Show V/O:
This is Alternative Allocations by Franklin Templeton, a monthly podcast where we share practical, relatable advice and discuss new investment ideas with leaders in the field. Please subscribe on Apple, Spotify, or wherever you get your podcast to make sure you don't miss an episode. Here is your host, Tony Davidow.
Tony:
Welcome to the latest episode of the Alternative Allocations podcast series. I'm thrilled to be joined today by Mark Steffen of Wells Fargo. Mark, welcome.
Mark:
Thank you, Tony. Appreciate being here.
Tony:
And this is very timely. We're going to have a discussion on your views on the market environment with a specific focus on where you see opportunities across the private markets and hedge funds. But maybe if I can just ask you a little bit to describe your role and maybe we'll get started on that journey of talking about where we see the opportunities in the year to come.
Mark:
Yeah, that sounds great. Thank you again for the opportunity. And my role – I'm the global alternative strategist at Wells Fargo Investment Institute. So I provide guidance on all things alternatives; that includes hedge funds as well as private capital strategies, including private equity, private debt, and private real estate. We provide guidance in terms of where we believe our investors should allocate their capital.
Tony:
Super. And again, I think very timely this time of the year, a lot of advisors are thinking about where they should be allocating capital and maybe more importantly, how they can have those discussions with clients about why the opportunities in private equity makes sense or private credit makes sense.
So maybe if you can, let's start macro and then we'll drill down a little bit into your views on private markets and hedge funds separately. But what's kind of your macro outlook as we look at a 2025, which likely will be quite a bit different than 2024.
Mark:
Yeah, absolutely. So, our base case is we think there will be an acceleration in U.S. growth and that will lead the world economy and we believe that will remain sluggish. So we think the soft landing scenario is the most likely scenario at this point. And then on the inflation front, we do expect a modest pickup in inflation by year end to around 3%. So that'll be driven primarily by rising fuel costs and slowing apartment supply.
But we do think overall that investment returns will remain solid, though maybe not quite as robust as maybe the past two years have been. We still think there'll be plenty of opportunity to earn a solid investment return throughout the year. We do think investors should strike a balance between growth and risk.
So given that we believe accelerating economic growth will continue to drive company revenues through deregulation, continued cost controls, as well as just the loosening credit conditions which really should support expanding profit margins in 2025. So we think stock prices can continue to march higher, really driven by earnings growth that should broaden to a more cyclically oriented areas of the market over time.
And then just in terms of investable themes. The U.S. industrialization, the infrastructure rebuilding and manufacturing reshoring from China, is a strong theme with strong spending on new technologies in areas like robotics and artificial intelligence are themes as well. And then on the interest rate side, lower interest rates tied to the Fed funds rate should really lessen the cost of credit for consumers as well as small businesses.
And following the slowdown in growth that we expect early on in the year, in 2025, we anticipate a stronger and more sustained growth to take hold in the U.S. in the back half of next year. So in terms of fed cuts, we expect year end 2025, the Fed funds rate will land right around 4 to 4 1/4 percent.
And so probably on the low end of what the market expects, or just the market sentiment in terms of where they expect rates to be over that time.
Tony:
Thanks, Mark. That's very helpful. And we'll make sure we provide a link to the outlook at the end of the podcast. I think it'd be really helpful for advisors to maybe get a deeper dive on some of those views that you've articulated.
If we can, maybe let's delve a little bit into private markets. And before you get into that, I'll just remind folks that we covered in January, Franklin Templeton Institute’s Private Market Outlook where we have similar sort of use on the macro environment, although specifically we like areas like secondary.
We like real estate. We think valuations have come down quite a bit, and we like real estate debt as an opportunity to kind of play some of the disruption going on in the space. I thought what was interesting in your outlook is you're neutral on private equity, private credit, and private real estate, but you do have specific views kind of within that of where you see attractive opportunities.
Maybe that's a perfect sort of jumping off point to maybe delve into that a little bit more and maybe help us kind of think through why you think some of those areas look more attractive in today's environment.
Mark:
Yeah, absolutely. Tony. And as you mentioned, we do continue to remain neutral on the broad categories of private equity, private debt, and private real estate.
But if you look under the hood a bit and look at the subcategories under each, we definitely have areas where we are more favorable. So we continue to maintain our favorable guidance on growth equity strategies as generally we prefer just the higher quality opportunities. These are companies that often have proven business models and generate significant revenue and or earnings.
