Category: Chart of the Week

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

How to Appraise the AI Craze

Even the most casual observers of market dynamics are likely aware that investor interest in artificial intelligence (AI) has surged in recent time. Within public equity markets, the share prices of companies tied to AI like Meta, Microsoft, and Nvidia have seen massive rallies since the start of the year, and a similar story exists in the world of venture capital. On a year-to-date basis through June 30, 2023, which is the most recent date for which information is available, companies focused on AI-related initiatives received 26% of total U.S. venture funding according to Crunchbase. This number represents a significant increase from the 11% figure posted in 2022. According to Pitchbook, a total of $23.2 billion has been committed to generative AI start-up businesses in 2023 through mid-October, which is already an increase of 250% when compared to last year’s total.

There are several factors that help to explain this surge in investor interest. First, recent advances in the field of generative AI have allowed for the automation of creative processes that have applicability across the market spectrum. To that point, a recent survey conducted by Boston Consulting Group found that roughly 70% of marketing companies are already employing generative AI processes for a variety of use cases including content creation and the personalization of advertising. Additionally, the field of adaptive AI, which includes machine learning, has also seen progress in recent time, with many companies now using these tools in forecasting and data analysis. Indeed, whether these new technologies are utilized to increase efficiency or decrease costs, it is clear that businesses across the economy find the benefits of AI extremely appealing, as do many investors.

Given the significant capital flows into the AI space this year, readers may be questioning the extent to which the current landscape mirrors that of the Dot-Com Bubble of the late 1990s. While it is likely too early to answer that question, it is clear that not all AI-related companies will succeed in the long run, and investors with excessive exposures to the space may be taking on elevated risk levels given a lack of diversification. At the same time, the use cases of AI are clearly significant and broad, so market participants will certainly benefit from some level of exposure to the space across both public and private markets. This dynamic speaks to the importance of investment manager due diligence and selection, which Marquette conducts on an ongoing basis across the asset class spectrum.

Small-Cap Healthcare: The Biggest Loser

Innovations in the field of weight loss are nothing new, as the first generation of products designed to provide individuals with slimmer waistlines were first developed nearly 100 years ago. These products primarily consisted of stimulants, such as dinitrophenol and methamphetamine. The healthcare industry has since moved on from such stimulants as other products have come to market in recent time, including Saxenda by Novo Nordisk. Saxenda, which was approved by the U.S. Food and Drug Administration (FDA) in 2014, represents the first GLP-1 product designed for weight loss management. A second Novo Nordisk product, Wegovy, was approved by the FDA in 2021. Indeed, these and other GLP-1s have been on the market for several years now, however, investors took particular note of these products in 2023, which led to notable impacts across the healthcare space in terms of equity performance.

On the positive side, many large-cap pharmaceutical companies, including Novo Nordisk and Eli Lilly, have benefitted from increased investor focus on GLP-1s this year. In August, new guidance related to these drugs was issued during the earnings calls for both businesses, fueling upticks in their respective share prices as shown in this week’s chart. Specifically, Novo Nordisk reported sales growth of 157% for its obesity-related drugs, with North American operations growing sales for these products by a staggering 207%. Elli Lilly also shared positive news on its August earnings call with investors, including robust sales growth of Mounjaro, the company’s diabetes drug. This growth led to investor optimism related to the potential of Elli Lilly’s weight loss management drug Zepbound, which was ultimately approved by the FDA in November. As of the time of this writing, the share prices of Novo Nordisk and Eli Lilly are up roughly 42.8% and 59.6%, respectively, on a year-to-date basis. Negative impacts stemming from increased investor focus on GLP-1s were primarily observed within the small-cap space, specifically the healthcare sector of the Russell 2000 Index. To that point, the weight loss products detailed above caused some investors to question the extent to which other healthcare products and services, including orthopedic surgeries and sleep apnea machines, would be utilized by new and existing patients going forward. This uncertainly led to a decline of the healthcare sector of the Russell 2000 Index of roughly 25% in the three months leading into November, though the space has recovered some of those losses within the last several weeks.

Even though GLP-1 drugs have been available in the market for some time, their adoption for weight loss management remains nascent and has investors excited for the future of the healthcare space. Time will tell how successful and disruptive these products will ultimately prove, and Marquette will continue to monitor the impact of these drugs on equity markets, both broadly and at the sector level.

Is China Guilty of Category Fraud?

