Category: Chart of the Week

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.

Selling Insurance: An Option for Diversification

The Aflac Duck, the LiMu Emu, and the GEICO Gecko may be fictional insurance salespeople (or sales-animals, perhaps), however, the market participants involved in the selling of financial insurance are all too real. Put options are a popular form of such insurance, as these instruments afford the option holder the right to sell an underlying security at a given level, effectively insulating the holder against significant drops in the price of the underlying security. That said, much like bundling your home and auto with Jake from State Farm, this insurance comes at a cost based on implied volatility. For those who choose to purchase options contacts on the broad-based S&P 500 Index as a means of insuring portfolios against losses, this implied volatility is measured by the VIX Index, which uses at-the-money S&P 500 Index options to assess expectations of near-term market fluctuations. Over the long term, these expected volatility levels tend to be higher than what is actually exhibited. Specifically, since the start of 1990, implied volatility of the S&P 500 Index was greater than what was subsequently realized in roughly 87% of daily observations, and the difference between the two was roughly 4.5% on average over the same time period. This phenomenon leads to the systematic over-pricing of put option contacts and is highlighted in the top half of this week’s chart.

The data points noted above demonstrate the fact that selling insurance contracts on the U.S. equity market has generally been a profitable endeavor over the last several decades. To that point, the CBOE S&P 500 PutWrite Index, which is comprised of short positions in at-the-money put options on the S&P 500 Index and short-term Treasury bills which serve to collateralize the option positions, is an effective tool for measuring exactly how beneficial this activity can be for investors. On a trailing 10-year basis as of September 30, the PutWrite index notched an annualized return of 6.7%. While this is significantly lower than the 13.1% figure for the S&P 500 over the same period, the PutWrite benchmark has notably delivered that performance with a lower annualized standard deviation — 9.7% vs. 15.0% for the S&P 500. Performance of the PutWrite benchmark during down markets has been particularly compelling, with the index outperforming the S&P 500 in six of the last seven calendar years during which the S&P 500 was negative. This performance pattern can be observed in the bottom half of this week’s chart. It is important to note that active managers within the space can provide additional value over the PutWrite index by selling the most attractive options, diversifying the portfolio of options across different strike prices and tenors, and optimizing the pool of cash with which the options are collateralized.

Readers should be aware of the fact that options selling is not without risk. Performance typically lags during strong, upward-trending markets, and a relatively high equity beta means that these types of strategies will be more correlated to stock market movements than other diversifying alternatives. That said, options-based strategies could present attractive opportunities for many investors due to the systematic processes with which they are implemented, the lower fees and better liquidity terms associated with them relative to other alternatives, and the likelihood that the volatility risk premium will persist into the future. Marquette will continue to monitor the persistence of this premium, conduct due diligence on investment managers in the options space, and provide education and recommendations to clients accordingly.

Survey Says…

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

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

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

The State of the IPO Market

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

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

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

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

Feeling the Squeeze

As investors and economists meticulously analyze data to predict future actions of the Federal Reserve, the domestic economy has maintained resiliency thanks in part to robust consumer spending in recent months. That said, challenges exist for the American public, including the fact that consumer interest payments now constitute an increasing proportion of U.S. household incomes. According to the Bureau of Economic Analysis, this figure, which excludes payments related to mortgage debt, reached 4.3% as of the most recent report published on July 31. Incidentally, this marks the highest level observed since 2008 during the Global Financial Crisis.

To this point, U.S. households have managed to withstand these increases in debt servicing payments while simultaneously confronting elevated levels of inflation. However, there are warning signs that this resilience may not be sustainable, particularly among lower-income households that have depleted robust savings amassed during the pandemic. One indication that households are beginning to feel financially squeezed is the fact that delinquency rates have escalated over the last few quarters. According to the Federal Reserve, new 30+ day delinquency rates for consumer credit card debt and auto loans have spiked since bottoming out in late 2021, reaching 7.2% and 7.3%, respectively, as of June 30. While current rates of delinquency remain well below those observed in the aftermath of the Global Financial Crisis, both figures now exceed pre-pandemic levels and may be poised to continue rising.

