A Slimming Economy

We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights into recent developments in equity and bond markets, the health of the economy, Fed policy, opportunities in fixed income, and the implications of the growing popularity of weight-loss drugs.

Market Performance: Total Return

Let’s start with markets. Equities were positive with large-cap growth enjoying another solid month. How are things looking as we move into the summer?

May was a strong month for risk assets. Economic data is showing signs of slowing growth, which provides more room for the Federal Reserve to cut rates. That was really the theme in May. The S&P 500 Index rose about 5% last month, while the Russell 1000 Growth Index was up about 6%. For the year-to-date ending in May, the S&P increased by more than 11%, and the Russell 1000 Growth was up about 13%. The S&P 500 Equal Weight Index is up about 5.5% for the year. We had decent returns, but the Russell 1000 Growth has lagged.

On the fixed-income side, we did have a little bit of rate relief. The Bloomberg Aggregate Bond Index (the Agg) was up about 1.7% for May but is still down for the year. The standout for the month was investment-grade corporates, with the Bloomberg US Corporate Bond Index up about 1.9% in May. But the standout for the year continues to be floating-rate loans, with the Credit Suisse Leveraged Loan Index up more than 4% year-to-date.

As you indicated, Treasury yields fell across intermediate and long maturities last month. Have investors come to terms with the inflation outlook?

I think they’re coming to terms with it. Yields on the 10-year Treasury eased a bit to end the month at about 4.5%. When we look back over the past two to three years, the yield has remained bound between the low 3% to high 4% range. It will be interesting to see which way it breaks. Most investors are expecting that it breaks to the lower side, especially if we have an economic slowdown, but right now, bonds are range bound on the higher end.

When we look at sector performance of the S&P 500, technology was the best performing sector in May, up 10%. The average year-to-date return for the Magnificent 7 is 25%, whereas the other 493 companies in the index returned just above 5%. Nvidia was miles ahead even among the Mag 7, with more than a 120% return year-to-date, whereas Tesla is the only company that’s actually negative for the Mag 7 year-to-date. Nvidia’s market cap hit $2.69 trillion at the end of May–that was more than four times the market cap of Walmart.

Impressive. That market cap is significantly larger than the entire broadly syndicated loan market, and even the high-yield market. That is a powerhouse company that is the darling of the market right now.

10-Year Treasury Yields

Concentrated Performance

What's the current data telling us about the economy?

I think we’re starting to see signs of a slowdown. The Atlanta Fed’s GDPNow growth estimate for the second quarter is now down from above 3% in May. We are talking before the May jobs data is released, but the April numbers indicated a normalizing jobs market. To me, the jobs picture is getting to be very important because as inflation comes down and as GDP growth gets revised lower, the jobs picture is what’s going to give the Fed the final confirmation to really move forward with a cut.

Looking at consumer spending, and this is according to the Bank of America daily credit card spend, for the bulk of May, online retail spending was up 3% year-over-year, and transit was up 7%. Those are the positive categories for May. To me, transit is not a discretionary item; that’s something you need to do, especially if you’re working. Conversely, home improvement, furniture, department stores, and clothing were all down last month versus a year ago. Those are more discretionary items: things consumers don’t have to purchase right away. All those trends point to a weaker consumer. Right now, the economy is fine, but the numbers are showing that things have been softening.

GDP, Inflation, Jobs, and Consumer Spend

Now, given that weak data, let’s talk about the Federal Reserve. What’s their next step in regard to interest rates?

I think the next step is to signal for more data. The most recent batch of data has shown signs that things are slowing. Going back to February, we were expecting quite a few cuts then, and every month since we saw the expectation for Fed cuts get pushed out. For the first time this year, we’ve seen expectations for a Fed cut get pushed in. Essentially rates are expected to be lower going forward than they were a month ago. If the Fed doesn’t cut this year, that would be a big surprise. Expectations now are split on one or two cuts, most likely in the fourth quarter. I think the market is waiting to see if more data will confirm a Fed cut in the fourth quarter.

Rick Rieder, the chief investment officer and co-head of global fixed income for Blackrock, has proposed the idea that the Fed actually needs to cut rates in order to bring down inflation. You think that holds water?

It's an interesting theory. Conventional wisdom is higher rates should lead to less economic activity because the cost of financing is higher. Here’s the counterargument: Assuming the economy has a substantially high number of savers, and they are hitting their savings goals with higher rates, they might be inclined to spend more and thus contribute to inflation. Given the amount of savers that have been sitting on large amounts of cash, getting paid 5% a year—a much higher yield than a few years ago—they may be using some of that interest income on spending. There’s probably something to Rieder’s conjecture, but the attribution would be difficult.

Recently, the Bank of Canada and the European Central Bank have cut rates. The Bank of England is signaling the possibility of rate cuts in the next few months. Do you think the Fed will be the last developed-market central bank to cut rates?

I kind of hope they are. The way I view it, we are the strongest economy of the developed markets. So, I’m fine with that if they are. Let the others cut. I view that as a signal of strength for the U.S. economy.

