Economic Data Watch and Market Outlook
Stock investors headed into the holiday season being the most optimistic since 2018 as inflation seemed to be moderating and the Fed had telegraphed the potential for rate cuts in 2024. This also improved the sentiment for fixed income investors but progress is often not in a straight line. Jobless claims came in a bit higher than expected during the holiday week (218K vs 210K estimate) as well as ISM employment data released on January 3rd which was also hotter than expected (48.1 vs 46.5 estimate). Lastly both ADP employment numbers (164K vs 115K estimate) and non-farm payrolls (216K vs 170K estimate) were both higher than expected.
November factory orders month over month also exceeded expectations (2.6% vs 2.4% estimate) and the October result was revised up to -3.4% from -3.6%.
With some profit taking expected, asset prices continued to decline as a result of the employment data. The MSCI World, the S&P 500, and the MSCI Emerging Markets indices fell -1.52%, -1.50% and -2.09% respectively for the week. The Bloomberg US Aggregate Bond Index fell -1.20%.
The oil market is starting the year with a pessimistic outlook from Wall Street, as major financial institutions such as Morgan Stanley, UBS Group AG, and Goldman Sachs Group Inc. have reduced their forecasts for Brent crude prices. Morgan Stanley has slashed its prediction to approximately $77 a barrel, a 9% decrease, suggesting minimal growth from current levels. This trend of lowering expectations is driven by analysts’ beliefs that increased oil supplies, primarily from US shale drillers outside the OPEC cartel, will meet the global oil demand which is expected to slow down considerably this year. While Brent futures were trading near $79 a barrel, the consensus among big Wall Street banks, including the more optimistic Bank of America Corp. and the more bearish Citigroup Inc., averages out to an expected price of about $81 a barrel for the year. Aside from utilities and consumer staples, energy related equities were one of the harder hit economic sectors in the S&P 500 for 2023, declining 0.72%
The transport of oil and other goods has become more difficult in 2024. As we noted in a late 2023 market commentary, drought in Panama has impacted the flow of goods, forcing heavier ships to go around the South American continent increasing costs and limiting supply of container ships. As the war between Hamas and Israel continues other actors are being drawn into the conflict, notably Houthi rebels. This group, based in Yemen and funded by Iran, have started to attack commercial vessels in the Red Sea that have an affiliation with Israel. According to Flexport, a logistics technology company, ships have started to avoid the Red Sea and passing through the Suez Canal, instead choosing to sail around the Cape of Good Hope. As of January 5th, they reported that 389 container ships, accounting for roughly 22% of global capacity have, or will divert around the African continent. From their most recent report, Flexport notes that prices of cargo coming from Shanghai as of January 5th have risen anywhere from 4% to 10% based on their destination.
Source: Flexport
Equities
All major averages snapped a nine week win streak to start the new year as investors participated in profit taking. A strong jobs report this week pushed yields higher, which also weighed negatively on equity markets. The better-than-expected economic data that came out this week reinforced the idea that the Federal Reserve may have maneuvered a soft landing but also gave second thoughts to a March rate cut and indices reacted.
During the week the Dow Jones Industrial Average fell (-0.56%), the S&P 500 dropped (-1.50%), and the Nasdaq fell (-3.7%). Small caps underperformed large caps as the Russell 2000 Index fell (-3.73%) versus the Russell 1000 Index which declined (-1.62%). From a style standpoint, growth lagged value stocks in both large and small cap companies. Growth and technology saw some of the biggest selling from overweighted positions in large cap names causing technology to be the worst performing sector during the week. Consumer discretionary, industrials, and real estate also saw losses while energy, utilities, and healthcare outperformed.
