Author: cvernon

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.

Survey Says…

During its September meeting, the Federal Open Market Committee (FOMC) opted to keep its policy rate unchanged — within a range of 5.25% to 5.50%. In doing so, policymakers signaled a commitment to keeping rates elevated over the coming months in order to achieve the central bank’s long-run inflation target of 2.0%. Fed officials appear to be taking a deliberate and cautious approach to recent policy now that interest rates have entered firmly restrictive territory and could potentially hinder growth. The Fed also noted the “lags with which monetary policy affects economic activity” in its September FOMC statement. These lagged effects would likely be an argument in favor of slowing the pace of tightening since the impact of previous rate increases may not yet be reflected in current economic data. To that point, the most recent Summary of Economic Projections, which in part serves as an assessment of FOMC participants as it relates to appropriate monetary policy, indicates that a majority of officials favor one more rate hike in early November before policy loosening in 2024 and beyond.

The September Summary of Economic Projections yielded additional interesting pieces of information related to how policymakers are viewing the current and future macroeconomic landscape. For instance, the median response of FOMC participants for 2023 GDP growth was 2.1%, which represents a significant increase from the 1.0% figure reflected in the June survey. The median estimate of long-run GDP growth in the September survey was 1.8%. Additionally, the September survey suggests that the median FOMC official expects the unemployment rate to tick up to 4.1% in 2024 before moderating to 4.0% over the longer term. Finally, median estimates for PCE inflation, which is the preferred measure of the Fed, sat between 2.0–2.5% over the coming years.

While it is encouraging to see inflation expectations moderating without substantial decreases in future growth or material increases in the projected unemployment rate, the Fed still faces obstacles related to obtaining these desired outcomes, including a potential government shutdown. Marquette will continue to monitor the actions of the central bank and keep clients informed accordingly.

The Implications of a Government Shutdown

The federal government will shut down if Congress is unable to pass funding legislation by October 1, and a bill appears increasingly unlikely amid contentious debates among lawmakers regarding levels of future spending. While some essential government employees (e.g., law enforcement personnel) will be unaffected and benefits like Medicare and Social Security will continue to be paid, other disruptions will likely arise as a result of a shutdown. This newsletter seeks to outline these disruptions and the potential implications of a prolonged stoppage on certain functions of the federal government.

Read > The Implications of a Government Shutdown

2023 Investment Symposium

Watch the flash talks from Marquette’s 2023 Investment Symposium livestream on September 15 in the player below — use the upper-right list icon to access a specific presentation.

 

Please feel free to reach out to any of the presenters should you have any questions.

The State of the IPO Market

After a red hot 2021, the initial public offering (IPO) market has materially slowed over the last two years amid an environment of equity price volatility and higher interest rates. Additionally, many of the companies that came to market during the post-pandemic boom have struggled in recent time as investors sought the safety of more proven business models and solid balance sheets. Listings within the Information Technology sector were hit particularly hard last year given widespread concerns about future growth and profitability.

Despite the recent headwinds within the IPO market, there have been several notable company debuts over the last several days. For instance, Arm Holdings, a British semiconductor and software design company, debuted last Thursday and climbed nearly 25% in its first day of trading before paring back gains to start the week. Additionally, Instacart, a grocery-delivery company, and Klaviyo, a global technology company, both started trading this week to varying degrees of success. According to Renaissance Capital, a total of 77 companies have gone public in 2023, which is higher than last year’s figure of 71. These developments have renewed hope among some that the IPO market will continue to heat up into 2024, as many companies that postponed public listings over the last two years are now reconsidering that course of action. That said, investors appear less likely to dive into these investments with the same levels of exuberance displayed in 2020 and 2021, which saw a combined total of more than 600 company debuts. Uncertainty related to future policy decisions of the Federal Reserve is partially responsible for this sentiment, as is the difficulty of actually valuing these newly listed companies given the changes to the interest rate landscape over the last few years. To that point, the majority of companies that listed in 2020 and 2021 are currently trading below their respective IPO prices, meaning investors that purchased equity in those deals are likely sitting on losses.

Marquette will continue to monitor dynamics within the IPO market and provide guidance to clients accordingly.

Print PDF > The State of the IPO Market

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.