INNOVATION IN AI AND GLP-1 MARKETS

Nothing captures the attention of investors like the promise of a new technology. Companies at the forefront of technology can rapidly take over markets and/or invent entirely new industries, while laggards and those directly threatened by disruption can find themselves wiped out more quickly than they ever could have imagined.

Over the past year, equity markets were heavily influenced by technology innovation—specifically, the emergence of generative AI technology and the rise of glucagon-like peptide drugs (GLP-1s)—and we are just starting to see the impacts play out across various sectors of the market.

Generative AI

The launch of ChatGPT in late 2022 opened a floodgate of investor interest in generative AI. From an investment perspective, NVIDIA has thus far been deemed the winner of the early rounds of AI innovation; its shares appreciated by 239% in 2023, on the heels of heavy demand for its GPUs by customers seeking to train AI applications. But the big challenge for investors is to figure out where value will accrue within the AI tech stack going forward: Hardware or software? Learning model or application?

One can think about the opportunity and impact of AI across four broad categories:

1. End-user applications: Companies like Adobe, Wolters Kluwer and Intuit offer applications directly to consumers or businesses that could benefit enormously from embedded AI (and in some cases, they already are).
2. Foundation models, including large language models (LLMs): This includes the development and deployment of advanced AI models, including large language models such as ChatGPT, as well as proprietary or use-specific datasets such as those owned by London Stock Exchange Group.
3. Cloud compute: Major cloud service providers like Microsoft Azure, Amazon Web Services (AWS), and Google Cloud play a significant role in AI infrastructure.
4. Technical infrastructure: This category covers GPUs, networking, memory and related value chains, including semiconductor equipment. Constituents include companies such as Marvell Technology, Taiwan Semiconductor, ASML and NVIDIA.

These four groups face fairly different opportunities and risks. Currently, we are most enthusiastic about the technical infrastructure and cloud computing opportunities. NVIDIA has been a clear winner so far, and currently its GPUs are best-in-breed solutions for anyone seeking to run AI applications and infrastructure. Taiwan Semiconductor and ASML represent the “picks and shovels” that NVIDIA relies on to manufacture those GPUs. Training and running AI models will require high-powered hardware for the foreseeable future, which should be a boon to cutting-edge semiconductor companies. Within cloud compute, Microsoft, Alphabet and Amazon have demonstrated that scale and resources matter in AI. The three tech behemoths are pouring resources into their respective cloud infrastructures, all to support additional AI workloads. Our investments across both of these hardware-centric categories added meaningfully to performance in 2023.

Moving up the tech stack, we expect competition to be fierce among AI foundation models—the core engines that drive AI-powered applications. Our research team has noted that these models are becoming easier to create and scale and thus face the risk of becoming commoditized going forward. OpenAI’s GPT-4 LLM, which powers ChatGPT, has so far captured the most mindshare among consumers and developers, but developers can build applications on other competing models, such as LLaMa (Meta’s open-source LLM), Gemini (Alphabet’s latest LLM) or Claude2 (developed by Anthropic, a private company and competitor to OpenAI that has recently received investments from Alphabet and Amazon).

Finally, application software companies like Intuit or Adobe may have current advantages, but they will likely need to be proactive about infusing AI into their applications to stay ahead of competitors. Throughout 2023, we saw software-as-a-service (SaaS) companies taking steps to add AI functionality; for example, Intuit incorporated a new AI Assist platform across its personal finance solutions. Of course, companies will need to invest more resources into these products, which may impact margins if customers aren’t willing to pay extra for new features. We expect more companies to announce new AI-enabled products, but given a more constrained economic environment, we also expect investors to put a premium on situations where AI truly leads to better customer outcomes.

In these early innings of AI, we’ve benefited from both public and private AI-related investments:

• Public markets: Our investments in cloud computing and technical infrastructure have already produced strong results, and we believe that companies like NVIDIA, Microsoft and Alphabet have the resources and scale to maintain their competitive positioning. Key questions going forward: How long will we see such elevated demand for these products (especially for NVIDIA’s GPUs)? Further, will margins be squeezed in the future, by price competition or “cap ex competition” among the key industry players?
• Private markets: Private market volumes and valuations are down broadly, but activity tied to AI has been robust. One recent example is Hugging Face, an AI company that recently raised $235 million in a series D financing round, at a post-money valuation of $4.5 billion according to Pitchbook— nearly 100x recurring revenue. Several of our private fund managers hold attractive stakes in promising AI companies, which should be a boon going forward, but we note that it may be more challenging to find good value in the space now, given the recent runup in AI-related valuations.

