Weekly Market Commentary – October 23, 2023

Economic Data Watch and Market Outlook

Global equity markets declined roughly 2% for the week while US bonds dropped over 1%. The S&P 500 is up over 11.5% on a year-to-date basis but is negative if you remove the seven drivers of performance notably called the “Magnificent Seven”.

Factored into the broad market (Russell 3000) stocks crossed into negative territory this week YTD.

With the rise of the ten-year Treasury and the decline in the S&P Earnings yield, there has been noticeable deterioration in the equity risk premium on a year-to-date basis.

US retail sales in September exceeded expectations, rising by 0.7% after an upwardly revised 0.8% gain in August. Excluding gasoline, sales also advanced by 0.7%. Control group sales, used to calculate GDP and excluding certain categories, increased by a better-than-expected 0.6% in September. In the three months ending in September, control group sales rose at an annualized rate of 6.4%, the largest end-of-quarter advance since June 2022, indicating robust consumer demand. Despite persistent inflation, strong consumer spending and a generally solid labor market are bolstering expectations of stronger economic growth in the third quarter, raising the possibility of further Federal Reserve interest rate hikes.

The consumer continues to be pressured in other areas as this week the 30-year mortgage hit its highest point, 8%, since June of 2000.

This week the Philadelphia Fed release its survey with participants indicating that they still intend to raise prices in the future. Chairman Powell indicated in a speech in New York City on October 19th that continued strength in the economy “May merit hiking.”

Equities

Monday was a brief moment of positivity as the S&P 500 posted the 15th straight Monday of gains but ultimately all major indices closed the week in the red. Rising rates and oil prices impacted the remainder of the week despite better-than-expected economic data supporting a soft landing for the US economy. Rising long-term bond yields rose to a 16-year high which weighed on sentiment and drove the S&P 500 to its biggest weekly decline in a month. Market participants moved to safety assets as gold rose to a three-month high. Stocks fell sharply Thursday following reports that a US Navy destroyer shot down a cruise missile headed towards Israel. Reports of a drone attack on a US base in Iraq also weighed on sentiment.

In the US, equities slid lower this week as rates rose. The S&P 500 closed Friday down a fourth consecutive day and the Nasdaq closed the week negative for a second straight week. During the week the Dow Jones Industrial Average fell (-1.6%), the S&P 500 fell (-2.4%), and the Nasdaq fell (-3.2%). Small caps were also negative as the Russell 2000 Index fell (-2.3%). Crude oil pushed back up to $90 a barrel as tensions grew in the Middle East during the period. Oil helped lift the energy sector to be one of the few sectors to post gains during the week (consumer staples being the other). REITs, consumer discretionary, financials, materials, and industrials were all laggards on the week. From a style standpoint, growth lagged value amongst both small caps and large caps as the Russell 1000 Growth Index fell (-2.9%) while the Russell 1000 Value Index dropped (-1.8%) and the Russell 2000 Growth Index fell (-2.4%) and the Russell 2000 Value Index fell (-2.1%).

Globally equities were negative as the MSCI World Index fell (-2.5%). Emerging markets lagged developed markets slightly but both in the red as the MSCI Emerging Market Index fell (-2.7%) while the MSCI EAFE Index, which tracks 21 developed markets globally, excluding the US and Canada, fell (-2.6%). European stocks fell as the Euro STOXX 600 fell (-3.4%) as uncertainty about interest rates and fears that the Middle East conflict could escalate. All major continental stock indices closed negative as Italy’s FTSE MIB fell (-3.1%), Germany’s Dax was down (-2.6%), France’s CAC 40 Index dropped (-2.7%), and the UK FTSE 100 Index declined (-2.6%). In Asia, Japan’s stock market was also negative as the Nikkei 225 Index fell

(-3.3%) and the TOPIX Index declined (-2.3%). These returns also follow a slight sign of inflationary pressure easing in the region. Chinese equities fell sharply as the property sector woes continue to hurt optimism about better-than-expected Gross Domestic Product. The Shanghai Composite Index fell (-3.4%) while the CSI 300 dropped (-4.2%) and Hang Seng Index declined (-3.6%).

Fixed Income

The 10-year Treasury yield reached levels not seen since 2007 this week, almost touching 5% on Thursday. The 10-year has risen 1.20% since July as investors have priced in higher for longer. Strong economic data in the labor market, retail sales, and other areas have pushed inflation expectations higher and influenced the Fed to harden their stance on where rates will go from here. Ultimately, rates finished the week higher with the 2-year Treasury yield closing the week up 3 bps, the 10-year Treasury yield finishing up 3 bps, and the 30-year Treasury yield climbing 31 bps. Major bond indices saw losses for the week with the Bloomberg US Aggregate Bond Index falling -1.73%, the Bloomberg US Corporate High Yield Index falling -1.17% and the Bloomberg US MBS Index falling -2.23%.

Overseas on Friday a European junk bond fear gauge hit its highest level since March in response to higher for longer rate bets and geopolitical strife. The iTraxx Crossover index, which tracks credit default swap credit risk, climbed to 475.5 basis points to end the week. Meanwhile the Bank of Japan released upgraded economic assessments for 6 of 9 regions, the most since 2022 according to its quarterly report released Thursday. Assessments that did not see increases were left unchanged. The move signals that confidence related to local economies in Japan is increasing.

