Category: Chart of the Week

Long and Variable Lags

The Federal Reserve has waged an aggressive campaign against elevated inflation in recent time, having raised its policy rate from near 0% to over 5% in just over one year. These actions represent the fastest pace of tightening in the history of the central bank. Since the Fed began hiking in the first half of 2022, readings of core CPI, which strips out more volatile components of the headline CPI calculation like food and energy prices, have retreated from a peak of over 6.5% to roughly 3.9% as of the time of this writing. While this moderation of core inflation has led to increased (and perhaps overly) positive sentiment on the part of many investors, it is important to remember that the battle against high price levels has not yet been won. The week’s chart attempts to underscore that point by highlighting the amount of time it has taken for peak inflation to reach more trough-like levels (i.e., those closer to the long-term median core CPI reading) over the last several decades. Readers may be somewhat disheartened to learn that it has taken an average of around two years for inflation to go from peak to trough, with the last two instances requiring roughly three years. For context, the peak figure from the current cycle came 17 months ago.

As it relates to the reason for these long-lasting campaigns against inflation, Fed Chair Jerome Powell has noted the “long and variable lags” with which monetary policy often acts. According to the Fed, one explanation of these lagged effects is that many economic transactions involve prices and quantities that are agreed upon months in advance by the buyer and seller. If these agreements occur in advance of significant changes in monetary policy, they will naturally not be influenced by new levels of interest rates. Additionally, the Fed has noted that lags may arise from the “inattentiveness” of business owners, who may set prices on an infrequent basis to avoid “menu costs,” or the costs associated with price updates. Such behavior would lead the current economic reality to be unreflective of the current monetary policy. Whatever the reasons for the lags detailed above, precedent clearly shows that it may take additional months for inflation to retreat closer to long-term average levels, which may lead to an environment of higher-for-longer interest rates.

Looking ahead, the CPI figure for February is scheduled to be released on March 12. This reading will likely prove informative as investors attempt to determine future actions of the Federal Reserve, which is currently expected to cut rates three to four times this year. Interestingly, market participants expected as many as six rate cuts in 2024 just a few months ago. Marquette will continue to monitor the macroeconomic landscape and provide updates to clients accordingly.

Show Some Maturity

As interest rates remain elevated, some market participants have questioned the extent to which the maturity wall in the below investment grade fixed income market is a sign of increased risk. On paper, concerns related to the maturity wall are understandable, as high yield and leveraged loan issuers face higher financing costs due to increased credit risk. Further, these companies could struggle to refinance debt as it matures and, as a result, incur much higher interest expenses in the future. These dynamics may lead to an eventual increase in default rates and create headwinds for fixed income performance.

In recent time, however, there have not been significant issues when it comes to below investment grade issuers refinancing debt and extending maturities. Since the beginning of 2023, the amount of high yield and leveraged loan debt maturing in 2024, 2025, and 2026 has been reduced by a combined $472 billion, which constitutes roughly 17% of the current market for outstanding high yield bonds and leveraged loans. Additionally, the pace of refinancings and the reduction in impending maturities has only accelerated over the more recent term, as issuers took advantage of lower interest rates in the fourth quarter of last year to term out debt. To that point, more than $54 billion of high yield and leveraged loans have been refinanced over the past three months alone. This is roughly double the pace of 2022, during which $28 billion was refinanced every three months, and nearly five times the $11 billion being refinanced every three months in 2021, during which the market for new issuance was almost non-existent.

Although refinancings abound in 2024, concerns related to impending maturities are not entirely unfounded. Over the next three years, over 21% of the below investment grade market is scheduled to mature. While this number is down slightly from year-end, it remains close to recent-term highs. However, this increased pace of refinancings is a welcome sign for fixed income markets broadly. Fundamentals remain resilient in the below investment grade space, and this resilience will likely allow companies to bear higher interest costs and continue to extend out maturities to time periods that may exhibit more rate favorability.

2 vs. 2000

A key metric that many investors use to measure the size of a company is market capitalization, which represents the total number of a company’s outstanding shares multiplied by the current market price per share. U.S. Steel became the first company to cross the $1 billion market capitalization threshold when it went public in the early 1900s. The first company to reach $10 billion in market capitalization was General Motors in 1945, and General Electric passed the $100 billion mark roughly 50 years later. More recently, two mega-cap technology companies crossed the $1 trillion milestone. Apple was the first to accomplish this feat in 2018, having come a very long way from its market capitalization of around $2 billion at the time of its initial public offering during the 1980s. The second company to gain membership into the exclusive $1 trillion club was Microsoft in 2019. These two behemoths have continued to achieve new market capitalization milestones in recent time, with both surpassing the $3 trillion mark within the last year.

