Above the Noise: Can the Fed stick the (soft) landing?

Does the Great Rotation have legs?
Small-cap and growth equities manager Justin Livengood shares his views on the viability of the Great Rotation, the evolution of the artificial intelligence boom, and two unexpected areas of the market that he’s excited about today.

Brian Levitt:

Welcome to the Greater Possibilities podcast from Invesco, where we put concerns into context and the opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And on the show today is Justin Livengood. Justin is a Senior Portfolio Manager for the Mid Cap Growth strategy and a Senior Research Analyst for the Discovery and Capital Appreciation strategies with a focus on financials, real estate, and health care.

Brian Levitt:

Yeah, thanks for the intro, Jodi. It's always good to have Justin on. I think our frequent listeners will remember, and I keep coming back to it, that Justin eased our concerns in 2023 during the week of Silicon Valley Bank failure, which I think was one of our more important episodes.

Jodi Phillips:

It was, absolutely. And earlier this year, Justin discussed his optimism about artificial intelligence (AI), which has obviously been a driver of market performance this year.

Brian Levitt:

I think you and I know the best people. I mean, I know the 45th president says it, but I think you and I know the best people.

Jodi Phillips:

Brian, no, we're not doing politics this week.

Brian Levitt:

Good, good. I think it's all anyone wants to talk about. So, I am very good to take 20 to 30 minutes off from the political environment in the US.

Jodi Phillips:

For sure, and you may also be happy to know that we're also not talking about the unwind of the yen carry trade and a market correction on this podcast either.

Brian Levitt:

Yeah, we've come a long way since then. I know investors get upset every time these 5% to 10% downturns happen. They happen almost every year. People always seem to freak out. They're almost always the result of policy uncertainty, tend to abate when we get greater clarity, and this was the case as well this time.

Jodi Phillips:

Yes, they do. And this time it was the Bank of Japan that needed to clarify their policy stance instead of the Federal Reserve. But I did like the stat, I will mention this. I like the stat you included in your article when all of that was going on, your article about market corrections, just reminding investors that the US stock market has recovered within an average of three months after one of those 5% to 10% corrections.

Brian Levitt:

Yeah, maybe three months was two pessimistic, but these are averages, right? So we'll see what September looks like. September's not always a great month for stocks, but nonetheless, that three month number worked out pretty nicely.

Jodi Phillips:

Yes, it did. So yeah, great question, September, where do we go from here? So I revisited my notes of Justin's comments back in 2023, you mentioned that podcast. One comment I'd like to come back to today, I'll quote, "We are returning to a proper equilibrium in monetary policy that may help provide a stronger base for the economy and the stock market to operate from in the next two to three years." That what he said back in 2023.

Brian Levitt:

Yeah, great comment. And that was one and a half years ago, so does Justin still feel that way?

Jodi Phillips:

Absolutely. And what about this so-called great rotation. I mean, Justin is a small and mid cap manager after all, so he's a great person to ask about markets broadening out, including greater participation from small company stocks.

Brian Levitt:

He's also a growth manager across market capitalization. So where are we with the AI trade? How big can this be? And what other themes are exciting? I mean, I love talking to growth portfolio managers.

Jodi Phillips:

Yep. Well let's do it. Let's talk to him instead of about him. Let's bring him on right now. Hi, Justin.

Brian Levitt:

Hey, Justin.

Justin Livengood:

Hi, Jodi. Hi, Brian.

Brian Levitt:

So, Justin, why don't we start with that quote that we brought up from 2023. Jodi and I take very good notes.

Jodi Phillips:

Thorough, very thorough.

Brian Levitt:

Copious notes.

Justin Livengood:

Do you?

Brian Levitt:

Yeah. So, do we still have a strong base for the economy and the stock market to operate in the next, I don't know, can I still say two to three years or have we cut into that two-to-three-year period?

Justin Livengood:

Yeah, no fair question. I think so. I feel a little better today, quite honestly than I did at the end of last year for two reasons.

