In the song "The Way You Make Me Feel," Michael Jackson crooned to the object of his affection, "I like this feelin' you're givin' me."
But it seems that investors aren't quite singing the same tune—rather they're remaining cautious about the markets, according to our U.S. stocks and economy report this month. Our report notes that while investors have continued to pile into the market via strong ETF flows and high margin debt balances, they've done so reluctantly with more subdued attitudes.
On the global front, we're seeing increased concentration in broad passive equity indexes, with portfolio exposures shifting toward technology and artificial intelligence (AI)-related industries and companies. In our report this month, we outline ways investors might be able to diversify more broadly to help manage the risks associated with that concentration.
When it comes to fixed income, Treasury yields remain elevated after the Federal Reserve's hawkish pivot, and we think they may stay that way. In our view, the risks of a rate hike have increased lately, but we don't believe we're there just yet. If the data changes—specifically if inflation comes in hotter-than-expected over the next few months—we'll likely change our view.
Read more from our experts:
U.S. stocks and economy: Investors remain cautious despite bullish positioning
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Investor sentiment is unusually split: subdued surveys contrast with elevated stock allocations, persistent ETF inflows, and record margin debt, so the market is not yet showing a uniformly euphoric extreme.
- Recent speculative excess has been unwound mainly through sharp rotations—especially in AI-related industries—rather than a broad index decline, creating the potential for reflexive rallies (sharp, short-lived market rebounds occurring after a period of heavy selling or a deep correction) in beaten-down market leaders.
- Longer-term risks remain elevated: near-record household equity exposure and surging leverage have historically pointed to weaker forward returns, while the economy's growing reliance on the stock-market wealth effect raises the stakes of a potential prolonged downturn.
See more: The Fallacy of Investing Based on Forecasts
Global stocks and economy: Diversification in the age of concentration
- The broad global equity indexes have become more concentrated due to an increased weight of the Information Technology and Communication Services sectors and the recent capital investment related to artificial intelligence (AI), which has seen an increased share of earnings growth from an overlapping group of firms.
- The concentration on one dominant growth driver has increased the risks for investors. A handful of technology companies are delivering over half the entire global market's earnings growth, which is being fueled by the massive spending of the largest of these same companies. The risk is an unexpected deceleration of AI-related capital spending, which could result in downward revisions in future earnings for broad passive indexes.
- The investment principle of diversification suggests investors diversify their portfolios by investing across asset classes, within asset classes, and across investment styles. Diversification can help smooth returns and lessen the impact of a poor outcome from a single holding. The issue for the equity asset class is that the broad passive global equity indexes have become less diversified due to the increased concentration on one growth driver.
- By looking beyond the broad passive large capitalization (cap) indexes, investors can improve equity diversification by adding any of the following to portfolios; international equities, stocks in sectors and industries with low correlation to the AI trade, small cap equities, and investments that are benchmarked to indices using alternatives to market capitalization weighting schemes, such as equal-weight or fundamental factors such as Value and Yield.
Fixed income: Higher-for-longer yields
- The Federal Reserve remains on hold for now, but the risk of a rate hike is still present, based on recent inflation data, resilient economic growth, and more hawkish Fed commentary, in our view.
- We raised our expected range for the 10-year Treasury yield, reflecting a higher-for-longer rate outlook, lingering inflation uncertainty, and fiscal concerns. Slower growth would likely be needed for the yield to fall much lower.
- In our view, investors may want to keep duration below benchmark but not move entirely into cash; today's bond yields may still offer income opportunities, especially in selective short- or intermediate-term fixed income investments.
This material is intended for general informational and educational purposes only. This should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decisions.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Past performance is no guarantee of future results.
Investing involves risk, including loss of principal.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate this risk.
Diversification and asset allocation, strategies do not ensure a profit and do not protect against losses in declining markets.
The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.
Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. For more information on indexes, please see schwab.com/indexdefinitions.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
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