If you look at 2024, growth equity deal volumes accounted for about 23 percent of all private equity transactions. And we expect this category to maintain and potentially increase its share into 2025 as private equity firms opt for more established firms that are growing rapidly and frankly, less reliant on debt financing overall.
Then in buyouts, we continue to favor small- to mid-buyout, which we have a favorable guidance on over the large buyout peers. And just the rationale there, while lower rates may bring a resurgence in some of the larger deals later this year, we just want to get a greater clarity on the extent of rate cuts and really the effect it may have on activity over the next few quarters, which may lead to an improved outlook in this category as well.
And then third, in private debt, we continue to believe the opportunity set for distressed credit special situation strategies remains robust, at least for the foreseeable future, and likely we expect that to really last into the early stages of the expected recovery in late 2025. So, while lower interest rates may ease the burden for many firms out there, we still expect that rates may not fall fast enough for some of those over-leveraged companies that are unable to pay their current debt service costs at this time.
And then you mentioned private real estate. We do have our guidance is currently neutral in private real estate. But we do see several positive signs that are emerging. Number one, bank lending standards continue to ease. So that's number one. Number two, obviously forecasted lower interest rates in 2025 should provide a boost to real estate in general.
And then we're seeing improved operating incomes and some favorable tailwinds in select sectors, whether it be industrials and data centers; data centers being driven by the artificial intelligence theme as well. So we do see some positives there, yet the potential employment market weakness and or stickier than expected inflation continue to remain as significant risks in real estate as a whole.
So, in general, though, we're recommending clients continue to add risk to their alternatives portfolios by reducing some of the more defensive strategies, primarily on the hedge fund side, but private capital as well, and beginning to start adding to strategies that we think can really benefit from a recovery scenario that we expect in 2025.
Tony:
Mark, thank you for that. Maybe if I could just pick up a little bit on your comments about real estate, I think we would agree with you that it's really more of a sector call. We see attractive opportunities in industrials, multifamily, life sciences. We still think there's tremendous headwinds for the office sector. But we are certainly getting more constructive because we think valuations have come down quite a bit.
I did want to pick up on one of your comments and maybe go back a little bit on your discussion about private equity, because certainly one of the things we have all noticed over the last couple of years is the slowdown in exits. Are you getting more constructive on maybe a pickup in M&A activity and IPO activity? And if so, is that driven by the new administration and perhaps lessening the regulation at all?
Mark:
The short answer of that is yes. I mean, we're definitely seeing some positive signs. It's difficult to tell exactly what sort of policies the administration will be able to enact, but in general, we do think there is a tailwind for less regulation and frankly, more deregulation as well.
So that trend will obviously be good for hedge fund strategies like merger arb, but also private equity, less regulation means it's easier to get deals done. So, it's going to be faster time to complete these deals. Corporate leadership has more confidence to do a larger number of deals. So that'll lead to more activity and combine that with potentially lower interest rates, we think private equity, more corporations are going to be willing to acquire private businesses. So that will help. And obviously you mentioned the exit environment has been very slow over the last couple of years. Funds are holding on to investments much longer than they anticipated. So having more strategic buyers or more corporations come back into the fold, I think would definitely give the PE industry a boost overall.
Tony:
Yeah. Thank you. That's very helpful. And maybe that's a natural segue into your discussion on hedge fund opportunities. You already mentioned merger arbitrage, but maybe walk through where you see opportunities there and what will be the driving forces.
Mark:
Yeah, absolutely. And in general, given that our macro view is we believe that a gradual economic recovery will occur in the back half of 2025, we're advising clients to, as I mentioned, position their portfolios for that transition now and start to layer in risk to their portfolios in anticipation of that recovery.
So that's incorporating more economically sensitive strategies. So, in terms of our plan, we not only suggest reducing exposure to some of the more defensive strategies, but also increasing exposure to areas that benefit from lower interest rates, a general rise in equity prices, as well as that gradual recovery that I mentioned.
So to those ends, a few select ideas on the hedge fund side. We favor increase in exposure to equity hedge directional strategies, which we have a favorable guidance on, as well as event driven activist strategies, which we recently upgraded from unfavorable to neutral. And there, the rationale is fairly straightforward as more of these equity-oriented strategies really should benefit from just the broadening of the large cap equity rally that we saw over the recent years.