Everything discussed above about AI technology is mostly focused on the intermediate term—how AI investments might pay off over the next five-to-seven years. Over the long term, the key question investors should consider in the coming years is how AI will change the world—and specifically, whether it will radically change productivity in the way that major technology advancements have in the past (see chart below). Global growth faces several challenges, from an aging populations to heavy sovereign debt to geopolitical disruptions, but AI and its promise of significant productivity gains could offset some of these headwinds.

TECHNOLOGICAL ADVANCES AND THEIR IMPACT ON PRODUCTIVITY AND GENERAL WELFARE (1860–2023)

Throughout history, technological innovations have tended to be powerful drivers of productivity (measured in this chart by the U.S. GDP per capita statistic over time) and general welfare (measured here by average U.S. life expectancy). The dot plot diverges far above the trendline during multiple historical periods marked by the advent of major transportation, communication, healthcare and other achievements. (Note that productivity gains are shown on a logarithmic scale.) Each dot on the chart below denotes a calendar year spanning from 1860-2023.

Source: Gap Minder, as of 12/31/2023.

GLP-1s

In 2023, the “glucagon-like peptide” (“GLP-1”) drug market exploded. For several sleepy decades, these drugs were used to treat diabetes, but newer GLP-1s can now successfully treat obesity and lower the risk of heart disease. Growth so far has happened outside of insurance reimbursement, and if insurers are eventually persuaded to cover these drugs for obesity, it would expand the market greatly (the drugs currently cost patients about $1,000 per month out of pocket).

GLP-1 leaders Novo Nordisk and Eli Lilly were among the best-performing healthcare names of 2023, on expectations about the future earnings impact of their respective drugs. Conversely, the market punished those potentially threatened over the long term by these emerging GLP-1 options, such as Intuitive Surgical and Edwards Lifesciences (GLP-1s may reduce overall demand for heart surgery), Dexcom and Insulet (GLP-1s may prevent many cases of diabetes in the future) and ResMed (maker of CPAP machines for sleep apnea).

These drugs have led many to speculate more broadly about a future where obesity is meaningfully reduced, and how other sectors of the economy and society may be affected. Here are a few of the many potential shifts we are considering:

• Orthopedics: A less obese population would likely exhibit different patterns of injury over time, forcing the health care industry to adapt. Populations may require fewer joint replacements if carrying less weight; on the other hand, people may become much more active, which could drastically increase the incidence of sports injuries and sports-related surgeries.
• Clothing/retail: A GLP-1 saturated world may produce hundreds of thousands of consumers every year who need to purchase an entire new wardrobe of clothing; in the current economic cycle, that could reaccelerate growth for some apparel companies.
• Online dating: If a few million people in the U.S. lose a ton of weight over the next year, it seems fairly likely that many of those people would feel newly confident and better prepared for the dating scene.
• Airlines: Fuel accounts for nearly a quarter of airline operating expenses; given the thin margins at which airlines operate, even a small reduction in passenger weight could translate into a significant boost to profitability.
• Restaurants and snack foods: To what extent will mass adoption of GLP-1s reduce demand for snack foods? To what extent will the “high calorie, high price” model followed by so many casual restaurants need to change in the future?

Market size is a key question in measuring the potential impact of GLP-1s. According to the National Health and Nutrition Examination Survey, as of Dec. 31, 2023, roughly 200 million U.S. adults are overweight, obese, or morbidly obese. What is the “steady state” market for GLP-1s—50 million of those adults? 10 million? All 200 million? The answer will determine how all of the aforementioned industries are impacted, but it will take time for our teams and other investors and analysts to get a better sense of the market’s scale.

Note: All commentary sourced from Brown Advisory as of 12/31/23 unless otherwise noted. Alternative Investments may be available for Qualified Purchasers or Accredited Investors only. Click here for important disclosures, and for a complete list of terms and definitions.

U.S. FISCAL SITUATION

The national debt and the size of the deficit have been a political issue since the Constitution was ratified in 1789. Ronald Reagan famously visualized the debt as a stack of $1,000 bills stacked 67 miles high (when the national debt first passed $1 trillion), and Ross Perot made it the centerpiece of his prominent third-party presidential campaign in 1992.

Attention to “debt politics” has been renewed of late, on the heels of the most significant peacetime expansion of government debt in U.S. history. The U.S. countered two major economic disruptions during this period—the 2008-09 credit crisis and the pandemic—with massive fiscal stimulus to stave off dire economic consequences. The plans in both cases “worked,” but today, the U.S. faces a 120% debt-to-GDP ratio, up from 63% in 2007. Until recently, low interest rates and cheap debt allowed the government to largely ignore this problem, but with Treasury yields soaring over the last two years, the Fed is feeling as much of a pinch from higher rates as every other American household.

