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A Sticky Situation

With persistent inflation, is a Fed hike on the table?

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We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights on recent developments in equity and bond markets, the health of the economy, the Fed's battle against sticky inflation, and opportunities in fixed income.

Let's start with markets. Equities fell across the board in April. What happened?

Let's review performance first. The S&P 500 was down 4% for the month, still up 6% year to date. The equal weighted index is underperforming the S&P, declining almost 5% in April and up just 2.7% for the year. The Russell 1000 Growth continues to lead the way, down 4.2% for the month, but up 6.7% for the year. Equities were generally weak across the board. Typically, in markets where equities are weak, fixed income tends to hold on, but rates moved higher. The Bloomberg Aggregate Bond Index (“the Agg”) declined 2.5% in April with most fixed rate instruments posting negative returns. The standout performer, once again, was floating rate loans, which increased 68 basis points in April and is up 3% for the year. The culprit for poor performance centers around inflation remaining high. Hope has faded for the Federal Reserve cutting its policy rate multiple times this year, which has created pressure on both bonds and equities.

Market Performance
Past performance does not guarantee future results. Source: Morningstar as of 4/30/24. *Equal Weight Index. HY Corporates represented by Bloomberg US Corporate High Yield Index, Bank Loans represented by Credit Suisse Leveraged Loan Index, IG Corporates represented by Bloomberg US Corporate Index, U.S. Aggregate represented by Bloomberg US Aggregate Bond Index.

Could you elaborate on the rise in rates, including U.S. Treasury yields?

Annual inflation, as measured by the Consumer Price Index (CPI), was 3.5% in March (as we are talking the April data has not been released). At the beginning of the year, the 10-year Treasury yielded about 3.9%, and ended April at about 4.7%. The yield remains range bound in a low 3% to high 4% range. Looking at inflation, in June of 2023 the CPI on all items was around 3%. Year-over-year inflation in March was 3.5%, so technically, Y/Y CPI has risen over the past year. Core CPI was 4% in October, and dipped slightly to 3.8% in March. So, inflation has been sticky, and, as mentioned prior, is putting pressure on the bond market and the equity market.

10-Year Treasury
Past performance does not guarantee future results. Source: St. Louis FRED as of 4/30/24.

Shifting to the Magnificent 7, they are crushing the year thus far, returning 13.4% through the end of April, versus 6.04% for the S&P. However, there has been significant performance dispersion with Nvidia achieving stellar returns, while Apple and Tesla had negative returns. Any thoughts?

It’s good to keep an eye on the Mag 7, but not much new to say. These are companies with trillion-dollar market capitalizations and tons of cash.

Year-to-Date Return
Past performance does not guarantee future results. Source: FactSet 1/1/2024 - 4/30/2024, MAG 7 Companies Sorted By Average Weight *Weighted average return, 3.20% of the total return of 6.04%. A full list of each fund's holdings can be found at www.aristotlefunds.com/resources/prospectuses-reports and are subject 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.

Well, that's a good problem to have. I want to get your thoughts on the economy. What's the current data telling us?

In general, the economy is doing fine. Consensus is that real GDP is hovering around 2%. The Atlanta Fed’s GDPNow has been a little over 3%, but should normalize as we move along the quarter, and nonfarm payrolls have been fairly stable over the past 18 months.

Evolution of Atlanta Fed GDPNow real GDP Estimate for 2024: Q2 Quarterly Percent Change (SAAR)
Source: Blue Chip Economic Indicators and Blue Chip Financial Forecasts as of 5/2/24.

The real story is still inflation. Prior to COVID, CPI was running at about 1.5% to 2%. Today, as mentioned, it’s at 3.5%, and seems to be normalizing at that level. We have discussed this multiple times: With all the money that was printed during COVID, I believe the Fed should adjust for sustained inflation, which it has not indicated it would do. If CPI levels off at this higher rate, how does this play out?

12-Month Percentage Change, Consumer Price Index, Not Seasonally Adjusted
Source: U.S. Bureau of Labor Statistics as of 3/31/24.

When I look at the consumer spending side, lower-income consumers are weakening. According to the Bank of America daily credit card spend that we use for the bulk of April, total card spend was up fractionally in nominal terms. So GDP is growing at a higher rate than consumer spending. Online retail and transit increased, but clothing, department stores, furniture, and entertainment all decreased, with entertainment experiencing a double-digit decline. It feels as though the revenge travel, post-COVID mentality of let's go out and do what we want to do and see we want to see, has been dying off, which tells me the consumer is slowing. Other elements of economic activity are hanging in just fine.

