Topic Tags: Fixed Income - Investment Grade

The Crystal Ball Has Clouded

Last month, Marquette published a Chart of the Week that highlighted the aberrational length of the current Treasury curve inversion. As outlined in that publication, a Treasury curve inversion occurs when short-term rates move higher than long-term rates, and a persistent inversion has historically served as a portent of an economic recession. To that point, an inversion preceded each U.S. recession by 18 months at the longest (usually less than a year) since the 1970s. That said, while the current inversion has persisted for nearly two years (and counting), an economic downturn has yet to materialize. Put simply, this time may be different. In fact, according to a recent Reuters poll of bond market experts, nearly two-thirds of respondents opined that the shape of the yield curve no longer maintains the predictive power it once held.

What could account for this shift? There are a few possible explanations, and the first relates to the long end of the curve. Specifically, long-dated bonds, or those with maturities of 10 years or greater, have experienced a multi-decade bull run due to strong demand from pension funds and insurance companies. These entities utilize longer-dated bonds to hedge liabilities, and demand from these plans helps prevent selloffs during periods of rate weakness. These dynamics have served to keep the long end of the yield curve relatively stable in recent time. Indeed, while the effective federal funds rate has climbed by over 5% since the Fed began its hiking cycle, the 30-year Treasury yield has risen by roughly half that amount over the same period. The second possible explanation is related to shorter-dated bonds, as 2-year Treasuries are quite sensitive to Fed policy. Given recent hiking and the central bank’s commitment to holding its policy rate higher for longer, yields on 2-year notes have been pulled higher and currently sit at elevated levels.

In order for the yield curve return to normalcy, short-term yields must fall more sharply than long-term yields. However, a resilient economy will likely keep short-term rates high, and strong technical factors have likely put a cap on yields on longer-dated securities. Given this situation and the changing market dynamics outlined in the previous paragraph, the historical relationship between yield curve inversions and recessions may not hold in the current environment.

Assessing the Likelihood of a Recession and Understanding the Impact on Portfolios

Is a recession coming to the U.S.? It’s a question that has been asked since 2022, as the Fed’s rapid rate hikes sparked concern that higher interest rates would lead to demand destruction and ultimately economic contraction. Nonetheless, here we are in the first quarter of 2024 and although the growth rate of gross domestic product has fallen, it is still positive. Unemployment remains at historic lows and inflation is falling. However, with the Fed unlikely to cut rates during the first half of the year and the full effect of the higher rate environment not yet settled, the recession threat still looms over the economy and markets. Given this background, the following paper presents three reasons for each side as to whether the U.S. may enter or avoid a recession in 2024, as well as recessionary implications across asset classes.

A Primer on Alternative Credit

Alternative credit, also referred to as private credit or private debt, has emerged as an area of significant interest for investors in recent time, offering attractive returns and distinct advantages compared to liquid credit markets across an array of strategy offerings. Over the last decade, alternative credit managers have stepped in to play a critical role within lending markets as traditional lenders (i.e., banks) have retreated in the face of liquidity constraints, more stringent regulatory requirements, and higher borrowing costs. As bank retrenchment has intensified, non-traditional credit providers have gained further prominence by offering stable, efficient, and long-term sources of funding for borrowers while also generating attractive returns for investors. Indeed, the leveraged credit market has grown rapidly since the Global Financial Crisis, evolving into a return-enhancing asset class with diversification benefits relative to public fixed income. Given current trends related to supply and demand for capital, as well as the efficiency with which providers can supply favorable loans within corporate capital structures, we expect alternative credit strategies will continue to offer attractive opportunities for investors going forward. However, while the broad opportunity set is particularly attractive, it is important to note that there are many types of strategies that fall into the alternative credit category, and each of these strategies offers varied risk, return, and liquidity characteristics. As it relates to risk broadly, investors should understand how the economic cycle, illiquidity risks, default rates, and increasing competition for deal flow can impact the asset class.

While Marquette has been an active participant in alternative credit markets for many years, the proliferation of the asset class and the expansion of offerings available to investors of different profiles serve as an impetus to examine the space in further detail. The aim of this whitepaper is to provide a background on the alternative credit space, highlight some of the key drivers of return and risk across various alternative credit strategies, and outline the prospects of the asset class going forward.

2024 Market Preview Video

This video is a recording of a live webinar held January 25 by Marquette’s research team analyzing 2023 across the economy and various asset classes as well as what trends and themes we’ll be monitoring in the year ahead.

Our quarterly Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real assets, and private markets, with commentary by our research analysts and directors.

Sign up for research alerts to be invited to future webinars and notified when we publish new videos. If you have any questions, please send us an email.

2024 Market Preview: A 40 Degree Day

A former colleague once described his brother-in-law to me as a “40 degree day.” The puzzled look on my face revealed my unfamiliarity with the term, so he went on to ask me: “When does anyone get upset about a 40 degree day?” I laughed and shook my head — it was genius, the perfect way to describe something more forgettable than memorable…not especially good or bad, just average.

