Category: Chart of the Week

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.

The Chart for Red October

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

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

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

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.

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.