Kayne Anderson Rudnick Chief Market Strategist Julie Biel discusses recent drivers behind market performance, the Fed and interest rate cuts, opportunities in small- and mid-cap stocks, artificial intelligence, and this year’s presidential election.


BEN FALCONE: Hello, this is Ben Falcone, managing director with Kayne Anderson Rudnick, and with me today, I have Julie Biel, Kayne Anderson Rudnick's Chief Market Strategist and portfolio manager. Welcome, Julie. Julie, market returns were broadly positive again in the first quarter amidst the talk about potential broadening of returns. The first quarter really reverted back to concentrated returns in the S&P and large-cap outperformance over mid- and small-cap categories. Can you provide our listeners with your perspective on markets for the start of 2024?

JULIE BIEL: So, in the first quarter, what we saw was a continuation of the trends that we saw in 2023. And I think it really makes sense if you buy into the idea that the majority of returns in the stock market are going to be driven by earnings. That has certainly been the case. Looking at the Mag Seven and parts of large cap, you've seen a much more solid recovery in earnings in the Mag Seven in particular and parts of large cap. We're starting to see earnings improvement. Estimates are starting to really kind of bottom and move in the right direction for mid-cap, and we are even starting to see very early signs of that happening in small cap. 

But if you think of investors as being largely rational, it makes sense to me that they would be flocking to the Mag Seven because these trends in AI feel very solid and durable. People are using the internet and other large technology disruptions as being an analog for this period and saying to themselves, this makes sense, right? This is an investment trend that we can really believe in, that we can really sink our teeth into, and if we're a little bit uncertain about the macro, which—hey, you have lots of good reasons to be uncertain about the macro, right? Credit card debt is at a trillion dollars. It's not clear how strong the consumer can continue to be. And we know that there is disruption that is starting to happen in supply chains as a result of the wars and conflicts. There's lots of stuff to make people and investors nervous. But broadly speaking, they're finding a real patch of light in these larger-cap companies, particularly in AI, but also GLP-1’s, right? Those stocks have really been on a tear. 

What I'm encouraged by is seeing an environment where more and more companies are getting a little bit more comfortable issuing more robust guidance. There seems to be a little bit more business confidence, and we've even started to see a turn in consumer confidence. So, all of that kind of makes sense to me as far as why we're here right now with the markets.

BEN FALCONE: Julie, Fed Chair Powell has continued with a measured approach to potentially lowering interest rates. With his recent comments, he still believes inflation is improving, with a view of three cuts in 2024. However, he still needs more data and is in no rush to ease policy while the economy and job markets continue to grow. Is this just part of the bumpy ride back to the pre-pandemic norms? Has your view changed at all? And what are the implications for markets if rate cuts are shallower than initially anticipated? 

JULIE BIEL: So, if I think about where Fed Chair Powell started the year and where we are right now, I think there was lots of optimism in the market starting in about November, December of last year that we were going to have all these rate cuts and they were all going to start in March. And the conviction around that among investors was very, very high, and it drove a rally towards, you know, the most beaten down interest-rate-sensitive stocks, particularly in December. 

What has surprised everyone is, the economic data has been more robust, the jobs data has been more robust, and unfortunately, inflation has been a little bit more sticky. The parts of inflation that we're paying a lot of attention to are more so in services. In a typical economy, what we often see is that goods deflation or inflation is pretty flat and services is typically up 2 to 3%. And that's kind of what gets us to that normalized 1 to 2% inflation that we've all enjoyed for a very, very long time. 

What we're seeing now that’s a little bit different is goods are deflating, which is great, but services are really pretty persistently high. And I think that's giving the Fed pause about how quickly they need to be cutting interest rates when they know that, you know, this is primarily a services economy. And what we don't want is, or what they specifically don't want is, any kind of wage spiral where you have workers that are demanding higher wages and then spending that money very quickly and reheating and reflating the economy faster than what we would like.

I think if you look overall at the jobs picture, think of what the mandate of the Fed really is, right? Investors sometimes lose sight of this, but the Fed's mandate is just to control inflation and support employment. And so, for them, with employment as strong as it is and as broad-based in its strength as it is, they're not in a very big hurry to be cutting interest rates. They recognize that higher interest rates seem to be well borne by the market.

