Author: cvernon

Keep Your Eye on the Labor Market

The Fed turned the page and began lowering interest rates with an outsized 50 bp cut at its September FOMC meeting. While Chairman Powell described the risks to achieving the Fed’s dual mandate goals of maximum employment and stable prices as balanced, the market’s reaction to Powell’s press conference seemed to reflect anxieties that the labor market is now the chief concern and the Fed’s larger rate cut was perhaps a result of not only foresight but fear.

This newsletter puts recent labor market data into historical context as the Fed considers the pace of additional rate cuts in the coming months.

A Cross Pacific Current

The pullback in global equity indices at the beginning of August left many investors racing to understand what had caused such outsized volatility. Amid this market turbulence, there were two seemingly unrelated economic events that occurred on different sides of the globe. On July 31, the Bank of Japan surprisingly announced that it would raise its benchmark interest rate from 0.10% to 0.25%, continuing its transition from the ultra-low rates that had been commonplace in recent time. Later that week, the July U.S. nonfarm payroll employment data, which many use to gauge the health of the domestic labor market, came in below estimates. This report led investors to question the strength of the U.S. economy and whether the Federal Reserve had waited too long to cut its policy rate. Simply put, equity markets reacted negatively. The Nasdaq, which is a growth-oriented U.S. large-cap stock index, exhibited a particularly sharp drop during this time, falling by roughly 7% in less than one week. The speed and severity of this sell-off left many asking if one poor labor report alone was solely to blame. As it turned out, the Bank of Japan’s interest rate decision earlier in the week may have been just as important as it relates to what had occurred in U.S. markets.

A “carry trade” is a strategy wherein an investor borrows in a low-yielding currency (in this case the Japanese yen) and invests the borrowed funds in a higher-yielding asset. While it is difficult to assess the size and scope of these trades, certain statistical relationships can emerge that may shine light on how borrowed funds are being invested. To that point, the chart above shows the year-to-date changes in level of the Nasdaq index and the value of the U.S. dollar (USD) relative to the Japanese yen (JPY). Interestingly, on a rolling 30-day basis since the start of the year, the movements of the NASDAQ and USD/JPY have been moderately correlated with a coefficient of 0.46 (a coefficient of 1 would indicate a perfectly positively correlated relationship). While indeed moderate, this relationship does indicate that as the dollar has weakened relative to the yen, the Nasdaq has weakened in a similar fashion. What might be driving this relationship?

While we cannot draw definitive conclusions based on correlation alone, the carry trade strategy may be partially responsible for the emergence of this relationship. In the first half of this year, U.S. large-cap stocks notched strong performance while the dollar steadily strengthened against the yen, which kept yen borrowing costs low. That said, when the Bank of Japan raised its policy rate (and the cost of borrowing yen) in late July, many carry trade investors were forced to sell assets to pay back the funds borrowed in yen, which was now rapidly appreciating against the dollar.  For those who had been investing borrowed funds in U.S. stocks, harvesting gains from these positions would be a logical move in order to post collateral. It is important to point out, however, that this process can snowball. Specifically, higher demand for yen drives up the value of the currency, which prompts collateral calls for more investors who have borrowed in yen, which leads to further selling of risk assets like U.S. stocks. This feedback loop can be observed in the shaded region of this week’s chart, during which the correlation coefficient between Nasdaq and USD/JPY jumped to more than 0.9.

While this chart highlights one relationship to provide insight into the recent spike in equity volatility, a broader conclusion readers should draw is that changing dynamics within global markets and the opaque nature of certain trades can make risks faced by investors difficult to identify and measure. As a result, it is important for investors to maintain well-diversified portfolios that can weather various market environments.

The Path Ahead

At the start of this year, economic forecasts called for up to five 25 basis point interest rate cuts by the Federal Reserve throughout 2024 beginning as soon as the first quarter. That said, over the course of the year, these expectations moderated significantly due to stubbornly high inflation, stronger-than-expected economic growth, and a resilient employment landscape. As recently as July, investors expected only two rate cuts before 2025 based on implied probabilities from options markets. Sentiment shifted once again in August, however, after a spike in equity market volatility and weaker labor market data. As can be seen in this week’s chart, investors now anticipate four to five 25 basis point cuts before year-end, with an additional four to five cuts coming in 2025. Should current expectations come to fruition, the effective federal funds rate would fall to below 3% within the next 12 months.