Globally, equities were negative as the MSCI World fell (-1.52%) and developed markets slightly outperformed emerging markets. The MSCI EAFE, which tracks 21 developed markets excluding the US and Canada, fell (-1.26%) while the MSCI Emerging Markets Index declined (-2.09%). In Europe, the Euro STOXX 600 Index ended the week lower by (-0.55%) and snapped seven consecutive weeks of gains. Most other major indices in Europe were flat or negative as optimism for an early rate cut faded. France’s CAC 40 Index fell (-1.62%), Germany’s Dax declined (-0.56%), Italy’s FTSE MIB was slightly positive gaining 0.29%, and the UK’s FTSE 100 Index declined (-0.56%).
In Asia, Japanese stocks were mixed over the shortened holiday week having resumed trading on Thursday.
The Nikkei 225 Index trailed the broader TOPIX index. The lackluster performance this week followed an earthquake that hit the Noto Peninsula in the Hokuriku region. The devastating human cost as well as economic effect and infrastructure damage threatened to impact manufacturing and other supply chains negatively. Chinese stocks continued to see red this week as economic concerns remained to start the new year. The Shanghai Composite Index declined (-1.54%) and the blue-chip CSI 300 Index dropped (-2.97%). In Hong Kong, the Hang Seng Index fell (-2.97%).
Fixed Income
Treasury yields rose across the board in the first week of 2024 with the 2-year Treasury yield climbing 17 bps, the 10-year Treasury yield climbing 17 bps, and the 30-year Treasury yield climbing 18 bps. Meanwhile, major bond indices fell with the Bloomberg US Aggregate Bond Index falling -1.20%, the Bloomberg US Corporate High Yield Index falling -1.12%, and the Bloomberg US MBS Index falling -1.26%.
With 2023 coming to a close, the Fed’s balance sheet has come into the spotlight as traders speculate on how much longer the Fed can continue to unwind. The main focal point is the Fed’s overnight reverse repurchase agreement (RRP) facility which allows eligible counterparties to store excess cash. Due to higher rates, money has been flowing out of the RRP to capitalize on higher yields. Since the start of 2023, the Fed’s RRP facility fell $1.4T until the last week of the year. Wall Street estimates that the RRP’s balance will be depleted by the second quarter of 2024 which should further cement the case that the Fed will be cutting by the beginning of Q2. Treasury traders are also holding strong on this bet with swaps contracts pricing in up to six 25 bps cuts with 70% odds of the first cut coming in March of this year.
Overseas the Yen is set for its worst week since 2020 in response to the massive New Year’s day earthquake which is expected to sway the Bank of Japan away from negative rates. The dollar-yen currency pair is up 3% to a 145 as of Friday morning and is moving towards a three-week high. Meanwhile in India, Prime Minister Modi’s administration is expected to decrease its budget deficit by 70 bps in the next fiscal year with a target of 5.2% to 5.4% of the country’s Gross Domestic Product. India’s deficit rose to 9.2% during the pandemic but aims to shrink the deficit to 4.5% by 2026. Furthermore, the ECB and BOE are paring bets on interest rate cuts, with money markets pricing in less than 150 bps of cuts in 2024. The easing of expectations was caused by a surge in US non-farm payrolls while the US unemployment rate remained steady.
In 2023, global sales of sustainability-linked bonds (SLBs) experienced a significant 22% decline, falling to $67.8 billion, marking the steepest annual drop since their inception in 2019. This downturn reflects growing skepticism among investors, who are critical of the bond’s often weak and flexible environmental, social, or governance targets, leading to increased risks of greenwashing. This skepticism is compounded by a high percentage of borrowers failing to meet key performance indicators (KPIs) with reports suggesting that nearly half are off track to achieve their targets. In contrast, sales of green bonds, which are used for specific sustainable projects, remained robust at $528.4 billion in 2023, just shy of the 2021 record, indicating a continued investor preference for more direct sustainability investments.