It's very frustrating for a lot of people who are out there and would like to buy a house and are a little bit on the sidelines. And it's certainly concerning for businesses that have a lot of leverage or who have a lot of variable rate debt. They would very much like to see a decline in interest rates. A lot of M&A bankers would love to see a decline in interest rates. But while job growth is as strong as it is, the Fed has less pressure to be cutting interest rates, particularly as we're seeing bumps up and down in the inflation rate. I think until services start to soften more in terms of their inflation, it's hard for them to really justify getting very aggressive. Now, the positive thing is that they have sort of committed to cutting interest rates this year. And now I think the question is how many cuts? So, we started the year thinking six to seven cuts, and now the market is pricing in fewer than three.

If you look at the Fed dot plot, they're kind of expecting three cuts. But if you look at the makeup of the Fed officials who are voting on interest rate cuts, 10 of 19 are looking for three rate cuts this year. So, that means it doesn't take much for them to switch down to two rate cuts, one rate cut, maybe none. We're talking about 25 basis rate cuts from, you know, 5 to 5.5% -- so, not really that material. What I think is starting to change is investor perception of, is this going to be kind of consistent rate cuts at every meeting, or are they going to cut 75, maybe 100 basis points, and then hold rates there? 

And I think that is a more interesting discussion, right? Is what is the natural rate that the Fed funds rate should be at, right? We had a very unusual period of more than a decade at zero or near zero. But I think we can all agree, right, that money, lending money should not be at 0%. That's abnormal, that's an aberration. I think it's probably a more natural rate you would expect is something more along the lines of 2 to 3%. 

And so, I don't think that there's going to be a lot of pressure for them to really cut interest rates unless something breaks. Unless we see a major swing in unemployment or there is some kind of unforeseen exogenous event, like what we saw with the pandemic. So, I think for us as investors, the outlook is really uncertain as far as interest rates. And I think it's really important then to focus on businesses that are not going to be harmed if interest rates stay higher for longer. 

BEN FALCONE: Julie while they are trading and attractive valuations compared to large caps, can you talk about the opportunity for U.S. small and mid-caps and international exposure for those thinking about allocations today? What would be the catalysts to see these markets outperform going forward?

JULIE BIEL: So, if I think about valuations broadly speaking, small caps, mid-caps, large caps, if I take out the Mag Seven, which we all are doing right? If I take out the Mag Seven, large caps look a little bit expensive relative to history. I don't think anything terrible. I think many large-cap stocks are really well positioned to benefit from any improvement in the economy, and I think that's reflected in their valuations, and of course, there are individual cases where there's dislocations and it makes sense where their valuations are trading. Mid-caps are slightly below historical trading wages. I think what we've seen is earnings for mid-caps really started to improve and look better and more compelling. And I think that is the broadening that we are all hoping for to start seeing in mid-caps.

Small caps are a little bit of a unique case, and I think it's really important to be able to break apart why small-cap valuations are where they are. So, if you think about small caps, they're typically thought of as being more levered and having more earnings variability. And I think that's a fair argument. But if you look at the makeup of small caps, there are a lot more banks, and there's a lot more real estate and REITs. Those typically are more levered businesses and often more sensitive and cyclical. 

If you exclude those businesses, the leverage levels in small cap are actually pretty normal. They do have more exposure to variable rate debt. And so, if interest rates are higher, for sure, that's going to be harder on those businesses than most large-cap stocks, which have more fixed rate debt. But I do think if you look at overall the small-cap landscape, there are many businesses who have been able to not just tread water with higher interest rates but have been able to kind of continue to grow their earnings. And so, those are the types of businesses, particularly on the small-cap side, that we're focused on.

And I think what's great is that generally speaking, small caps, it feels like have been moving around more so by sentiment, and so, a lot of small-cap valuations for what we would consider high-quality businesses are actually quite attractive. So, for us as small-cap investors, in particular, this is a really nice attractive time to be looking at the markets.

BEN FALCONE: Julie, as AI is a dominant topic across markets and a driver of near-term performance, can you speak about where you see opportunities and risks?

