market are such that the more cyclical areas could be supported by declining interest rates. So, it takes some pressure off of the debt burden of small companies. That, at least temporarily, can allow them to perform a little bit better relative to large. But in the intermediate and longer term, we're still more supportive of large cap over small cap and growth over value.

Branstad: We talk a lot in these discussions about how earnings drive markets over time. So, what's the outlook on earnings right now?

Lowe: Overall, pretty solid. If you look at the expectations, they are supposed to be up around 10% in 2024 and 15% in 2025. That's on about 5% revenue growth, so that's contingent on margin expansion, essentially. The key issue is, if you look at overall market earnings, they’re overly reliant right now on large-cap tech earnings.

Cyclical companies have lagged along with small caps. So, if you look at the Big Six—which is basically the Magnificent Seven, ex Tesla—earnings growth is around 30%, and it was higher in prior years.  AI is driving a lot or some of that. If you look at the rest of the S&P 500, it's kind of mid-single digits. So, it's very concentrated. That gap is expected to narrow as tech slows from unsustainable rates, because you can't keep growing 50, 60% every year. The math just doesn't work.

Our expectation is that you could see some pickup elsewhere, kind of broadening in that. But we still expect large caps to outperform significantly.

Looking into 2025, it obviously depends on the economy. Soft landing or recession, our expectation is that will remain solid with the soft landing.

I think another trend that we've already seen in spurts is that the market is going to demand proof from companies involved in AI that they can actually make money at this and monetize it, kind of “show me the money.” That excludes the chip companies, the semiconductor companies that are already making money off this. So, overall, relatively positive, but challenges.

Part 6: Fixed Income Perspective

Branstad: Kent, credit markets have been relatively rich. How do valuations look there? Are you seeing any signs of weakness in credit or in the companies therein?

White: Credit market valuations still remain relatively rich. They've been that way for most of the last year or so. We don't have much cushion in credit spreads if the economy were to weaken, and spreads began to widen. So, we're a little defensive there. But under the soft-landing scenario that we're expecting, one with moderating growth and moderate inflation, credit generally performs pretty well in that environment. So, we may not like valuations particularly at this point, but from a yield perspective, an all-in yield perspective, we do still find credit attractive.

Investment-grade corporate yields are still far higher than they've been over most of the last 15 years. As for corporate fundamentals, corporate balance sheets are still pretty well positioned right now. We're unlikely to see any meaningful weakness or deterioration in those, even if the economy is a bit weaker than we're expecting.

I think the one part of the credit market that would benefit the most from a Fed rate cutting cycle are the riskiest parts of the high yield market, especially triple-Cs. Many of these companies finance themselves with floating-rate debt. As the Fed was raising rates to fight inflation, the interest burden on these companies made it really difficult for them to survive. A lot of them have just been barely getting through. Now with Fed cuts and Fed rate cutting cycle on the horizon, that will begin to flow through to their loans, which will relieve some of this burden.

Branstad: So, Kent, what do you like best within fixed income right now? Is it low quality or higher quality? Rate exposures?

White: We're still biased to being slightly defensive in credit, just because of the rich valuations I just mentioned. So, generally, we’re somewhat up in quality, and we're also still favoring the front-to-intermediate part of the curves or those maturities, like 3- to 7-year in corporates, and 30-year corporates continue to look very rich to us. So, when we're looking for duration in any of our portfolios, we're kind of leaning more towards the Treasury market for that duration as opposed to corporates.

Part 7: Key Areas to Watch

Branstad: What are you more focused on looking ahead?

Lowe: Yeah, it would be the labor market. Because the defining characteristic of recession is rising unemployment.

White: We're definitely keeping an eye on the health of the consumer. We've been seeing a pickup in delinquencies from some lenders recently, particularly in the lower-income segment.

Spangler: Now, I would add a little bit in that re-acceleration of inflation could be a risk. But now, with a preemptive 50-basis-point rate cut, if we continue to have rate cuts down to what we presume to be the Fed's neutral rate, there is the risk that we could have a re-acceleration of inflation as something that we definitely need to keep our eyes on.

Part 8: Portfolio Positioning

Branstad: Let's finish up by going through our mixed-assets positioning. Steve, broadly, how are you positioned?

Lowe: Yeah, we're moderately overweight risk, which means we're overweight equities versus fixed income. We've dialed it back a bit because of more mixed economic signals; recession is still a risk. We want to see signs of really re-accelerating growth to get a lot more aggressive.

Branstad: Okay. David, how about equity positioning?

Spangler: Within equity’s position, as we've talked a little bit about, we're overweight equity modestly. So, a little bit under our long-term strategic, but overweight equity relative to our benchmarks. We are, within equity, overweight domestic over international, and within international, developed over emerging markets. One thing that I think that we should call out too, though, is that we're overweight large caps, we're overweight mid caps, and we're only a little bit underweight small caps.

In the context of a broadening out—if there is a broadening out beyond just the Equal Weight S&P 500 and into mid caps—we are overweight mid caps, and we will benefit from that, and only modestly underweight small caps, which I think is a reasonable position at this point, because long-term strategic underweight to small caps is where we want to be.  If there is a resurgence in risk assets, we will benefit from being overweight mid caps.

Branstad: Kent, how about on the fixed income side?

White: I think the main takeaway is that we're still very constructive on fixed income overall. All-in yields are still at very attractive levels relative to the past 15 years, even after coming off the recent peaks. Fixed income has yield again and can act as a ballast to a portfolio if the economy were to weaken more than we expect.

Lastly, now that the Fed has begun their rate cutting cycle, we may begin to see money market yields start to decline pretty rapidly. It's not too late to begin extending out the curve and locking in some of these yields.

Branstad: Kent, David, Steve: thank you all for sharing your insights and perspective today.  thank you all for joining us and we hope to see you again soon.