Fed Futures: Accelerating Timing of Rate Cuts

Let’s shift gears and talk about the Type 2 diabetes medications that have become very popular for weight loss. To start things off, what is a GLP-1 drug, and how did it come to be used for weight loss?

First, as we address this, we want to focus on the economic implications, not who should take the medication. Keeping the discussion at a high level, a GLP-1 medication helps regulate blood sugar and weight management. Thus, this class of drug seems to be impacting the health of millions of Americans and is probably the biggest blockbuster drug of the decade.

From June of 2021, when the FDA approved Wegovy for chronic weight management, stock of Eli Lilly and Novo Nordisk—which are the leading producers of GLP-1 drugs—have skyrocketed. Eli Lilly has delivered nearly a 700% return since June 2021, whereas traditional weight-loss companies Medifast and WW International (Weight Watchers) have delivered negative returns over that time. Could you discuss the trend in prescriptions?

The latest data we have, which is as of October, indicated there’s about five million prescriptions, a 56% increase in under two years. I think the number now is substantially higher, given so many Americans struggle with their weight. The foundation of this is better health, but the game-changing element plays into American vanity. These drugs are helping people get healthier, look better, and feel better. The economic ramifications are the stocks of these drug producers are up substantially and prescriptions are up substantially.

Drug Companies are Winning the Weight Loss War

What is the impact of more and more people taking this type of drug?

Those covered by insurance—usually for treatment of pre-diabetes or Type 2 diabetes—are paying about $300 to $400 a month, which is not cheap. However, for those not covered by insurance, which generally means they are taking the drug for weight loss, are paying around $1,000 a month. That is a lot of money to spend on a single medicine. I recall hearing on a podcast a guestimate that if Medicare approved covering these drugs, it could take up the entire prescription budget for all of Medicare.

Popular Weight Loss Drugs Costs for Consumers

GLP-1 U.S. Drug Prescriptions Have Increased 56% in the Year Ending September, Driven by Ozempic, Mounjaro and Wegovy

Now what about the day-to-day? How is this playing out?

Morgan Stanley surveyed 300 people taking one of these drugs, asking about their lifestyle choices. About 30% of participants said they are spending less on groceries, with 23% saying they are spending more, so not a big net change. However, more than 60% of participants said they are spending less on getting food delivery or dining out, and only 8% or 9% said they are spending more. That is a substantial cut in spending in these areas.

Morgan Stanley estimated that by 2035 there would be a decline in consumption of foods heavy in carbs and fats, with the top five being ice cream, cakes/pastries, cookies, candy, and chocolate. I found it interesting, assuming the medication is an appetite suppressant, that I did not see proteins on the decline list or even breads, which are a staple in many diets. The most substantial reduction in consumption are for items we know are not good for our health. The main takeaways: These drugs are heavily highlighted right now, so any little misstep or side story is going to get publicized, but the data is telling us Americans are losing weight, they’re changing behaviors, and they’re cutting out really bad things. The data suggests their health should be improving.

Shift in Spending and Snacking Trends

Given all these shifts in spending, is this good or bad from a GDP standpoint?

The quick and dirty answer is yes, it’s good for GDP. Goldman Sachs researched the GDP implications with some interesting findings. Obesity-related health issues subtract roughly 3% from per capita output, via both missed workdays and lost productivity. Workers who feel better and have more energy tend to be more productive and also tend to spend more. Thus, there is a potential net positive boost to GDP, even though people taking these drugs are likely to consume less food. This is in addition to paying for the expensive medication. Goldman looked at three scenarios for users by 2028: 15 million, 30 million, and 60 million, with 30 million their baseline prediction. In that baseline scenario, they forecast a 0.4% increase in GDP. I think the 30 million prediction is realistic; it would not surprise me if 8% of 10% of our population eventually takes this medication. Considering U.S. GDP is increasing at about 3%, and as I indicated earlier, may decline closer to 2%, than a boost of close to half a percentage point is significant.

Weight Goes Down, GDP Goes Up

Now let’s talk bonds. Where do you see opportunities in fixed income today?

Yields remain compelling—in the 5%-plus range—for the investment-grade market, as tracked by the Agg. Investment-grade bonds and bank loans remain attractive. I have mentioned the appeal of a barbell strategy in the past, combining fixed-rate bonds a little bit longer on the curve with floating-rate loans, which we’ve been constructive on for quite some time. Bank loans continue to yield double digits, and are up 4% for the year through May, as measured by the Credit Suisse Leveraged Loan Index. Of course, past performance is no guarantee of future performance, but if that math continues investors would enjoy a healthy return on those loans. With the economy slowing down and tight monetary policy seeming to finally impact growth, on the barbell side I think duration is more attractive than it was. Last month I was not quite ready to put on a full duration call, but as we sit today, I am much closer to putting on the duration call, but floating-rate loans are still attractive.

Let’s move to the lightning round. Bitcoin versus gold.

Still Bitcoin; it’s a couple percentage points below the all-time high.

Ethereum, ETF approval.

That could be a pig in the python. Ethereum is still a bit off its all-time high, but again, that’s just the emergence of crypto as an asset class. 2024 will be the year that crypto emerged as an asset class due to ETFs. It will be fascinating to see the market cap over the next several years in those two cryptos.