And then for activist strategies, which is also an equity-oriented strategy should benefit from obviously rising equity prices. But just given the fact that we've gone through a period of slower growth, higher rates, corporate leaders still may be willing to engage, or constructively engage, with activist shareholders and really embrace changes that we think will enhance the long-term value at some of these companies.
In addition to that, we remain favorable on relative value, long/short credit strategies. We like this category for a few reasons. The strategy should really offer the ability to participate in an improving credit environment, which we expect, but also provide some protection during some of the market pullbacks that we may encounter over the course of the year.
Obviously, higher bond market volatility has been kind of the norm over recent quarters, and we expect that trend to continue. So, in looking back at the strategy, if you look at how it's performed in some of the past recovery periods. You look back to the post great financial crisis period, as well as the pandemic era period, these strategies have performed quite well. So, another area we like in addition to that, we continue to favor macro discretionary strategies as you should really be well suited to navigate the challenging geopolitical risks and markets that are often driven by some of the central bank influence and interactions that take place.
Aside from that, as I mentioned, we recently upgraded merger arbitrage to neutral. And again, the rationale there is the strategy should benefit from lower interest rates that drive greater levels of M&A activity. During the Fed's previous rate cutting cycle, that began in July 2019, deal volumes actually increased about 32%.
So from July 2019 to December 2021, deal volumes increased dramatically. So, we expect a similar effect here in the coming year. In addition, just the improved regulatory environment that we mentioned with the new administration and less potential economic uncertainty should ensure deals are getting completed without major roadblocks at this point.
Tony:
And Mark, if I can, I'll pick up on one of your comments there, which is macro. And of course, macro serves as a bit of a shock absorber should we get future shocks to the market. You mentioned earlier, you're anticipating rates cutting as I think we and the rest of the street are. You talked about inflation being a little stubborn.
You talked about geopolitical risk. Are there other things that you're watching that would change your point of view or is it really something where it's probably something that we're not anticipating that will surprise the market?
Mark:
Yeah. I mean, it does seem to always be something that we don't anticipate that provides the shock to the system.
Yet, I think the two biggest risks out there are inflation and interest rates, and obviously those two elements are tied together. But if we do see a resurgence in inflation, obviously that will have a direct impact on the rate cutting cycle. If the Fed were to have to reverse course and start to raise rates to combat a resurgence, that would obviously impact a number of different asset classes, including private equity, private debt, as well as many of the hedge fund categories as well. So having those diversifiers in your portfolio is also something we recommend. The different hedge fund strategies can really serve different purposes in a portfolio. So you have income generators, you have return enhancers, and then you also have diversifiers that can smooth the ride out for investors over time.
Tony:
Thanks, Mark. I wanted to maybe switch gears a little bit here since the purpose of this call is to help advisors in allocating capital specifically to alternative investments. I'm curious, have you seen a change from the advisors in the way that they're adopting alternatives in their client portfolios, the way that they're using some of the research that you and your team are producing?
And maybe specifically, we've certainly heard a lot more interest in the private markets. Are you starting to see more of a pickup there where they're becoming tools that are advisors are embracing client portfolios.
Mark:
Yeah, absolutely. And I think one of the biggest trends that we're seeing is really the democratization of alternative strategies. So meaning we're seeing a tremendous growth in strategies that are really more accessible to the average investor. Alts has always been sort of thought as the realm of the ultra high net worth investor. And increasingly that's just not the case anymore. So some of the new fund structures that are out there, whether you call them evergreen funds or perpetual funds, these new product structures that include tender offer funds, interval funds, et cetera.
They offer much lower investor qualifications. They offer greater liquidity. They often provide quarterly liquidity with limitations, obviously, at the fund level. Greater transparency. Improved tax reportings. Offer 1099 tax reporting versus that dreaded K-1 that many investors try to avoid. And they're fully invested often at day one versus the typical drawdown structure that invests over the first one to three years.
And so these are just very easy vehicles to get access to alternative strategies. And I think we've seen tremendous growth across a number of different areas in that space, whether it be real estate, whether it be direct lending. And even private equity is a kind of booming area in that space as well.
