We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights into the rally in bonds, holiday shopping trends, the Federal Reserve’s next move, and opportunities in fixed income. We finished up with a speed round of questions and a personal reflection.

Market Performance: November 2023

Let’s start with market performance. What happened in November?  

November was a great month for assets in general. Equities were up across the board—mostly between 9 and 10%—led again by the Russell 1000 Growth Index. The tech-heavy index was up 10% in November and is up 36% for the year. The S&P 500 Index crossed 20% for the year.

When you look at the fixed-income side, the Bloomberg US Aggregate Bond Index (Agg) was buoyed by rates dropping. Credit performed in line. You’re seeing that, in general, risk assets are having a good year, which is not what the market expected going into 2023. In November, the Russell 2000 indices flipped into positive territory, as did the Agg.

Magnificent 7: Concentrated Performance and Weight Within S&P 500 Index May Be A Cause For Pause

Can you shed light on how narrow the equity rally has been?  

As I mentioned, the S&P 500 is up over 20% for the year. But the Magnificent 7—the largest tech companies—are responsible for 71% of that performance. Obviously, that calls into question how healthy the broad market is. Related to this, the Magnificent 7 accounts for more than 25% of the S&P 500 Index weight. A bearish investor would say that concentration should give cause for a pause, while a bullish investor would state the rest of the market is undervalued.

U.S. Treasury yields have fallen in the past month, with the 5- and 10-year maturities leading the way. Do you think the markets have given an all-clear signal with regards to no additional Fed hikes?

As it relates to Fed hikes, yes. If the Fed raised, it would be a negative surprise markets. The market is now focused on Fed cuts.

The Agg had a great month in November, up more than 4%. Do you think the rally will continue in December?

On a positive note, I think seasonality is in its favor. Folks are coming into the bond market with rates going to what I think is a more appropriate level. However, bond markets are also adjusting to a slowing economy and a less hawkish Fed. Risk assets have rallied, and I think they will continue  to rally. But make no mistake, the narrative can  change quickly.

When you think about fixed-income markets in 2023, what three words come to mind?

“Surprising” is the first word that comes to mind; most folks thought rates would be lower, but they’re higher. “Interesting” is the second word because of yield levels. The third word would be “rewarding” because returns have been strong, particularly in certain areas of credit.

Do you see economic growth slowing in the fourth quarter and 2024?

The short answer is yes, which is why we’re seeing markets adjust with lower rates and expectations of Fed cuts next year. As a data point, GDPNow is forecasting the fourth quarter at 1.3%, which is substantially lower than the 5.2% print we saw  
in Q3.

Thanksgiving Weekend In-Store and Online Shoppers per Day

How is the holiday season looking?

Let’s look at the Black Friday weekend—and this data is from the National Retail Federation. Overall, spending was up about 2% over last year, propelled by a record 200 million shoppers. In-store purchases were down slightly, and online shopping was up. Overall, compared to last year, there were four million more online shoppers and 1 million less  in stores.

For online shopping, 44 million people did it from their desktop computers and 40 million did it from their phones.

When you look at what they purchased, clothing still is on top of the list—about half of the shoppers purchased clothing. And for the first time, personal care and beauty cracked the top five categories. It displaced video games, food and candy, and electronics from previous years.

Year-Over-Year Change in Store Traffic on a Weekly Basis

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Black Friday Top 5 YOY % Traffic Growers

Black Friday Biggest 5 YOY % Traffic Decliners

How are department stores faring?

There is consistent weakness in in-store shopping. That means in-store retailers need to offer discounts, and they did on Black Friday—from 15 to 20% for the most part. But strong brands, such as those in the athletic leisure section (Lululemon, Athleta, Alo Yoga, etc.), offered minimal to no discounts. You’re seeing a clear trend in who needs support from the consumer and who doesn’t.

Implied Fed Funds Rate

Let’s shift to the Federal Reserve. Do you see the Fed raising rates later this month?

I do not. Let’s assume rate hikes are over.

How much do you think the third quarter economic growth of 5.2% will affect the Fed’s rate decision?  

I think they’re past the 5.2% number and are focused on the 1% economic growth this quarter and 2024.

Do you see the Fed in practice or in rhetoric coming off its 2% inflation target?

I see them giving themselves more optionality, which they can do with slight changes in wording, allowing inflation to remain above 2%, yet easing conditions.

What’s the current base case for rate cuts in 2024?

Expectations are for 150 basis points in cuts over the next 14 months with the first cut around the second quarter and additional cuts over the next three quarters. I think that’s very accommodative and markets may be getting overzealous with those thoughts.

Now if the economy has a hard landing, the cuts will be greater. If it’s a soft landing, it’s going to be lighter than 150 basis points. Right now, forecasts are for a smooth glide path.