Is the inverted yield curve recession indicator dead?

It’s not dead, but it’s different this time. What is different this time to me is we had legitimate inflation. Think about the past 30 years: We had some asset-price inflation, but we didn’t have strong labor or cost of goods inflation, and the economy was performing well. In this particular case, the inverted curve has shown itself to be more of a stagflation fighter, plus, we printed trillions of dollars the years before. The indicator is not dead. The context matters.

Peloton.

Well, I was not a Peloton guy. I thought you had to pay a ton for the bike and the subscription. The way I see it now, I just have to take a pill. Its stock has taken a big hit, trading at around $3 a share.

Scarlett Johansson’s voice.

This one to me is very interesting, and this has to do with ChatGPT’s release. One of the voices they wanted was Scarlett Johansson. She played a character in the movie “Her,” and they had asked her if she was willing to allow them to use her voice. She said no. So instead, they came out with another voice that was extremely similar to her voice—to the point where she claimed her friends were telling her congrats on the contract. They reached out to her, and apparently there were texts from Sam Altman, or tweets from Altman, that alluded to the fact that they were going down the route of using her voice. She has since sued OpenAI. This has to do with protection of someone’s likeness. It will be fascinating to see how this plays out; with the emergence of AI, how close to a particular brand or person can one legally be without asking for copyright permission.

NCAA allowing player payments.

The capitalist in me says good. The sports fan in me says this is exhausting, and it takes away a lot of that special something about being a student-athlete. Colleges now own sports teams–that’s how I view it. The questions before these colleges are: How will they choose to pay their staff, and will students become employees?

Summer travel.

We are headed to Iceland in July. Can’t wait. It’s going to be a big group. Summer there means 21 hours of daylight and temperatures in the 50s, so yay. Look forward to it though.

Northern lights too, right?

I’m sure they’ll be going on. It’s just three hours of darkness, which reduces our odds substantially.

Let’s close with a personal reflection.

My son, who is about to graduate college, just started an internship. He is in another city, and he’s expected to work quite heavily. The advice we gave him was conduct yourself for the job you want. Meaning don’t leave when the other interns leave. Leave when the first years leave. Come in when the first years come in. Leave them with the impression that you can do the job. Don’t act like an intern; act like a first year. Don’t just focus on what you are doing today, also focus on where you want to go.

Definitions

The 10-year Treasury note is a debt obligation issued by the U.S. government with a maturity of 10 years upon initial issuance.

The Atlanta Fed GDPNow is a running estimate of real GDP growth based on available economic data for the current measured quarter.

Bank loans (or floating-rate loans) are financial instruments that pay a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest-rate level.

The barbell is an investment strategy often used in fixed-income portfolios, with the portfolio split between long-term bonds and short-term bonds.

The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, invest-ment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.

The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. senior secure-credit (leveraged-loan) market.

Duration can measure how long it takes, in years, for an investor to be repaid a bond’s price by the bond’s total cash flows. Duration can also measure the sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates.

Gross Domestic Product (GDP) is the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period.

High-yield bonds (or junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds.

An inverted yield curve represents a situation in which long-term debt instruments have lower yields than
short-term debt instruments of the same credit quality.

Investment grade refers to the quality of a company’s credit. To be considered an investment grade issue, the company must be rated at ‘BBB’ or higher by Standard and Poor’s or Moody’s.

The Magnificent 7 stocks are a group of high-performing and influential companies in the U.S. stock market: Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla.

Market capitalization shows how much a company is worth as determined by the total market value of all outstanding shares.

Monetary policy is a set of actions to control a nation's overall money supply and achieve economic growth.

The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-value ratios and higher forecasted growth values.

The S&P 500 Index is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.

The S&P 500 Equal Weight Index is the equal-weight version of the widely used S&P 500 Index, which is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.

Stagflation is an economic condition that combines slow growth and relatively high unemployment with rising prices, or inflation.

The U.S. Treasury yield curve refers to a line chart that depicts the yields of short-term Treasury bills compared to the yields of long-term Treasury notes and bonds.

Yield is the income returned on an investment, such as the interest received from holding a security.

Any performance data quoted represent past performance, which does not guarantee future results. Index performance is not indicative of any fund's performance. Indexes are unmanaged and it is not possible to invest directly in an index. For current standardized performance of the funds, please visit www.AristotleFunds.com.

The views expressed are as of the publication date and are presented for informational purposes only. These views should not be considered as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment or market. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.

A full list of each fund's holdings can be found at www.aristotlefunds.com/resources/prospectuses-reports and are subject to risk and to change at anytime. Any discussion of individual companies in this presentation is not intended as a recommendation to buy, hold, or sell securities issued by those companies.

Investors should consider a fund’s investment goal, risks, charges, and expenses carefully before investing. The prospectuses contain this and other information about the funds and can be obtained by visiting AristotleFunds.com. The prospectuses and/or summary prospectuses should be read carefully before investing.

Investing involves risk. Principal loss is possible.

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