There is also another challenge with which millions of citizens must now grapple — the resumption of student loan payments, which were reinstated earlier this month. Given this new reality, the proportion of total interest payments relative to household income will almost certainly increase, which may lead some consumers to rely more heavily on credit cards to maintain current spending levels. This type of waning consumer strength would likely have significant ramifications for securities markets and the broader economy, and Marquette will continue to monitor indicators related to these dynamics as we head into the fall.

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

CHIPS Ahoy!

The U.S. Department of Commerce recently celebrated the one-year anniversary of the CHIPS and Science Act, which was signed into law on August 9, 2022. This federal statute provides nearly $280 billion in new funding and is aimed at boosting domestic research and manufacturing within the semiconductor sector. Additional goals of the statute include increasing onshore manufacturing jobs, bolstering domestic supply chains, and improving the positioning of the United States within the global semiconductor space. Specifically, the CHIPS and Science Act provides over $52 billion for U.S. semiconductor research, development, and workforce enhancement, including $39 billion in manufacturing incentives and $13 billion for research. Also included within the statute is a 25% investment tax credit for capital expenses related to the manufacturing of semiconductors and similar equipment.

U.S. Census Bureau data on private manufacturing construction spending by industry can be analyzed to help determine the effects of the CHIPS and Science Act on business activity. To that point, over the last decade, private manufacturing construction spending in the computer, electronic, and electrical industries (“CEE”) represented less than 15% of total domestic manufacturing construction spending. However, spending on CEE-related manufacturing construction increased significantly within the last 12 months, surging to more than $110 billion at the end of July. This spike in spending represents an increase of roughly 125% over the last year, and CEE expenditures now account for more than 55% of total private manufacturing construction outlays in the United States.

Perhaps unsurprisingly, the return of the S&P 500 Semiconductor & Equipment index is significantly in excess of that of the broader S&P 500 index since the CHIPS and Science Act was passed (53.7% vs. 13.3% for the trailing 12-month period ending July 31). While a portion of this rally can be attributed to optimism surrounding the prospects of artificial intelligence, the increase in manufacturing spending detailed above has also been a material tailwind for semiconductor companies and those in related industries. Additionally, the fact that the statute contained a clause that prevents companies from using taxpayer money to repurchase stock or issue dividend payments suggests that the majority of recent gains within the semiconductor space reflect organic growth. The sector could be poised for continued strong performance given the importance of semiconductors across the globe, however, investors should weigh any potential benefits offered by the space against risks which include increasingly lofty valuations.

Where’s the (Affordable) Beef?

Readers who have recently shopped for Labor Day barbeque supplies may lament the fact that beef prices have climbed to extreme levels. This sharp increase in the cost of beef is in part thanks to an elevated price of corn, which, as the primary feed source for cattle, is a key input in the beef manufacturing process. Due to this relationship, the two prices have moved in a highly correlated matter over the last few decades, albeit with a lag. For instance, corn prices rose from roughly $2 per bushel in 2000 to over $8 per bushel in 2012 as ethanol usage became more prevalent during that time. Live cattle futures increased by roughly 70% over that same interval and kept climbing to nearly $1.70 per pound before tapering off in 2014.

The lagged nature of this relationship is attributable to beef market dynamics. Specifically, when corn prices increase, beef producers first try to pass these higher input costs on to consumers. However, this can only be accomplished to a limited extent before the margins of producers begin to come under pressure. At that point, farmers are forced to cull their herds to reduce the supply of beef, raise prices, and protect margins. Since it takes an extended period of time to rebuild herds, beef prices often moderate over several years after the initial reversion of input prices back to normal levels.

After the onset of the COVID-19 pandemic, corn prices skyrocketed due to various shocks, including a spike in demand from ethanol producers and a fertilizer shortage that increased production costs. The invasion of Ukraine further boosted the price of the commodity given the nation’s status as the fourth-largest corn exporter in the world, accounting for roughly 15% of the global corn trade. After increasing by more than 110% since the start of 2020, corn prices peaked in July of last year at roughly $8.20 per bushel. Perhaps unsurprisingly, these dynamics have led to a commensurate rise in the cost of beef in recent years, with prices rising from less than $1 per pound at the beginning of the pandemic to an all-time high of over $1.80 per pound today.

The good news is that it does appear that corn prices have started to moderate, falling by roughly 42% since last summer. That said, it will likely take a few years for beef prices to fully reverse course due to the factors detailed above. Until that time, grillmasters everywhere may need to find more cost-effective ingredients to use during their cookouts.

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