Why has the market been more optimistic about the possibility of rate cuts than the Fed?

The market is seeing the data. Inflation is rolling over. GDP is coming down from a 5 to a 1% print. And the final leg to me in the decision-making is the jobs data. As you see jobs data weakening, I think the market will question the Fed’s position.

That, to me, is why I believe the market’s a bit ahead of the Fed, which has been stubborn in whatever views they have had: stubborn to hike and then stubborn to stop hiking or cut.

Percent Change in Sales From a Year Ago by Price Range

Let’s talk housing. Home sales are slumping, and mortgage rates and prices remain high. What are your thoughts on the housing sector?

First of all, transactions are down substantially, and they’re down across housing price points and across regions. This is something that isn’t targeted. This is thematic across the country.

Affordability

With transactions down, is the average homeowner putting more money on his or her current home?

Not really. During the pandemic, people were spending a ton of time in their homes, so there was a large increase in home-improvement purchases. Now, I think homeowners have a desire to move up or, in the case of first-time buyers, simply move into a home of their own, so the spending on current dwelling is being muted. As soon as things open up, I think you’re going to see a flood of houses come on the market as the conditions for mobility improve.

How do you see things unfolding in 2024?

In general, what forecasts are expecting is prices will be flat, incomes will increase, and rates will go down.

10-Year Treasury

Let’s talk about bonds. Where do you see opportunities in fixed income today?

In general, I’ve been constructive across fixed income for some time. We’ve had a pretty big move in the 10-year Treasury rate. In November, it was down 50 basis points, and that rally has continued so far in December, down 20 basis points or so. Looking at investment grade, year-to-date returns are 4 to 5% and are probably going to be a little higher assuming rates continue to drop in December. Yields have also fallen a bit lower. So, on the margin, investment grade to me is now slightly less attractive because you’ve had a pretty big rally. Meanwhile, high yield and floating-rate loans are slightly more attractive.

Attractive Yields

Where do you go in defense of that?

Bank loans. They were up a percent in November, but that’s underperformance relative to other areas. Year-to-date returns are more than 11%. We’ve been extremely constructive on bank loans for over a year. It’s an underappreciated asset class that’s still yielding 10%. On the margin, loans are more attractive to me now than they were last month given the drop in longer-term rates. High yield keeps clipping away. Balancing between the two, you’re just pairing a little bit of your gains from this rate rally and then putting into a rate-defensive instrument. Remember, the return of the S&P 500 Index outside of the Magnificent 7 has been about 6% this year, and a lot of fixed income is up more than that. Fair enough. All right, let’s shift gears and move to the lightning round.

Let’s start with the passing of Charlie Munger, vice chairman of Berkshire Hathaway.

He was a very wise man. A legend. I love his simple advice on living a good life: “You don’t have a lot of envy. You don’t have a lot of resentment. You don’t overspend your income. You stay cheerful in spite of your troubles. You deal with reliable people. And you do what you’re supposed to do. All these simple rules work so well to make your life better.”

A ride-hailing or driverless trip?

Several folks on our team have ridden in Waymo driverless cars in Phoenix, and they all gave the experience rave reviews.

The death of Henry Kissinger.

One of the greatest diplomats in U.S. history. He tackled some big-boy problems. We’ll see how history ultimately views him. I think he did a lot of great things and had to make many difficult decisions.

OpenAI.

That one’s been fascinating. On one hand, you have a nonprofit governed by a board whose mission is to ensure the technology is for the benefit of humanity. But you also Q* (Q-Star), the secretive OpenAI initiative. It all shows how fast AI is moving and how powerful it is. It’s going to be a fascinating story to watch over the next year or two.

Formula 1 in Las Vegas.

I had a chance to view the race in person. I’m not a big Formula 1 guy, but I would be very curious to see it in Europe. In my view, in most of the Formula 1 venues, the race belongs to the city. In Las Vegas, I think the race belonged to the casinos. It didn’t sit well with me. If you didn’t pay what the casinos wanted you to, they didn't want you watching the race.

The College Football Playoff?

Michigan.

Favorite holiday movie.

“National Lampoon’s Christmas Vacation.”

Favorite holiday tradition.

Cinnamon rolls in the morning.

All right, we’re coming up on New Year’s, and I know you’re big on New Year’s resolutions. How’d you do in 2023?

Not well at all. I did about 10% of what I wanted to do, so I’m kicking those resolutions out to 2024.

Let’s close with personal reflection.

One of my favorite sayings is: “Time is undefeated.” In our life, we have to play against it, and will always lose to it. So, while we play, play hard, play happy, and play with teammates you love.

This information is presented for informational purposes only. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole investment making decision. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are based on current market conditions and are subject to change without notice.