Economic Data Watch and Market Outlook
Positive returns in equity markets continued globally (MSCI World +23 basis points) for the week as US large cap growth names (Russell 1000 Growth + 2.21%) drove broad market indices higher (S&P 500 +1.19%) while value stocks (Russell 1000 Value -20 basis points) and small cap stocks (Russell 2000 -33 basis points) declined. The chart below shows the decline of small caps even as the NASDAQ approaches an all-time high.
Bonds also ticked downward (Bloomberg US Aggregate Bond Index -110 basis points) as economic data releases were better than expected and Fed comments pointed to no immediate rate cuts.
However, investors, encouraged by the prospect of Federal Reserve interest rate cuts, have significantly increased their US stock holdings to a two-year high, according to a Bank of America Corp. survey (see below chart). This increase aligns with a major rally in US equities anticipating a soft global economic landing in 2024. While the focus is on leveraging the expected Fed rate cuts, and despite US stock holdings reaching a two-year high, investors maintain a cautious stance, still investing heavily in money-market funds, indicating a balanced approach to risk. Moreover, with only a minority expecting a downturn in profits in the next 12 months, the sentiment remains cautiously optimistic, highlighting a nuanced investor approach amid changing economic conditions.
Wall Street executives, having endured a two-year slump in dealmaking that significantly impacted earnings, are now optimistic about a rebound. This renewed confidence is linked to the Federal Reserve’s shift away from consistent interest rate hikes. Key figures, including Goldman Sachs CEO David Solomon and Morgan Stanley CFO Sharon Yeshaya, express hope for increased activity in initial public offerings (IPOs) and mergers & acquisitions. Despite this optimism, they remain cautious, acknowledging global uncertainties and market sensitivities to interest rate movements. This cautious optimism follows a period of tumultuous cycles on Wall Street, marked by a dealmaking boom in 2021 due to low rates and pandemic stimulus, followed by a sharp decline in 2022 with the end of the Fed’s easy-money era.
While disparities remain within the housing market, the average 30-year rate has declined from over 7% to 6.6% for the week ending January 19. Fannie Mae suggested that rates could fall to below 6% in 2024. The chart below also indicates a positive trend in building permits after the worst decline since the great financial crisis.
Equities
Mega-cap technology and semiconductor stocks lifted major averages again this week reversing losses in major indices year-to-date. This week pushed the Dow Jones Industrial Average, S&P 500, NASDAQ, and the Philadelphia Semiconductor Index to new record highs. Major indices wrestled with mixed economic data early in the week following manufacturing, retail sales, and the jobless claims reports which pushed yields higher Thursday. Investor sentiment improved on hopes that the economy may be stronger than anticipated. Taiwan Semiconductor reported very strong earnings and raised guidance for 2024 which helped lift the S&P 500 to record high and helped the Philadelphia Semiconductor Index rise +8.0% this week. The S&P 500 Equal Weighted Index saw a modest loss as the gain in the S&P 500 Index was lifted by larger growth stocks. We have Q4 2023 earnings results from 52 S&P 500 companies and earnings are up 1.4% compared to Q4 2022 with 4.8% higher revenues and 80.8% beating EPS estimates and 63.5% beating revenue estimates.
Q4 EPS and revenue beats are within their historical averages. To start the season the beats percentage was lower but has now moved into a more normal range. On Tuesday, Boeing shares fell following their earnings report stating possible delivery delays around safety issues for their 737 MAX airline. The shares recovered most of the losses to close the week.
For the week the Dow Jones Industrial average rose 0.76%, the S&P 500 jumped 1.19%, and the Nasdaq gained 2.26%. From a market cap standpoint, large caps outperformed small caps as the Russell 1000 Index returned 1.11% during the week while the small cap Russell 2000 Index fell (-0.33%). From a style standpoint, growth outperformed value across market caps. From a sector standpoint, technology saw the largest gains followed by strength in communication services, financials, and consumer discretionary. Rate sensitive sectors such as utilities, real estate, and consumer staples struggled while energy and materials also trailed the broader market.
The MSCI World posted a slight gain during the week returning 0.23%. Developed markets outperformed emerging markets slightly but both recorded declines during the week. The MSCI EAFE Index, which tracks 21 developed countries excluding the US and Canada, fell (-2.13%) while the MSCI Emerging Markets Index dropped (-2.54%). Emerging markets were impacted again by China’s underperformance as the latest economic indicators signaled a weak outlook for the economy. The Shanghai Composite Index fell (-1.72%) and marked the eighth weekly decline in the past nine weeks per Bloomberg data. The CSI 300 Index also fell (-0.44%) and marked its ninth weekly decline in the past 10 weeks. In Hong Kong, the Hang Seng Index dropped (-5.76%). Japanese stocks rose during the week as the Nikkei 225 Index gained 1.09% and reached a 34-year high while the broader TOPIX Index rose 0.63%. In Europe, the Euro Stoxx 600 Index ended the week lower, falling (-1.58%) as comments from central bank policymakers triggered markets to scale back bets on an early action to rate cuts. Other indices in the region were also slightly lower as France’s CAC 40 Index fell (-1.25%), Italy’s FTSE MIB declined (-0.61%), the UK’s FTSE 100 Index dropped (-2.14%), and Germany’s DAX declined (-0.89%).
