Topic Tags: Interest Rates

Mind the Gap

Any ride on the London Tube reminds riders to mind the gap: Beware the space between train car and platform as you board and depart the train. A recent trip to London brought this phrase back to me and it seemed like a perfect description of how to look at financial markets this year, with the “gap” serving as the difference between expectations and reality, most particularly in terms of interest rate cuts.

In our market preview, we identified the Fed pivot as a primary driver of financial markets this year, most especially how expectations of cuts would line up with actual Fed policy. Going into the year, the market had priced in at least five cuts, which helped fuel a furious fourth quarter rally and investor optimism for 2024. One quarter in, however, those expectations have been turned on their head. Hotter than expected inflation and jobs reports in March have created a “higher for longer” narrative with the market expecting no more than two cuts during the second half of the year. Some economists have taken an even more bearish stance, suggesting there will not be any cuts. Overall, rates rose across the curve during the quarter as current U.S. debt levels sustained the long end of the curve while the short end was relatively unmoved.

Intuitively, many investors would expect such a big change in rate expectations to weigh heavily on markets, both equities and bonds. In that sense, equity performance was surprising during the first quarter, as the upward trend from 2023 continued. Predictably, bonds suffered as rates rose, but below investment grade sectors were profitable. To be fair, though, it should be noted that equities have endured a difficult start to this month, down 4.6% through April 22 as the higher for longer narrative has gained momentum.¹

Going forward, what should we watch for from asset classes as we venture into a market environment that looks much different than what we were expecting only three months ago?

Japan: This Year’s Vacation Recommendation

Foreign investment isn’t the only thing streaming into Japan. In 2023, the number of travelers to the country surpassed long-term average levels, though that figure still sat below pre-pandemic highs. That said, last year was a clear sign of recovery for Japan’s beleaguered tourism industry, and this trend has continued into 2024. Through the first two months of this year, the number of visitors to Japan is already close to 22% of last year’s total, with tourists coming from surrounding Asian countries and the Western world as well. To that point, nearly 150,000 U.S. citizens visited Japan in the month of February alone. A major driver of Japan’s appeal to tourists is the weak yen. In April, the yen hit a low not seen in over 30 years relative to the dollar, thanks in part to disparity between the policies of the Federal Reserve and the Bank of Japan. These dynamics have allowed U.S. travelers to enjoy more “bang for their buck.”

Earlier this year, Japan slightly curtailed its long-running accommodative monetary policy with the goal of addressing the country’s chronic deflation problem and spurring economic growth. The influx of tourists described above might also provide these desired effects, with several industries, including transportation, restaurants, entertainment, and hospitality potentially standing to benefit. For instance, there has been a material increase in average daily hotel rates in Japan, which recently hit highs not seen since the late 1990s. Although this is just one example of travelers having an impact on Japanese price levels and growth, it is illustrative of what could happen more broadly to industries directly tied to tourism. While the outlook for economic growth and future tourism in Japan is uncertain, it is encouraging to see certain data reflect the pre-pandemic environment.

The Banks’ Real Estate Problem

First quarter earnings season is getting started, with the largest banks reporting first. In the wake of last year’s regional banking crisis and the potential new normal of higher-for-longer interest rates, all eyes are on the health of the U.S. financial system. With commercial real estate (CRE) still searching for its bottom, losses related to CRE exposures are of particular concern for the banking industry. There is $5.7 trillion in commercial real estate debt outstanding and small to mid-size banks hold a disproportionate amount of it, putting the group at higher risk. Regional lender New York Community Bancorp (NYCB) — with the fifth largest concentration of CRE loans, as shown above — garnered headlines earlier this year after reporting a sizeable fourth quarter loss and disclosing material weakness in the way it reviewed its loan portfolio, prompting a $1 billion emergency investment. While NYCB’s outsized exposure to rent-controlled multi-family property loans may limit contagion to the broader banking sector, risks remain. As consumers respond to the higher rate environment, bank funding costs increase, eating into the higher lending profits the sector has enjoyed. Combined with losses and provisions tied to the troubled real estate sector, banks may limit lending, which flows through to the consumer and economy. As the macro backdrop remains in flux and the consumer continues to adjust to a higher-for-longer environment, any bank weakness could become more of a threat and bears watching as earnings season continues.

First to Cut: The Fed or the ECB?

Based on implied probabilities derived from options markets, investors are currently forecasting an 82% chance that the European Central Bank will cut its policy rate at or before its June meeting. For the full year, market participants currently expect roughly three rate cuts by the ECB in total. By comparison, investors believe there is only a 46% chance the Federal Reserve will lower its policy rate in or before June and are now expecting fewer than two rate cuts from the U.S. central bank over the course of the full year.

