A year ago, Wall Street was worried about inflation, “higher for longer” interest rates, and a fresh war in Europe. It was a clash of economic headwinds that was supposed to trigger a U.S. recession, leading to some bearish market outlooks from Wall Street. But while geopolitical tensions remain—and have worsened with a new conflict between Israel and Hamas—inflation is fading; the Federal Reserve is now projecting interest rate cuts; and that recession never came.
The economy’s resilience has created a few key opportunities for investors in 2024, from riding the AI hype train to playing the private credit boom. Wall Street leaders and wealth managers can’t stop talking about these new investment trends (trust me on this one). However, with the presidential election ahead, wars raging, and higher interest rates still weighing on consumers, the environment remains uncertain and risks abound.
Finance gurus’ new favorite trends could prove immensely profitable, but they all come with serious downside potential, especially if it turns out that Wall Street’s recession predictions were not wrong but simply premature. Still, for the savvy investor—or even the layperson who wants to get an inside look into the pros’ new favorite plays—it could pay to follow these trends next year.
The AI boom
The opportunity
After a year of nonstop headlines, academic papers, and Wall Street reports, most people are tired of hearing about AI. But to ignore it when discussing the key investing themes for 2024 would be impossible. Many Wall Street leaders believe AI is ushering in the fourth industrial revolution. It’s a modern-day “gold rush” for investors similar to the invention of the internet, says Wedbush top tech analyst Dan Ives.
For CFRA Research analysts Janice Quek and Angelo Zino, the main benefit in the rise of AI for investors in 2024 will be increased IT budgets as businesses spend more to create AI applications. They point to a Gartner forecast that shows IT spending will accelerate 8% year over year in 2024, with software spending jumping 13.8% amid the AI boom. That’s compared with just 3.5% growth in IT budgets this year.
Quek and Zino highlighted tech giant Microsoft, as well as software companies ServiceNow and Datadog and cybersecurity firms CrowdStrike and Palo Alto Networks, as top AI picks for 2024. These firms’ wide range of AI-enabled products and cloud-based services are well positioned to “capture” the boom in AI-related IT spending, they argued in a Thursday note.
For more top AI picks, check out Fortune’s rundown of the top stocks to buy for 2024, featuring some of Wall Street’s top investors.
The risks
There may be enough AI enthusiasm on Wall Street to fill the Grand Canyon, but the technology still has its skeptics. George Mateyo, Key Private Bank’s chief investment officer, said there’s broad consensus that AI will eventually benefit a wide range of companies, from health care and tech firms to manufacturing and financial services giants. But the crucial question is how much of AI’s potential is going to translate into earnings growth in 2024—and no one really knows the answer.
“The AI adoption cycle is really short, quite noticeably so. There’s been a more rapid adoption of AI than there was for smartphones and PCs before that,” Mateyo told Fortune. “But I do think that there might be a little bit too much optimism that this [AI-linked earnings growth] is all going to happen in 2024.”
Mateyo argued it may take a few years before the boost to worker productivity from AI improves the bottom lines of many public companies, even if the tech’s positive impact will eventually “broaden out.”
Sue Crotty, chief investment officer at Segal Marco Advisors, went a step further when detailing her views on AI. “While in the long term [AI] will be a game changer, today I think it’s a lot of hype, you can quote me on that,” she said. “AI is getting a lot of headlines, but the realities on the ground are different.”
Private credit’s glory days
The opportunity
Another key theme for 2024 is likely to be the continued rise of private credit. Higher interest rates have raised banks’ deposit costs and capital needs in recent years, leading them to lend less frequently. That’s opened the door for private lenders to fill the void for companies or real estate projects that need some cash.
The private credit market has grown into a $1.6 trillion giant over the past few years, according to data from BlackRock, Bloomberg reported. And that growth is expected to continue, with the market reaching a value of $2.8 trillion by 2028, according to a study from Preqin, or even $3.5 billion, by BlackRock’s own estimates.
Ben Miller, cofounder and CEO of alternative investment platform Fundrise, described the lure of direct lending (a.k.a. private credit) amid high interest rates. With banks tightening their lending standards, many real estate development or leasing projects are struggling to get funding. “The banks just aren’t lending. And I don’t think they’re likely to for a long time,” Miller told Fortune, arguing that a lot of banks’ assets have been “locked up” in long-term loans that were made when rates were low.
This lack of public lenders is forcing many companies and real estate projects to head to the private market, which will offer loans, but with far higher interest rates. “We focus mostly on private lending for residential apartments. And we can get a 14% interest rate for a really good property,” Miller explained. “That’s outrageously good.”
However, even Miller sees the risks in the private credit market. He argued that the real estate market may have hit its bottom with interest rates set to fall—but the rest of the economy hasn’t, and a recession is on the way.