One notable fact related to these dynamics is that in 2023 both Apple and Microsoft became larger than the entire Russell 2000 Index, a market capitalization-weighted benchmark that tracks the U.S. small-cap universe. While this is in large part due to robust growth of these technology giants, poor performance from smaller companies in recent years has also given rise to the trends depicted in this week’s chart. All of this being said, recent pressure on Apple shares, in conjunction with a small-cap rally to close out last year, has led to Apple falling back below the $3 trillion mark and the Russell 2000 Index, which now sits at roughly $2.95 trillion in total market capitalization. It is possible that Microsoft will soon follow suit given concerns related to its potentially lofty valuation, as well as the relatively attractive multiples of small-cap equities in general.

If the Treasury Curve Could Talk

While most of Marquette’s research is written in the third person, this edition of our Chart of the Week series endeavors to anthropomorphize a key feature of the financial system to provide a unique perspective on the current state of capital markets. The following is what readers might expect to hear from a sentient Treasury curve, which is currently suffering from a prolonged inversion.

I just want to feel “normal” again.

For most of my life, longer-dated bonds have provided higher yields than those with shorter maturities. This is often the case since investors expect increased compensation for the increased risks (e.g., higher duration, lower liquidity, etc.) associated with holding long-term bonds, and I am considered upward sloping and normal when these factors are at play. On certain occasions, however, I have been upended as a result of the reversal of those dynamics, though I have usually been able to snap out of those periods of inversion relatively quickly. To that point, the average length of my inversions was less than one year prior to my current funk, which began in July of 2022 and has yet to abate. During this painful time, the 2-Year Treasury yield has been higher than that of the 10-Year by an average of 54 basis points. Put simply, I feel stuck.

The last time my inversion was this prolonged or this extreme was during a period of roughly 20 months beginning in the late 1970s amid rampant stagflation. Led by Paul Volcker, the Federal Reserve began aggressively raising the federal funds rate in 1978 to combat elevated price levels, and these efforts led to an acute inversion of more than 200 basis points. I was offered a brief respite in May of 1980, but this period of normalization lasted only a few months before short-term rates started moving higher once again. You may remember this period as the “double-dip recession,” but I think the “double-dip inversion” is just as apt a descriptor given my behavior! I have inverted on a few occasions since that difficult time. Specifically, I became inverted again in the late 1980s after a lengthy peacetime expansion drove inflation higher and the federal funds rate increased as a result. Still, that inversion lasted less than a year, as then-Fed Chair Alan Greenspan was forced to cut rates to mitigate a recession that began in 1990. I next became inverted when the Fed increased rates in the early 2000s after the longest period of domestic economic growth to that point. This inversion lasted around seven months before Greenspan came to the rescue once again by cutting rates following the busting of the Dot-Com Bubble, a fall in business investing, and the September 11th attacks. When I became inverted in the lead-up to the Global Financial Crisis, it was Ben Bernanke who straightened me out after just six months.

As I mentioned earlier, my current inversion is particularly pronounced relative to my history, and I have spent the last several months asking myself the following question: How can I get out of this predicament? In theory, longer-dated yields could increase and restore my normalcy, however market participants have such strong demand for long-dated bonds at present that those yields may be range-bound. With that in mind, an appeal to Jerome Powell to lower the federal funds rate may be my only hope. This being the case, you can imagine my dismay at this week’s CPI reading, which came in hotter than expected at 3.1% on a year-over-year basis. Until we see inflation inch closer to the 2.0% target established by the Fed, I believe that Powell will likely hold short-term rates at their current levels and my inversion will continue.

Another (Down) Round

Venture-backed companies tend to be nascent and typically deploy investment capital in an effort to drive revenue expansion, often to a point at which they are losing money. Given this profile, these businesses must raise new capital every few years to fund future growth. In normal circumstances, each capital raise is conducted at a higher valuation, assuming the company remains financially viable. That said, there are occasionally instances in which the market’s perception of valuation has materially changed or the company is not achieving specific growth targets. Cases like these, which are referred to as down rounds, result in companies being forced to raise capital at lower valuations than the ones exhibited during the most recent fundraising period.