With movie awards season around the corner, some entertainment pundits may use the term “category fraud” to describe races in which an individual has been nominated for an ill-suited honor instead of one that more accurately describes the work in question (e.g., best actor vs. best supporting actor). The concept of category fraud can be applied to the investment world as well, specifically as it relates to certain index constituents potentially not reflecting the attributes of the indices in which they are held. In recent time, some investors have questioned whether China’s roughly 30% weighting in the MSCI Emerging Markets Index, a commonly used benchmark that tracks the space, is an example of category fraud, given the size of the nation’s economy and its robust growth over the last several decades. To investigate the extent to which China is guilty of such “fraud,” it is necessary to examine the construction methodology of the index provider in question.

In order to create its indices, MSCI evaluates countries around the world on an annual basis to determine whether they should be classified as developed, emerging, frontier, or standalone markets. When doing so, the provider aims to strike a balance between a country’s economy and the accessibility of its market, while at the same time preserving index stability. MSCI’s classification framework consists of three criteria: economic development, size and liquidity, and market accessibility. In order to be classified in a given investment universe, a country must meet the requirements of all three criteria as detailed in this week’s chart.

It does not take long for China to fall short of the requirements established by MSCI for being classified as a developed market country. As it relates to the economic development standard, the most recent World Bank high income threshold is a gross national income (“GNI”) per capita of $13,846, meaning that China would need to have posted a GNI per capita of more than $17,307 (25% above the threshold) in each of the last three years to be considered developed. However, China has never recorded such a figure in its entire history, with the nation’s highest-ever GNI per capita of just $12,850 coming in the last year. Interestingly, according to the World Bank, more than 60 nations notched higher GNI per capita figures in 2022, including other emerging market countries like Chile, Greece, Hungary, Poland, and the United Arab Emirates. These data points underscore the notion that while China has certainly emerged as an economic giant on the world’s stage, a significant portion of its vast population still has yet to achieve the same standard of living as individuals in more advanced nations. While several large Chinese companies like Alibaba, Baidu, Meituan, PDD, and Tencent meet the developed market size and liquidity requirements established by MSCI, the market accessibility criteria represent additional areas where China may fall short of developed standards. These criteria are admittedly more qualitative and subjective than the ones detailed above, however, it could be easily argued that China’s authoritarian government renders its economic and business landscape less efficient, open, and stable than those of developed countries. Examples of this dynamic include Beijing’s recent regulatory crackdown on major technology companies that led to significant value destruction, as well as the country’s history of limiting capital flows and foreign ownership.

As it relates to the charge of category fraud that some have brought against China concerning its inclusion in the MSCI Emerging Markets Index, many readers may be inclined to return a verdict of not guilty in light of the information presented above. Indeed, China still has some distance to go, particularly along GNI per capita and regulatory policy lines, to be considered by MSCI and other classifiers as a developed market, and slowing economic growth and geopolitical tensions with Western countries could inhibit this progression in the near term. Marquette will continue to monitor China’s trajectory along these lines, as well as any updates to the market classification standards established by the major security index providers.

‘Tis the Season to Spend!

The holiday spending frenzy is well underway as some of the biggest shopping days of the year, including Black Friday and Cyber Monday, occurred in the last week. Consumer activity during the holidays can help investors gauge overall spending trends, which may serve as indicators of the health of the economy at large. To that point, the current macroeconomic environment is presenting challenges for the American consumer, including higher costs of living driven by elevated inflation, increased borrowing costs, and depleted savings. All of these factors tend to have negative impacts on the purchasing power of consumers. Despite these challenges, however, Americans still spent in record-breaking fashion during the most recent “Cyber Week” (Thanksgiving through Cyber Monday), with year-over-year spending growth up by roughly 7.5% and 9.6% on Black Friday and Cyber Monday, respectively. Adobe Analytics is projecting overall holiday spending levels in 2023 to increase by 4.8% relative to last year’s figures, with total spending of around $221.8 billion.

The implications of the trends detailed above are somewhat unclear. At first glance, this robust spending could be interpreted as continued strength of the American consumer, however an examination of other data points may suggest that both consumers and retailers are feeling the effects of economic pressures. For instance, according to shipping company DHL, consumer spending leading up to Black Friday in 2023 was lower than that of previous years, which suggests that Americans were deferring purchases until significant discounts were made available to them. And these discounts were indeed significant, as uncertain demand forced retailers to offer steeper price cuts than they had in previous years. Additionally, an increasing number of consumers are now financing their spending via “buy now, pay later” programs. This information, along with the fact that credit card balances are at historically high levels, suggests that consumers are accumulating significant debt in order to finance their purchases. This could prove especially problematic given the current environment in which many are already feeling the pressure to make debt servicing payments (outlined in a recent Chart of the Week, Feeling the Squeeze). With the holiday season now in full swing, Marquette will continue to monitor consumer spending trends closely as investors weigh the possibility of a U.S. recession and a slowdown in economic activity.

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.