Category: Chart of the Week

The Elusive Small-Cap Revival

U.S. small-cap equities have trailed their larger peers for over 13 years. Although the asset class has shown intermittent signs of strength throughout that period, including at the end of 2023 and in July of this year, a lasting shift in leadership continues to be elusive. When assessing the prospects of small-cap equities going forward, it may be helpful to analyze the high yield bond market, as the behavior of high yield spreads can serve as an indicator of small-cap strength. The primary reason for this relationship is likely that tighter spreads indicate economic strength and lower recession risk, and performance of small-cap stocks is closely tied to the health of the economy. To that point, over the last two decades when high yield spreads retreated below key levels outlined in this week’s chart, small-cap equities have tended to perform well. A recent example of this phenomenon came in late 2020, when spreads fell sharply, and the Russell 2000 Index advanced by over 22%. Spreads fell again in November of last year and remain tight to this day, and the Russell 2000 Index has advanced by roughly 36% over this period.

Although large-cap stocks continue to propel markets into the fourth quarter, there are several potential catalysts for small-cap equities that could be unlocked in the near future. First, forward valuations (e.g., price-to-earnings ratios) for small caps relative to large caps sit near historic lows. Additionally, investors may see a shift in Federal Reserve policy as a trigger for a market regime change, as small-cap equities are more negatively impacted by higher interest rates given the larger debt burdens these companies typically carry. Put simply, lower interest rates have historically been a tailwind for small-cap stock performance. Perhaps most importantly, the fundamental backdrop for small caps shows signs of improvement. Specifically, easing pressures from interest expenses and a reacceleration of sales may support earnings growth, which has fallen short of lofty expectations from the beginning of the year. Finally, the benefits of reshoring and recent government spending that will likely accrue to smaller companies have yet to be fully realized.

Despite these potential catalysts, a revival within the small-cap space remains elusive, at least for now. While a softer inflation reading in July spurred a brief rally in small-cap equities, the Russell 2000 Index has retreated by roughly 50 basis points since the Fed cut its policy rate. This figure is well below the 2.4% return notched by the S&P 500 Index since that time. Indeed, large-cap stocks may currently be perceived as a safe haven amid higher levels of market volatility, economic risk, geopolitical conflicts, and consumer weakness. Still, Marquette believes a dedicated allocation to small-cap stocks will ultimately prove beneficial to investors in the future given the diversification benefits offered by the space and the potential catalysts for stronger performance outlined above.

Can Interest Rate Cuts Revive Private Equity?

It has been well documented that private equity has been experiencing pressures over the past two years, marked by declines in both deal activity and recent performance relative to the strong returns generated in prior years. Since the asset class is heavily reliant on leverage to fund deals, the private equity landscape has been impacted by the historic rise in interest rates that has made debt more expensive over the last several quarters. That said, the Federal Reserve has now shifted its policy stance with inflation seemingly contained, and several rate cuts are expected to occur in the near term. But will lower rates drive a rebound in private equity activity?

While a recovery in activity likely won’t occur overnight, private equity firms seem to be preparing for a significant increase in deal making on the horizon. Due to the high financing costs associated with higher interest rates, recent years have seen a shift away from debt-laden leveraged buyouts (LBOs) and towards growth and expansion deals, as those transactions typically require minimal leverage. Over most of the last 15 years, LBOs consistently accounted for a larger share of U.S. private equity deals relative to growth and expansion transactions, but this dynamic reversed in 2023. We do not expect recent trends to continue in perpetuity since lower borrowing costs should usher in a new wave of LBO activity. More broadly, M&A activity appears to be showing signs of turning a corner. To that point, in the first half of this year, North American M&A activity advanced by roughly 13% on a year-over-year basis in terms of both deal count and value (including estimates for unreported deals).

In short, recent shifts in monetary policy may provide tailwinds for the private equity sector. In addition to lower borrowing costs that will likely underpin future deal activity, rate cuts also benefit existing portfolio companies by easing the debt service burdens on their balance sheets. This offers companies the flexibility to pursue new acquisitions, initiate organic growth initiatives, and, ultimately, drive potential returns higher for investors. As always, we continue to closely monitor the emerging trends and their implications for the performance of the private equity asset class.

Lower Rates, Better Fates?

