A Market in Transition
Markets have continued to reach new highs, but the forces driving those gains are evolving. While a relatively small group of companies dominated returns in recent years, leadership has begun to broaden as investors look beyond the technology sector and the perceived winners of the AI theme. At the same time, interest rates remain well above the levels experienced for much of the post-Global Financial Crisis period, creating a more demanding environment for businesses and investors alike.
This has created a more nuanced investment landscape where company-specific fundamentals should matter more, and speculative market behavior may be reined in by increased funding costs. Recent market performance has begun to reflect this shift, with a wider range of sectors and industries contributing to returns rather than gains being concentrated among a handful of mega-cap stocks.
For investors, a broadening market may create a richer opportunity set. As performance becomes increasingly differentiated across companies and industries, active managers may be better positioned to identify businesses with improving fundamentals and attractive long-term prospects before they are fully reflected in market prices.
Navigating Opportunities in a Higher-Rate Environment
For most of the last two decades, interest rates in the U.S. and around the world remained historically low. Low rates tend to enhance the present value of companies whose earnings growth is expected further into the future. As interest rates have moved higher and closer to levels more commonly seen before the Global Financial Crisis, businesses have been forced to adapt. This higher-rate environment is influencing how companies invest, how consumers spend, and how markets evaluate future growth opportunities. For example, marginally positioned companies that are dependent on frequent debt or equity issuance are seeing their stocks come under pressure, while companies in stronger financial positions with the ability to self-fund their growth from their own free cash flow are beginning to be revalued positively by the market.
This backdrop may create a more favorable environment for active stock selection. Rather than lifting entire sectors at once, we believe markets are becoming more selective, placing greater emphasis on business quality, profitability, cash flow generation, and capital discipline Importantly, the impact of higher rates is not uniform, creating both opportunities and risks across industries and regions. For active managers, today's environment may provide greater opportunity to add value through disciplined security selection.
Where Active Management Added Value
When one long standing trend drives markets for a multi-year period, the careful consideration of individual company fundamentals can take a back seat to broader thematic decisions. In this type of market environment, the “rising tide lifting all boats” phenomenon usually dominates. In a less trending market where the long-standing boost provided by ultra-low interest rates is absent, the value of active management is more visible
In the current market landscape, the future for most companies encompasses a broader range of outcomes and is less likely to be just a continuation of what happened in the recent past. For example, within the US equity SMAs, we have found housing related stocks in the consumer discretionary and financials sectors compelling. These groups of stocks have been battered by a multi-year slowdown in home sales, affordability challenges for home buyers, and a slower pace of household formation than in the past. And these were challenges prior to the recent increase in mortgage rates. However, this is not exactly “new” information for the market, and housing-related stocks already reflect much of this bad news and are already trading at decade or multi-decade low valuations, and at a wide discount to the overall market as represented by the S&P 500. If housing market conditions simply stopped deteriorating, we believe many of these companies are poised to deliver attractive earnings that may exceed very low embedded expectations. Strong active managers focused on the future earnings potential of these companies and not anchored by recency bias of what happened in the past, may be able to find the better positioned companies in this attractively valued corner of the market.
Within International Equity SMAs, active management has provided flexibility to identify opportunities that may be overlooked by broad market indexes. This has included select companies in the financials sector where we maintain overweight positions compared to the index. Financials such as banks and insurance companies that are benefiting from a more normalized interest-rate environment are among the companies we have found whose earnings potential may not be fully appreciated by investors.
As market returns become increasingly driven by company-specific outcomes, we believe active management can play an important role in helping investors navigate a more differentiated investment landscape. By focusing on business quality, earnings durability, competitive positioning, and valuation, active managers may be better positioned to identify emerging opportunities while managing potential risks.
Positioning for the Months Ahead
While market headlines often focus on what is happening at the moment, our attention remains on the drivers that are shaping opportunities to come. We continue to look for companies with durable competitive advantages, healthy cash-flow generation, and management teams that can navigate an evolving economic environment. As market leadership broadens, we are finding opportunities in areas of the market where improving fundamentals may not yet be fully reflected in valuations.
Within U.S. Equity SMAs, we trimmed outperforming positions in the energy sector where the gap between price and value narrowed. Conversely, we used the underperformance of software related stocks within the technology sector earlier in the year to acquire companies we believe have attractive valuations as well as a strong potential for growth even in an environment where AI agents disrupt the role of traditional software companies.
Within International Equity SMAs, we continue to focus on high-quality businesses with strong competitive positions and opportunities to improve profitability over time. The competitive intensity among telecommunications companies with the communications sector has become more intense, and we trimmed positions among those types of holdings. Conversely, we added to more reasonably valued beverage and tobacco companies within the staples sector as well as to semiconductor companies within technology.
Rather than relying on broad macroeconomic forecasts, our investment approach emphasizes disciplined research and careful security selection. As market outcomes become increasingly differentiated across companies, we believe active management can play an important role in identifying businesses with improving earnings potential, durable financial characteristics, and attractive long-term prospects before they are fully recognized by the market.
Opportunity Beyond the Headlines
While market narratives often focus on the largest companies or latest trends, today's market is increasingly rewarding differences in business fundamentals. As leadership broadens and performance becomes more dispersed, active management may play an important role in helping investors identify opportunities, manage risks, and stay focused on long-term investment objectives.