“High interest rates won’t hit most companies, and most people, until next year and into the following year,” he warned, arguing that private lending to businesses will be riskier than lending to residential real estate projects in 2024.
The risks
The risks in private lending are definitely high. So much so that Senate Banking Committee chair Sherrod Brown (D-Ohio) sent a letter to the Fed’s vice chair for supervision Michael Barr, FDIC chairman Martin Gruenberg, and acting comptroller of the currency Michael Hsu in November, warning that the private credit market may be filled with hidden dangers. “Unlike the traditional banking industry, the private credit market is subject to minimal, indirect regulatory oversight,” the senator wrote. “The lack of transparency in this market obscures its true size and risk.”
Experts Fortune interviewed were also concerned with rising risks in the direct lending market. Rich Steinberg, chief market strategist at the Colony Group, explained that the 9% to 14% returns that private credit offers are enticing many new investors into the space, but “it’s getting more crowded.” That means anyone seeking to put money to work in private credit needs to take time to find the right opportunities and ensure the underwriting for the private loans was done with the proper due diligence by trusted lenders.
Overall, private credit “is really for more sophisticated clients that have the ability to have that as a piece of their diversified income strategy,” he told Fortune.
Certuity’s chief investment officer, Dylan Kremer, said that he also believes investors “need to pursue private credit with more diligence.”
“So much capital now is chasing into private credit that investors need to be fully aware of the [managers] and the funds that they’re using to ensure that the underwriting criteria and the structuring of the private loans are done the right way,” he said.
There are a lot of opportunities in private credit overall, according to Key Private Bank’s Mateyo, but the products are also “less transparent” and can be risky for lower-income investors. “It’s not right for everybody in the sense that it is an illiquid asset class,” he explained. “It’s not like T-bills, where you can sell them tomorrow and have the money to spend on something.”
A small-cap resurgence?
The opportunity
For investors who are convinced that Wall Street’s recession forecasts are off base, small-cap stocks may be the right opportunity next year. Small-caps have underperformed their larger peers for years, but many experts believe that will change in 2024 and beyond.
Fundstrat Global Advisors cofounder Tom Lee recently argued that the Russell 2000, which tracks small-cap stocks, could surge 50% next year as inflation returns to the Fed’s 2% target and interest rates fall. Small-caps, which typically have more debt than their larger competitors, have been hit hard by rising borrowing costs over the past few years, but that’s coming to an end, according to Lee. On top of that, small-caps are historically cheap. “On a price-to-book basis, [small-caps] are trading at where they were in 1999, relative to the S&P. And that was the start of a 12-year outperformance cycle,” Lee told CNBC.
Ronald Temple, chief market strategist at Lazard, said he, too, sees “signs of the beginning of a reversal” in the fortunes of smaller public companies. Like Lee, he noted that small-cap companies have more debt, including more floating rate debt. “Given this floating exposure, if the Fed transitions to cutting short-term rates, small-cap stocks should likely benefit more than large-caps,” he wrote in an early December note.
Temple also argued that small-cap companies offer a “compelling” value relative to large-caps, and because they generate more of their revenue in the U.S., they could benefit from the U.S. economy’s ongoing outperformance versus its developed market peers.
“Russell 2000 index constituents generate about 90% of their revenue in the United States versus around 60% to 65% of the S&P 500 index revenue,” he explained. “In our view, the domestic orientation of these companies should be a positive given the expected relative resilience of U.S. growth in 2024 and beyond.”
The risks
While small-caps could rebound in 2024, they have also underperformed large-caps this year for a reason. Some 40% of the companies in the Russell 2000 lost money in the past year, according to Lazard. And many smaller public companies still need to refinance floating rate debt that they took out when interest rates were low with today’s much higher interest rates. This combination of weak earnings and rising debt costs could be a challenge in 2024, particularly if a U.S. recession finally manifests.
Some experts even warn that many smaller U.S. companies with unprofitable business models were kept alive during the era of near-zero interest rates that came after the Global Financial Crisis, meaning that a sizable number of dead-on-their-feet firms are about to go bust. The percentage of these so-called zombie companies has grown from just over 6% of public U.S. companies in 2000 to more than 10% in 2021, according to a recent IMF study.
As Fortune previously reported, David Trainer, CEO of New Constructs, has been tracking zombie companies for years, warning that as interest rates rise, many will go bankrupt. Last month, after the collapse of WeWork (one of Trainer’s zombies), he once again issued a warning. “WeWork’s bankruptcy is just the beginning of the zombie company collapse. Investors need to focus on companies that actually make money and have viable business models,” he said. “Burning cash is not a business model.”
To be clear, most small-cap stocks are not zombies, but if the bears are right, the walking dead of the business world could pull down their peers in 2024, making small-cap stock investments less appealing.
