Author: cvernon

The Taming of the VIX

October proved tumultuous for investors as all major U.S. equity indices were negative and the CBOE VIX Index, which serves as a measure of expected near-term market volatility and is often referred to as the “Wall Street Fear Gauge,” spiked above long-term average levels. November has seen a reversal of these trends, given a rebound in equity markets and a decline of VIX measures back to below long-term average levels. The Federal Open Market Committee (FOMC) meeting earlier this month may have served as a turning point for investor sentiment, as a cautious but less hawkish tone was set by policymakers and the federal funds rate remained at a constant level (5.25% – 5.50%). Additionally, yields fell as the U.S. Treasury announced a slower pace of increases in sales of 10- and 30-year securities, which may have further contributed to increased investor optimism. Finally, the most recent consumer price index reading of 3.2%, which came in below consensus expectations, has further bolstered equity markets over the last few days and has led to the VIX retreating to its lowest level since September.

The data points outlined above may suggest that a “soft landing” for the U.S. economy may be increasingly likely, however the full economic picture is still somewhat mixed. Indeed, while wage increases are beginning to soften and hiring has slowed, the labor market remains tight and job openings abound. Additionally, the “higher for longer” interest rate environment means that borrowing costs for both businesses and consumers will remain elevated into the future, while credit card and other loan delinquencies (e.g., auto loans, mortgages, etc.) continue to climb. These factors could pose challenges to the health of the American consumer and equity markets over the coming months. So, while the Fed appears to have been effective at bringing inflation levels down to this point, there are still several potential landmines of which policymakers and investors should be cognizant. Marquette will be closely monitoring macroeconomic dynamics, as well as the final FOMC meeting of the year in December, in order to assess the outlook for equity market performance and volatility into 2024 and beyond.

Realizing the Impact of Unrealized Losses

Earlier this year, the regional banking crisis and eventual collapses of Silicon Valley Bank, Signature Bank, First Republic Bank, and Silvergate Bank highlighted issues related to bank assets (e.g., U.S. Treasuries and mortgage-backed securities) sharply losing value due to higher interest rates. In many of these cases, uninsured depositors learned of growing unrealized losses at the institutions in question and feared the worst (i.e., that banks would become insolvent and pull deposits). Unfortunately, the story of declining bank asset values is relevant not only to uninsured regional banks, but to FDIC-insured depository institutions as well. To that point, the most recently published FDIC Quarterly Banking Profile highlighted growing unrealized losses across these institutions. Specifically, unrealized losses on securities totaled $558.4 billion in the second quarter of 2023, which represents an increase of $42.9 billion from the previous period. Rate hikes have certainly exacerbated these figures, as current losses are more than two standard deviations removed from the average levels exhibited since the Global Financial Crisis. An understanding of the implications of increased losses across different security types (e.g., available-for-sale vs. held-to-maturity) can be particularly useful. Notably, while held-to-maturity securities are reported as noncurrent assets on a company’s financial statements and earned interest income appears on a company’s income statement, changes in the prices of these securities are not reflected on the income statement if the securities have maturities longer than one year. As a result, some financial metrics (e.g., earnings) of certain banks may be somewhat overstated at present.

Even today, interest rates continue to chip away at the value of bank assets, and additional upward pressure on rates may strain bank profitability as held-to-maturity securities approach maturity. Banks will be hoping that the end of the current rate hiking cycle comes before these losses make their way to the income statement, which could cause many to question the health of various institutions. On a positive note, the FOMC announced during its most recent meeting that it would be holding its policy rate at a constant level, which may assuage some investor concerns related to this topic. Marquette will continue to monitor the impact of interest rates on the banking sector and the overall economy.

The Chart for Red October

U.S. equities declined for the third consecutive month in October amid an environment of higher yields and underwhelming earnings reports for many key index constituents. The S&P 500 Index, while still positive on a year-to-date basis, dropped by more than 2.0% during the month and is now more than 8.0% off its July peak. The Nasdaq-100 Index, which skews more heavily to growth-oriented segments of the market like Information Technology, also saw a decline of more than 2.0% in October. Finally, the Russell 2000 Index, which tracks the U.S. small-cap market, returned roughly -6.8% during the month and is now negative on a year-to-date basis.

As stated above, elevated yields have weighed on equity indices in recent time. The yield on the 10-year Treasury, for instance, recently eclipsed 5% for the first time in over 15 years, while most short-end rates remain at levels not seen since the Tech Bubble of the early 2000s. Higher yields have the effect of applying pressure to equity price multiples and enticing investors to allocate away from stocks and toward bonds. Smaller companies are often disproportionately impacted by higher rates because of the large debt burdens typically associated with those businesses, which helps to explain the underperformance of the Russell 2000 Index relative to the broad market over the last several months. Additionally, optimism surrounding some of the mega-cap technology companies that have exhibited robust returns this year, commonly referred to as the “Magnificent Seven,” appears to be waning. For example, Alphabet (the parent company of Google), saw its shares decline by roughly 10% the day after it reported a smaller-than-expected profit in its cloud computing segment. Amazon, Meta, and Tesla have also seen their shares trade lower in recent weeks due to investor concerns about future sales and margins. While it is important to note that none of these companies reported overly problematic earnings data for the third quarter, lofty valuations and investor exuberance have left their share prices vulnerable to pullbacks when results are even slightly disappointing.

