Category: Chart of the Week

Brazil Eases Into the Fall

On August 2, Brazil’s central bank cut its benchmark interest rate by 50 basis points, from 13.75% to 13.25%. This marks the country’s first rate cut in over three years and is in stark contrast to moves made by Brazilian policymakers in recent time. To that point, between February 2021 and July 2022, Brazil increased its key rate from 2.00% to 13.75%, representing the most aggressive monetary tightening by any central bank during this period. The August cut was made possible by a moderate domestic inflation rate of 3.2%, which sits well below the country’s post-pandemic peak of 12.1% exhibited in April of last year. Brazilian authorities have indicated that additional cuts are likely in the near future, thanks in large part to an improving consumer price outlook and longer-term inflation expectations that continue to fall. These dynamics place the country ahead of much of the globe when it comes to the cycle of interest rates, as many nations, particularly those in the developed world, continue to fight elevated inflation via restrictive monetary policy. Alternatively, other Latin American countries like Chile, Mexico, and Peru have either lowered rates in recent time or are expected to embark on easing campaigns within the coming months.

As it relates to performance, Brazilian equities have been a bright spot within the emerging markets space in 2023 and have significantly outpaced the MSCI EM index on a year-to-date basis through the end of July (22.6% vs. 11.4%). Expectations of a shift in monetary policy which has now come to fruition, coupled with better-than-expected fiscal and political outlooks, have boosted sentiment and helped fuel these strong returns. Should monetary conditions continue to ease, Brazil and its Latin American peers may continue to provide an attractive opportunity set for investors going forward.

Revisiting the Banking Industry

Though the regional banking turmoil that surfaced in March has largely faded into the background, Moody’s brought focus back to the sector last week when the rating agency downgraded 10 regional banks one notch (all remain investment grade). Moody’s also placed six larger lenders under review for a potential downgrade and cut the outlook for another 11 banks from stable to negative, indicating their ratings could be downgraded in the future. The rating agency cited interest rate and asset-liability management risks, as well as growing profitability pressures and expectations for a mild U.S. recession in early 2024 as reasons for these changes. Similar to Fitch’s downgrade of U.S. credit the week prior, the timing of these moves is being critiqued as deposit flows have generally stabilized since March, the Federal Reserve is likely at or near peak rates, and a soft landing appears increasingly likely.

Bank stocks pulled back modestly on the news, after notably outperforming the broader market in July. From here, a number of moving pieces remain at play. These include sensitivity of the banking industry to commercial real estate issues, tighter lending standards, and potentially higher-for-longer rates, though it is important to note that overall credit quality remains strong and the banking system remains well capitalized. Though the Moody’s downgrades may have little practical impact, they do serve as a reminder — especially after the strong performance of equities since the start of the year — that a number of uncertainties remain and, therefore, market volatility along with elevated dispersion could likely continue for the remainder of 2023.

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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.

Honey, I Shrunk the Money Supply

M2 money supply, as defined by the Federal Reserve, includes M1 (currency and coins held by the non-bank public, checkable deposits, and travelers’ checks) plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds. M2 rapidly increased throughout 2020 and 2021 amid COVID-related monetary stimulus, to a peak of almost $22 trillion in July 2022. As the economy reopened and inflation accelerated — with headline CPI hitting a peak of 9% year-over-year in June 2022 — the Fed responded with a series of rate hikes and quantitative tightening measures. The result has been a rapid decrease in the money supply, with M2 down 3.6% year-over-year as of June 2023. The effects of the swift reduction in M2 have likely only begun to be felt, but a continued contraction — facilitated by higher-for-longer rates and continued quantitative tightening — could help cool inflation further and contribute to a soft landing for the economy.

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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.

When the Bill Comes Due

The U.S. economy has proved more resilient than expected this year, buoyed by ongoing consumer strength. Labor market dynamics and pandemic-era savings have allowed consumers to continue to spend despite higher costs. Those excess savings, however, are projected to be fully depleted by the fourth quarter. On top of that, millions of Americans will soon have another monthly charge to factor into budgets, as student loan payments are set to resume in October for the first time in years.
Collectively, U.S. consumers owe $1.6 trillion in education debt, with monthly payments averaging $200–$300. The CARES Act put student loan payments on hold in 2020, saving consumers approximately $185 billion over the last three years.¹

Moreover, the pause in payments brought delinquency rates to historic lows, which helped improve borrowers’ credit scores, enabling them to take on additional debt. As a result, some consumers are now facing greater obligations that may detract from spending on goods and services. Apollo Global Management estimates that student loan payments alone could reduce consumer spending — which makes up two-thirds of U.S. GDP — by more than $100 billion per year. Whether the U.S. tips into recession remains to be seen, but evolving dynamics like the depletion of excess savings and the resumption of student loan payments could change current trajectories. We will continue to watch these factors and their impact on the macroeconomic outlook closely.