Many venture-backed companies raised capital in 2020 and 2021 at relatively high valuations. Since that time, a significant portion of those companies have seen cash levels depleted and are now returning to the market in order to fund operations for the next few years. However, today’s market environment looks quite different from those of 2020 and 2021, which means these companies are being confronted with much lower valuations as they attempt to raise capital. As displayed in this week’s chart, these dynamics have led to a steady increase in the number of down rounds over the last several quarters. To that point, down rounds (as a percentage of all fundraising rounds) hit a new high of nearly 27% in the third quarter, which is more than double the long-term average.

The trends depicted in the chart above are likely to lead to some disappointing returns for venture capital funds with vintages from 2018 through 2021, as these funds deployed significant amounts of capital during those years and now face a more challenged valuation landscape. On the bright side, these dynamics may present an opportunity for funds with more recent vintages and fresh capital to invest at more attractive valuation levels. Marquette will continue to monitor developments within the venture capital space and provide recommendations to clients related to existing exposures and future commitments.

A Tale of Two Emerging Markets

While Chinese equities have largely languished in recent time amid robust performance of Indian stocks, it is important to note that these dynamics were quite different just a few years ago. To that point, the MSCI China Index outperformed its Indian counterpart by roughly 45% on a cumulative total return basis between 2016 and 2020. During that period, global investors were optimistic about the growth prospects of many Chinese companies and benefitted from an expanded opportunity set given the addition of local market shares to the MSCI Emerging Markets Index. Chinese stocks grew to comprise nearly 40% of the benchmark at the end of 2020 as a result of these developments, which caused many market participants to wonder if China should still be considered an emerging country.

As most readers are likely aware, these trends have shifted dramatically in the last few years. Since the start of 2021, the MSCI China Index is down roughly 50%, as the country has presented investors with myriad headwinds including changes to the regulatory environment, increased government debt, a challenged property sector, heightened geopolitical tensions, and a weaker-than-expected post-pandemic economic recovery. In contrast, the MSCI India Index has returned more than 60% on a cumulative basis over the last four years. Market participants have been drawn to India due to its strong structural growth story which centers on favorable demographics, government reforms, and robust economic expansion. As a result of increased investor attention and equity market appreciation, the weight of Indian equities within the EM benchmark has roughly doubled since 2016. Going forward, continued growth may push Indian equities higher, though many investment managers are now becoming wary of current valuations. Many Chinese stocks, on the other hand, are trading at historically low multiples and facing extreme levels of negative sentiment. These dynamics could lead to a reversal of the trends outlined above in the near term.

As it relates to investing in emerging countries, it is important to highlight the need for patience and diversification given the variability of returns associated with the asset class when compared to most developed markets. Investors should also consider the use of actively managed strategies within the space due to return dispersion and the demonstrated ability of most managers to beat the MSCI Emerging Markets Index over long periods of time. Marquette will continue to source best-in-class managers within the asset class, monitor performance trends, and provide recommendations to clients accordingly.

Lost in Transaction

The 10-year Treasury yield notably displayed significant movements throughout 2023. Specifically, it was largely range-bound over the summer (between 3.5%–3.8%), then shot up to around 5.0% in October before falling back down to under 4.0% before year-end. It currently hovers slightly above 4.1%. Thanks in large part to these movements in yields, the real estate market seized up and very few transactions occurred in the fourth quarter of last year. As a result, the full calendar year of 2023 exhibited the lowest transaction volume in the last five years. Limited transactions in the market provide a hurdle for real estate managers and third-party appraisers to accurately determine asset values. As such, the pace of contraction for the private real estate index NCREIF-ODCE has been choppy, with the latest quarter responsible for nearly one-third of the benchmark’s gross return correction of -16.4% since late 2022.

Quarterly returns for the underlying index managers have been volatile in recent time as well. Based on a sample of 18 of the 25 ODCE index funds, the average spread of gross returns over the last five quarters has been nearly 6 percentage points. For context, the longer-term spread is closer to 4 percentage points. Additionally, each fund in that sample has underperformed the ODCE benchmark in at least one of the last six quarters. These figures underscore the notion that recent marks have displayed an elevated degree of dispersion and noise.