While recent performance of equity indices has surely been challenged, there are several reasons for investors to stay the course. For instance, the Federal Reserve is likely nearing the end of its hiking cycle, meaning the pressure being applied to stock prices by higher yields may soon abate. It is also important to remember that markets often exhibit mean-reverting patterns of performance, meaning strong equity returns typically follow periods of stress. Marquette will continue to monitor dynamics within stock markets and provide guidance to clients accordingly, while also emphasizing the need for prudence and a long-term approach as it relates to equity investing.

3Q 2023 Market Insights Video

This video is a recording of a live webinar held on October 26 by Marquette’s research team, featuring in-depth analysis of the third quarter and themes we’ll be monitoring for the remainder of the year.

Our Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real estate, infrastructure, private equity, and private credit, with presentations by our research analysts and directors.

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Portfolio Trick or Treat

Coming into 2023, investors were cautiously optimistic about 2023 market returns; cautious considering the broad losses across asset classes during 2022 but optimistic about more attractive valuations and the inherent upside potential stemming from these price points. Nine months into the year, which of these opportunities have been “treats” for investors, and which have been “tricks”?

In this edition:

  • The biggest trick of them all: Investment grade fixed income
  • But not all of fixed income has been a trick…
  • Tricks come in all sizes: U.S. small-cap equities
  • Trick, treat, or both? U.S. growth stocks
  • Currency movements still tricky
  • More treat than trick: Emerging markets
  • If you’re not surprised, it’s not a trick: Commercial real estate

Temperatures Drop but Hiring Heats Up

A few weeks ago, the Bureau of Labor Statistics reported that total nonfarm payrolls rose by 336,000 during the month of September. This figure was roughly double that of the Dow Jones consensus estimate and more than 100,000 higher than the job gains posted during the previous month of August. These increases occurred across a variety of industries, including leisure and hospitality (96,000 job adds), health care (41,000 job adds), and professional, scientific, and technical services (29,000 job adds). Government employment also increased by 73,000 during the month. Additionally, the unemployment rate remained constant at 3.8% in September, and both of these data points can be observed in this week’s chart.

The robust job gains notched in September beg the natural question: How will a strong domestic labor market impact upcoming decisions of the Federal Reserve as it relates to the path of interest rates? Clearly, labor market data is supportive of “higher for longer” messaging, especially since inflation remains above the central bank’s long-run target of 2%. Based on futures markets, most forecasters believe that it is not until the middle of 2024 that the Fed’s policy rate will ultimately come down. In the more immediate term, futures markets indicate the likelihood of a pause at the next FOMC meeting, however, any decisions after that will depend on additional inflation and labor market data. Marquette will continue to monitor dynamics within the domestic labor market, assess current and future Fed policy, and provide guidance to clients accordingly.

Pause for Effect

With higher rates dragging on performance, investment grade fixed income securities experienced a challenging third quarter. While September CPI data may lead to a final rate increase by the Federal Reserve before the end of the year, a tactical pause by the central bank in the months following the next FOMC meeting appears likely. Based on prior pause cycles, investors may have reasons for optimism as it relates to the trajectory of investment grade fixed income in the near future.

The chart above highlights policy rate pause cycles overlayed with 1-year trailing returns of the Bloomberg U.S. Aggregate Bond Index and the upper bound of the federal funds rate over the last 45 years. For this analysis, a pause cycle was defined as a period immediately following a rate hike during which the policy rate was maintained at a single level for more than two consecutive FOMC meetings. As rate policy is dictated by economic data, looking beyond two FOMC meetings helps to distinguish pause cycles from stair-step rate increases. Based on this framework, there have been 13 such cycles since 1980, which have lasted roughly six months on average.

In Marquette’s most recent Quarterly Letter from the Director of Research, Halftime Adjustments, it was suggested that the overall yield environment, coupled with fewer Fed rate hikes going forward, could generally serve to benefit the fixed income space. This optimism is supported in part by the relatively strong bond market performance observed during 12 of the 13 pause cycles detailed above, with the lone exception coming in 1983 and 1984. This pattern aligns well with intuition, as a flat rate environment allows investors to collect coupon payments from bond holdings while prices hold steady, which leads to positive returns. Investors should remember, however, that the differences between past environments and current realities must be considered when assessing the return potential of all asset classes, including fixed income. While past performance does not guarantee future returns, Marquette will be watching closely to see if trends similar to those outlined above unfold over the coming months.

