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Growth Team Weekly Investment Insights

1) Equity Market Roller Coaster

Recession concerns and market returns gyrated back and forth all of last week. Weakness on Monday was due to a series of events that created the perfect storm. Kicking things off was the US Federal Reserve’s decision to hold rates steady at restrictive levels. Then, a series of economic indicators from the prior Thursday and Friday hinted at US economic weakness (the ISM manufacturing index fell further into contractionary territory and the labor market weakened). Lastly, Japan raised interest rates, and the yen rapidly strengthened.  

The magnitude of Yen appreciation had a significant impact on equities due to a popular carry trade strategy in which investors borrowed yen (at very low interest rates) and used the money to invest in global equities. The diverging monetary policy moves between the US and Japan led to the currency strength, margin calls, and selling pressure as investors had to raise funds to meet those margin calls.

 

 

 

 

 

 

 

 

 

 

 

 

 

However, subsequent economic data during the week alleviated concerns. The ISM non-manufacturing (i.e., services) index for July moved back to expansion territory after slipping into contraction territory in June. The services index covers areas like financial services, health care and hospitality. These areas make up the bulk of US economic activity.

 

 

 

 

 

 

 

 

 

 

 

 

And from a labor market perspective, we received initial jobless claims on Thursday that showed a 17,000 decline in weekly initial jobless claims, to 233,000, suggesting labor market resilience.

2) Shifting Bond Market Expectations and Volatility

As markets have priced in expected Fed rate cuts, government bond yields have fallen. Looking at Q3 (as of 8/9/2024), the 10-year Treasury yield has fallen by 54bps (4.48% to 3.94%), and the 2-year has fallen by 71bps (4.76% to 4.05%). Not only do markets expect a rate cut at the September meeting, but the odds of a 50bps cut now exceed those of a 25bps rate cut.

 

 

 

 

 

 

 

 

Recent volatility has not been confined to the equity market. High-yield credit spreads reached their lowest levels of the year on July 24, rocketed 91bps higher by August 5, and then fell by 44bps to end the week at 3.49%.

 

 

 

 

 

 

 

 

 

3) Why Aren’t Mortgage Rates Lower?

On the topic of interest rates, an anticipated bright spot of falling rates is falling mortgage rates. However, a falling 10-year Treasury rate is only one part of the equation. The other is the rate above the 10-year (or spread) that lenders can offer consumers due to mortgage-backed security (MBS) demand. Historically, that spread has averaged around ~175bps, far lower than the 300bps+ levels we are at now. 

Why is the spread higher?

• One thing to point to is the elevated duration risk of holding MBS now. The duration of an MBS is not fixed because mortgage bonds have prepayment risk (people move or refinance as rates fall). In a normal environment, the duration of a basket of mortgages tends to be around seven years. As mortgage rates have increased, duration has meaningfully increased (people aren’t moving or refinancing), and thus, the amount investors want to be paid to take on that duration risk has increased.
• The other factor to point to is demand. There has been a notable change in demand for MBS as the Fed went from buying up MBS during its quantitative easing policy to letting its positions run off of its balance sheet.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

This means it will likely take more than just falling interest rates for consumers to experience mortgage rates back down around the levels just before the pandemic.  

4) Airbnb Points to Consumer Weakness

As highlighted in this Financial Times article, Airbnb shares declined after it released its most recent earnings results, in which it warned that cautious US consumers would weigh on sales.

• The peak summer season will be marked by a “moderation” in the number of nights and experiences booked compared to the latest quarter, with “some signs of slowing demand from US guests,” Airbnb said.

This is just the latest example of a challenging earnings season for many consumer discretionary companies. So far in Q3, there has been a meaningful performance deviation between discretionary and staples companies.

 

 

 

 

 

 

 

 

 

 

5) US Infrastructure Project Delays

This Financial Times article highlighted challenges around US infrastructure projects. The Inflation Reduction Act (IRA) and Chips and Science Act offered more than $400bn in tax credits, loans and grants to spark the development of a US cleantech and semiconductor supply chain.

The reporters tracked 144 large projects (those worth >$100mn) with a total value of $227.9bn. Of these projects, $84bn worth has been delayed. Some of the cited reasons for delay include:

• Supply Chain Issues: While the IRA’s tax credits extend until 2032 and the Chips Act awards generous funds to selected applicants, companies often cannot receive funding until they achieve certain production milestones. “Everybody’s running into higher-than-expected costs just because of labor and supply chain,” said Craig MacFarland, mayor of Casa Grande, Arizona.
• China overproduction: China dominates the production of clean technologies, manufacturing more than three-quarters of the world’s solar panels. Solar panel manufacturers have delayed their US factories in the past year following a collapse in global pricing driven by overproduction in Beijing. 
• Macro pressures: Slowing US demand for electric vehicles has also set back manufacturing plans.
• Policy uncertainty: Lack of clarity on IRA rules have left a number of projects at a standstill. Nel Hydrogen, an electrolyzer manufacturer, has paused its $400mn factory project in Michigan due to uncertainty over tax credit rules for hydrogen.