Year-Over-Year Change in Spending
Source: BofA Securities and Aristotle Funds as of 4/27/24.

Let's discuss the Federal Reserve, which met on May 1st. How's the market positioning?

We entered the year with hopes of four Fed rate cuts, and now we will feel one is the hope this year. That decline in rate-cut expectations has been the driver of market volatility. On the flip side, the Fed communicated some information around quantitative tightening and adjustments to the balance sheet. I think the Fed is adjusting to liquidity conditions in the marketplace. Bottom line: The Fed is more hawkish on rates and inflation than at the beginning of the year.

Implied Fed Funds Rate and Number of Hikes/Cuts
Source: Bloomberg, as of 5/2/24.

Aside from causing higher interest rates, how is inflation affecting people?

Let’s look at fast food, where prices are up significantly since pre-COVID, and it’s the brands we know, making coffee, donuts, and hamburgers. Higher labor costs are a core reason. It’s worth keeping in mind that this is a core consumption element: Folks need to eat, and higher fast-food prices can disproportionately affect lower-income folks.

Menu Prices Have Outpaced National Inflation Rates at Every Fast Food Restaurant Since 2014
Source: Finance Buzz, “Is Fast Food Affordable Anymore? Here’s How Menu Prices Have Changed Over the Years 2024,” as of 5/1/24. Based on average cost for 10 different menu items per restaurant. Price data was gathered for the same 10 menu items over time.

Rents have eased off their peak, but they are still much higher than they were pre-COVID, around 30% higher. Consider also that mortgage rates are higher, and the median home price in this country is above $400,000. One needs a median income north of $100,000 to qualify for a home mortgage, with variance by geography, of course.

United States Median Rent (2017 to Present)
Source: Apartment List, as of 4/30/24.

Insurance costs also have been rising, such as to insure homes and vehicles. With food, shelter, and insurance costs higher these days, and all are necessities, there is clearly pressure on consumers. Further, I expect insurance costs to keep trending up, as our analysis suggests personal insurance companies are tending to lose money on current policies, instead making up for it on their investment portfolios.

Historic Divergence in Sector Underwriting Results
Source: S&P Global Market Intelligence -statutory financial data. Forecast from S&P Global Ratings. As of 1/31/24.

What are the investment implications of prolonged inflation?

We've certainly seen performance dispersion among types of equities. For example, the Russell 2000, which tends to include companies with more leverage, has underperformed the Russell 1000. Also, large tech companies don't tend to have a lot of debt; they're not relying on financing or leverage. Unlevered companies generally weather storms better than levered ones in these times.

More broadly, leverage exists throughout our economy, and when rates rise, the rising cost of leverage can restrict economic activity. We usually see this in long-dated investment projects, such as infrastructure builds. Not only do borrowing costs rise with rates, but the discount rate of future cash flows also increases, leading to higher present day cost and lower present day value for investments. Thus, higher rates should eventually lead to less investment, which begins a cycle of declining investment, declining economic activity, etc. I think the excess liquidity pumped into the system in response to COVID has delayed the slowdown.

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

We've been kind of pounding the table on the same message for a while now. Because of the uncertainty in long-term rates and inflation, fixed rate bonds have seen a tremendous amount of volatility. The Agg was down about 3% through the end of April, but is now yielding more than 5% on April 30. So once again, in general, fixed rate bonds have been suffering quite a bit, but the yield is more attractive. The defense against that uncertainty has been floating rate bank loans, and that has been the case for two years now. I am still constructive on that trade, with bank loans yielding above 10%, and as long as the curve is as inverted as it is on the short end.

Attractive Yields
Past performance does not guarantee future results. Source: Bloomberg and Credit Suisse, as of 4/30/2024. Yield quoted is yield-to-worst, except for Bank Loans which represents 4-year effective yield. US Treasury represented by the Bloomberg US Treasury Index. Investment-grade corporate bonds are represented by the Bloomberg US Corporate Index. Short term investment grade corporate bonds are the 1-3 year component of the Bloomberg US Credit Index. Bank loans are represented by the Credit Suisse Leveraged Loan Index and index components. High yield is represented by the Bloomberg US Corporate High Yield Index.