Even with the considerable drop in valuations, real estate fundamentals remain relatively healthy outside of the office space. Most do not believe assets are broken, and rent growth still exists within the multifamily, industrial, and self-storage sectors (albeit at lower levels than in prior years). As it relates to the road ahead, real estate investors should remain patient as market dynamics play out. To that point, it may take several quarters for buyers to come off the sidelines, after which more transactions can occur and ultimately be reflected in valuations. Marquette will continue to monitor the real estate landscape while emphasizing the importance of prudence and a long-term perspective.

Equities: Slow Down to Yield

While robust equity market performance in 2023 was certainly in part spurred by the strength of mega-cap technology stocks, economic data and the movement of interest rates also played a critical role. To that point, a decline in Treasury yields to start last year helped fuel a low-quality rally in equity markets, though yields moderated over the next few months following the regional banking chaos that unfolded in February and March. Dynamics shifted in July, however, when yields began to surge as the U.S. Treasury announced new debt issuance to help fund a growing budget deficit. As the year progressed, the continued strength of the domestic economy, including a robust labor market and a resilient consumer, combined with hawkish Fed rhetoric caused yields to climb even further. The 10-Year Treasury yield notably rose to nearly 5% by mid-October, its highest level in over 15 years. Equity markets largely sold off in tandem with this spike in yields, with the Russell 2000 Index reaching an intra-year low on October 27, 2023. Market dynamics once again shifted in the final weeks of 2023, as cooling inflation data led to a more dovish tone from the Fed and widespread investor anticipation of near-term interest rate cuts. This changing sentiment supported a reversal in the 10-Year Treasury yield in late October. As a result of renewed optimism, equity markets exhibited a sustained rally to close the year, with the S&P 500 Index approaching all-time highs in late December. Small-cap equities, which were shunned by investors for much of 2023 amid an environment of higher rates, climbed nearly 25% from their October lows through year-end. Though this rally saw the reemergence of market breadth, as both cyclicals and growth-oriented equities notched strong returns, actively managed strategies struggled due to the outperformance of lower-quality stocks.

This “Santa Claus rally” that ended last year has ultimately tapered off, with equity markets declining to start 2024 amid slightly higher yields. While this trend could foreshadow further challenges for equities in 2024, it may also be a necessary correction. Specifically, given the sharp rise in stocks to close last year, investors may have priced in an overly optimistic probability of interest rate cuts and are just now beginning to consider the possibility that the Fed will not be as accommodative as expected in 2024. This recent correction may also provide some valuation support in the event of any missteps during this quarter’s earnings season, which is slated to kick off in the coming days. As 2024 progresses, policy decisions by the Federal Reserve and the movements in Treasury yields will likely continue to impact investor sentiment and market performance.

A Case of Bad Breadth

The new year presents an opportunity for a fresh investment outlook. As investors hypothesize about where markets may be headed in 2024, a look back at performance during 2023 may prove beneficial. To that point, one of the major narratives over the last year was the dominance of U.S. equities relative to many other asset classes, as the S&P 500 Index returned approximately 26.3% in 2023. As many readers are no doubt aware, the “Magnificent Seven” companies (Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia, and Tesla), which represent nearly one-third of the index, accounted for roughly two-thirds of the calendar year return for the benchmark. While the S&P 500 Index is often considered a proxy for the overall U.S. stock market, it is worthwhile to investigate the extent to which the 2023 return of the benchmark is indicative of broader strength across the equity spectrum, given the fact that just a handful of companies drove the majority of index performance. One way to do this is to assess the returns of equal weight indices and compare them to those of the more traditional, market capitalization weight benchmarks, since equal weight indices eliminate the outsized influence of mega-cap companies like the Magnificent Seven.

For the full calendar year of 2023, the S&P 500 Equal Weight Index returned approximately 13.9%, significantly underperforming its market capitalization weight peer. The S&P 500 Equal Weighted Index also underperformed its international counterpart, the MSCI EAFE Equal Weight Index (+16.9%), meaning the average developed large-cap international stock outperformed the average domestic large-cap stock last year. This comparison suggests that, due to greater breadth of returns, international equity exposure may serve as an attractive complement to domestic stock exposure at the overall portfolio level, given the performance concentration currently exhibited by the U.S. equity market. It is also important to remember that the S&P 500 Equal Weight Index has outgained the S&P 500 Index in 6 of the last 12 calendar years, as these figures speak to the mean-reverting nature of performance over time. Dynamics related to performance breadth and concentration will be important to watch in the year ahead, especially as investors monitor how companies such as the Magnificent Seven navigate the prevailing environment of higher interest rates and slower global growth. Above all else, both recent and longer-term market trends underscore the importance of portfolio diversification, as investors seek to reap potential future benefits of the mega-cap exposure, while also accounting for the risks of index concentration and the opportunities that exist elsewhere.