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¹Goldman Sachs via The New York Times, Student Loan Pause is Ending, With Consequences for Economy

 

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.

Emerging Opportunities Beyond China

Equity performance in China, with the MSCI China Index down 5.5% through the first half of the year, has disappointed amid hopes for a strong post-COVID recovery. While macro data started the year strong, momentum quickly waned, with a cautious consumer and a slowdown in manufacturing. China’s property sector troubles have continued, and U.S./China tensions remain, with the U.S. moving toward stricter regulation and reduced investment in the Chinese technology sector in 2024. Along with human rights concerns and the general unpredictability of the Chinese government, the debate around China’s investability continues on.

Take China out of the emerging markets picture, however, and the story is different. The MSCI Emerging Markets Index excluding China — the largest single country weight in the index at nearly 30%¹ — has outperformed the broader benchmark since late 2021. Latin American countries like Brazil and Mexico — almost 6% and 3% weights in the index, respectively — have benefited from central banks that began their monetary policy tightening cycle earlier. Additionally, as renewable energy trends continue, Latin American regions rich in natural resources should see exports grow. Nearshoring trends have also benefitted emerging market countries such as Taiwan — the second largest country weight in the index at nearly 16% — and Mexico, with the latter exporting nearly as much to the U.S. as China, something not seen since 2003. And in India — the third largest country weighting in the MSCI EM Index at approximately 15% — government reform programs have drawn in significant investor flows.

Looking into the second half of the year, the evolving macro picture in China, including any potential stimulus, will continue to be a driving factor of overall MSCI EM performance. And outside of China, there are a number of interesting trends playing out across the emerging markets space that should present investment opportunities for active managers.

 

¹All country weights as of June 30, 2023

The FTC vs. M&A

Higher interest rates have broadly impacted capital markets, including M&A deal flow given the significant increase in financing costs. Along with that, elevated regulatory risk has been another headwind for the space.

Since her appointment as Chair of the Federal Trade Commission (FTC) in June 2021, Lina Khan has emerged as one of the most aggressive anti-trust leaders the U.S. and Wall Street have seen in some time. For large corporations seeking growth via M&A, the regulatory requirements for FTC approval have increased significantly. Deals that would likely have been approved with ease in prior administrations now face costly lawsuits, injunctions, and other challenges by the Commission. Coupled with higher financing costs, the FTC’s aggressive agenda has significantly prolonged the timeline for deals to close. In the second quarter of 2023, completed M&A deal volumes came in at mere $95 billion, just above the $83 billion of deals closed at the height of COVID in the second quarter 2022. At the same time, the volume of pending deals awaiting regulatory approval has substantially increased, reaching $183 billion in the second quarter.

The FTC’s actions have had a clear impact on the M&A environment, leading to significantly wider deal spreads in 2023 amid increased uncertainty. This is both an opportunity and a risk for hedge funds specializing in merger arbitrage. While deal spreads appear attractive, they come with heightened risks that require expertise to successfully navigate. For investors, selecting experienced managers with a proven track record of success across different regulatory regimes is critical to achieving favorable risk-adjusted returns.

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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.

Credit Trash is Return Treasure

“One man’s trash is another man’s treasure” may be a cliché, but it has never been more applicable to the below-investment grade, or junk, market. As the macroeconomic backdrop has proven to be more resilient than investors feared heading into 2023, one of the primary beneficiaries has been CCC corporates — traditionally the riskiest securities within the high yield and leveraged loan markets. CCC bonds and loans are the least credit-worthy within their respective markets and tend to perform poorly in periods of economic stress. With the economy so far avoiding recession, this segment of the market has posted significant gains year-to-date. CCC bonds and loans were up 11.0% and 8.3% through the first half, respectively, notably outperforming the broader high yield and leveraged loan indices, up 5.8% and 6.3%, and especially the highest-rated, or BB, segments of each market, up 4.5% and 4.6%, respectively.

On top of better-than-feared macroeconomic conditions, other factors have contributed to the junk rally in these markets. Leveraged credit balance sheets, even amongst the lowest-rated issuers, remain well positioned to weather headwinds. High yield issuer leverage is at a 10-year low while leveraged loan issuer leverage levels are at multi-year lows with interest coverage metrics slightly below all-time highs. Defaults are expected to increase, though only to the long-term average of the asset class, assuaging fears of a wave of defaults. Additionally, market technicals have helped fuel this rally as issuance has remained light, causing what supply is out there to benefit from a continual bid due to the elevated yield on these securities. All of this said, CCCs are still typically the riskiest part of the fixed income market, and continued performance hinges on the notoriously-unpredictable economy.