With the first Federal Reserve rate cut of the current loosening cycle in the rear-view mirror, investors are now questioning how markets will react to a new era of macroeconomic policy. While each rate cycle is unique, examining how the S&P 500 and Bloomberg Aggregate indices have responded to prior instances of rate cuts can give investors some insight on what to expect going forward. To that point, this week’s chart highlights the returns of these benchmarks following the first cut of last six periods of easing by the Federal Reserve. Although rate cuts have historically portended higher near-term equity returns, there have been two instances of negative S&P 500 Index performance in the wake of Fed easing. Specifically, the 1- and 3-year returns following rate cuts in 2001 (the Dot Com Bubble) and 2007 (the Global Financial Crisis) were both negative. That said, performance of the Bloomberg U.S. Aggregate Bond Index was positive during both of those periods, as well as during the other four easing cycles shown in this week’s chart. Even during the 3-year period following July of 2019, which included six months of rate hikes in 2022, the fixed income benchmark returned 0.4% on an annualized basis. In summary, although Fed rate cuts have historically coincided with recessions in the U.S., investors can gain comfort from that fact that both equities and bonds have fared relatively well amid periods of monetary policy loosening.

A Cross Pacific Current

The pullback in global equity indices at the beginning of August left many investors racing to understand what had caused such outsized volatility. Amid this market turbulence, there were two seemingly unrelated economic events that occurred on different sides of the globe. On July 31, the Bank of Japan surprisingly announced that it would raise its benchmark interest rate from 0.10% to 0.25%, continuing its transition from the ultra-low rates that had been commonplace in recent time. Later that week, the July U.S. nonfarm payroll employment data, which many use to gauge the health of the domestic labor market, came in below estimates. This report led investors to question the strength of the U.S. economy and whether the Federal Reserve had waited too long to cut its policy rate. Simply put, equity markets reacted negatively. The Nasdaq, which is a growth-oriented U.S. large-cap stock index, exhibited a particularly sharp drop during this time, falling by roughly 7% in less than one week. The speed and severity of this sell-off left many asking if one poor labor report alone was solely to blame. As it turned out, the Bank of Japan’s interest rate decision earlier in the week may have been just as important as it relates to what had occurred in U.S. markets.

A “carry trade” is a strategy wherein an investor borrows in a low-yielding currency (in this case the Japanese yen) and invests the borrowed funds in a higher-yielding asset. While it is difficult to assess the size and scope of these trades, certain statistical relationships can emerge that may shine light on how borrowed funds are being invested. To that point, the chart above shows the year-to-date changes in level of the Nasdaq index and the value of the U.S. dollar (USD) relative to the Japanese yen (JPY). Interestingly, on a rolling 30-day basis since the start of the year, the movements of the NASDAQ and USD/JPY have been moderately correlated with a coefficient of 0.46 (a coefficient of 1 would indicate a perfectly positively correlated relationship). While indeed moderate, this relationship does indicate that as the dollar has weakened relative to the yen, the Nasdaq has weakened in a similar fashion. What might be driving this relationship?

While we cannot draw definitive conclusions based on correlation alone, the carry trade strategy may be partially responsible for the emergence of this relationship. In the first half of this year, U.S. large-cap stocks notched strong performance while the dollar steadily strengthened against the yen, which kept yen borrowing costs low. That said, when the Bank of Japan raised its policy rate (and the cost of borrowing yen) in late July, many carry trade investors were forced to sell assets to pay back the funds borrowed in yen, which was now rapidly appreciating against the dollar.  For those who had been investing borrowed funds in U.S. stocks, harvesting gains from these positions would be a logical move in order to post collateral. It is important to point out, however, that this process can snowball. Specifically, higher demand for yen drives up the value of the currency, which prompts collateral calls for more investors who have borrowed in yen, which leads to further selling of risk assets like U.S. stocks. This feedback loop can be observed in the shaded region of this week’s chart, during which the correlation coefficient between Nasdaq and USD/JPY jumped to more than 0.9.

While this chart highlights one relationship to provide insight into the recent spike in equity volatility, a broader conclusion readers should draw is that changing dynamics within global markets and the opaque nature of certain trades can make risks faced by investors difficult to identify and measure. As a result, it is important for investors to maintain well-diversified portfolios that can weather various market environments.

The Path Ahead

At the start of this year, economic forecasts called for up to five 25 basis point interest rate cuts by the Federal Reserve throughout 2024 beginning as soon as the first quarter. That said, over the course of the year, these expectations moderated significantly due to stubbornly high inflation, stronger-than-expected economic growth, and a resilient employment landscape. As recently as July, investors expected only two rate cuts before 2025 based on implied probabilities from options markets. Sentiment shifted once again in August, however, after a spike in equity market volatility and weaker labor market data. As can be seen in this week’s chart, investors now anticipate four to five 25 basis point cuts before year-end, with an additional four to five cuts coming in 2025. Should current expectations come to fruition, the effective federal funds rate would fall to below 3% within the next 12 months.

As investors assess the future of Fed policy, it is important to remember that expectations regarding the path of interest rates are often inaccurate, as evidenced by the paragraph above. To that point, a material divergence in current expectations and the actual changes in interest rates over the coming quarters could have an impact on equity and fixed income markets. Investors will gain some clarity on the trajectory of interest rates at next week’s Federal Open Market Committee meeting, which will include a press conference from Chair Jerome Powell and the publication of committee members’ projections of appropriate future rate levels.