Given what markets have been through over the last four years — COVID, outsized returns both good and bad, record inflation, sky-rocketing interest rates, geopolitical conflict, and elevated volatility — I know I’m not alone in hoping that 2024 market returns will resemble a 40 degree day. Indeed, an “average” year of returns across markets will equate to positive portfolio performance for most asset allocations and allow investors to satisfy their risk and return goals.

Of course, there are potential stumbling blocks to a “normal” year. In particular, we will closely watch the Fed pivot and the disparity between expected and actual rate cuts, geopolitical conflicts, and the U.S. presidential election.

With that as background, we offer our annual outlook across asset classes, highlighting trends and themes for the year ahead. Happy reading and here’s to a year of normalcy!

Equities: Slow Down to Yield

While robust equity market performance in 2023 was certainly in part spurred by the strength of mega-cap technology stocks, economic data and the movement of interest rates also played a critical role. To that point, a decline in Treasury yields to start last year helped fuel a low-quality rally in equity markets, though yields moderated over the next few months following the regional banking chaos that unfolded in February and March. Dynamics shifted in July, however, when yields began to surge as the U.S. Treasury announced new debt issuance to help fund a growing budget deficit. As the year progressed, the continued strength of the domestic economy, including a robust labor market and a resilient consumer, combined with hawkish Fed rhetoric caused yields to climb even further. The 10-Year Treasury yield notably rose to nearly 5% by mid-October, its highest level in over 15 years. Equity markets largely sold off in tandem with this spike in yields, with the Russell 2000 Index reaching an intra-year low on October 27, 2023. Market dynamics once again shifted in the final weeks of 2023, as cooling inflation data led to a more dovish tone from the Fed and widespread investor anticipation of near-term interest rate cuts. This changing sentiment supported a reversal in the 10-Year Treasury yield in late October. As a result of renewed optimism, equity markets exhibited a sustained rally to close the year, with the S&P 500 Index approaching all-time highs in late December. Small-cap equities, which were shunned by investors for much of 2023 amid an environment of higher rates, climbed nearly 25% from their October lows through year-end. Though this rally saw the reemergence of market breadth, as both cyclicals and growth-oriented equities notched strong returns, actively managed strategies struggled due to the outperformance of lower-quality stocks.

This “Santa Claus rally” that ended last year has ultimately tapered off, with equity markets declining to start 2024 amid slightly higher yields. While this trend could foreshadow further challenges for equities in 2024, it may also be a necessary correction. Specifically, given the sharp rise in stocks to close last year, investors may have priced in an overly optimistic probability of interest rate cuts and are just now beginning to consider the possibility that the Fed will not be as accommodative as expected in 2024. This recent correction may also provide some valuation support in the event of any missteps during this quarter’s earnings season, which is slated to kick off in the coming days. As 2024 progresses, policy decisions by the Federal Reserve and the movements in Treasury yields will likely continue to impact investor sentiment and market performance.

Many Happy Returns: A Look Back at 2023

After a challenging 2022, during which significant drawdowns were exhibited by equity and fixed income indices alike, last year saw resurgent performance from most areas of the public market landscape. U.S. stocks were higher in 2023, with the S&P 500 and Russell 2000 indices posting returns of 26.3% and 16.9%, respectively, during the year. Key themes within domestic equity markets in 2023 included increased investor interest in GLP-1 obesity drugs, which led to strong performance from large-cap healthcare companies like Eli Lilly, as well as advances within the field of artificial intelligence. These advances resulted in narrow market leadership for much of 2023 and helped fuel a strong 42.7% calendar year return for the Russell 1000 Growth Index, which is home to each of the “Magnificent Seven” companies (Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia, and Tesla) that were ultimately some of the largest beneficiaries of AI-related fervor. Some may have expressed skepticism that U.S. equity markets would exhibit such robust calendar year returns in March of 2023, which saw a banking crisis that led to the shuttering of Silicon Valley Bank, Signature Bank, and First Republic Bank amid an aggressive monetary tightening campaign by the Federal Reserve and widespread runs on deposits. Fortunately, concerns about broader contagion were allayed when the Fed announced plans to protect uninsured deposits at the affected institutions, though performance of mid- and small-cap indices did suffer due to these events.