First, we at least now are on the doorstep of the Fed easing regime. We'll see the exact magnitude, but a year ago, we still weren't sure if higher for longer was the reality, and now we can at least put that debate behind us.

The second thing that makes me a little more optimistic is that the economy has hung in better than I would've feared. There's definitely been some impact to the tighter monetary policy. We've seen some wobbly statistics. Clearly, the low-end consumer, the middle-income consumer even is feeling a little more strain, but it hasn't yet created a recession or pressure the economy even to get much below 2% GDP growth year to date. We overall have hung in a little better this year economically, both from the consumer, but particularly from the commercial industrial side than I might've predicted.

So, I am optimistic going forward that maybe for the next couple of years, we'll go to the low end of that two-to-three-year range, that the foundation for the stock market is pretty solid. To me, monetary policy is the most important thing. And so again, the fact the Fed is going to be cutting to some degree, my guess right now is at least 100 bps (basis points) over the next four meetings. Gives us a little bit of a tailwind.

The one thing that concerns me or that might change my answer the next time we're on this podcast would be inflation. So, the fact inflation in the US has come down into the twos is a relief and it needs to stay there. If, for whatever reason, that starts to drift higher again, I do then worry the Fed slows or stops its easing campaign perhaps at some point next year and leaves the economy in a little bit more of a precarious position. I see no evidence of that right now, but I'm just saying, that would be the one scenario that I worry about and I'm hearing a lot of chatter about that from the buy side community. That is the one, if there is macro concern in stock market is, boy, it's great to see inflation get down to these levels, sure hope it stays here.

Brian Levitt:

Jodi, Justin mentioned that the economy was better than he would've feared. I feel like that's everything in my life. Everything ends up better than I would've feared.

Jodi Phillips:

You're taking the pessimistic approach, Brian.

Brian Levitt:

Well, I'm not-

Jodi Phillips:

You got to be more of an optimist.

Brian Levitt:

Well, that's the optimist's view, right? We worry about things, but things almost always end up better than we would've feared.

Jodi Phillips:

I suppose, I suppose. Well, in any case, we do have some good sound bites here that we can read back to Justin-

Brian Levitt:

A couple years from now.

Jodi Phillips:

... a year and a half from now.

Justin Livengood:

That's right.

Jodi Phillips:

But I'm curious, Justin, maybe what do you attribute that to? I mean, what perhaps were you expecting to see in the economy that didn't come to pass? What might be some of the driving forces behind that better-than-expected scenario?

Justin Livengood:

Yeah, I think that a handful of things have helped. First of all, even though as I said a minute ago, the low end consumer struggling, the broader consumer economy is doing pretty well. The stock market having held in there, the housing market having held in there, people actually have decent savings and that has propped up spending. Travel has been resilient. So some things like that have been pleasantly surprising.

On the commercial industrial side, there's been a lot of reshoring going on as companies have brought operations back from either China or perhaps parts of Europe. And so that's driven a little bit more of demand than maybe we would've expected to see a year ago. So again, I don't want to, by any means, give the sense that we're all clear, but the downside case that Brian correctly was referring to, and I take that glass half empty view as well on most things, fortunately hasn't played out yet. And I think with the Fed now ready to cut, the downside risk or that tail risk to the downside is smaller.

Brian Levitt:

When I think of the balance of risk though, it's interesting to hear you talk about inflation. I view inflation as something that we didn't have for decades and then a pandemic caused it, right? I think we all had too much money right at the exact moment businesses got rid of all their workers and all their stuff, right? I have a hard time envisioning that coming back. If I were to look at the balance of risk, it would be on the growth side. What would you need to see to fear that there would be a recession coming? Is there anything that you're looking at that would give you that fear?