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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.

More Bang for Your… EM Local Currency?

Local currency emerging markets debt has been one of the standout fixed income asset classes this year. The J.P. Morgan GBI-EM Global Diversified Index — which tracks local currency bonds issued by emerging market governments — is up nearly 5% year-to-date.¹ This compares with the Bloomberg US Agg up 2.5% over the same period. Yields for the emerging markets index peaked in the fourth quarter of 2022 and remain near multi-year highs. Local currency EM debt could stand to benefit for three reasons: higher starting yields, proactive emerging markets central banks, and emerging versus developed GDP growth differentials.

  • Real yields in EM local currency debt are at attractive levels relative to history as well as relative to developed markets. As of June 26, GBI-EM yields were 6.28%. This compares with the U.S. 10-year Treasury yield at 3.72%. This yield differential compensates investors for the higher risk and positions them to benefit from yield compression if global macro headwinds start to abate.
  • Several EM countries such as Brazil and Mexico began their rate hiking cycles much sooner than their developed market counterparts. To the extent that positions these emerging central banks to cut policy rates sooner than the rest of the world, yield compression could benefit total asset class returns.
  • EM local currency debt should benefit from higher GDP growth than is expected in developed markets. Based on projections from the International Monetary Fund, EM economies are projected to grow approximately 4% per annum through 2024. This compares to advanced economies, where real GDP is projected to grow roughly 1.5% through 2024.

In sum, a number of tailwinds could continue to position EM local currency debt for strong relative returns as the year progresses.

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¹Through June 26, 2023

 

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.

The Tides of Trade

As globalization has slowed in recent years, geopolitical and geoeconomic risks have reemerged across global markets. Amid disrupted shipping lanes, upended supply chains, and economic sanctions, all markets — developed or emerging — are vulnerable to some degree. While these risks are nearly impossible to eliminate, they can be managed, and efforts to minimize exposures seem to be driving a trend of regionalization across markets. To help visualize this trend, this week’s chart highlights economies (green) that may benefit from increasing regionalization based on three core constraints.

First, direct geographic access to primary shipping lanes. The OECD estimates that around 90% of all traded goods travel by sea. This suggests that countries with both direct access to shipping lanes (dashed lines) and fewer choke point exposures (blue circles) have competitive advantages over those without access or those vulnerable to bottlenecks. Second, industrial capability. Countries with greater material inputs, labor pools, and facilities inherently have a comparative advantage over those without. Third, foreign exchange purchasing power. Relative to the U.S. dollar or the euro, countries utilizing weak alternative currencies have a comparative advantage in attracting investment and in production costs. This textbook dynamic heavily suggests that denominating costs in relatively weak currencies may be the strongest differentiator between otherwise equal markets.

While there are certainly many other dynamics and constraints at play including multilateral trade agreements and demographics, direct access to shipping lanes, industrial capability, and foreign exchange rates offer three core measures to assess and expand on.

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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.

Bear Scare?

The S&P 500 index — up 9.6% on a year-to-date basis through May — recently entered into a technical bull market, mostly due to a resurgence of growth-oriented areas of the U.S. equity space like Information Technology and Communication Services. At the same time, data related to futures contracts on the index could indicate extremely bearish sentiment on the part of hedge funds and speculators. As of the end of last month, these investors and traders were net short more than 400,000 E-mini S&P 500 futures contracts — the largest such position since Bloomberg started tracking the metric in the early 2000s.

There are several potential explanations for this phenomenon. First, investors may believe the recent run of the S&P 500 is not reflective of the current economic climate and overly dependent on a small basket of securities. To that point, the year-to-date return of the benchmark would actually be negative through the end of May excluding just seven high-performing index constituents (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla). This type of sentiment could lead the index to retract meaningfully should one of these companies stumble. However, this same group of investors has maintained net long positions on similar NASDAQ futures contracts in recent time, which does not support the notion that investors are inordinately bearish on these stocks. Dynamics within S&P 500 futures markets could also be a reflection of hedge funds and other investors having a significant number of high-conviction long positions with fewer alpha short ideas, which could necessitate hedging to lower net exposures and would actually be a bullish indicator. Whatever the reason for this positioning, it is important for investors to remember that no one variable is sufficient when it comes to explaining overall market machinations. Marquette will continue to monitor equity and futures markets and advise clients accordingly based on our findings.

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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.