September is the Cruelest Month

The S&P 500 Index pulled back by more than 2% yesterday in a move that is not unprecedented based on the history of the benchmark. Specifically, the bellwether equity index has averaged a return of roughly -0.7% in the month of September dating back to 1928, which is particularly striking given that average performance of the benchmark has been positive in every other month of the year. There are several possible explanations for the potential anomaly that some have dubbed the “September Effect.” First, sales by investors returning from summer vacations aiming to lock in taxable gains or losses prior to the end of the year could be a driving force behind lackluster September returns. Additionally, September could see higher levels of equity sales due to market participants seeking to fund tuition costs for their children prior to a new academic year. The September Effect could also be seen as a self-fulfilling prophecy, as expectations for poor near-term equity returns could lead to widespread investor selling.

It is important to highlight a few points related to the September Effect that may assuage concerns related to equity performance over the coming weeks. First, many economists chalk the September Effect up to pure chance, given that any persistent market anomaly would be exploited by investors, causing it to disappear over time. It is also important to remember that the S&P 500 Index has actually notched a positive return in roughly 52% of September months dating back to 1928, meaning that the average figure cited in the first paragraph is skewed by a few negative observations of significant magnitude. As it relates to this year, several factors could buoy equity prices in the near term, including resilient corporate earnings, moderating inflation, and a high probability of a reduction in interest rates by the Federal Reserve at its meeting later this month. While challenges also face equity markets at present, market participants should remain disciplined as it relates to portfolio allocation and adhere to long-term investment policy objectives. Indeed, while the September Effect may serve as a notable phenomenon worthy of additional study, it ultimately should not factor into the investor decision making process.

Profits and Employment: A Balancing Act

Following last week’s preliminary annual benchmark review from the Bureau of Labor Statistics that suggested U.S. job growth has been weaker than initially estimated, investors have been closely monitoring the labor market for signs of strain. Corporate profit margins may be particularly important to watch as they directly impact the labor market and have historically served as a leading indicator of layoffs and economic frailty.

Using the quarter-over-quarter percentage increase in average initial jobless claims as a proxy for changes in employment, this week’s chart highlights the relationship between the labor market and pre-tax corporate profit margins. Over the past three decades, corporate profit margins have generally trended higher and sit at approximately 12.2% today. While current margins are down slightly from recent cycle peaks, they remain elevated compared to historical levels. This signals that corporate profitability remains relatively robust. Despite challenges caused by higher rates and inflationary pressures, these higher margins have allowed companies to avoid significant layoffs by tapping into other cost-control measures as needed. Given that workforce reductions are often seen as a last resort for companies due to the high costs associated with obtaining, training, and retaining employees, significant layoffs typically do not occur until corporate profit margins have declined precipitously from cycle peaks. The orange line illustrates this point by showing sharp increases in initial jobless claims during economic downturns, including the Dot-Com Bubble, the Global Financial Crisis, and the COVID-19 pandemic, during which quarter-over-quarter jobless claims spiked by an astonishing 165%.

While there were certainly other dynamics at play during each of these recessionary periods, significant increases in layoffs generally coincided with slower growth and material declines in corporate profitability. These trends underscore the importance of monitoring these indicators in tandem.

The Magnificent Five of Private Equity

In investment management, asset allocators and their advisors frequently revisit the concept of portfolio diversification — whether by geography, market capitalization, security, or industry. While Marquette advocates for a diversified portfolio within private markets, it is important to recognize that not all diversification strategies are equally effective. Certain industry characteristics make specific sectors more attractive for private investments, particularly those that exhibit sustainable growth driven by favorable demographic or secular trends, fragmentation, capital constraints, and market inefficiencies. These features are often advantageous in private markets as they create opportunities for value enhancement and potential alpha generation.

Within the private equity asset class, five core sectors — what we refer to as the “magnificent five” — have consistently dominated merger and acquisition activity over the past six years. These sectors are healthcare, technology, industrials, business services, and financial services. According to Dealogic, over 60% of deals across 13 tracked industries have been concentrated within these five sectors, as measured by transaction count. Moreover, these industries have outperformed relative to top-quartile multiple on invested capital (MOIC). It is therefore logical that private equity managers would focus their capital in areas with higher probabilities of outsized returns, which in turn shapes the composition of investor portfolios. It is also important to note that this concentration also intensifies competition for deals within these sectors.

