Category: Chart of the Week

Deficit Dangers

Large-scale government programs aimed at stabilizing the nation’s economy in the wake of the pandemic, higher interest costs, and an increase in healthcare and retirement benefit spending have fueled higher deficit levels in recent time. To that point, the nearly $2 trillion U.S. federal budget deficit in the fiscal year that ended in September represented 6.4% of GDP, which was the largest such figure ever outside wartime periods or global crises (e.g., the Global Financial Crisis, COVID-19, etc.). Based on forecasts from the Congressional Budget Office, 2025 will be the third consecutive year that the United States will see a federal budget deficit in excess of 6% of GDP. The overall national debt has ballooned to more than $36 trillion as federal spending continues to outweigh tax revenues. This week’s chart outlines these dynamics above.

There are several risks posed by excessively high debt levels, including higher inflation, lower economic activity, and the potential that the nation will be equipped with fewer financial tools to handle geopolitical challenges as a large portion of U.S. debt held is by foreign investors. One risk that incoming Treasury Secretary Scott Bessent and other officials have highlighted is “rollover risk,” or the possibility that a drop in investor appetite at Treasury auctions would render the government unable to raise cash to pay for rapidly maturing debt. Bessent has made reducing the federal deficit a top priority via a combination of spending restraint, deregulation, and tax cuts aimed at fueling economic growth. While significantly reducing the federal budget deficit over the next four years may prove challenging for policymakers, it should be noted that the U.S. did manage to shrink its fiscal gap from 9.8% of GDP in 2009 to 4.1% in 2013 at the end of the Global Financial Crisis. That said, this moderation in the deficit came during a period of extreme economic recovery, which is a decidedly different environment than the current climate. Readers should note that efforts to return the federal deficit to historical levels will likely span years and different presidential administrations, though the structural advantages of the U.S. economy provide a buffer against the risks detailed above.

Back to Back!

This week’s chart details each calendar year return for the S&P 500 Index dating back to 1928, with consecutive 20%+ returns highlighted in orange. Despite a slight pullback over the last few weeks, the index posted a return of more than 20% in 2024, which represents only the fifth time in history that the benchmark has recorded such a figure in consecutive years (note that the five straight years of 20%+ returns in the 1990s are counted as one instance). As investors look ahead to 2025 and beyond, many are asking the following question: How have markets performed after such strong periods?

In the years following the first three of these instances (1937, 1956, and 1984), the S&P 500 Index notched a significantly lower return, with an average of -1.1%. Interestingly, each of these years was marked by either tighter monetary policy, inflation, decreased industrial production, higher unemployment, or some combination of these trends. As mentioned above, the late 1990s saw a staggering five consecutive years of 20%+ returns for the S&P 500 Index, fueled by a boom in investor interest in e-commerce, software, and telecommunications companies. The so-called “Dot-Com Bubble” led to widespread speculation related to unprofitable companies and a rapid expansion in market valuations, and the bursting of this bubble caused the S&P 500 Index to decline sharply in the first three years of the new millennium.

In the last two years, performance of the S&P 500 index has been largely driven by investor interest in artificial intelligence and the Information Technology sector. The Magnificent Seven stocks (Apple, Microsoft, Amazon, Alphabet, NVIDIA, Meta, and Tesla) have led the charge, accounting for over 50% of the total return for the benchmark since the beginning of 2023. As artificial intelligence becomes increasingly integrated into the global economy, these and other similar companies are expected to attract more investment and drive additional index returns. While there are some similarities between the current environment and the Dot-Com Bubble, the U.S. economy continues to show resilience and most of the winners from the last two years are well-established businesses with healthy profits. Still, history has shown us that periods of robust equity market performance do not continue forever. As the calendar changes to 2025, investors should keep this idea in mind as it relates to expectations for near-term stock returns.

A Damsel in Distress

An increase in defaults across below investment grade issuers, which are viewed as the weakest and riskiest, is often the “canary in the coal mine” that the economy is entering a downturn. Recently, below investment grade defaults have moved higher from record lows seen in 2021, fueled by defaults in the leveraged loan market. However, an increasingly greater share of defaults is coming in the form of distressed exchanges.