Hedge Funds (as of Thursday, January 4th)
It was a challenging start to the new year for hedge funds’ (HFs’) PnL as equities sold-off globally. The average global fund was down ~80 bps WTD through Thursday yet, this compared to the MSCI World tracking 1.7% lower. The downside captured was ~45% which isn’t too atypical compared to other down markets historically. Long/short (L/S) equity funds globally were more challenged (down of -1.2%), particularly those based in the Americas with the average Americas-based L/S fund posting losses of 1.4%, representing ~80% of S&P’s losses on the week (S&P -1.7%). HFs were hurt from the underperformance of TMT-related stocks (TMT makes up a large portion of the top 50 crowded longs which were down 3.1% WTD). The crowded shorts fell more vs. longs (shorts down 4.7%, resulting in a positive L/S spread of +1.6%), but given that HFs aren’t running as high short exposure to these names vs. what they have in the past, the impact of the positive short alpha wasn’t enough to mitigate the negative alpha on the long side as many might have hoped. In other regions, HF performance relative to benchmark indices was particularly challenging. In Europe this week the average EU-based HF underperformed the Euro STOXX 600, posting losses of ~50 bps vs. the benchmark down 25 bps. Asia-based funds also posted losses (average Asia HF down ~90 bps) due to the MSCI Asia Pacific falling 2.1% this past week. The average Asia-based equity L/S fund and China-focused equity L/S fell ~85 bps and ~1.1% respectively.
Regarding flows, HFs were net sellers of global equities, with most of the major regions tilting towards being net sold. Much of the selling globally took place in North America (NA), where HFs added shorts across single-name equities while trimming ETF longs. Looking at the single-name flows, HFs added shorts across most sectors, but the selling within tech stood out the most. Within tech, the short adds were spread across most-related themes, though there appeared to be a preference towards selling the lower-quality/growthier cohort of the TMT space as well as selling longs in mega-cap tech. Outside of tech, materials were net sold in relatively large amounts as it was the lone single-name sector where HFs trimmed longs and consumer discretionary was sold in the largest amount since September. There was a reversion in how HFs traded at the factor level this past week vs. the prior few months, as they flipped towards buying quality and size vs. selling growth. As mentioned above, HFs were also net sellers of Europe and Asia-ex Japan as HFs trimmed longs across both regions. Within Europe, the bulk of the aggregate selling was concentrated within financials (banks, insurance) and consumer discretionary (hotels, restaurants & leisure). In AxJ, the selling was broad-based across most countries within the region. China ultimately saw a greater portion of the selling, with these flows driven by HFs adding shorts in local shares and trimming longs in US-listed ADRs. Japan flows were more muted due to the shortened holiday week.
Private Equity
Private equity advisers are optimistic about a rebound in exit activity for 2024, driven by the pressure on firms to address a backlog of maturing investments. In 2023, PE exit activity declined as firms held onto investments, anticipating a recovery in valuation multiples. PitchBook data reveals that Q3 2023 witnessed the second-lowest level of PE exits in over a decade, with a 29% and 12.7% decrease in deals and total value, respectively, compared to the same period in the previous year. The pressure to monetize investments and return capital is increasing for PE managers.
Factors contributing to the urgency to exit include the finite life of buyout funds, leading to the need to return capital to LPs. The sluggish exit activity has resulted in a stockpile of assets in funds nearing their term life end. Vintage funds from 2017 are predicted to reach maturity with a substantial portion of capital still locked in assets. PE managers, especially those seeking to raise new funds, must market assets for sale to generate liquidity.
Additionally, term loans financing buyouts are maturing, resulting in a debt overhang for transactions closed from 2016 to 2018. Rising interest rates and credit spreads have increased refinancing costs, prompting some firms to consider selling companies to resolve maturities. As more assets come to market, sellers may need to adjust their valuation expectations.
While multiples for desirable assets may remain high due to strong competition, companies struggling to find buyers may lower their price targets. The scarcity of PE exits in 2023 doesn’t mean managers haven’t been preparing; many have been waiting for the market to stabilize. The uptick in exit activity is anticipated in the first half of 2024, with companies likely bringing deals to market in early 2024. This early move allows them time to respond to potential changes, such as antitrust scrutiny or the impact of the upcoming US presidential election, on deal timing.
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
Josh Friedberg, Fall Associate
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.