As investors assess the future of Fed policy, it is important to remember that expectations regarding the path of interest rates are often inaccurate, as evidenced by the paragraph above. To that point, a material divergence in current expectations and the actual changes in interest rates over the coming quarters could have an impact on equity and fixed income markets. Investors will gain some clarity on the trajectory of interest rates at next week’s Federal Open Market Committee meeting, which will include a press conference from Chair Jerome Powell and the publication of committee members’ projections of appropriate future rate levels.

Are You Ready for Some Fixed Income?

As the leaves change to autumn and the authors cheer on their Fighting Leathernecks, fall is the perfect time for investors to reassess their fixed income portfolios. Fixed income is a hybrid security that offers both offensive and defensive properties. Much like a good football team, a fixed income portfolio needs to combine a strong offense with a solid defense.

Some strategies provide more offensive characteristics while others are more defensive. Portfolios with too much offense act like the Greatest Show on Turf. They do well when the economy is strong, but falter in down markets. Conversely, a fixed income portfolio that is overly reliant on defensive strategies will do well in a risk-off environment but will struggle in a strong economy like the Super Bowl Shufflin’ ’85 Bears.

While those were great teams, they were not a dynasty that stood up to the test of time. To build an all-weather fixed income portfolio that will perform in multiple market environments, an investor needs to balance offense and defense.
Fixed income has three primary objectives: income, diversification, and liquidity. Income, or yield, is what an investor is paid for loaning money to another entity. Fixed income helps to diversify portfolios primarily through duration. When risk assets are selling off, interest rates are generally falling. Duration is what drives fixed income prices higher in such scenarios. Finally, fixed income assets can be a source of liquidity. The weight of these qualities is dependent on if the strategy is more offensive- or defensive-minded.

This white paper outlines offensive and defensive fixed income characteristics and strategies and considerations for investors when building a “gameplan” for their fixed income allocation.

September is the Cruelest Month

The S&P 500 Index pulled back by more than 2% yesterday in a move that is not unprecedented based on the history of the benchmark. Specifically, the bellwether equity index has averaged a return of roughly -0.7% in the month of September dating back to 1928, which is particularly striking given that average performance of the benchmark has been positive in every other month of the year. There are several possible explanations for the potential anomaly that some have dubbed the “September Effect.” First, sales by investors returning from summer vacations aiming to lock in taxable gains or losses prior to the end of the year could be a driving force behind lackluster September returns. Additionally, September could see higher levels of equity sales due to market participants seeking to fund tuition costs for their children prior to a new academic year. The September Effect could also be seen as a self-fulfilling prophecy, as expectations for poor near-term equity returns could lead to widespread investor selling.

It is important to highlight a few points related to the September Effect that may assuage concerns related to equity performance over the coming weeks. First, many economists chalk the September Effect up to pure chance, given that any persistent market anomaly would be exploited by investors, causing it to disappear over time. It is also important to remember that the S&P 500 Index has actually notched a positive return in roughly 52% of September months dating back to 1928, meaning that the average figure cited in the first paragraph is skewed by a few negative observations of significant magnitude. As it relates to this year, several factors could buoy equity prices in the near term, including resilient corporate earnings, moderating inflation, and a high probability of a reduction in interest rates by the Federal Reserve at its meeting later this month. While challenges also face equity markets at present, market participants should remain disciplined as it relates to portfolio allocation and adhere to long-term investment policy objectives. Indeed, while the September Effect may serve as a notable phenomenon worthy of additional study, it ultimately should not factor into the investor decision making process.

The State of the American Consumer

The U.S. economy has long been driven by consumers, with consumption constituting more than two-thirds of GDP growth: As the consumer went, so went the economy. More recently, robust consumer spending has fueled positive domestic GDP growth and helped buoy the prices of financial assets. That said, there are now signs that these trends may be shifting. For instance, delinquency rates across various consumer loan types have ticked up, as have debt burdens as a share of overall household income. Additionally, personal savings rates in the U.S. have now dropped below long-term averages. From a big picture perspective, what do these trends mean for the overall health and growth of the economy?

This newsletter examines long-term tailwinds and emerging headwinds for the American consumer and expectations for both consumers and overall GDP growth going forward.