A distressed exchange is a type of out-of-court negotiation between a borrower and its creditors that occurs when the borrower is in danger of defaulting. The recent surge in the volume of distressed exchanges has come largely in the form of Liability Management Exchanges — or “LMEs” — which are voluntary proactive paths that primarily, but not always, distressed borrowers may take in lieu of a traditional default or restructuring. These types of transactions have grown in usage because of looser covenants and weaker protections on a company’s debt, particularly within the loan market, which can be seen in the above chart. On a year-to-date basis, distressed exchanges as a share of overall default volume are more than 60%, which is the highest percentage seen since at least 2000 when data became widely available. The year-over-year increase in distressed exchanges of nearly 30% is the result of the greater use of LMEs.

The proliferation of distressed exchanges may overstate the overall observed default rate. To that point, the 2024 rates (including distressed exchanges) for high yield and leveraged loans were 1.4% and 4.0%, respectively. Stripping out distressed exchanges, the 2024 default rate falls to 0.3% for high yield bonds and 1.5% for leveraged loans. While distressed exchanges are technical defaults since the terms of the debt agreement are altered, the recovery rates are more favorable for distressed exchange transactions relative to traditional defaults. Specifically, over the past 12 months, the recovery rates on distressed exchanges for high yield bonds and leveraged loans were 48.2% and 18.3% higher, respectively. Distressed exchanges, particularly LMEs, can grant a borrower the liquidity and flexibility needed to correct critical issues, and certain transactions are included in these default statistics even if there is no principal loss. At times, however, there are abusers of these transactions who are merely “kicking the can” on their debt as fundamental issues remain or increase.

Recent data points show that distressed exchanges can lead to better outcomes relative to outright defaults, but the long-term effect of their proliferation is not currently known. What is known is that, based on recent trends, the amount of distressed exchanges, and LMEs, are not going away any time soon.

Cryptocurrencies Surge Post-Election

The cryptocurrency space is making waves again after a robust post-election rally drove bitcoin over $100,000 earlier this month. While it is tempting to attribute recent performance to speculation or momentum, a deeper understanding of the dynamics that fueled this surge may help investors navigate markets in 2025 and beyond. To that point, this week’s chart outlines the year-to-date performance of Bitcoin, Ethereum, XRP, and the MarketVector Digital Assets 100 Index, a market-cap weighted benchmark comprised of the top 100 cryptocurrencies (excluding stablecoins). The vertical line represents the beginning of the post-election cryptocurrency rally.

During the months leading up to the election, broad cryptocurrency performance appears to have been largely tied to bitcoin. As bitcoin is the most established, recognized, and capitalized digital asset, it follows that its liquidity and capital base would generally define the market. However, recent divergences between bitcoin and other cryptocurrencies are less intuitive and can largely be attributed to bitcoin’s position in a space beset by regulatory ambiguity and incongruous guidance. Put simply, this year bitcoin appears to have benefited from increased regulatory clarity and investor confidence. By the end of the second quarter, aggregate assets in the top 12 bitcoin ETFs exceeded $50 billion, with the iShares Bitcoin Trust ETF accounting for nearly 40% of that figure. Additionally, the access and standards afforded by the ETFs increased investor confidence, led to modest institutional acceptance, and expanded bitcoin market dominance. Meanwhile, other cryptocurrencies like XRP have faced headwinds that have weighed on performance. Embroiled in litigation since 2020, XRP was delisted by most U.S. exchanges and, as a result, struggled to perform during most of this year despite increased cryptocurrency adoption. This dynamic is demonstrated by XRP’s losses prior to the U.S. election.

