Rebalancing after 2024's concentrated equity bull market poses challenge, says J.P. Morgan strategist

Public equities performed strongly in 2024, driven primarily by U.S. large-cap growth assets. That created some imbalances in portfolios, which requires thoughtful rebalancing, said Jared Gross, managing director and head of institutional portfolio strategy at J.P. Morgan Asset Management.

Simply rebalancing in the traditional manner of pulling money out of equities and into fixed income is not as compelling as in the past given the extreme concentration of last year’s equity returns, Gross said in a Feb. 6 interview.

For the year ended Dec. 31, the Russell 3000 index returned 24.5%, an impressive amount, but the differences between Russell's subindexes based on market capitalization and style was significant.

The Russell 1000 Index returned 24.5%, well above the Russell 2000 index return of 11.5%, while within the large-cap universe the Russell 1000 Growth index returned 33.4% well above the Russell 1000 Value index return of 14.4%.

Instead, because of that concentration in performance among growth companies, particularly among the largest tech firms, investors should think about reshuffling the deck within equities in addition to rebalancing into fixed income, Gross said.

“Within equities, there are opportunities to rebalance,” he said. “Given the way 2024 transpired, most investors crossed (the end of the year) overweight large cap and overweight the U.S. relative to the rest of the world. How would you then rebalance from that? One path is simply if you’re in passive cap-weighted equities to go to active because an active manager can diversify away from that very small group of ‘Magnificent Seven’ kind of AI hyper-scalers that had been seeing such a large run-up.”

He said active managers can create that diversification without necessarily underweighting technology companies and others that are poised to benefit from the AI boom.

For those investors with active portfolios, moving to small- and midcap strategies within the U.S. equities portfolio is another option.

“You’re just taking those winnings from 2024 and redistributing them into other parts of the market that are more attractively valued,” Gross said.

“We often say to clients, you want to do the rebalancing before the market does it for you. When you’ve had this large run-up, if you wait for it to fix itself, you’re missing an opportunity to capitalize on that valuation change by selling something that is extremely valuable and richly priced and moving that capital into something that’s cheaper. So we encourage people to do a rebalancing in the most thoughtful possible way.”

Approaching rebalancing a U.S. equity portfolio’s overweight to the rest of the world also requires a more thoughtful approach than simply moving some U.S. equity assets to a cap-weighted global benchmark or MSCI ACWI ex-US benchmark, he said.

Doing so may force moving an asset owner's capital into some economies or regions that, while not necessarily struggling, are certainly in a less positive position than the U.S. is in right now, Gross said.

“We like an active global strategy,” he said. “There are different varieties of what that means …but broadly speaking, you want to have the global mandate that potentially includes the U.S. in addition to international so that the managers are not forced to exclude U.S. opportunities but have the option of moving capital elsewhere.”

For the year ended Dec. 31, the MSCI ACWI returned 17.5%, but the MSCI ACWI ex-U.S. returned 5.5%.

The stronger return for the global index including the U.S. gives investors the maximum flexibility to find the best companies in the best industries no matter the region, he said.

Meanwhile, Gross said the challenge a lot of investors see in the bond market is that there are very narrow spreads between investment-grade and high-yield corporate credit.

While yields are quite compelling, the risks are that spreads can’t get too much tighter or that if there’s any kind of credit reversal that results in widening spreads, the performance of assets could diminish, he said.

“I don't want to draw too many parallels between today and 2007 because the markets were very different in 2007. But just in a very broad sense, if you go back to the last time we had relatively high Treasury yields and extremely tight credit spreads, it would be the period immediately preceding the great financial crisis,” Gross said. “(I’m not saying) that today's tight spreads are going to lead to a financial crisis. We're not seeing the kind of overborrowing and high degree of leverage that characterize certain parts of the fixed-income markets back then.”

“But, just directionally, it may be more plausible that the next move is for spreads to either stabilize or even widen from this point forward,” he said.

Investors that would allocate to a traditional fixed-income index with a reasonably high allocation to investment-grade corporate credit, Gross said, need to manage the diminished performance potential of doing so.

Gross said active management within fixed income is well understood to be superior to passive management, particularly if given the right amount of flexibility across the underlying sectors.

“I think a core plus or unconstrained strategy that can use the full spectrum of fixed income would be a much better place to land,” Gross said, “because there are sectors now that are trading at more compelling levels, particularly certain sectors that securitize markets where you can pick up some additional yield that’s maybe a bit more compelling than what you’re getting in corporate credit.”

“So, the rebalance into fixed income remains a very plausible destination for money coming out of equities, but you have to be careful about the type of fixed income you choose,” he said.

The Bureau of Labor Statistics reported Feb. 12 that the CPI rose an annualized 3% in January from a year ago, above the 2.9% figure recorded in December, which was also above forecasts.

Gross was interviewed before the surprise news of the hike in inflation, which economists expect will prevent the Federal Reserve from making more interest rate cuts, But he did say at the time that he is seeing a world in which we’re “probably in a higher-for-longer interest rate environment.”

What that means is finding asset classes that are able to capture some degree of passing through inflation, and revisiting real estate, even though it's been out of favor the last few years, Gross said.

“When you step back from real estate and look at how it's performing, you saw this sort of whipsaw from COVID, which initially hit office very hard, hit retail very hard, but was actually net positive for industrial and warehouse distribution based on ecommerce,” Gross said.

However, retail has come back very strongly and while office’s reputation has suffered due to poor returns, there are opportunities growing within that sector.

“Even within office, if you look at the highest quality properties in the best locations, they are being leased out at incredibly attractive rates, and there's an incredible level of demand for those properties,” Gross said. “So, what we've seen is a little bit of a decline in the net absorption of square footage as people become more selective about the properties they want to occupy, but they're willing to pay a very high price for the best properties.”

Gross said overall, private real estate looks to be on the upswing, primarily because he said one of the forward-looking indicators for the asset class is the performance of public real estate, which has been on the upswing.

For the year ended Dec. 31, the FTSE Nareit All REITs equity index returned 4.9%. For the three years ended Dec. 31, the index posted a loss of 4.3%.

“It would be great for real estate if rates fell significantly, but even at today's rate levels, you're buying into the assets with new money at the correct price for the current market,” Gross said. “That’s a very compelling story, because they do mark themselves to market much more transparently than other private asset classes do.”

Gross also noted infrastructure as an attractive asset class in the higher-for-longer environment, particularly in areas like energy distribution that has a regulated revenue stream.

“(This is) where you can go back to the regulator as prices increase and capture a higher level of revenue from the rate payers through the regulatory process,” Gross said, “so that's a very safe way to capture is that sort of nominal GDP sensitivity in your revenue stream.”

He also noted transportation, such as shipping assets and rail cars, airplanes, very long-lived assets with long-term leases that reset on a periodic basis, so investors can capture the current price level.

“They tend to be sensitive to economic growth and activity in ways that many other public market categories are not,” Gross said.

One bit of advice he said is that rebalancing back to the prior year’s strategic asset allocation will not provide investors with the optimal outcome.

“You want to be thoughtful about what looks better now, so that you can push money in that direction and not just be sort of wedded to some legacy view of the market, and that's why I think some of those alternatives look pretty compelling,” he said.