EV's Latest Charge

We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights on the hot equity market at the beginning of the year, the mixed fixed income market performance, the implications of sticky inflation, and a deep dive on the future of electric vehicles.

Let's start with markets. Equities continued to rise in March. What do you think is driving the move higher?

The economy is performing better than expected and market participants are shifting their views to expect a soft landing as a base case rather than a recession. When we look at returns, the S&P 500 was up more than 10% in the first quarter of this year, and that's coming off a strong 2023. The fixed income market did not perform as well because the economy is performing better than expected and inflation is stickier than expected. Rates have drifted upward. The Bloomberg US Aggregate Bond Index ("The Agg") was up in March, but it's still down for the year, and bonds are generally flat to slightly down. However, on the credit side, high yield returned 1.47% in the first quarter, as measured by the Bloomberg US High Yield 2% Issuer Capped Bond Index. Leveraged loans outperformed in the first quarter, returning 2.52%, as measured by the Credit Suisse Leveraged Loan Index.

Total Return

You mentioned yields drifting upward recently. What do you see happening next when it comes to yields?

At the beginning of the year, 10-year Treasury yields were below 4%, and at the end of March the yield was close to 4.25%. Investors are adjusting their expectations to appreciate sticky inflation and resilient economic activity. The yield curve, inverted for a while, is now flattening.

10-Year Treasury

The Magnificent 7 have driven much of the equity gains this year that you mentioned. What are your thoughts going forward?

We looked at four-month market rallies over the past 50 years, and found the current rally ranks 10th. For the nine rallies that were stronger, the S&P was higher six months and 12 months later in each of the rallies. So, the empirical data suggests that despite the strength we've seen, the market should continue to rise. Of course, as we all know, past performance does not guarantee future performance.

Contribution to S&P 500 Index Year to Date 2024 Performance

Let’s shift to the economy. What's the current data telling us?

As recently as April 10, the Atlanta Fed’s GDPNow estimated real GDP growth of about 2.4% in the first quarter, which is stronger than the 1% expected growth at the beginning of the year by the Blue Chip Economic Indicators. Clearly, the economy continues to outpace expectations.

Evolution of Atlanta Fed GDPNow real GDP estimate for 2024: Q1 Quarterly percent change (SAAR)

For inflation, we have cleared the major COVID-induced hump, but inflation persists above the Federal Reserve’s 2% target. I expect inflation to remain sticky considering all the money we printed during COVID.

12-month percentage change, Consumer Price Index, not seasonally adjusted

In addition, the job market remains strong, even as certain companies are tightening their belts.

Monthly Change in Nonfarm Payrolls

Looking at daily spending, based on credit card data tracked by Bank of America, total spending for March was on the upside of flat. Most spending sectors were down, but consumers spent enough online shopping and on transit to make up for the hit to furniture, department stores, lodging, and other sectors.

Year-over-Year Change in Spending

Despite flattish consumer spending, the job market is strong, consumers are fine and continue to evolve in their tastes, and the economy is holding firm. Yet with consumer spending modest, why is inflation so sticky? One of the culprits: insurance costs. Housing insurance, auto insurance, and health insurance are all up substantially. Those costs are sticky and hard on consumers. That is certainly a factor, in my opinion, contributing to keeping elevated inflation.

Well, the mention of inflation leads us to a discussion of the Federal Reserve. The Fed held tight in March with no changes to the fed funds rate and forecasting three cuts in 2024. What are your thoughts?

I think last year people "knew" rates were going to drop and we would have a recession. At the beginning of this year, people once again "knew" rates were going to drop and there would be a recession. By the end of March, investors expected three to four rate cuts this year. Less than two weeks later, the market has shifted to expecting one to two cuts this year, and the second cut is perhaps a 50-50 chance. We will see how this plays out. The CPI release for March came in stronger than expected and we will have to wait and see if inflation remains above target and whether we get one or two cuts this year, or none.

Implied Fed Funds Rate and Number of Hikes/Cuts

Let’s shift to our special topic for this discussion. Henry Ford once said, “The remains of the old must be decently laid away; the path of the new prepared. That is the difference between revolution and progress.” Let’s discuss the new path, being prepared for cars to move from internal combustion to electric engines. How are we progressing along the new path? How has adoption been of electric vehicles (EV) in the US and abroad?