So how did these dynamics ultimately contribute to a broad post-election rally, and how could they be relevant in the future? Challenges faced by XRP and the broader cryptocurrency market have led to criticism from industry stakeholders, particularly following the collapse of FTX, which exacerbated regulatory scrutiny. Cryptocurrency advocates and industry leaders widely viewed the responses from regulators as heavy-handed, raising concerns over potential stifling of innovation. As the 2024 election cycle ramped up, stakeholders within the cryptocurrency space increasingly engaged with policymakers, pushing for clearer regulatory frameworks and a more balanced approach. This heightened engagement coincided with a surge in political spending, reflecting the industry’s efforts to influence the regulatory landscape and mitigate perceived risks. Estimates suggest that bipartisan political spending by the cryptocurrency industry during the 2024 election cycle totaled more than $320 million, outpacing the roughly $275 million spent by Elon Musk and $175 million spent by Charles Koch and affiliates.

While it is unclear how cryptocurrencies may benefit from the incoming administration, the nomination of Paul Atkins, a known digital assets advocate, for SEC Chair indicates a potential shift toward more favorable regulatory policies for the sector. Additionally, the appointment of venture capitalist and cryptocurrency proponent David Sacks as the new administration’s “crypto czar” seems to have renewed industry optimism. These and other developments suggest that the incoming administration could provide a more supportive environment for digital assets.

Reluctant to Spend

In recent years, the Chinese economy has struggled to return to pre-pandemic levels of consumption and economic growth. This lackluster rebound can be attributed to factors including prolonged lockdowns from the country’s zero-COVID policy, regulatory crackdowns on private sector companies, and pervasive weakness in the country’s property sector. Recently, the Chinese government, in tandem with the People’s Bank of China (PBOC), has enacted measures to address the country’s myriad issues. For instance, the PBOC announced a monetary easing package in the third quarter that included interest rate reductions and cuts to reserve requirement ratios for Chinese banks. While the Chinese equity market saw a sharp September rally as a result of these measures, investor excitement has since waned, with the MSCI China Index down roughly 20% over the last two months.

One key reason measures to restore growth in China have been unsuccessful is that they have failed to boost domestic demand, of which consumption plays a large part. Economic uncertainty has made Chinese households reluctant to spend and consumer confidence in China remains well below long-term average levels, a trend outlined in this week’s chart. While a general malaise contributes to this lack of confidence, there are aspects of the Chinese economy that pose unique challenges for the government as it relates to economic revitalization efforts. One such challenge is the distribution of citizens’ wealth. To that point, approximately 80% of household wealth in China is comprised of real estate assets, rendering Chinese consumers particularly vulnerable to the ongoing instability in the country’s housing market. Additionally, only 10% of Chinese citizens own stock (as opposed to 70% of U.S. citizens), meaning any propping up of the Chinese equity market by the government may not result in a commensurate increase in domestic wealth and consumer demand. Consumer confidence in China has also been hampered by the country’s high levels of youth unemployment, as the jobless rate for 16–24-year-olds exceeded 17% at the end of the third quarter. Young educated Chinese workers in particular are facing a weak job market, along with a mismatch in job availability and their skill sets. These and other challenges have plagued the Chinese government for years, and while policymakers are now taking action to address them, whether new measures are sufficient to restore business and consumer confidence in China is yet to be determined.

First-Time Buyer Beware

Over the last 20 years, U.S. homeowners’ total home equity value has risen by more than 150% to roughly $35 trillion. This meteoric rise in home prices has helped many Americans build wealth but has been hazardous for a particular demographic: first-time homebuyers. These higher prices, along with high mortgage rates (the average 30-year fixed-rate loan is around 7.0% as of this writing) and reluctant sellers, have combined to keep potential first-time buyers largely out of the housing market. In 2024, a record low 24% of U.S. home purchases were made by first-time buyers; this figure is down from 50% in 2010. The median age of first-time buyers has also increased to 38, significantly higher than a historical average that is nearly 10 years younger.

With no signs of U.S. housing prices falling, many prospective buyers will be forced to continue to rent. This dynamic should sustain tailwinds for multifamily housing rentals, to which investors can gain exposure via core ODCE funds. Indeed, as of the end of the third quarter, multifamily housing constituted nearly 30% of the NFI-ODCE index. These trends in home affordability have also led institutional investors to increasingly move into the single-family housing market. While some cities have seen a glut of multifamily supply in recent years as investor capital has poured in, broader fundamentals remain sound.