A critical point to consider is the dispersion of returns between top and bottom quartiles across industries — the wider the dispersion, the greater the risk. It is no surprise that the highest-performing industries, healthcare and technology, are often heavily represented in private equity portfolios. In this competitive and risk-laden environment, particularly within the private equity asset class, manager selection becomes increasingly crucial for investors seeking to achieve superior outcomes.

Keep Calm and Carry On

U.S. equity markets began last week on a volatile note, with the S&P 500 Index experiencing its biggest daily drop (-3%) since 2022. The factors behind this sharp decline were outlined in last week’s publication, “Volatility Pops as Equities Drop.” In recent days, however, investors appear to have been appeased by more favorable economic data and carry trade exposures that are now much less significant. To that point, the S&P 500 experienced its largest daily gain since 2022 just a few days after Monday’s drop, rising 2.3% last Thursday, August 8. This week’s chart illustrates the most significant daily changes in the S&P 500 since 2020 in an attempt to compare recent market swings to those of previous years. Based on the information above, it is clear that last Monday’s 3% decline was much less severe than the most extreme daily losses exhibited by the index in 2020 and 2022. Interestingly, the largest daily loss of 12% for the S&P 500 in 2020, which came in response to the COVID-19 outbreak, was followed later that same week by the benchmark’s largest daily gain for the year (+9%).

The significant price movements within equity markets exhibited last week and more broadly illustrate two important points. First, market action can sometimes be driven by “animal spirits,” a term popularized by economist John Maynard Keynes that describes the emotional factors that occasionally supersede logic in investment decision making. Animal spirits are important for investors to keep in mind, as they help explain that many market swings are not indicative of a permanent shift in the economic landscape, but rather stem from human emotions such as fear or hope, which can be fickle. The second point is that adverse reactions to market selloffs can result in even more pain for investors since significant daily losses are often followed closely by large gains. To that point, an investor who allocated to the S&P 500 Index in the 1990s and missed the five best days of index performance would have seen a roughly 37% reduction in their final investment value relative to one who missed zero days (through the end of last week). Put simply, keeping calm and carrying on is often the best prescription for bouts of market turmoil.

Volatility Pops as Equities Drop

Recent days have proved quite challenging for equity investors. On the international front, the Nikkei 225 — which tracks the performance of large, public companies in Japan — dropped by more than 12% in Monday’s trading session. This figure represents the most significant single-day drawdown for that index in more than 35 years. Other non-U.S. equity benchmarks have exhibited similar pullbacks: The MSCI EAFE and MSCI EM indices are both down roughly 6% on a month-to-date basis as of the time of this writing. Performance has been similarly challenged for domestic stocks, with the S&P 500 and Russell 2000 indices down around 6% and 10%, respectively, over that same period. Perhaps unsurprisingly, the CBOE Volatility Index (“VIX”) reached a level not seen in more than four years during Monday’s trading session as investors grappled with broad market turbulence. Despite some moderation throughout the Monday session, the VIX remains well above its 10-year average after a prolonged period of muted volatility. These dynamics can be observed in the chart above.

As is often the case during market downturns, there is not a single force driving recent performance but rather a variety of factors at play. Some of the factors in this case include the following:

  • Friday’s lackluster jobs report, which detailed a higher U.S. unemployment rate (4.3% in July vs. 4.1% in June) and monthly nonfarm payroll gains for the last month that came in well below expectations (114,000 realized vs. 185,000 estimated). These and other souring economic data points may be leading investors to question the extent to which a soft economic landing can truly be achieved in the months ahead.
  • Waning enthusiasm surrounding the artificial intelligence trade, which has led to historically high concentration risk within many indices. Price drops of many large index constituents, many of which have benefitted from AI-related fervor, have exacerbated pressures on U.S. equity benchmarks in particular.
  • Technical factors, particularly related to a popular carry trade featuring the Japanese yen. A stronger yen and an unwinding of global yen carry trades, wherein investors borrowed in the low-yielding currency and reinvested the proceeds elsewhere, have created a negative feedback loop that has led to equity price pressures.

The dynamics described above have further clouded the future. As recently as last month, market participants expected roughly two rate cuts from the Federal Reserve for the remainder of 2024; now that figure sits at around five, with two 25 basis point cuts forecasted at the next FOMC meeting in September. To that point, the yield on the 2-Year Treasury, which closely tracks expectations surrounding Fed policy, briefly sank below 3.7% on Monday before pulling back to around 3.9% later in the trading session.

It is important to remember that the current market decline is not unprecedented. Investors should recall that equity indices are prone to corrections, with the S&P 500 Index exhibiting a drawdown of 10% or greater in 19 of the last 30 calendar years. As always, we encourage investors to maintain a long-term outlook related to their portfolios and not overreact to short-term volatility. A disciplined portfolio rebalancing policy coupled with a long-term strategic asset allocation is the most proven method to achieve risk and return objectives.