It's fascinating because it's really the first time in a hundred years that the internal combustion engine has a legitimate market rival.

EVs accounted for about 15% of autos sold globally in 2022, up from about 2% just five years ago. The growth trajectory has been tremendous.

Global electric vehicle sales and market penetration Millions (LHS): % (RHS)

Cost declines have been a key factor. EVs used to cost substantially more than traditional internal combustion engine, which we call ICE, vehicles, reflecting both the research and development (R&D) expenditure to develop EVs and the premium for not having to pay for gas. Things changed when supply chains freed up after COVID, and with Tesla growing quickly and managing to bring cheaper vehicles to market. While very few things have dropped in price over the past five years, popular Tesla Models have.

The gap between EV and ICE prices dropped from about 30% percent to 10%. Factoring in that its generally cheaper to pay for electricity than gasoline, and costs are now in EVs favor.

US vehicle prices for EVs and industry average ($1,000 /vehicle)

Could you discuss the breakdown of market share in the U.S.?

Tesla is the dominant player, with more than 50% of the market share in EVs, and they are doing it with four models. When you look outside of Tesla, a lot of the companies that are coming in aren't standalone EV companies. They have an ICE platform, they have distribution, they have manufacturing, and they have scale. After Tesla, the next largest EV-only company is Rivian, with under 4% EV market share. I expect the market will consolidate around Tesla, large auto manufactures with EV as one business line, and maybe a handful of smaller EV-only companies.

U.S. EV Market Share

What about global market share?

The global market does not have the same legacy as the U.S. with the internal combustion engine; there is less of a status quo to disrupt. Looking ahead to 2026, some experts expect EV sales will outpace ICE sales in China, which is the world’s second largest economy. Globally, there is an expectation that EVs will eventually be the norm. We will see if that occurs, but certainly factors are aligned in EVs favor with building to scale, cost efficiencies, and the popularity in major markets such as China.

BNEF Estimated Passenger Vehicle Sales by Year in China

What does the investment in infrastructure look like?

One of the big benefits that Tesla has is a massive charging infrastructure. When you look at a major competitor, Chargepoint, it has less than half of the number of stations, and other competitors have a fraction of the number of stations.

DC Charging Ports

To put this in context, Tesla has close to 55,000 charging stations. Chevron is the fifth largest gas station operator with about 70,000 gas pumps at all its stations. Assuming Tesla's growth continues, I would expect in the next year or two Tesla will have the same number of charging stations as Chevron has pumps.

Toyota has been unique in devoting R&D to hybrids as opposed to fully electric vehicles. Why do you think they're going their own way?

The Prius was introduced more than 20 years ago. Toyota has clearly mastered the hybrid engine, which functions well, while EVs still have some challenges. EVs may have issues in cold weather, and the longevity of battery life is unproven. Meanwhile, Toyota has had this hybrid infrastructure for decades, and they are leaning in and creating more value in their hybrid engine. The average consumer seems to have faith, even in cold weather, in hybrid vehicles.

We have touched on this already, but any other thoughts on the winners and losers in this space?

As I have said, Tesla stands out by any measure, including the performance of their stock. Over the five years from April 2019, Tesla stock has achieved a total return of nearly 850% for all the reasons we have discussed, including their dominant market share. Toyota has also been a strong performer in that time frame, returning close to 140%, with much of that return over the past year or so due to the popularity of hybrids. Meanwhile, in the same period, standalone EV companies such as Rivian and Lucid, have had negative returns. Fisker has been delisted.

5 Year Cumulative Total Return (%)

I think smaller EV companies are learning a fundamental tenet of business: Ideas are great, but execution is difficult. Making the first car can be easy; making the 10,000th car consistently is extremely hard. In interviews, when someone asks Elon Musk how he looks at Henry Ford, Musk has described him as a next level genius, considering what Ford accomplished with the assembly plant, and advancing the automotive industry. Yet even as innovative and as dominant as Telsa has been, the company is still having manufacturing and logistic issues with some of the new models. To be successful with EVs, I believe the scale and infrastructure of the major ICE companies is needed to navigate the challenges of manufacturing and distribution.