Many Happy Returns: A Look Back at 2023

After a challenging 2022, during which significant drawdowns were exhibited by equity and fixed income indices alike, last year saw resurgent performance from most areas of the public market landscape. U.S. stocks were higher in 2023, with the S&P 500 and Russell 2000 indices posting returns of 26.3% and 16.9%, respectively, during the year. Key themes within domestic equity markets in 2023 included increased investor interest in GLP-1 obesity drugs, which led to strong performance from large-cap healthcare companies like Eli Lilly, as well as advances within the field of artificial intelligence. These advances resulted in narrow market leadership for much of 2023 and helped fuel a strong 42.7% calendar year return for the Russell 1000 Growth Index, which is home to each of the “Magnificent Seven” companies (Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia, and Tesla) that were ultimately some of the largest beneficiaries of AI-related fervor. Some may have expressed skepticism that U.S. equity markets would exhibit such robust calendar year returns in March of 2023, which saw a banking crisis that led to the shuttering of Silicon Valley Bank, Signature Bank, and First Republic Bank amid an aggressive monetary tightening campaign by the Federal Reserve and widespread runs on deposits. Fortunately, concerns about broader contagion were allayed when the Fed announced plans to protect uninsured deposits at the affected institutions, though performance of mid- and small-cap indices did suffer due to these events.

Non-U.S. equities posted gains in 2023 as well, with the MSCI EAFE and EAFE Small-Cap indices, which track developed market stocks, returning 18.2% and 13.2%, respectively. UK stocks, while still positive for the year, lagged the broad market due to economic stagnation and higher borrowing costs. Japanese equities, on the other hand, served as a bright spot within the developed market space given recent shareholder-friendly corporate governance reforms and monetary policy that continues to be accommodative. The MSCI Emerging Markets Index was positive for the year as well, notching a return of 9.8%. Companies domiciled in Latin American countries like Brazil and Mexico were some of the largest gainers within non-U.S. markets during the year, as many have benefited from a reconfiguration of global supply chains and favorable population demographics. Additionally, the Taiwanese company TSMC, which is the largest constituent of the MSCI EM Index, exhibited strong performance in 2023 thanks to the enthusiasm surrounding AI advances detailed above. Despite these positive outcomes, the 2023 return of the EM benchmark was hampered due to continued challenges faced by China, which was among the worst performing countries during the period. Indeed, a slump in its property sector, ongoing geopolitical issues, a weak job market, and widespread debt stress in the corporate space have spelled trouble for China’s economy in recent time, however, many believe the nation’s slowdown has bottomed.

Fixed income indices were also positive in 2023 after a dismal 2022, with falling inflation, a resilient economy, and expectations of interest rate cuts on the horizon leading to a bond market rally to end the year. To that point, the yield on the 10-year Treasury, which sat above 5.0% less than three months ago, has now dropped to below 3.9%. Thanks in part to these dynamics, the Bloomberg Aggregate Index notched a return of 5.5% in 2023, while high yield bonds (+13.4%) and bank loans (+13.0%) posted their best calendar year performance figures since 2019 and 2009, respectively.

It is important to note that private markets asset classes, including private equity and real estate, report performance on a lagged basis, meaning full calendar year returns for these spaces will not be available for some time. In the coming weeks, Marquette will be providing more detailed analysis related to both public and private market performance in 2023, as well as what investors might reasonably expect in the new year. We encourage clients, in tandem with their consultants, to review these analyses, as well as existing investment exposures and policy targets, to ensure the appropriate positioning of portfolios in 2024 and beyond. Finally, as it relates to the new year, we wish all readers many happy returns!

 

Benchmarks:
Core Bond: Bloomberg Aggregate Index
High Yield: Bloomberg High Yield Index
Bank Loans: CS Leverage Loan Index
Broad U.S. Equities: Russell 3000 Index
Large Cap: S&P 500 Index
Mid Cap: Russell Mid Cap Index
Small Cap: Russell 2000 Index
Broad Intl Equities: MSCI ACWI ex-USA Index
Intl Large Cap: MSCI EAFE Index
Intl Small Cap: MSCI EAFE Small Cap Index
Emerging Markets: MSCI Emerging Markets Index
Commodities: S&P GSCI