Justin Livengood:

Well, I think, yeah, on the demand side of the economy, if China's problems spilled a little bit more into the global economy and we had just less exports and a little bit more stress on the industrial side of the economy here domestically, that would concern me. That would cause some of the growth fears that you're referring to. I think if the problems the low-end consumer is feeling as they are having to increasingly prioritize their spending, if that creeps up the economic spectrum a little bit more, it could get a little tricky. That's going to be very much dependent on employment. I think we need to see employment get a lot worse before that really becomes a major concern, but it could. So those are probably the two things that worry me the most, again, from the demand side. Assuming inflation stays behaved though, I think the Fed's going to pull this off. If I had to bet right now, I think China and the consumer are going to hang in there just long enough for them to get rates back down to a level that avoids these types of demand or growth issues.

Brian Levitt:

Are they lucky or are they good, this-

Justin Livengood:

I'm going to say a little both, right?

Brian Levitt:

All right, I like that answer.

Jodi Phillips:

It's a good combination.

Brian Levitt:

Just in case Jay Powell's listening.

Justin Livengood:

Yeah, I'm sure he will.

Jodi Phillips:

So Justin at the top, we mentioned the great rotation during our intro. Would love to get your views on that. What do smaller cap companies need in order to outperform and is that more dependent on the rate environment we've been talking about or the growth environment or, again, a combination of two things?

Justin Livengood:

Well, it's a combination, but in that order, so the rate cuts, the monetary policy is the most important thing. Small cap stocks are particularly sensitive to the yield curve given they're more dependent on financing than their large cap peers are. And just to put some numbers to that, in the last 13 periods where the Fed was cutting interest rates, going back over 50 some odd years, 10 of those 13 times, small caps outperformed large caps three and six months after the initial Fed cut. So if history's a guide, then what's about to happen here in September should, by the end of this year, demonstrate small cap outperformance as we move into 2025.

But that's not sufficient. It's a necessary first condition to have rates come down. But the second almost as important condition is you need to see earnings start to come through more for those small cap companies. And happily we've seen that here. In Q2, small cap earnings for the first time in over a year outperformed large cap earnings. Not dramatically, but that gap that had been present for a while where large caps were really doing better has finally started to turn a bit. So if that continues at least somewhat into the end of this year, beginning of next year, that earnings recovery should pick up the baton, if you will, from lower interest rates and help this broadening out that the market's seen for a while. I've been getting this question all summer and at first, the question was, "Can the markets broaden in small caps?" But now it's been like four or five months where small caps have at least maintained equal performance with large if not outperformed large caps. And so there's growing evidence that this has some legs to it.

The last thing I'll say on this rotation or this topic is 10, maybe even 15 years ago, small caps as a percent of the overall US stock market capitalization were about 10%. 10% of the market was the Russell 2000, 90-ish percent was everything above that. Today, small caps, the Russell 2000 represent only 4% of the market's capitalization, which means that when people want to go invest in small caps, the door's a lot smaller for everyone to jam through. And so you get a lot more volatility. And we saw that a little bit at periods this year where you would have, like earlier this summer, that big spike in small cap relative performance. It was in part just because there's not as much to buy.

So when traditional investors like me want to get more engaged, I'm always engaged. I'm not really the incremental buyer small caps, but when asset allocators, when quantitative trading strategies decide they want to move some money back to small cap, that has a much more pronounced impact on the market since it's a smaller slice. And so there's going to be more volatility. My point here is just be ready for it to be a little bumpier than normal.

Brian Levitt:

How did we get to 4%? Was that the result of just market moves or was that the result of more businesses staying private for longer?

Justin Livengood:

More the former. Mostly just the significant outperformance of the big, big stocks, the terra caps as Ron Zibelli likes to call them. That is-

Brian Levitt:

The terra caps.

Justin Livengood:

Yeah, yeah, that's his favorite word.

Brian Levitt:

I like it. Ron Zibelli being your co-portfolio manager on a number of strategies, yes.

Justin Livengood:

That's right. And he's right. I mean, the biggest companies have generated an enormous amount of incremental market caps since the pandemic ended, and that has moved mathematically a lot of that market cap shift that I referred to. A secondary reason is that the private economy is financing a lot of companies longer, and that's a durable trend. That's going to have an impact, I think, for a long time. I may have mentioned this on a prior podcast, but I'm pretty bullish on private credit, private equity for the longer term. I think those asset classes are going to continue to grow a lot, make a lot of sense. There's obviously a lot of money there for companies to tap, and often, it's the right thing to do. It's if it's not cheaper, it's least an easier form of capital for a lot of private companies to access.