At Odds

In the weeks leading up to the 2024 presidential election, many thought the contest would be one of the closest in recent memory, with most polls showing a toss-up race between Donald Trump and Kamala Harris. The Economist notably listed a 56% chance of Harris defeating Trump in its final election projection, which relied heavily on traditional polling data. Ultimately, however, the election was not as close as many predicted, with Trump defeating Harris 312-226 by electoral vote count and 50.2% to 48.1% by popular vote count (as of the time of this writing). The discrepancies between polling data and the results of this and other recent contests beg the question: Is there a better way to predict the outcome of elections? Enter the betting markets…

While betting directly on election outcomes is new, indirect betting is not. In 2016, Sam Bankman-Fried (yes, that Sam Bankman-Fried) and Jane Street, a global proprietary trading firm, built robust models that incorporated data all the way down to the county level to help predict the outcome of that year’s election. While the firm could not bet directly on the outcome of the race, it could take positions that the team believed would be profitable based on the model’s projected result. To that point, Jane Street was able to front-run election updates from major media outlets and build a short position in the S&P 500 Index, as the team thought a Trump victory, which their models projected far before the mainstream press, would be negative for markets. While this trade initially showed signs of promise, it ultimately led to some of the biggest losses in the history of the firm as equities turned positive in the wake of Trump’s first electoral victory.

This presidential election cycle provided more opportunities for speculators to bet directly on the outcome of the race, with odds updating by the minute. Shortly after the first presidential debate on June 27, for instance, betting markets exhibited much higher odds of Harris winning the presidency than then-nominee Joe Biden. Then on July 21, Harris replaced Biden at the top of the Democratic ticket, a move forecasted weeks earlier by betting markets. While Harris surged in betting markets in the weeks following this change, Trump became the odds-on favorite to win the contest in the days leading up to election day, with a 54% chance of taking the presidency. Betting odds started moving quickly last week on election night when results began pouring in. Roughly 40 minutes after the first polls closed, betting markets began shifting heavily toward Trump despite the electoral count being just 23-3 in his favor (with 512 electoral votes outstanding). Harris was a longshot bet in a matter of hours despite still having several paths to victory, as betting markets indicated a 95% chance of a Trump victory before midnight. The Associated Press finally called the election for Trump at 5:34am.

Going forward, odds markets may be better predictors of election results than more traditional polling data. This is due to the wisdom of crowds, the incorporation of extensive data in odds calculations, and the fact that people tend to be more honest when betting than they are with pollsters.

Presidents, Real Estate, and Consistency

With the 2024 presidential election in the books, investors have now turned their focus to what the incoming Republican administration might mean for the performance of various asset classes. As it relates to the real estate space, the Trump victory did lead to a subsequent swing in both mortgage rate levels and the prices of housing-related equities, which are highly rate-sensitive. To that point, the average rate on a 30-year fixed mortgage climbed 9 basis points yesterday to more than 7.1% and housing stocks dropped, with home builders and materials companies like Lennar, D.R. Horton, and Home Depot down more than 3% during yesterday’s trading session.

While it is too early to forecast the impact that the new administration will have on commercial real estate specifically, readers should note that returns of the NCREIF Property Index, which tracks private real estate owned by institutional investors, have been nearly identical across Democratic and Republican administrations throughout history. Specifically, the index has posted an average annual return of roughly 8.7% under each party dating back to the 1970s. This consistency suggests that real estate performance is more closely aligned with economic cycles, long-term fundamentals, demographics, and property demand than it is with the political landscape.