The Magnificent Five of Private Equity

In investment management, asset allocators and their advisors frequently revisit the concept of portfolio diversification — whether by geography, market capitalization, security, or industry. While Marquette advocates for a diversified portfolio within private markets, it is important to recognize that not all diversification strategies are equally effective. Certain industry characteristics make specific sectors more attractive for private investments, particularly those that exhibit sustainable growth driven by favorable demographic or secular trends, fragmentation, capital constraints, and market inefficiencies. These features are often advantageous in private markets as they create opportunities for value enhancement and potential alpha generation.

Within the private equity asset class, five core sectors — what we refer to as the “magnificent five” — have consistently dominated merger and acquisition activity over the past six years. These sectors are healthcare, technology, industrials, business services, and financial services. According to Dealogic, over 60% of deals across 13 tracked industries have been concentrated within these five sectors, as measured by transaction count. Moreover, these industries have outperformed relative to top-quartile multiple on invested capital (MOIC). It is therefore logical that private equity managers would focus their capital in areas with higher probabilities of outsized returns, which in turn shapes the composition of investor portfolios. It is also important to note that this concentration also intensifies competition for deals within these sectors.

A critical point to consider is the dispersion of returns between top and bottom quartiles across industries — the wider the dispersion, the greater the risk. It is no surprise that the highest-performing industries, healthcare and technology, are often heavily represented in private equity portfolios. In this competitive and risk-laden environment, particularly within the private equity asset class, manager selection becomes increasingly crucial for investors seeking to achieve superior outcomes.

Keep Calm and Carry On

U.S. equity markets began last week on a volatile note, with the S&P 500 Index experiencing its biggest daily drop (-3%) since 2022. The factors behind this sharp decline were outlined in last week’s publication, “Volatility Pops as Equities Drop.” In recent days, however, investors appear to have been appeased by more favorable economic data and carry trade exposures that are now much less significant. To that point, the S&P 500 experienced its largest daily gain since 2022 just a few days after Monday’s drop, rising 2.3% last Thursday, August 8. This week’s chart illustrates the most significant daily changes in the S&P 500 since 2020 in an attempt to compare recent market swings to those of previous years. Based on the information above, it is clear that last Monday’s 3% decline was much less severe than the most extreme daily losses exhibited by the index in 2020 and 2022. Interestingly, the largest daily loss of 12% for the S&P 500 in 2020, which came in response to the COVID-19 outbreak, was followed later that same week by the benchmark’s largest daily gain for the year (+9%).

The significant price movements within equity markets exhibited last week and more broadly illustrate two important points. First, market action can sometimes be driven by “animal spirits,” a term popularized by economist John Maynard Keynes that describes the emotional factors that occasionally supersede logic in investment decision making. Animal spirits are important for investors to keep in mind, as they help explain that many market swings are not indicative of a permanent shift in the economic landscape, but rather stem from human emotions such as fear or hope, which can be fickle. The second point is that adverse reactions to market selloffs can result in even more pain for investors since significant daily losses are often followed closely by large gains. To that point, an investor who allocated to the S&P 500 Index in the 1990s and missed the five best days of index performance would have seen a roughly 37% reduction in their final investment value relative to one who missed zero days (through the end of last week). Put simply, keeping calm and carrying on is often the best prescription for bouts of market turmoil.

Volatility Pops as Equities Drop

Recent days have proved quite challenging for equity investors. On the international front, the Nikkei 225 — which tracks the performance of large, public companies in Japan — dropped by more than 12% in Monday’s trading session. This figure represents the most significant single-day drawdown for that index in more than 35 years. Other non-U.S. equity benchmarks have exhibited similar pullbacks: The MSCI EAFE and MSCI EM indices are both down roughly 6% on a month-to-date basis as of the time of this writing. Performance has been similarly challenged for domestic stocks, with the S&P 500 and Russell 2000 indices down around 6% and 10%, respectively, over that same period. Perhaps unsurprisingly, the CBOE Volatility Index (“VIX”) reached a level not seen in more than four years during Monday’s trading session as investors grappled with broad market turbulence. Despite some moderation throughout the Monday session, the VIX remains well above its 10-year average after a prolonged period of muted volatility. These dynamics can be observed in the chart above.