And so, I think that's going to be a durable trend. And you're right, that has an impact on the public markets. It definitely has had an impact on my opportunity set, but I think it will have a bit more pronounced one over the next four or five years if I'm right, and these private markets keep growing.

Brian Levitt:

So, what would you do about that as a investor in more publicly traded names?

Justin Livengood:

So, it probably will have, over time, a little bit of an impact on valuation. I think the public companies that are doing really well that stay public and choose not to go private will get a little bit more valuation. So, I think it's important to not be too valuation sensitive. Remember, I'm a growth guy, so that's always my mantra, but I think perhaps a little bit more so going forward.

I think the other thing that is happening here is some of it is public companies today are perhaps going to go private because there's going to be great offers from private investors to take them private, but some of it's just trading among private equity funds, alternative asset managers where companies never get public and they stay private throughout their company's life. So, it's incumbent on me and my team to be more aware of those kinds of companies while they're private and just better understand that ecosystem because there's competitive information that's relevant there for the companies that I do own and invest in.

I'm not necessarily going to get to see everything in an industry because some of the relevant competitors in a particular sector are going to stay private forever, but I still need to understand what they're doing. I still need to make sure that I have an opinion on them. And so that's something our team is increasingly doing. It's funny, when I go to investor conferences, the next two and a half days, I'm going to be at one of the biggest health care conferences of the year, there increasingly are tracks for just private companies. It used to be you go to these conferences and it's just all the big public companies. Now there are dedicated tracks for private companies. And it's not just because those companies are looking to go public. It's this dynamic I described of folks on my side of the table wanting to learn more about that private universe.

Jodi Phillips:

So Justin, as you said just a minute ago, you're a growth guy, so we have to ask you about AI as we teed up in the intro a little bit. What are your thoughts on the AI trade right now? Is this just about NVIDIA, four or five big customers or is it bigger and broader than that? Just wanted to get your thoughts about how you're thinking about it.

Justin Livengood:

I definitely think it's bigger and broader than that. I think in our small and mid-cap portfolios, we've been able to find a lot of great companies that are providing pieces of the puzzle that are going to help the data center and electrical grid get big enough to support all of these artificial intelligence applications that hopefully are going to emerge over the next 5, 10, 15 years. So there are a lot of parts of the ecosystem that we can invest in. I don't think the trade is over.

I will, however, say that in the last few months, there definitely have been indications, particularly from some of the largest companies, hyperscalers in this space, that we're evolving from the first phase to maybe a second phase of this whole AI boom where the clients, the companies that are spending on AI need to start to develop more use cases to justify their investments. So I think in '23, '24, when chief technology officers were looking at their budgets, it was, "I'm going to invest anything that smells like AI. I don't want to miss out. I want to make sure my company is doing everything it can to keep up with our competitors." Now as we go into the '25 budgeting cycle, there's a little bit more of, "Okay, I did everything last year. Now I'm going to refine that a little bit. I want to be a little more specific in where I put my money. I want to see more ROI."

So we're hearing a little bit from the Amazons, the Facebooks of the world, that they're still planning to spend a lot on capex to build out their services for AI, but the incremental demand might be, on a scale of one to 10, it was an 11. Now maybe it's a nine and a half, which is still extremely healthy. But there's, again, that little bit of an element of prioritizing within spending by clients. That's healthy, that's understandable. And so we're evolving into this next phase of the AI trade. And so you're seeing a little bit of that in the reaction, the stocks that are involved in this theme. And that's good. I think it's healthy to have some of these companies and expectations around these companies get reset to a little bit more reasonable levels. That'll just add to the length that this opportunity, this trade plays out, which I still think will be several more years.