Now time for the lightning round. Bitcoin versus gold.

I'm still up with Bitcoin, though it dropped in April while gold had a good month.

Paramount takeover.

I haven’t been following it that closely. I understand there are two bidders, Skydance and a combined bid with Sony and Apollo. As I understand it, the Skydance bid is lower for nonvoting shareholders, but is better for the voting shareholders. The value of voting rights isn't very high until there's high need for voting rights. Will see how this plays out.

Llama versus ChatGPT.

This is something more recent, but I think it's a fascinating business case. ChatGPT was open source, and then closed it after it had a substantial lead on the other AI platforms. Mark Zuckerberg opened up Meta’s AI platform for open source, putting it in the hands of thousands and thousands of developers to improve the platform. I believe Llama has probably not only narrowed the gap but may now be on par with ChatGPT.

I think if you go into Facebook or Instagram and search, you'll see Llama there. And then if you type in something, it immediately goes to what people are familiar with on the ChatGPT interface. This is destroying foundational value in ChatGPT, while Meta gains in search. It's going to be fascinating to see what this type of decision does to AI over the next three to five years. It's a shrewd move by Meta, and so far, I think it's working. They were way behind on AI before this.

Tesla Supercharger team layoffs.

What I have read on this doesn’t make any sense to me because the Tesla charging network was well ahead and seemed to be executing well. This is just from online searching, but I read that Elon Musk brought up layoffs with the head of the division, they had a dispute, and Musk ended the discussion by axing the entire 500-member team. I view this as Elon sending a message internally, not necessarily sending a message externally.

NBA media rights deal.

I think the NBA is close to signing what is more than a $70 billion deal over 11 years. To give folks a sense of where the bids are coming in, Disney, which owns ESPN, is about $2.5 billion a year, Amazon, which is a new entrant, close to $2 billion a year, Warner, which AT&T owns, is $2.5 billion a year. NBC is competing, I think, for a slot as well. This is substantially higher than the last media deal. With the onslaught of streaming, cable providers don't have many options to differentiate their service, and live sports is one of them. So the relevance of live sports to the legacy media companies is hugely important. As a result, they're going to be some absurd contracts for NBA players over the next 10 years. Why would you pay an athlete $50, $60 million a year? Here's why, right here, these are big numbers: $7 to 8 billion a year to the NBA due to the importance of live sports.

Favorite things to grill?


Dry rub or barbecue sauce?

Dry rub.

Best grilling side?

I make a mean potato salad.

NHL playoffs. Who's going to win?

No idea. So I'll pull a rabbit out and say, Carolina.

Let's close with a personal reflection.

I'll try and make this short and sweet. This was inspired by stoic readings that I tend to peek into. When you do something, it changes your world, but also when you don't do something, it changes your world. In each of those decisions, there's going to be good and bad whether you do something or don't, but more often than not, there's good when you do something. So be a doer.

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 interestrate level.

One basis point equals 0.01%.

The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, investment-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 Bloomberg US Corporate High-Yield Index measures the USD-denominated, high-yield, fixed-rate corporate bond market.

The Bloomberg US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and an on-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.

The Bloomberg US High Yield 2% Issuer Capped Index measures the USD-denominated, high-yield, fixed-rate corporate bond market and limits each issuer to 2% of the index.

The Bloomberg US Treasury Index includes public obligations of the U.S. Treasury.

Blue Chip Economic Indicators is a monthly survey and associated publication by Wolters Kluwer collecting macroeconomic forecasts related to the economy of the United States. Bonds are debt instruments and represent loans made to the issuer. Governments and corporations commonly use bonds in order to borrow money.

The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.

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.

The effective yield is the return on a bond that has its interest payments (or coupons) reinvested at the same rate by the bondholder.

The nominal Gross Domestic Product (GDP) growth rate compares the year-over-year (or quarterly) change in a country’s economic output to measure how fast an economy is growing. Real GDP is GDP adjusted for inflation.

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.

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 Russell 2000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell1000 companies with lower price-to-book ratios and lower expected 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 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.

Yield to worst is the lowest potential yield that can be received on a bond without the issuer defaulting.

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.

Foreside Financial Services, LLC, distributor.

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