Economic Data Watch and Market Outlook
The MSCI World rose1.06%, with US growth stocks contributing the majority of that return. The S&P rose 1.40% while the MSCI EAFE benchmark rose just 11 basis points. The Bloomberg US Aggregate Bond Index fell 82 basis points.
New York Community Bank’s debt was downgraded two notches to junk by Moody’s on Tuesday, February 6th citing issues related to their commercial real estate exposure. The bank had previously cut payouts and added to reserves to cover losses in their commercial real estate book (not surprising as office vacancy rates in New York and San Francisco made headlines in 2023). Some workers have returned to the office, but rates are still in the teens in those markets. In January, Moody’s noted that the national vacancy rate hit 19.6%, the highest since 1979. This compares to markets in Tokyo (6.1%), Berlin (5.7%), Seoul (6.2%), London (9.4%). The US market is adapting as there has been a significant uptick since 2021 in office to residential conversions but this is a slow-moving process so trouble in the US commercial office space will likely still occur.
We’ve written in the past about global shipping rates and this past week they have tracked lower. Keep in mind that these are spot rates and do not immediately impact shipping costs due to the crisis in the Red Sea and drought along the Panama Canal. What has most affected shipping costs are insurance rates with tankers flying US, British, or Israeli flags seeing cost increases of 50% or more.
The upcoming week will shed light on housing starts, manufacturing data from the New York and Philly Feds, but most will view CPI data released on Tuesday to be a key data point into the views on the direction of rates.
Equities
The rise of the Russell 1000 of 1.49% was a healthy return for the week but the return was largely due to growth names. The Russell 1000 Growth benchmark rose 2.58% versus a meager 14 basis points for the Russell 1000 Value. While paltry on a relative basis, returning 14 basis points each week (7.28% annually) would satisfy the return requirement of most pensions.
Dividends of the S&P 500 are now at their lowest level since 2021. The only lower point was the late nineties. The Wall Street Journal highlighted the topic this past week as META Platforms announced they will begin paying a small dividend of $0.50 per share per quarter.
The emphasis on recycling excess cash back into the business is a trend more recent to the 21st century and it has proven a good strategy to enhance returns especially since the 08/09 crisis and more so since the pandemic as the chart points out in the image below.
As earning season starts to come to a close, 75% of names in the S&P 500 have beaten their fourth quarter estimates, slightly higher than their ten-year average.
Small stocks for the week jumped 2.44% as indicated by the Russell 2000. Small growth outperformed small value with the Russell 2000 Growth advancing 3.53% while the Russell 2000 Value rose 1.36%
Developed markets rose slightly with the MSCI EAFE benchmark rising just 11 basis points. Japan is the largest component of that benchmark at just over 23%. Its market, the Nikkei rose, 2.06% for the week with a year-to-date return of 10.27%. Emerging markets rose just 75 basis points.
Fixed Income
The Bloomberg US Aggregate Bond Index fell 82 basis points with the mortgage market, Bloomberg MBS, declining 79 basis points. The current yield curve remains inverted with the slope more defined than one year ago with continued expectation that the US will experience a recession in the coming months.
The chart below looks at the market expectations of Fed cuts and how they are currently priced. Seven were expected in mid-January but those expectations have been curtailed with market pricing in just four for the remainder of the year.
We will gain more insights on future rate changes when the Bureau of Labor Statistics releases CPI data on Tuesday, February 13th.