Earnings Don’t Grow to the Sky

Loyal readers of Marquette research publications are likely aware that a small handful of U.S. large-cap technology-oriented stocks, dubbed the “Magnificent 7,” has comprised an outsized portion of performance of the overall domestic equity market over the last several quarters. Specifically, Apple, Microsoft, Amazon, Alphabet, Nvidia, Meta, and Tesla have accounted for roughly 55% of the total cumulative return of the S&P 500 Index since the beginning of last year. Much of this performance has been fueled by the remarkable earnings growth exhibited by these companies since early 2023, which can be observed in this week’s chart. Readers will note the striking periods of 3Q23, 4Q23, and 1Q24, during each of which the Magnificent 7 posted year-over-year earnings growth of more than 50%. This is in stark contrast to the growth notched by the S&P 500 Index during those periods, which was never more than 8%. As a result of these dynamics, the Magnificent 7 stocks have surged to a combined weight of roughly 32% of the S&P 500 Index as of the time of this writing.

Many of the Magnificent 7 companies are set to report third quarter results later this week, and this basket of stocks is expected to post year-over-year earnings growth of more than 18% for the period (compared to roughly 4% for the S&P 500 Index as a whole). While outsized results like these are expected to continue into the fourth quarter, analysts expect a moderation of earnings growth for these high-flyers in 2025. Specifically, by the end of next year, consensus forecasts call for only a 3% differential between Magnificent 7 earnings growth and that of the S&P 500 Index. Investors may have already started to take note of these moderating expectations. To that point, since July 10, which represented the culmination of a 22% rally to begin 2024, the Bloomberg Magnificent 7 Index has fallen by roughly 2%. This performance figure lags that of every major S&P 500 Index sector during that time.

While the healthy forecasted earnings growth by the Magnificent 7 over the coming quarters should reassure investors that these businesses remain fundamentally sound, it is fair to question the extent to which these stocks will drive S&P 500 Index performance going forward. Investors should certainly expect more moderate returns, both on an absolute basis and relative to the broad market, from this cohort in the years ahead. Remaining broadly diversified across sectors, industries, and geographies, as well as thoughtful exposure to products (i.e., equal-weighted indices) that help mitigate market concentration risks where appropriate, are some tactics equity investors can use to navigate an environment of slowing earnings growth for the Magnificent 7.

A New Tariff in Town?

During his presidential term, Donald Trump increased tariffs on Chinese imports to address unfair trade practices including intellectual property theft. Specifically, using Section 301 of the Trade Act of 1974, the Trump administration imposed an initial 25% tariff on certain Chinese imports in 2018 that triggered a trade war that persists to this day. After this initial levy, Chinese imports fell by 17% on a year-over-year basis in 2019 and an additional 4% in 2020. That said, imports from China returned to pre-trade war levels in 2021 and 2022. There are a few reasons for this trend. First, in 2019, Trump administration officials feared trade restrictions would ruin the holiday season for American consumers and delayed the enactment of tariffs on certain holiday gift favorites including toys, video game consoles, smartphones, laptops, and computer monitors. Simultaneously, the COVID-19 pandemic shifted consumer preferences away from services and toward goods, resulting in increased demand for Chinese imports despite the tariffs. Additionally, from 2019 to 2022, Chinese imports unaffected by the Section 301 tariffs increased by nearly 50%, offsetting the decline in taxed imports. These factors resulted in an unexpected net increase in overall Chinese imports into the United States over that period.

While certain tariffs have expired, the Biden administration has reinforced several Trump-era trade policies. Earlier this year, for instance, tariffs were increased on goods like steel and aluminum, electric vehicles, battery parts, solar cells, ship-to-shore cranes, syringes, and needles. Given the upcoming U.S. presidential election, it is interesting to note that both major political parties seem to agree that China’s trade practices warrant a continuation of tariffs. To that point, semiconductor tariffs will likely increase from 25% to 50% over the next year. Additionally, in two years, tariffs on lithium-ion non-EV batteries will likely increase from 7.5% to 25%, and those on graphite permanent magnets will likely increase from 0% to 25%. Since the effect of these future tariffs is ultimately unknown, investors should maintain a diversified portfolio to mitigate the fallout from a potential escalation in the current trade war between the U.S. and China.