Non-U.S. equities posted gains in 2023 as well, with the MSCI EAFE and EAFE Small-Cap indices, which track developed market stocks, returning 18.2% and 13.2%, respectively. UK stocks, while still positive for the year, lagged the broad market due to economic stagnation and higher borrowing costs. Japanese equities, on the other hand, served as a bright spot within the developed market space given recent shareholder-friendly corporate governance reforms and monetary policy that continues to be accommodative. The MSCI Emerging Markets Index was positive for the year as well, notching a return of 9.8%. Companies domiciled in Latin American countries like Brazil and Mexico were some of the largest gainers within non-U.S. markets during the year, as many have benefited from a reconfiguration of global supply chains and favorable population demographics. Additionally, the Taiwanese company TSMC, which is the largest constituent of the MSCI EM Index, exhibited strong performance in 2023 thanks to the enthusiasm surrounding AI advances detailed above. Despite these positive outcomes, the 2023 return of the EM benchmark was hampered due to continued challenges faced by China, which was among the worst performing countries during the period. Indeed, a slump in its property sector, ongoing geopolitical issues, a weak job market, and widespread debt stress in the corporate space have spelled trouble for China’s economy in recent time, however, many believe the nation’s slowdown has bottomed.

Fixed income indices were also positive in 2023 after a dismal 2022, with falling inflation, a resilient economy, and expectations of interest rate cuts on the horizon leading to a bond market rally to end the year. To that point, the yield on the 10-year Treasury, which sat above 5.0% less than three months ago, has now dropped to below 3.9%. Thanks in part to these dynamics, the Bloomberg Aggregate Index notched a return of 5.5% in 2023, while high yield bonds (+13.4%) and bank loans (+13.0%) posted their best calendar year performance figures since 2019 and 2009, respectively.

It is important to note that private markets asset classes, including private equity and real estate, report performance on a lagged basis, meaning full calendar year returns for these spaces will not be available for some time. In the coming weeks, Marquette will be providing more detailed analysis related to both public and private market performance in 2023, as well as what investors might reasonably expect in the new year. We encourage clients, in tandem with their consultants, to review these analyses, as well as existing investment exposures and policy targets, to ensure the appropriate positioning of portfolios in 2024 and beyond. Finally, as it relates to the new year, we wish all readers many happy returns!

 

Benchmarks:
Core Bond: Bloomberg Aggregate Index
High Yield: Bloomberg High Yield Index
Bank Loans: CS Leverage Loan Index
Broad U.S. Equities: Russell 3000 Index
Large Cap: S&P 500 Index
Mid Cap: Russell Mid Cap Index
Small Cap: Russell 2000 Index
Broad Intl Equities: MSCI ACWI ex-USA Index
Intl Large Cap: MSCI EAFE Index
Intl Small Cap: MSCI EAFE Small Cap Index
Emerging Markets: MSCI Emerging Markets Index
Commodities: S&P GSCI

Realizing the Impact of Unrealized Losses

Earlier this year, the regional banking crisis and eventual collapses of Silicon Valley Bank, Signature Bank, First Republic Bank, and Silvergate Bank highlighted issues related to bank assets (e.g., U.S. Treasuries and mortgage-backed securities) sharply losing value due to higher interest rates. In many of these cases, uninsured depositors learned of growing unrealized losses at the institutions in question and feared the worst (i.e., that banks would become insolvent and pull deposits). Unfortunately, the story of declining bank asset values is relevant not only to uninsured regional banks, but to FDIC-insured depository institutions as well. To that point, the most recently published FDIC Quarterly Banking Profile highlighted growing unrealized losses across these institutions. Specifically, unrealized losses on securities totaled $558.4 billion in the second quarter of 2023, which represents an increase of $42.9 billion from the previous period. Rate hikes have certainly exacerbated these figures, as current losses are more than two standard deviations removed from the average levels exhibited since the Global Financial Crisis. An understanding of the implications of increased losses across different security types (e.g., available-for-sale vs. held-to-maturity) can be particularly useful. Notably, while held-to-maturity securities are reported as noncurrent assets on a company’s financial statements and earned interest income appears on a company’s income statement, changes in the prices of these securities are not reflected on the income statement if the securities have maturities longer than one year. As a result, some financial metrics (e.g., earnings) of certain banks may be somewhat overstated at present.

Even today, interest rates continue to chip away at the value of bank assets, and additional upward pressure on rates may strain bank profitability as held-to-maturity securities approach maturity. Banks will be hoping that the end of the current rate hiking cycle comes before these losses make their way to the income statement, which could cause many to question the health of various institutions. On a positive note, the FOMC announced during its most recent meeting that it would be holding its policy rate at a constant level, which may assuage some investor concerns related to this topic. Marquette will continue to monitor the impact of interest rates on the banking sector and the overall economy.

The Chart for Red October

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

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

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

3Q 2023 Market Insights Video

This video is a recording of a live webinar held on October 26 by Marquette’s research team, featuring in-depth analysis of the third quarter and themes we’ll be monitoring for the remainder of the year.

Our Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real estate, infrastructure, private equity, and private credit, with presentations by our research analysts and directors.

Sign up for research alerts to be invited to future webinars and notified when we publish new videos. 
For more information, questions, or feedback, please send us an email.