- On the Horizon
- High yield debt, financial stocks offer value amid uncertainty
- An optimistic outcome is priced into most assets, leading to some conflicting signals.
- 2024-11-15 22:49
There is not enough uncertainty priced into markets. While 2025 could certainly turn out to be another year of prosperity, an optimistic outcome is already priced in to almost every asset category, generating sometimes conflicting cross‑asset signals. Against that backdrop, there are two primary questions that will determine the direction of markets in 2025:
1. How long and variable is the lag after Federal Reserve action on monetary policy?
If the lag is lengthy, it will take more time for the effects of Fed easing to work through the economy. In this scenario, we should worry more about the labor market (and potentially a recession), not resurgent inflation. If it is short, we should be more concerned about inflation than unemployment.
Our view is that the lag from Fed easing will be relatively short, making us more positive on growth but wary of sticky inflation.
2. Will the hyperscalers maintain the needed very high levels of capital expenditure on artificial intelligence?
The AI revolution drove the 2024 gains in mega‑cap U.S. technology stocks. The durability of hyperscaler (mega‑cap companies that provide cloud computing services) spending on AI will help determine the fate of this group of stocks as well as whether the rally can broaden.
AI spending could be peaking, making 2025 a year of transition. If this is the case, we could see AI enthusiasm take a back seat to other market themes. The economy has also benefited from AI spending—we have essentially had modest growth with an AI kicker that made it look stronger. A capex slowdown would weigh on economic expansion.
Fixed income yields are attractive
(Fig. 1) High yield bonds offer premium to equities
Past performance is not a reliable indicator of future performance.
January 29, 2010 through October 15, 2024. Source: Bloomberg Finance L.P. Earnings yield is 12-month earnings per share divided by stock price.
Earnings yield uses forward earnings estimates. Actual outcomes may differ materially from forward estimates.
1 Fixed income yields (Bloomberg U.S. High Yield, cash, Bloomberg U.S. Aggregate) are yield to worst. Equity yields (S&P 500, S&P 500 ex. Magnificent 7) are earnings yield.
2 The “Magnificent 7” is Apple, Alphabet, Amazon, Meta, Microsoft, NVIDIA, and Tesla. The specific securities identified and described are for informational purposes only and do not represent recommendations.
Value in non‑investment‑grade debt
High yield bonds and bank loans, which typically have non‑investment‑grade credit ratings, are two segments that offer attractive all‑in yields despite tight credit spreads. High yield bonds and loans feature credit quality that has steadily improved since the global financial crisis, and their current yields more than compensate for their credit risk even if the economy weakens.
Financials expected to benefit from steeper yield curve
In equities, we favor the health care and energy sectors as well as financials, so 2025 could see a resurgence in value stocks over growth companies. Bank stocks in particular should benefit from expanding net interest margins as yield curves steepen with the Fed cutting rates. International small‑caps, with their relatively heavy weights in cyclically sensitive sectors like financials, consumer discretionary, and industrials, also fit this thesis.
Across international markets, Japanese equities stand out even after their strong performance in recent years. Corporate governance in Japan continues to improve. The country has finally succeeded in generating reflation and now needs to manage it effectively, but the level of uncertainty in Japan is meaningfully lower than in other developed markets.
Key takeaway
In an environment where not enough uncertainty is priced into most asset classes, high yield debt, value stocks, and Japanese equities are attractive.
ETFs are bought and sold at market prices, not NAV. Investors generally incur the cost of the spread between the prices at which shares are bought and sold. Buying and selling shares may result in brokerage commissions which will reduce returns.
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Financial Terms: For a Glossary of financial terms, please go to: www.troweprice.com/en/us/glossary
Investment Risks
International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. The risks of international investing are heightened for investments in emerging market and frontier market countries. Emerging and frontier market countries tend to have economic structures that are less diverse and mature, and political systems that are less stable, than those of developed market countries.Commodities are subject to increased risks such as higher price volatility, geopolitical and other risks. Commodity prices can be subject to extreme volatility and significant price swings.
Investing in technology stocks entails specific risks, including the potential for wide variations in performance and usually wide price swings, up and down. Technology companies can be affected by, among other things, intense competition, government regulation, earnings disappointments, dependency on patent protection and rapid obsolescence of products and services due to technological innovations or changing consumer preferences. Financial services companies may be hurt when interest rates rise sharply and may be vulnerable to rapidly rising inflation.
The value approach to investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that a stock judged to be undervalued may actually be appropriately priced. Growth stocks are subject to the volatility inherent in common stock investing, and their share price may fluctuate more than that of a income-oriented stocks.
Small‑cap stocks have generally been more volatile in price than the large‑cap stocks.
All investments involve risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market.
Fixed‑income securities are subject to credit risk, liquidity risk, call risk, and interest‑rate risk. As interest rates rise, bond prices generally fall. Investments in high‑yield bonds involve greater risk of price volatility, illiquidity, and default than higher‑rated debt securities. Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency.
T. Rowe Price cautions that economic estimates and forward‑looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual outcomes could differ materially from those anticipated in estimates and forward‑looking statements, and future results could differ materially from any historical performance. The information presented herein is shown for illustrative, informational purposes only. Any historical data used as a basis for this analysis are based on information gathered by T. Rowe Price and from third‑party sources and have not been independently verified. Forward‑looking statements speak only as of the date they are made, and T. Rowe Price assumes no duty to and does not undertake to update forward‑looking statements.
Additional Disclosures
For more information on Third Party Market Data please visit troweprice.com/marketdata.
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Important Information
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of November 2024 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.
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