Monetary policy seems to have dominated investor attention in recent years. Markets twisted and turned in response to the U.S. Federal Reserve rate hikes that started in 2022 and have been eagerly anticipating the start of the cycle of cuts this year. But markets may become more sensitive to fiscal policy through the remainder of 2024 and beyond, given the growing influence of U.S. government spending, deficits and debt over economic activity, and the upcoming U.S. election—as investors bet how different candidates’ policies may affect the economy—according to Morgan Stanley Investment Management’s Portfolio Solutions Group.
No matter the winner of this year’s U.S. presidential election, investors should consider how government spending and debt can lead to higher inflation, and how tariffs in response to trade tensions can fuel price increases, says Jim Caron, Chief Investment Officer of the Portfolio Solutions Group. The next six to 18 months may be critical in determining the potential course of inflation, and fiscal policy that swells national debt could lead to higher risk premiums and headwinds for asset prices, he says.
The good news for investors is that the drawbacks of higher risk premiums may not be evenly distributed across asset prices, which means there can be winners and losers among sectors depending on the degree of the influence of fiscal policy, Caron says. Investors aiming to structure portfolios that can benefit from these challenges can consider opportunities in emerging market debt, U.S. equities, loans and private real estate.
A Weakening Dollar May Boost International Assets Like Emerging Market Debt
The value of the U.S. dollar is influenced by relative interest rates and growth differentials between the U.S. and the rest of the world. On both counts, trends that have strengthened the greenback may have run their course, making it an opportune moment to explore non-U.S. currencies and international assets, like international equities and emerging market debt.
“Economic activity is showing strength beyond America’s borders, and we find a less compelling case for U.S. economic growth to continue outperforming the rest of the world,” says Jitania Kandhari, Deputy Chief Investment Officer of the Solutions and Multi Asset Group in Investment Management.
Among investing opportunities related to dollar depreciation, emerging market debt offers the potential for increased income and portfolio diversification,1 adds Brad Godfrey, Co-Head of Emerging Markets in Investment Management. “Emerging market debt doesn’t need a weaker dollar to perform well, but it helps to not have dollar strength as a headwind for the asset class,” he says. Country picking matters most when it comes to investing in emerging markets (compared to other investment factors), Godfrey says, and given elections around the world and geopolitics, there has never been a better time to be a country picker in emerging markets. Emerging market debt is under-owned by investors, Godfrey adds, and flows into dedicated emerging market debt funds may be poised to turn after several years of strong outflows.
Equities Outlook: Upward Earnings and Government Spending
The 2025 earnings forecast for the S&P 500 has been rising, and that suggests that the index could be closer to 6,000 by the end of this year after climbing past 5,000 in February, says Andrew Slimmon, Head of Applied Equity Advisors in Investment Management.
The caveat is that markets don’t move in a straight line, Slimmon says. Historically, U.S. stocks see a correction of about 10% about once a year. The last drop of that size was in the fall of 2023, so the market may be due for another steep drop.
While fiscal spending may contribute to market uncertainties, it may also directly support certain sectors, such as industrials and materials, as with the Infrastructure Act, and semiconductors and equipment, as with the Chips Act. “Our focus is now on the areas where the U.S. government is spending the money,” Slimmon says.
Tailwinds for Bank Loans and CLOs
Credit markets may benefit from strong fundamentals and outsized starting yields: Growth is easing but remains positive, inflation is falling and peak interest rates appear to be in the past, according to Christopher Remington, Managing Director of Product & Portfolio Strategy in Investment Management. Near double-digit yields go a long way to buffer potential risks on the horizon, he says.
Bank loans and collateralized loan obligations (CLOs), single securities backed by a pool of debt, are particularly attractive among fixed income options, Remington says. They offer a senior/secured credit profile, high income with effectively zero rate duration, and they are trading cheaply compared to other assets. These factors can help bank loans and CLOs serve as effective hedges.
“The absolute yield in bank loans is one of the highest in fixed income, with levels comparable to long-run equity returns, and CLOs offer even higher yielding—and higher rated—opportunities,” Remington says. “We see loans and CLOs as two of the most attractive opportunities available to investors.”
An Early Opportunity in Private Real Estate Investing
Private real estate values have fallen by approximately 20% from their peak in the second quarter of 2022, with transaction activity set to expand as existing financing matures and investors are required to recapitalize at higher costs, says Steve Turner, Head of Investment Selection in the Portfolio Solutions Group, Investment Management.
While pockets of positive, but moderating, demand meeting elevated supply has put pressure on rents and vacancies, the long-term operating outlook for the asset class is strong, Turner says. Real estate supply is set to diminish meaningfully by the end of 2024 and into 2025, and debt markets remain relatively healthy.
“We are entering an attractive opportunity within private real estate for credit providers and equity investors,” Turner says.