Hedge Funds as of February 8, 2024
February has started strong as all strategies and regions are positive on the month. The average global hedge fund (HF) posted gains of ~90 bps vs. the MSCI World +2%, while the average equity long/short (L/S) fund is up slightly more at +1.30%. The average US L/S fund is up 1.60% relative to the S&P 500 which is up 3.2% in February so far. More notable is the performance of other regions as the average Europe-based HF returned ~ 50bps whereas the Euro STOXX 600 was down 7 bps and the average Asia-based fund also outperformed its regional index, as they posted gains of 1.5% compared to the MSCI Asia up only ~60 bps. HFs meaningfully pushed into global equities this week as most regions (excluding AxJ) saw long additions. This week posted as the 2nd largest week of net buying observed globally since early December. North American (NA) equities had the bulk of inflows, and also accounted for the majority of net short additions across all regions. Looking closely at NA flows, technology (software & semiconductors) led the net buying, though there were significant long additions across the relatively ‘under-owned’ sectors from a gross perspective: industrials, materials, and energy (industrials were net bought for a 6th straight week and saw the largest net buying in a year – led by long adds). HFs also continued to sell out of positions within the ‘Magnificent 7’, however, while these seemingly oppositional flows might be indicative of a rotation to broaden out ownership, it’s important to highlight that the HF community broadly remains ‘overweight’ the ‘Magnificent 7’ vs. ‘underweight’ the other areas of the market, and the flows represent very early innings of a rotation. HFs have returned to selling quality in recent weeks, but the selling had been driven by HFs adding shorts to high-quality names as opposed to them trimming longs. Regarding market-cap, after positioning reached peak bearishness in October 2023, HFs have consistently added to small-cap names since the beginning of the year. Small-cap medtech/biotech accounted for a large portion of the buying YTD, but HFs have also added longs in small-cap banks and industrial related industries.
Looking across other regions, there has been appetite to add longs in Europe. While most sectors tilted net bought this week (except for financials, utilities and TMT-related sectors), the long additions were relatively concentrated across healthcare, industrials and energy. However, both gross and directional positioning to the region remain at multi-year lows as EU-based funds have been the only funds to meaningfully re-engage the region; US and Asia-based HFs have been less involved in the recent buying. There has been a push to own Japan which has carried through the recent week as HFs added to longs across most sectors, however tech, industrials/materials and consumer discretionary stocks led the net buying. Meanwhile, HFs were net sellers of Asia ex-Japan led by India, Taiwan and China. HFs had played China to the upside in the week prior via both equities and options, but there wasn’t any follow through in the trade this week. Korea was the only region within Asia to be net bought this week, and notably this marks the first time since the November sell-off that there has been any directionality in the flows. HFs have added length almost every trading session since the start of February, though gross deployed in the region remains at multi-year lows.
Private Equity
In 2023, the dominant theme in venture capital was Generative AI, and this trend is expected to continue into the current year. PitchBook data reveals that a staggering $29.1 billion was invested in 691 Generative AI deals last year, indicating a substantial 268.4% increase in deal value compared to 2022.
Investors have largely been focused on companies specializing in large language models, such as OpenAI and Anthropic. However, as the Generative AI market matures, attention is shifting towards Vertical AI, which involves developing specialized applications tailored to specific industry verticals rather than general-purpose solutions.
Vertical AI is gaining traction as it addresses industry-specific challenges and needs, offering more targeted solutions. In contrast, Horizontal AI, which provides general solutions, is facing fierce competition, making it increasingly difficult for companies to compete at the foundational model level.
Vertical AI projects typically work with smaller datasets, requiring less computational power, reducing costs, and saving time. They can deliver more accurate solutions quickly, providing a faster return on investment for businesses. Customer acquisition is also more straightforward for Vertical AI companies, given their products are designed for specific market segments. However, the total addressable market for Vertical AI is smaller than for Horizontal AI, which means these startups are less likely to achieve outsized valuations.
Financial services and healthcare are prime targets for Vertical AI. In the financial sector, despite its vast amount of data and history of implementing machine learning, adoption has been slow, but it is expected to grow with more large language models in production. In healthcare, startups like Hippocratic AI and Corti have already secured substantial investments to personalize treatments and analyze medical data.
In conclusion, the rise of Vertical AI in venture capital reflects a shift towards more specialized applications within specific industries. This trend is driven by lower costs, faster ROI, and increased profitability potential. However, it comes with its challenges, including longer sales cycles and a smaller addressable market. Investors need to combine their understanding of Generative AI with sector-specific expertise to navigate this evolving landscape effectively.
Authors:
Jon Chesshire, Managing Director, Head of Research
Elisa Mailman, Managing Director, Head of Alternatives
Katie Fox, Managing Director
Michael McNamara, Analyst
Sam Morris, Analyst
Data Source: Apollo, Barron’s, Bloomberg, BBC, Charles Schwab, CNBC, the Daily Shot HFR (returns have a two-day lag), Goldman Sachs, Jim Bianco Research, J.P. Morgan, Market Watch, Morningstar, Morgan Stanley. Pitchbook, Standard & Poor’s and the Wall Street Journal.