So I think from that standpoint, many more advisors are really looking to incorporate alternatives in their portfolios, but by and large, there's still a segment that hasn't done a lot in alts. So I think one of the biggest opportunities out there in the coming year is just for more advisors, more investors to take a look at alts and see how it can help build diversification and build a more resilient portfolio, whether it be diversifying your income streams by using private credit or looking at strategies that can enhance returns over time, like private equity.
My suggestion to people is always start small and start by adding one or two strategies and then kind of slowly build your alts portfolio from there. So, there's definitely a segment that is still hesitant out there, I think.
Tony:
So, Mark, thank you. That's a lot of great insights on where you're seeing opportunities today.
I'm kind of curious, are there areas that you're looking at that maybe you haven't addressed which appear attractive and might be areas that advisors want to pay attention to?
Mark:
Sure, Tony. And yeah, great question. There are a couple of other areas that, while, we don't offer official guidance on. We are very constructive on.
So number one is infrastructure assets. So, think of roads, bridges, airports, power grids, communication and data networks. So, these are large scale, high cost projects that require significant government involvement. And this asset class really can offer several different attractive attributes, including relatively stable cashflow and income growth potential. It can act as a great hedge against inflation. And I think it's really no secret that the U.S. infrastructure systems really have deteriorated over the course of the several decades. So, I think they'll require significant investment, both from public and private sources to really bridge the funding gaps that are required to improve the overall quality and capacity of the assets.
So, in addition to that, a tailwind from the investment expected from the Inflation Reduction Act, as well as just growth in the digital infrastructure areas, specifically from artificial intelligence related themes can really also act as drivers to some of these strategies.
In addition to that, we also are constructive on secondary investments in general. So I think there's several positives related to secondaries. So obviously prices in secondary market following 2022 really declined, and they've improved modestly since then. But we still think they're at levels that we deem attractive at this point, and they can really offer several different advantages to a portfolio.
So, they’re obviously not a blind pool. So, these are typically mature funds that secondary investors are buying. So you get a good look at what the actual investments are. Typically, the life cycle is shortened. So that J curve where early on in the life cycle of a drawdown fund, the returns are impacted by the fees and capital commitments.
And early on in the life cycle of a fund, obviously primary funds are impacted. The returns are impacted by the fees and the initial capital investments that are needed. So, these secondary funds are well into their J curve. They're starting to provide distributions to investors. And so the combination of attractive valuations within that space, they can really add greater diversification to a portfolio, as well as the fact that the shortened life cycle just helps with managing a portfolio and allocating across vintage years.
Tony:
Yeah, Mark, thank you. Those are terrific ideas. We wholeheartedly agree with your views on secondaries. That's one of our highest conviction ideas, largely the way that you've described it. The valuations look attractive, but also those structural advantages that I think are really conducive for individual investors. And the whole idea of infrastructure, I think, sounds very interesting and we are starting to see more infrastructure funds coming to the market, so it aligns with the opportunity that you've outlined for us. So, thank you. That's really helpful and constructive. We appreciate that.
Mark:
Yeah, thanks Tony.
Tony:
We really are excited about where we are as an industry. We think there's a lot more work to be done and not to use a baseball analogy, but we're likely in the third or fourth inning, and it's an exciting journey that we will all be on together.
So thank you for your time here today, Mark. I really appreciate your insights on the market opportunity. I think that's really helpful for advisors when they start the discussion about allocating capital. And also when they think about sitting down to do a quarterly review, what's the rationale for a strategy in a given environment and the more that we can collectively provide a narrative that helped advisors have better discussions with clients, I think that's a win for all of us. So Mark, thank you for your time. A lot of great insights. We'll make sure that we include a link to the outlook that you've referred to, as well as that private market outlook that came from Franklin Templeton Institute to help advisors along in their journey. For all of our listeners out there who have been listening to our podcast series, if you haven't already done so, we encourage you to tell us what you like, rate our podcast, let us know if there are topics that you want us to consider for future podcasts.
We've had great receptivity. We've grown our audience considerably over time, but we want to make sure we're addressing issues that are near and dear to all of you. So thank you for your loyalty. Thank you for participating. Thank you for all reaching out and letting us know what you like to hear and continue to do so.
Mark, thanks so much and we appreciate your insights here today.
Mark:
Yeah. Thank you, Tony. I appreciate the opportunity and have a great week.
Tony:
Thank you all.
Show V/O:
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