Outside the U.S., China’s BYD has grown rapidly with the country’s demand for EVs and government subsidies for EV makers, and BYD outsold Tesla in the fourth quarter of last year, though Tesla surpassed it again in the first quarter of this year. BYD has grown outside China as well, which is good for the company considering competition has heated up in China. BYD in March lowered prices on nine models. The company’s chairman said profit margins are likely to shrink this year amid a price war in China, but the company still expects to grow sales in 2024. We will see.

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

The beauty is yields are elevated. With rates where they are, the loan story still has substantial value, and we are seeing it. We saw it in March, and rates are higher in April. Coupons on loans are over 10%. The narrative in the marketplace has been: Extend duration because rates have got to move lower. Well, it's been a year and a half, and that narrative has not played out. Loans continue to be a standout performer. There are two factors contributing to risk-adjusted performance of loans. The yield, of course, is attractive, and the volatility of loans has been extremely low relative to the volatility of Treasuries. Thus, when the economy outperforms, investors have the potential to earn higher yield, with less volatility than Treasuries.

Attractive Yields

I've mentioned the barbell strategy before, which could include combining floating rate instruments with longer duration instruments as yields rise. I certainly find duration-based assets more interesting as rates have risen, but I'll say it again there is value in the loan trade with loan yields 500 basis points above the Agg’s yield, as well as much lower expectations for rate cuts by the Fed this year.

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

The SEC approval to me was a big deal, and we're seeing flows into crypto exchange-traded funds (ETFs).

California's new minimum wage for fast food and healthcare workers.

I don't like governments coming in and setting floors. It’s inflationary and distorts things in general. For example, coffee prices increased shortly after the minimum wage increase took effect. The minimum wage increase applies directly to larger corporations only, because politicians don’t want to force the mom-and-pop business to pay workers more, but those smaller businesses will have to adjust, or their workers will leave for better paying jobs.

Ukraine and NATO.

This is, in my opinion, may be the most important topic of the month. Antony Blinken, the U.S. Secretary of State, has said Ukraine will be a NATO member. It's a bold statement. Blinken is sharp; he knows all those words have a purpose, whether it's posturing to get Russia to back off, whether it's a scare tactic, whether it's something to try and get the funding bill passed. But Article 5 of the NATO Treaty dictates that an attack on one member is an attack on all. Therefore, if Ukraine joins NATO, then to honor Article 5, we would be at war. We should not be at war. This is something that I think is extremely important to watch and that Americans should care about. We need to keep our eyes on this.

TikTok Ban.

That’s an interesting one, and we've chatted about it in the office. Congress would not necessarily institute a ban; TikTok would be allowed to remain if it is divested from any entity linked to the Chinese government. The House last Month overwhelming voted for the ban/divestiture, but the Senate is undecided. There are a few reasons to support the bill. China does not allow our social media platforms in their country, so reciprocity is missing. In addition, there is an argument for data protection. The counterarguments are that we need to be a more open society, more open economy, and just allow this. The argument is that government should not dictate what we're able to see on social media. So, there are arguments for both sides. I feel like an 11th hour solution will come into play, but we'll see.

How did your March madness bracket do?

I didn't do one because I don't know the players. The only player I knew outside of my alma mater was Caitlin Clark. Nearly 14 million people watched the Iowa-Connecticut game, the most ever in women's basketball. It was entertaining.

NBA, what do you think?

I'm a UCLA guy. I've always wanted a ring for Russell Westbrook, so go Clippers.

What are you reading?

“Outlive.” It's a longevity book discussing the four horsemen that hit when you get older and what you can do about them earlier in life.

Spring break travel.

Just got back from Europe and visited family, flew out there, went to London, went to Amsterdam, which was amazing. We chose Amsterdam because the tulips were in season – they're in season from March to May, and it was stunning.

Let’s close with a personal reflection.

Don't prepare the road for the kid, prepare the kid for the road.

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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.

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.

Fed funds futures are financial futures contracts based on the federal funds rate and traded on the Chicago Mercantile Exchange (CME) operated by CME Group Inc. (CME). Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price.

The federal funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight.

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.

A soft landing refers to a moderate economic slowdown following a period of growth.

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.

A U.S. Treasury note is a government debt security with a fixed interest rate and maturity between two and 10 years.

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.

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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.

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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.

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