JULIE BIEL: So, I don't think I'm able to go into any meeting without talking about AI, and I think that absolutely makes sense to me because to me, AI is probably as large, if not larger, in its impact on the global economy as the internet. The thing is, that we may sometimes forget, is when the internet came about, we sort of didn't know what its highest and best use was going to be. We threw a lot of spaghetti at the wall. And I think AI is not going to be dissimilar. If I think about, what is going to be the highest and best use of artificial information, which I also like to call just plain automation, I don't think I necessarily would have assumed it would be being able to copy music, or being able to create art, or be able to do all of these creative functions, right?

So, I think there are lots of opportunities for investing in AI that don't necessarily look like the generative AI that we hear about in the media all the time. And I think that's where we are focusing right now is in companies that are using automation, artificial intelligence, in their businesses to either make themselves more efficient, or make their products better, or make their ability to go to market faster. Beyond the Mag Seven that you hear about, beyond Open AI at Microsoft, et cetera, if I think of smaller companies like Certera, which is a bio simulation software.

And what this business does is they are able to leverage mathematical models for drug development to help researchers decide, hey, this drug compound based on our models is going to be absorbed by the liver in this way. You can mathematically figure out that sort of thing. But they are also creating some products with a generative AI capability where they can suggest new molecules to researchers, and these novel molecules can be compelling for further research.

So, that's the kind of business that is maybe less sexy and exciting than, you know, the Copilots of the world, but that have a lot of embedded domain expertise in their artificial intelligence. And of course, that is where we see a lot of opportunity for these businesses. But it's not just within tech and it's not just within software. To the extent that any business can be made more efficient, more automated, we see a lot of opportunity. I think what's interesting is, if we look at productivity in this country, we've had booms and busts of productivity, and we had been in a bit of a lull of productivity, which has been a great driver of economic output in the U.S. without causing a lot of inflation.

And so, if we think of the opportunities for automation to kind of continue to propel productivity in this country, it can have a real benefit for economic output without necessarily overheating and inflating the economy. I just think that a lot of this technology is still pretty uncertain, and it will take time for it to hit its stride and find its way into our normal daily lives where we feel the impact of generative AI on a more routine basis, just the way we feel the impact of traditional artificial intelligence more slowly, right? It took us a while before we were all adopting Google Maps and using that as the de facto standard for how we get anywhere. But I do think that its impact will be pretty profound. It will just take a little bit of time.

BEN FALCONE: Lastly, Julie, now that we've narrowed down the presidential candidates in the upcoming election, do you see any differences in policies between them that would impact industries into 2025 and beyond?

JULIE BIEL: So, in looking at our list of presidential candidates in the upcoming election, I think it's pretty challenging to know exactly what the policies are going to look like between the two of them because so much is really dependent on the makeup of the rest of Congress. It really will limit or enhance their ability to push through any of their policies going forward. We try at Kayne to really put politics to the side because I think we really believe in the idea that no president is going to make a good company bad and a bad company good, right? We know that there can be specific instances of regulation that can have a positive impact on our companies if we own companies that benefit from infrastructure spending, for sure, they’ve positively benefited from President Biden's administration. If we own businesses that are dependent on less regulation, those are the types of businesses that are going to benefit from a more conservative president as well. 

So, I think for us, it's really more important that we look at this kind of on the fringe and not let it be a primary driver of our investing strategy. We all understand that politics is a very personal and compelling thing that we can get very excited about, but generally speaking, it doesn't change a lot of the fundamentals other than maybe at the margin. We think the real opportunities and industries that are still ahead of us are generally at the…they're really being driven by what's happening within innovation, right? What's happening in healthcare innovation with GLP-1’s? It's not super impacted by which president is going to be in office. It could change in terms of how insurance and Medicare will actually reimburse those industries. But broadly speaking, we're really trying to put politics to the side and focus on the main issues at hand, which for us are the level of economic output, the strength of competitive protections around these businesses, and their ability to be profitable over the long term.

BEN FALCONE: Julie, thanks as always for taking the time to provide your insight to our KayneCast listeners. 

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The commentary is the opinion of Kayne Anderson Rudnick. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.

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