Brian Levitt:

I always like a Spinal Tap reference. We'll turn things up to 11. And it seems like just by saying that, you gave such a, without even mentioning, just a good explanation for the NVIDIA earnings report, which was so outsized, and yet the market took it a little rough. And that's, I think, just going from 11 to nine and a half is probably all you need to say about that.

Justin Livengood:

Yeah, yeah.

Brian Levitt:

Do you think that the market has even begun to contemplate, beyond just who's going to provide the hardware or the software, the services on AI, has the market even begun to contemplate the productivity gains to the economy or what that may mean downstream to other businesses?

Justin Livengood:

I don't think so. It's a great question. And that's the really strong bull case for what I was just describing as far as this trade has some years to go. We need to see more of that. It needs to be more than just, "Oh, we can, through AI, cut out a few headcount positions in companies where there were maybe some redundant operations and things that AI can now replace. It needs to be more revenue generating, more client-facing. I think that's what we're hearing companies try to find more of. I've heard a lot of companies in financial services, for example, where I spent a lot of time on the research side.

It's one thing to parse data and try to find the best customers and clients for a credit card or a bank account. AI can help with that, but it's not just managing claims and doing back-office stuff. Again, it's helping be more efficient on the front end to make sure we find new clients more efficiently and that those clients end up spending more and doing more with that credit card company or that bank so that there's a really high growth case, not just an expense savings case. I don't think the broader stock market probably has factored in the revenue upside possibilities from AI. And so that's probably where we're going to see, over time, more excitement and upside if the markets ascribe value there. That would be my hope for what pushes this trade to the next level later this decade.

Jodi Phillips:

Great. So, what other themes are we missing here, Justin? What else are you watching that has you excited about the future?

Justin Livengood:

Yeah. Well, there're always a bunch of different things going on, particularly in my parts of the market, the small and mid-cap universe, that excite me. I'll throw out two right now that I think are really interesting and timely. The first is commercial aerospace. And Brian, I don't know if you travel much, but-

Brian Levitt:

You know I do.

Justin Livengood:

The airlines are still pretty crowded. Those planes you're on are still pretty full, maybe not quite as much as last year, but demand remains really healthy and that demand is offset by the reality that the planes in this country and globally are getting older, not getting replaced as quickly as they used to. The issues with Boeing and now Airbus are material, they're going to last a long time, and what it's doing is putting more and more strain on the commercial fleet of airplanes. And so that is requiring a lot more repair, a lot more maintenance and upgrade than we've ever seen before.

And so there are a bunch of companies that do aftermarket support, not just for Delta and American and United, but for international airlines and for even the original equipment manufacturers like Boeing and Airbus. The last two to three years has been probably the best operating environment for that collection of companies in the aerospace supply market and repair market that I've ever seen. And the outlook going forward for the next year or two is just as good. I mean, Q2 earnings for a bunch of those companies were off the charts great. So, we have a lot of exposure to aerospace companies in all our portfolios, but particularly our small cap and mid cap portfolios, and they are some of our largest holdings and some of our highest conviction ideas right now.

The other theme I'll quickly mention is real estate.

Brian Levitt:

Interesting.

Justin Livengood:

One of the best performing, quietly, parts of the stock market year to date has been REITs. REITs, particularly in the last four months, have been on fire. A lot of that's interest rates, people getting excited about the Fed cuts and the way the curve is starting to re-steep, and that's good for REITs, but it's also more than that, it's fundamentals. The office issues are well known and well documented, but even there you're starting to see transactions happen. Commercial real estate brokers are increasingly talking about even places like New York and San Francisco, buildings that for the last year or two have been troubled and no one's willing to go in and either refinance the mortgage or consider taking out some of the equity. Now stuff's starting to trade. We're starting to have price discovery and even in stronger markets away from the coasts, that's been happening more consistently for over a year. So the office markets are gradually perking up.

