October, 2024

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As we enter the final quarter of 2024, we find ourselves not only reflecting on an eventful year but also stepping into even more unpredictable territory. With the leaves turning and the news dominated by election coverage, we at SG & Co. remain committed to maintaining a calm and thoughtful approach on behalf of clients. Perhaps Mark Twain captured our cautious nature best: “October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”

Private equity has become a buzzworthy asset class in recent years, but as with any trend, we believe it’s essential to approach it with a critical eye. The rosy picture often painted around private equity has dimmed, particularly as we move beyond the era of near-zero interest rates that helped fuel its rise. It’s also worth noting that when celebrities with little to no formal business training start entering a particular space, it’s probably a sign to be even more skeptical. For instance, both Kim Kardashian (SKYY Partners) and Chicago Bears rookie quarterback Caleb Williams (Midas 88) have co-founded private equity firms in recent months.

As with any election year, questions abound—not just about the eventual victor, but also about how markets will respond under either outcome. While there are nuanced differences in which sectors and asset classes may perform better under a Republican versus a Democratic administration, we believe both options ultimately follow a similar path, as they confront the challenge of navigating a more polarized electorate than at any time since the Civil War, a volatile geopolitical landscape, and a range of economic challenges.

The New Big Short

Since the early 2010s, the global private equity market has surged in popularity, driven by historically low interest rates. In 1980, there were just 24 private equity firms, but by 2022, that number had ballooned to over 17,000, employing nearly 12 million people and managing more than $4 trillion in assets in the U.S. alone (Chart 1). 

At this point, you might be thinking, “I’m not a private equity investor, so why should I care?” The truth is, private equity has likely touched your daily life in ways you don’t realize. Whether you’re dining at a restaurant, getting your car washed, or visiting the dentist, there’s a good chance those businesses are owned by private equity. You may have also noticed declining service quality and rising prices—symptoms of private equity firms prioritizing short-term gains since a firm’s stated goal is often to extract maximum value from each customer and transaction. At its core, private equity funds aim to acquire underperforming businesses, streamline operations, and improve efficiency in order to sell them later at a higher valuation.

As private equity’s popularity has boomed, a phenomenon known as “crowding” has emerged—where investors increasingly converge on similar strategies, squeezing out potential future upside. Substantial inflows of capital from pension funds and endowments, which are often tied up in private equity for extended periods due to typical fund lockups of 5 to 10 years, have left private equity managers scrambling to find viable companies to buy. As a result, private equity firms have been forced to “downgrade” their target markets, acquiring businesses with lower margins and less growth potential compared to more traditional investments. Examples of these downgraded markets include car washes, bakeries, and laundromats.

Given private equity firms’ tendency to use leverage (debt) in acquisitions, it’s inevitable that a time will come when some of this debt will need to be refinanced—especially as PE firms struggle to sell these businesses at profitable valuations. This situation presents two possible scenarios. The first—and most optimistic—is that returns diminish gradually, making the private equity space far less attractive to investors over time. The second, more concerning scenario, is a recession occurs, private valuations fall in line with public markets and investors begin demanding their capital back. This would force firms to sell portfolio companies at a loss, likely resulting in the loss of hundreds of thousands of jobs nationwide. In a worst-case scenario, this could trigger a cascading effect across the financial ecosystem, reminiscent of the Great Financial Crisis. It’s reasonable to suggest that once it becomes widely known that, over the past decade, investors have paid an estimated $230 billion in performance fees for funds whose returns are merely on par with the S&P 500, coupled with the increasing risks in private equity, there could be a flight to defensive stocks as disillusioned investors seek safety and capital preservation.

Elections and Markets 

The polarizing nature of this election has undoubtedly heightened tensions across the nation. While certain equity styles and sectors may benefit depending on which candidate wins, we believe the ultimate outcome will be two sides of the same coin.

Starting with the Republican platform, a Trump administration would likely favor the Real Estate, Materials, and Energy sectors. Conversely, a Harris victory, seen as a continuation of the status quo, could benefit Healthcare and Tech. Regardless of the outcome, Healthcare, Utilities, and Communications are expected to remain tactical favorites as these sectors continue to regain prominence. It’s worth noting that historically, equity returns tend to soften in the short-term following a change in incumbency Chart 2, as sector leaders often transition to become laggards in response to shifts in policy. While it’s intriguing to consider specific sector implications, one underlying theme is clear: no matter who occupies the White House, both candidates are likely to open the floodgates and unleash a torrent of spending, leading to wider budget deficits. Though the paths may differ, both scenarios ultimately lead to higher long-term inflation—a theme we explored in detail in the previous Viewpoints issue, where we discussed “fiscal dominance” and how the combination of rising inflation and massive deficits would leave the Fed with limited options.

Ultimately, the bond market would demand higher interest rates to compensate for the government’s escalating debt. Additionally, it’s important to note that neither side is likely to secure a clean sweep of the House and Senate, which would result in a continuation of the relative gridlock we’ve seen in recent years. Given how tight the race is, we at SG & Co. heed John Bogle’s sage advice: “The idea that you can time the market with political events is a fool’s errand. Focus on the long term, and the market will take care of itself.”

A Cautious Approach

We are poised for a turbulent end to 2024. The typical volatility from a market on edge heading into an election, coupled with the Fed’s recent rate cuts—and the potential for further reductions—amid what we anticipate will be accelerating inflation, is likely to create an increasingly uncertain market environment. While we certainly cannot direct the wind, we can adjust our sails. At SG & Co., we err on the side of caution, remaining committed to defensive equities that provide generous dividends as we navigate the uncertainty heading into year-end. It’s worth noting that defensive equities have been and remain especially attractive in light of the paradigm shift we’ve observed over the past year, as 40 years of deflationary expectations give way to inflationary expectations (Chart 3.) As always, we remain curious and poised to seize opportunities when valuations align with our strategy. On the fixed income side, we believe our recent focus on TIPS—Treasury Inflation-Protected Securities, the only government-backed instrument that adjusts its coupon payments for inflation—will keep our clients protected in the months and years ahead, especially as the growing national debt issue moves to the forefront of economic concerns.

In Conclusion

2024 has been an unforgettable year. With uncertainty looming large, the remaining months will undoubtedly test the predictive powers of both economists and political scientists alike. Yet, we remain firm in our belief that while no one can predict the future, you can certainly prepare for it. As we approach election season, history reminds us that market volatility is to be expected, and these are precisely the moments for which long-term investors like us are built for. As our managing partner, Jeff Gordon, often says, “If our clients can sleep at night, then so can we.”

Michael P. Moeller

Portfolio Manager and Research Analyst