Some of the primary reasons for these expectations involve both economic growth and inflation. To that point, in the fourth quarter of 2023, the U.S. economy grew 5.9% on a year-over-year basis. This is in stark contrast to the euro area, which produced 0.0% year-over-year growth for that same period. Estimates for first quarter GDP growth tell a similar story in terms of divergence between the two regions, as the U.S. economy continues to perform well due to a strong labor market and a resilient domestic consumer. On the inflation front, both regions have seen price levels fall from peaks seen in 2022, though European inflation has proved less sticky than that of the U.S. Specifically, the March reading for domestic CPI was 3.5%, which came in above both consensus expectations and the 2.4% figure for the euro area. In short, as it relates to monetary policy expectations, lower levels of economic growth call for more supportive monetary policy, and lower levels of inflation allow for such policy. Should current forecasts related to the trajectory of interest rates come to fruition, the U.S. dollar is likely to benefit relative to the euro, which may create a short-term headwind for non-U.S. equity returns. However, more accommodative monetary policy by the ECB may also serve as a medium-term tailwind for international stocks should the move result in stronger economic growth for the European continent.

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.

Long and Variable Lags

The Federal Reserve has waged an aggressive campaign against elevated inflation in recent time, having raised its policy rate from near 0% to over 5% in just over one year. These actions represent the fastest pace of tightening in the history of the central bank. Since the Fed began hiking in the first half of 2022, readings of core CPI, which strips out more volatile components of the headline CPI calculation like food and energy prices, have retreated from a peak of over 6.5% to roughly 3.9% as of the time of this writing. While this moderation of core inflation has led to increased (and perhaps overly) positive sentiment on the part of many investors, it is important to remember that the battle against high price levels has not yet been won. The week’s chart attempts to underscore that point by highlighting the amount of time it has taken for peak inflation to reach more trough-like levels (i.e., those closer to the long-term median core CPI reading) over the last several decades. Readers may be somewhat disheartened to learn that it has taken an average of around two years for inflation to go from peak to trough, with the last two instances requiring roughly three years. For context, the peak figure from the current cycle came 17 months ago.

As it relates to the reason for these long-lasting campaigns against inflation, Fed Chair Jerome Powell has noted the “long and variable lags” with which monetary policy often acts. According to the Fed, one explanation of these lagged effects is that many economic transactions involve prices and quantities that are agreed upon months in advance by the buyer and seller. If these agreements occur in advance of significant changes in monetary policy, they will naturally not be influenced by new levels of interest rates. Additionally, the Fed has noted that lags may arise from the “inattentiveness” of business owners, who may set prices on an infrequent basis to avoid “menu costs,” or the costs associated with price updates. Such behavior would lead the current economic reality to be unreflective of the current monetary policy. Whatever the reasons for the lags detailed above, precedent clearly shows that it may take additional months for inflation to retreat closer to long-term average levels, which may lead to an environment of higher-for-longer interest rates.

Looking ahead, the CPI figure for February is scheduled to be released on March 12. This reading will likely prove informative as investors attempt to determine future actions of the Federal Reserve, which is currently expected to cut rates three to four times this year. Interestingly, market participants expected as many as six rate cuts in 2024 just a few months ago. Marquette will continue to monitor the macroeconomic landscape and provide updates to clients accordingly.

Show Some Maturity

As interest rates remain elevated, some market participants have questioned the extent to which the maturity wall in the below investment grade fixed income market is a sign of increased risk. On paper, concerns related to the maturity wall are understandable, as high yield and leveraged loan issuers face higher financing costs due to increased credit risk. Further, these companies could struggle to refinance debt as it matures and, as a result, incur much higher interest expenses in the future. These dynamics may lead to an eventual increase in default rates and create headwinds for fixed income performance.

In recent time, however, there have not been significant issues when it comes to below investment grade issuers refinancing debt and extending maturities. Since the beginning of 2023, the amount of high yield and leveraged loan debt maturing in 2024, 2025, and 2026 has been reduced by a combined $472 billion, which constitutes roughly 17% of the current market for outstanding high yield bonds and leveraged loans. Additionally, the pace of refinancings and the reduction in impending maturities has only accelerated over the more recent term, as issuers took advantage of lower interest rates in the fourth quarter of last year to term out debt. To that point, more than $54 billion of high yield and leveraged loans have been refinanced over the past three months alone. This is roughly double the pace of 2022, during which $28 billion was refinanced every three months, and nearly five times the $11 billion being refinanced every three months in 2021, during which the market for new issuance was almost non-existent.

Although refinancings abound in 2024, concerns related to impending maturities are not entirely unfounded. Over the next three years, over 21% of the below investment grade market is scheduled to mature. While this number is down slightly from year-end, it remains close to recent-term highs. However, this increased pace of refinancings is a welcome sign for fixed income markets broadly. Fundamentals remain resilient in the below investment grade space, and this resilience will likely allow companies to bear higher interest costs and continue to extend out maturities to time periods that may exhibit more rate favorability.

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.

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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!