US corporate debt markets are showing signs of a weakening landscape as we reach the back half of October. Spreads on investment grade bonds have climbed to their highest levels since June, while junk bond market yields have hit their highest level this year, in turn creating a challenging landscape for companies looking to offload debt. Combined with the looming wall of refinances that will be required in the next 18-36 months. There is nowhere to hide in October as the selloff in Treasuries has permeated all corners of credit markets. Long term investors that can stomach the volatility view this as an entrance opportunity with the possibility to lock in attractive yields for the long term.

Hedge Funds as of Thursday, October 19th

After the challenged performance last week, hedge funds (HFs) were able to limit losses to only a fraction of their respective indices’ downsides. The average global fund was only down ~25% of the index at -36 bps WTD vs. -1.4% for the MSCI World Index. Not surprising, equity long/short (L/S) funds fared slightly worse, with US-based equity L/S funds down 44 bps (vs. S&P 500 -1.1%) and Europe-based L/S funds down 65 bps (vs. Euro STOXX 600 -2.1%). Asia-based L/S funds captured the largest portion of their regional index’s downside with the average fund down 1.2% (vs. MSCI Asia -2.2%).

HFs flipped to being large net sellers of global equities this week as each region was net sold in sizable amounts. By region, Asia ex-Japan (AxJ) saw the largest net selling which coincided with the regional index being down the most compared to the other regions. This week ranked as the 4th largest week of net selling of AxJ equities over the past year with the bulk of the selling coming from short additions. The selling was particularly heavy in consumer staples (largest week of AxJ staples selling in 12 months), financials, and communications services. Japan and Europe were also net sold as shorts additions outweighed long buying in both regions. Contrary to AxJ, Japanese communications services and financials were net bought, though HFs were similarly net sellers of Japanese consumer staples. Europe saw most of the net selling within healthcare, whereas flows to other sectors were more muted. In North America (NA), HFs were relatively larger net sellers with the entirety of the selling coming via the short side. US L/S short leverage climbed back to the highest level seen since 2010 resulting in net exposure continuing to fall. At the sector level, the bulk of activity was seen across cyclical sectors though net flows were either flat or negative for each single-name sector over the week. NA funds were able to limit their downside this week as some of the names that hold elevated positioning on the short side were sold off in the market. The bulk of short exposure sits in consumer cyclical names across consumer discretionary, which was one of the worst performing sectors on the week. Crowded shorts were down ~3% resulting in positive short alpha of ~1.8% over the week. Industrials were net sold last week followed by energy, despite the outperformance of the sector. Real estate was the most net sold sector, and similarly had the worst performance. Looking at the index level, HF flows to ETFs moved inversely to single-names as they were net bought over the week. Tech saw large net selling and was net sold in every region despite CTAs showing a bias towards the Nasdaq over the Russell 2000.

Private Equity

In the third quarter of this year, the private equity (PE) industry experienced a disappointment as the anticipated rebound in PE exits did not materialize, marking one of the lowest exit volumes since the Global Financial Crisis. According to data from PitchBook’s US PE Breakdown, the value of PE exits in Q3 plummeted by 40.7% from the previous quarter, totaling just $44.1 billion. This decline dashed hopes for a sustained recovery in PE liquidity, following a short-lived boost in exit value during Q2.

This downturn in exit value reached its lowest point since 2008, except for the lockdown-related slump of Q2 2020. Additionally, new PE dealmaking decreased, with an exit-to-investment ratio of 0.37x by the end of Q3, indicating nearly three PE acquisitions for every exit. This is a significant drop from the 0.48x ratio observed in 2021 when firms were making only two acquisitions for every exit.

The report highlights the contrast between the higher deal value and the reduced deal count in PE exits to corporate and strategic buyers, shedding light on which types of buyers remain active. In Q3, corporations acquired the fewest PE-backed companies on record, even though strategic sales continued to be the most common exit route for such companies. The median deal value surged to $414 million, up from the 2021 record of $297 million, largely due to buyers’ substantial cash reserves and bond issuance.

Notably, deals like Thales Group’s acquisition of Thoma Bravo’s Imperva for $3.6 billion in July and Campbell Soup’s purchase of Sovos Brands from Advent International for approximately $2.7 billion in August contributed to this historically high median exit value for strategics.

Looking ahead, the outlook for exit activity in the remainder of 2023 is uncertain, with recent events such as the lackluster IPO of L Catterton-backed Birkenstock on October 11 raising concerns about the IPO market’s viability. In Europe, Triton-backed Renk, a German automotive transmission manufacturer, postponed its public offering, and Bain Capital delayed an IPO for airline Virgin Australia until 2024. Despite these challenges, 19 PE-backed companies had filed S-1s with the SEC or expressed interest in going public by the end of Q3.

If exit volume doesn’t see a significant uptick soon, the PE industry could face a maturity wall, with a growing pile of assets that could impact fund performance and disappoint limited partners (LPs).

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.