Fixed Income
Treasury yields had a challenging week as they hit their highest level so far this year. Yields on the shorter end of the curve saw the most volatility in response to the strong consumer sentiment reading, forcing investors to re-consider the previously priced in March rate cut. Rate cut expectations have now been pushed out to May at a 93% probability, and a 100% probability of a cut in June, with many expecting three 25 bps cuts this year. The 2-year Treasury yield rose 6 bps on Friday, while longer-dated yields rose less but still hit their year-to-date high as the 10-year Treasury yield breached is 50-day average. The next set of Treasury auctions including two, five, and seven-year notes begins on Tuesday and should provide upward movement on yields next week as well. Ultimately yields finished the week higher with the 2-year Treasury yield jumping 25 bps to 4.39%, the 10-year Treasury yield climbing 19 bps to 4.15%, and the 30-year Treasury yield climbing 16 bps to 4.36%. Meanwhile, major bond indices fell with the Bloomberg US Aggregate Bond Index falling -1.10%, the Bloomberg US Corporate High Yield Index falling -0.52%, and the Bloomberg US MBS Index falling -1.37%.
Early in the week, the US dollar rallied significantly, marking its biggest advance in 10 months, with the Bloomberg Dollar Spot Index climbing 0.8%. This surge defied predictions of a dollar decline, anticipating the Federal Reserve’s monetary policy easing. Heightened by geopolitical tensions and China’s economic fragility, the dollar’s ascent reflects traders’ overestimation of Fed rate cuts. Central banks, such as the ECB, maintain a cautious stance on reducing rates due to inflation and geopolitical risks, reinforcing a stronger dollar outlook.
Junk-rated emerging market borrowers have seen a massive influx of cash so far this year with investment-grade issuers such as Chile, Mexico, and Hungary being extremely active in the last several weeks. So far developing economies have issued $64B of debt this year which is just below the $66B in the same period last year. Expectations for volatility later in the year due to Fed decisions and the US election are creating some urgency to lock in rates.
Hedge Funds (as of Thursday, January 18th)
Hedge funds (HFs) posted small losses as equities globally tracked lower. The average global fund posted losses of 30 bps vs. the MSCI World down 1%. Long short equity (L/S) funds experienced a greater portion of the downside, with those based in the Americas ranking among the weaker relative performers across all strategies (average Americas-based L/S fund -30 bps vs. S&P 500 flat). Despite the crowded longs vs. shorts in North America (NA) performing well, with longs outperforming the S&P by 1% and shorts lagging by 90 bps, L/S funds were unable to capture this positive alpha given most are not running as high exposure to these names vs. what they have in the past. Performance fared better in other regions. EU-based HFs were able to limit their losses to just 20 bps on average vs. the Euro STOXX 600 down 1.3% WTD through Thursday. This leaves the average EU fund down ~25 bps for the month through Thursday vs. the Euro STOXX 600 Index down 1.7%. Asia-based funds also limited losses to just a fraction of what the benchmark index was down, with the average Asia-based HF and Asia-based L/S fund down ~80 bps and 90 bps respectively (vs. MSCI Asia Pacific -3.3%). China-focused equity L/S funds fared the worst on an absolute basis this week with losses of ~2.1%, though this compares to the MSCI China Index down nearly ~5%.
The gross additions across equities globally YTD extended into this week, with HFs adding longs and shorts in a near equivalent amount (resulting in flows ending flat on a net basis). The gross additions this week took place in most regions other than NA (where volumes were lighter on the shortened trading week). In NA, the flow was relatively quiet until Thursday when equity indices rallied leading to a sizeable amount of long additions. For the full week, the aggregate buying was limited to TMT and industrials with the long adds in industrials being somewhat notable given HFs had steadily sold longs within the sector during the ~2 months leading up to this week. At the industry-level, the buying across both TMT and industrials was spread across most sub-sectors. Managers are also pressing shorts in cyclicals and small-caps as they are working. Elsewhere, there was little directional flow except macro products which were net sold let by short sales. In other regions, HFs adding more shorts than longs in Europe led to the region being net sold. At the sector level, the selling was broad-based across most sectors, with industrials, tech, financials, and energy ranking among the most net sold. HFs added shorts in Asia-ex Japan as equites underperformed this past week, with the short adds most concentrated in China (particularly local shares) and Taiwan. The trend in an uptick in long additions in Japan equities extended this week. The bulk of what was bought on the long side was seen in financials (particularly banks, though the long buying was partially offset by funds also adding shorts to Japan banks), industrials, and real estate.
Private Equity
In the current financial landscape, private equity (PE) firms are increasingly targeting startups for acquisition, particularly those struggling with liquidity and unable to secure further venture capital funding. These startups, often unable to turn to their existing venture backers for additional capital and sometimes defaulting on debts, find themselves in difficult positions, leaving them open to acquisition at significantly reduced valuations. Industry experts note that private equity-backed platform companies are actively seeking these startups, drawn by their products or high-profile customers, which could enhance the portfolio of the acquiring company.
Typically, PE firms have shied away from acquiring companies before they reach profitability, as applying the Leveraged Buyout (LBO) model to a non-cash flow generating business is challenging. However, the recent market downturn has seen some startups cutting expenses and generating cash, making them more appealing to PE firms. These buyers are price sensitive, often offering low revenue multiples – sometimes as low as 1x or 2x, compared to the 3x to 5x multiples these businesses might have commanded in more stable times.
The biotech and pharma sectors, where startup valuations have significantly dropped, are also attracting considerable interest from acquirers. Despite the attractive lower valuations, the process of acquiring troubled startups can be lengthy, sometimes taking twice as long as acquiring a stable company. This is due to several factors: acquirers may prolong negotiations to lower the price further, and these transactions require more intensive due diligence. Additionally, these deals often involve complex negotiations over earn-out terms. Earn-outs are used to bridge valuation gaps in uncertain markets, offering sellers a sum today with the promise of additional compensation based on future performance targets. However, these lead to intense negotiations over control of the acquired company during the earn-out period and the appropriate metrics for measuring performance. Nonetheless, analysts suspect 2024 to reach record levels of acquisition activity within the private equity space.
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.