U.S. Equities: Surprising Strength Gives Way to Macro Risks

Equity market strength through the third quarter continues to challenge the common expectation going into the year. Cumulatively through September 30, the slowdown many investors anticipated has been averted thus far as the strength in certain segments of the market has more than offset the weakness in others. Following the strength of value equities — with Energy the lone positive sector in 2022 — markets experienced a shift in leadership to begin 2023. Companies that were challenged by supply chain issues and wage pressures rebounded to begin the year, primarily within growth-oriented sectors including Communication Services, Information Technology, and Consumer Discretionary. Overall, markets were strong through the first nine months of the year, as the S&P 500 rose 13.1%. However, September — historically the worst month of the year for equity markets — saw a somewhat unsurprising pullback. As we enter the final quarter of the year, we feel it is important to examine the underlying market dynamics driving performance and highlight the risks of a narrow market as well as the opportunities available on the sidelines.

The Back to Work Barometer

The allure of work-from-home flexibility continues to impact the utilization of office buildings across the United States. Based on analysis of data from key fobs — the form of identification that grants one access to an office building — average occupancy across the country in the last week was roughly 49.7%. Cities in Texas like Houston (60.0%) and Austin (58.9%) lead the pack in terms of office occupancy, thanks in part to population growth in the last few years, attractive employment opportunities, and newly developed office assets with attractive amenities. It is also worth noting that the occupancy spread across specific days of the week continues to be significant at the national level. As of the end of September, Tuesday (59.4%) and Friday (32.9%) were, on average, the highest and lowest days of the week in terms of occupancy, respectively.

Many are paying close attention to these trends, as utilization is a robust indicator of future demand for office assets. For instance, real estate managers can identify in- and out-of-favor trends within portfolios based on occupancy levels. Additionally, companies can study the patterns of employees to understand future office footprint needs. To that point, among businesses with at least 10,000 employees, 68% plan to undertake a reduction in office space in the near future. Smaller employers seem less inclined to reduce space at present, with 36% of businesses with fewer than 1,000 employees planning to downsize according to a recent publication by The Real Deal, a leading source for real estate news and information.

The data points displayed in this week’s chart underscore the notion that work-from-home trends will likely persist into the future, which will have impacts at various levels of society. For instance, cities must continue to adjust to a relative lack of foot traffic, which has already been disruptive to demand for restaurants, shopping centers, and parking garages. City budgets may also exhibit ongoing strain due to reduced funds collected from public transportation and lower tax revenues resulting from depressed office asset valuations. In conclusion, it is impossible to omit the “stickiness” of full or hybrid work-from-home environments which have persisted for more than three years when discussing the outlook for the office market at both the national and local levels. Marquette will continue to monitor dynamics within the office market and provide education and guidance to clients accordingly.

Selling Insurance: An Option for Diversification

The Aflac Duck, the LiMu Emu, and the GEICO Gecko may be fictional insurance salespeople (or sales-animals, perhaps), however, the market participants involved in the selling of financial insurance are all too real. Put options are a popular form of such insurance, as these instruments afford the option holder the right to sell an underlying security at a given level, effectively insulating the holder against significant drops in the price of the underlying security. That said, much like bundling your home and auto with Jake from State Farm, this insurance comes at a cost based on implied volatility. For those who choose to purchase options contacts on the broad-based S&P 500 Index as a means of insuring portfolios against losses, this implied volatility is measured by the VIX Index, which uses at-the-money S&P 500 Index options to assess expectations of near-term market fluctuations. Over the long term, these expected volatility levels tend to be higher than what is actually exhibited. Specifically, since the start of 1990, implied volatility of the S&P 500 Index was greater than what was subsequently realized in roughly 87% of daily observations, and the difference between the two was roughly 4.5% on average over the same time period. This phenomenon leads to the systematic over-pricing of put option contacts and is highlighted in the top half of this week’s chart.

The data points noted above demonstrate the fact that selling insurance contracts on the U.S. equity market has generally been a profitable endeavor over the last several decades. To that point, the CBOE S&P 500 PutWrite Index, which is comprised of short positions in at-the-money put options on the S&P 500 Index and short-term Treasury bills which serve to collateralize the option positions, is an effective tool for measuring exactly how beneficial this activity can be for investors. On a trailing 10-year basis as of September 30, the PutWrite index notched an annualized return of 6.7%. While this is significantly lower than the 13.1% figure for the S&P 500 over the same period, the PutWrite benchmark has notably delivered that performance with a lower annualized standard deviation — 9.7% vs. 15.0% for the S&P 500. Performance of the PutWrite benchmark during down markets has been particularly compelling, with the index outperforming the S&P 500 in six of the last seven calendar years during which the S&P 500 was negative. This performance pattern can be observed in the bottom half of this week’s chart. It is important to note that active managers within the space can provide additional value over the PutWrite index by selling the most attractive options, diversifying the portfolio of options across different strike prices and tenors, and optimizing the pool of cash with which the options are collateralized.

Readers should be aware of the fact that options selling is not without risk. Performance typically lags during strong, upward-trending markets, and a relatively high equity beta means that these types of strategies will be more correlated to stock market movements than other diversifying alternatives. That said, options-based strategies could present attractive opportunities for many investors due to the systematic processes with which they are implemented, the lower fees and better liquidity terms associated with them relative to other alternatives, and the likelihood that the volatility risk premium will persist into the future. Marquette will continue to monitor the persistence of this premium, conduct due diligence on investment managers in the options space, and provide education and recommendations to clients accordingly.