The Deep Dive: How can alternative credit help my portfolio? (6:23)

Investors are increasingly looking at alternatives in their allocations to credit. CIO’s Karim Cherif discusses the opportunities in this space and how investors can incorporate these strategies in their portfolios.

Thought of the day

US equities edged 0.1% lower on Monday after ending last week at an all-time high, amid caution ahead of the release of the US consumer price index data for January. The yield on US 10-year Treasuries stood at 4.18%, up from around 3.9% at the start of February, as investors have scaled back expectations over the timing and pace of rate cuts from the Federal Reserve. Markets are now pricing a roughly 58% chance of a cut by the Fed's May policy meeting, lower than a month ago, based on the CME's FedWatch Tool.

This has been a particular headwind for small-cap stocks, which rely more on floating-rate debt compared to large-cap companies. While the small-cap Russell 2000 outperformed the S&P 500 on Monday, rising 1.8%, it is still up only 1% so far in 2024, compared to a gain of 5.3% for the large-cap index.

In our view, investors will be looking to several factors for guidance on whether small-caps can play catchup:

A benign inflation release could help small-caps make up lost ground. The consensus forecast from economists points to a slowing rate of headline inflation to 2.9% year-over-year, from 3.4% in December. This would be the first reading below 3% since March 2021. The core rate, which excludes volatile food and energy prices, is also expected to decline, to 3.8%, from 3.9% in the previous month. After strong evidence of disinflation in goods, investors will be hoping for clearer signs that a similar trend is taking hold in services. Last week, data from the Bureau of Labor Statistics showed US inflation was about the same at the end of last year as initially reported after incorporating annual revisions, suggesting price pressures are receding steadily.

Investors will be hoping for more dovish comments from top Fed officials. While Fed officials have continued to push back against market expectations of an imminent rate cut, we believe the start of a rate-cutting cycle remains on the horizon, with our base case for 100 basis points of easing this year, most likely kicking off in May. Minneapolis Fed Chief Neel Kashkari said the US central bank is not looking for “better” inflation data, just “additional inflation data,” while Fed Chair Jerome Powell has said the base case for the Fed is to cut rates this year. “We’re just trying to pick the right time, given the overall context,” he said in an interview with CBS’s 60 Minutes earlier this month.

Markets will be looking for evidence that small-cap earnings growth will pick up faster than for large-caps. The fourth-quarter earnings season for the large-cap S&P 500, which is drawing to a close, has been better than expected. This has supported our view that earnings per share are on track to grow by around 8% this year. However, swings in earnings are typically greater for small-cap companies. We expect this also to be the case in 2024. After a 13% decline in earnings for small-caps last year, consensus expectations are pointing to 14% growth this year. With the recent trend toward stricter lending standards abating, according to the Fed’s latest Senior Loan Officer’s Survey, we have more confidence that accelerating earnings growth could be a catalyst that benefits small-caps.

So, with Fed rate cuts on the horizon and earnings growth gaining momentum, we expect smaller companies to outperform in 2024. While investing in small-caps has certain drawbacks, including higher volatility and lower liquidity, a modest allocation to this part of the equity market has the potential to boost returns and improve diversification for the long term, in our view.