As is often the case during market downturns, there is not a single force driving recent performance but rather a variety of factors at play. Some of the factors in this case include the following:

  • Friday’s lackluster jobs report, which detailed a higher U.S. unemployment rate (4.3% in July vs. 4.1% in June) and monthly nonfarm payroll gains for the last month that came in well below expectations (114,000 realized vs. 185,000 estimated). These and other souring economic data points may be leading investors to question the extent to which a soft economic landing can truly be achieved in the months ahead.
  • Waning enthusiasm surrounding the artificial intelligence trade, which has led to historically high concentration risk within many indices. Price drops of many large index constituents, many of which have benefitted from AI-related fervor, have exacerbated pressures on U.S. equity benchmarks in particular.
  • Technical factors, particularly related to a popular carry trade featuring the Japanese yen. A stronger yen and an unwinding of global yen carry trades, wherein investors borrowed in the low-yielding currency and reinvested the proceeds elsewhere, have created a negative feedback loop that has led to equity price pressures.

The dynamics described above have further clouded the future. As recently as last month, market participants expected roughly two rate cuts from the Federal Reserve for the remainder of 2024; now that figure sits at around five, with two 25 basis point cuts forecasted at the next FOMC meeting in September. To that point, the yield on the 2-Year Treasury, which closely tracks expectations surrounding Fed policy, briefly sank below 3.7% on Monday before pulling back to around 3.9% later in the trading session.

It is important to remember that the current market decline is not unprecedented. Investors should recall that equity indices are prone to corrections, with the S&P 500 Index exhibiting a drawdown of 10% or greater in 19 of the last 30 calendar years. As always, we encourage investors to maintain a long-term outlook related to their portfolios and not overreact to short-term volatility. A disciplined portfolio rebalancing policy coupled with a long-term strategic asset allocation is the most proven method to achieve risk and return objectives.

Semi-Charmed Country

Index concentration has been top of mind for investors in recent time, as fervor surrounding advances in artificial intelligence has led to outsized weights of a handful of constituents (e.g., Microsoft, NVIDIA, etc.) within domestic equity benchmarks like the S&P 500 Index. It is important to note, however, that index concentration is not simply a domestic phenomenon. For example, the Taiwanese equity market is notably exposed to technology-oriented companies, as roughly 80% of the MSCI Taiwan Index is comprised of Information Technology positions. Moreover, the index is heavily tilted toward one company in particular: Taiwan Semiconductor Manufacturing Company (TSMC). TSMC comprises just over 50% of the benchmark and has generated a year-to-date return of roughly 55% through the end of June. As it relates to these dynamics, readers may call to mind two questions: First, how did technology (and semiconductor manufacturing, in particular) come to play such an integral role within the Taiwanese economy? And second, to what extent are global semiconductor supply chains reliant on Taiwan?

TSMC was founded in 1987, with capital provided by the Taiwanese government in hopes of starting a new national industry. At that time, the company decided to focus solely on semiconductor production, which meant creating fabrication plants to manufacture chips for other businesses. This innovative model, commonly known as the foundry model, allowed TSMC to work with semiconductor companies that designed their own chips as opposed to competing against them. It is evident now that this model was hugely successful, as the current revenue share of TSMC accounts for more than 60% of the global semiconductor foundry market. The total market share of Taiwan reaches 70% when one includes other Taiwanese foundry companies (e.g., UMC, PSCM, and VIS). Factors that have led to the country’s strong success in this market include the aforementioned creation of the foundry model, as well as the highly efficient nature of Taiwanese semiconductor companies and the fact that employees in Taiwan’s semiconductor workforce are compensated well relative to those employed in other industries.

Taiwan is clearly the dominant participant in the foundry market, but it is important to note that the production of semiconductors depends on multiple players, including “fabless” chip designers (e.g., NVIDIA), companies that test and package chips, and end manufacturers. This means that the semiconductor supply chain extends well beyond Taiwan, although the country’s role within that chain is clearly crucial, as evidenced by the global chip shortage during the COVID-19 pandemic. In the wake of that shortage, and with continued geopolitical concerns surrounding China and Taiwan, countries around the world have aimed to de-risk supply chains and, therefore, have made significant investments in their domestic semiconductor industries. To that point, many European countries, as well as China, Japan, and the United States, have all committed significant resources to this endeavor. With increasingly complex artificial intelligence requiring more sophisticated chips, the semiconductor space still appears to present compelling investment opportunities, both within Taiwan and throughout the rest of the world.