Category: Chart of the Week

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

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.