Other property classes though, like multifamily apartment, to some degree, warehouse, industrial, very strong. Even senior living, some of the health care senior living companies are doing exceptionally well. There's a ton of incremental demand there and not enough supply. So the REIT market and commercial real estate more broadly, really, really interesting. I think we're early stages in what is going to probably be a multi-year run for that part of the market. That's been a laggard group for three plus years, and it's just turning. Valuations are still not too extended. I really like senior living. I really like apartment and warehouse. I like the commercial real estate brokers that are not really exposed on the property value side. They're more just transaction exposed types of businesses. All of that is really compelling to me, and the stocks are starting to move, and so we're very much exposed in that area as well.

Brian Levitt:

As a guy who spends most of his life on airplanes and in office buildings, you are definitely speaking my language. Any parting shots from you, Justin? Anything before we go?

Justin Livengood:

No, I guess the only thing I would add is going into the end of the year here, I think we're relatively well set up for the markets. As you alluded to earlier, Brian, I think September will always be a little bit of a choppy month, but I think the backdrop is relatively constructive going into 2025. I'm not too concerned about the election-

Brian Levitt:

Me either.

Justin Livengood:

... in so far as I don't think it's going to derail the broader thesis around the stock market. It'll certainly create a little bit of headline noise here and there, but I don't think much is going to happen that changes the outlook for the next year or two. So like I said, compared to a year ago, I'm feeling okay right now.

Brian Levitt:

Good. So as Green Day's saying, we'll wake us all up when September ends and we'll be on our way. Justin, thank you so much.

Justin Livengood:

That's like your fourth reference to a band in this podcast. That's impressive.

Brian Levitt:

Yeah. Well, I need my pop culture references, otherwise I feel like I didn't give the audience what they wanted.

Jodi Phillips:

You have to listen to music when you're sitting on airplanes for as long as you do. It's just top of mind.

Brian Levitt:

That is so true, so true.

Jodi Phillips:

Well, thank you so much Justin, for joining us. And Brian, where can we find more commentary from you?

Brian Levitt:

Well, thanks for asking Jodi. Visit invesco.com/brianlevitt to read my latest commentaries, and of course you can follow me on LinkedIn and on X @BrianLevitt.

Jodi Phillips:

Thanks for listening.

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of September 3, 2024, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward-looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Past performance is not a guarantee of future results.

An investment cannot be made into an index.

Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.

The health care industry is subject to risks relating to government regulation, obsolescence caused by scientific advances and technological innovations.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.

REIT stands for real estate investment trust.

Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.

All data provided by Invesco unless otherwise specified.

The average length of time it has taken the US stock market to recover from downturns was sourced from Bloomberg, based on the performance of the S&P 500 Index since 1957.

The level of US gross domestic product, or GDP, was sourced from the US Bureau of Economic Analysis.

Year-over-year US inflation was 2.9% in July 2024, according to the US Bureau of Labor Statistics.

Statements about the performance of small-caps versus mid-caps during the last 13 periods of rate cutting by the Federal reserve sourced from Bloomberg. Based on the performance of the Russell 2000 Index versus the S&P 500 Index.

Statements about small cap earnings outperforming large cap earnings in the second quarter sourced from FactSet Research Systems, based on the earnings of the companies in the Russell 2000 Index and the S&P 500 Index.

From May to August, the S&P 500 Index was up 13.1% compared to 12.5% for the Russell 2000 Index, according to Bloomberg.

Comments on small caps as a percentage of the overall US stock market capitalization sourced from Bloomberg as of September 2024.

Comments on the performance of REITs year to date sourced from Bloomberg. Based on the performance of the FTSE NAREIT All Equity Total Return Index, which is an unmanaged index considered representative of US REITs. That index returned 10.7% year to date ended August 2024 and climbed over 21% from May 2024 to August 2024.

The Russell 2000® Index, a trademark/service mark of the Frank Russell Co.®, is an unmanaged index considered representative of small-cap stocks.

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

BPS, or “bips,” stands for basis point, which is one-hundredth of a percentage point.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.

ROI stands for return on investment.

Capital expenditures, or capex. is the use of company funds to acquire or upgrade physical assets such as property, industrial buildings, or equipment.

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