The problem stems from three factors: the size of the debt, the rising cost of debt service, and the trajectory of deficit spending. None of these are truly at unprecedented levels, but the combination creates a challenging fiscal picture.

Level of debt: While the “official” level of U.S. public debt is around $32 trillion, the relevant figure is its “net debt” of $26 trillion (this figure excludes loans between Federal entities). This figure is roughly 95% of GDP today (it peaked at 105% just after WWII), as shown in the chart below. This ranks the U.S. in the middle of the G-7 pack (see chart below); Italy and Japan’s comparable ratio has exceeded 100% for decades, and the U.K. peaked at 250% after WWII, so the current scale of U.S. debt does not represent an inevitable crisis.

VOLUME VS. EFFICIENCY

Despite its large absolute debt balances (both net and total), the U.S. is not overly indebted in relation to other developed countries. The relative indebtedness of the U.S. as a percentage of GDP places the U.S. in the middle of the developed-economy pack.

Source: Bloomberg, Brown Advisory analysis.

Cost of debt: Despite the aforementioned growth in debt levels, U.S. debt service in 2021 was only 1.5% of GDP, below its post-WWII average, all thanks to low interest rates. However, rising rates have changed all of that for the world’s largest lender. The Congressional Budget Office (CBO) estimates that the government’s net interest expense was $640 billion in 2023, and that this figure has grown by 35% in each of the past two years. It will almost surely continue to grow as the government refinances maturing debt at higher rates; the CBO expects net interest expense to exceed $1 trillion by 2029, and represent 3.2% of GDP, the highest rate on record. The chart below illustrates the extent to which interest payments are growing in the U.S. as a percentage of government receipts, a pattern we are not seeing in other developed economies.

Further, higher debt service costs create pressure to expand deficit spending (see chart below), which complicates any effort to reduce the size of the debt.

Deficit trajectory: The U.S. budget deficit ballooned to 15% of GDP in 2020 as the government rallied to support a locked-down country; the situation improved markedly in the following years, dropping to around 5% of GDP in 2022—still above the post-WWII average of 2%–3% but seemingly on the right track.

But in 2023, tax receipts fell, spending grew, and the deficit jumped up above 6% of GDP again. Worse, the current deficit trajectory appears structural, as opposed to event driven. During the post-WWII era, deficit spending was required by the moment, and after the war ended, both the U.S. and U.K. governments produced budget surpluses for the next decade. But spending today is different; Social Security and Medicare cost the U.S. $2 trillion in 2022, and given the aging demography of the U.S., these programs’ costs are very likely to grow faster than GDP without meaningful reform. Further, interest costs on the debt are likely to grow meaningfully; overall, the scale of interest costs and entitlement spending makes overall spending that much more difficult to curtail and puts ever-greater pressure on other parts of the budget.

In sum, the combination of debt scale, debt cost and deficit trajectory may not produce an imminent crisis, but it suggests that a crisis is inevitable if these factors aren’t managed more effectively going forward.

Addressing the Elephant in the Room

The consequences of excessive debt cannot be avoided forever. Even if there is no storm on the immediate horizon, the U.S. economy is already paying a burden for the government’s debt, in the form of cash outflows to international holders of Treasury bonds, the potential dampening of private investment activity if the government’s borrowing is sopping up too much market demand from investors, and finally in the form of higher interest rates (which are boosted by the government’s insatiable appetite for capital). Overall, high debt levels can create a challenging feedback loop where low economic growth leads to weak government receipts (from income taxes and such), which leads to higher deficits and yet more debt, which further increases pressure on economic growth. Italy and Japan have been trapped in such feedback loops for decades; the U.S. needs to address the situation before something similar happens to it.

There are three primary ways for countries to trim debt:

1. Economic growth: The most “pleasant” path to reducing debt levels is to “grow beyond them.” The last time the U.S.’s debt-to-GDP ratio fell notably was in the 1990s, when the tech boom and dot-com rush ushered in multiple years of high tax receipts, budget surpluses and a rapidly growing GDP in relation to debt. The challenge is that “rapid economic growth” is not a policy option; governments can try to facilitate growth, but in the end, game-changing growth cycles emerge from innovation and ideas, not from policy tweaks.
2. Austerity: European policymakers imposed this belt-tightening strategy on highly indebted countries like Greece and Italy (to various extents) when dealing with Europe’s debt crisis a decade ago. While fairly straightforward in addressing the issue, this solution is politically unattractive to most policymakers; the backdrop of the 2008-09 credit crisis empowered this approach from the EU, but in many “normal” situations, austerity would nearly ensure defeat in the next election. Austerity also must be balanced with economic considerations, as it generally produces a drag on economic growth.
3. Inflation: This path is the equivalent of writing down one’s debt valuation; since government debt is in nominal dollars (aside from TIPS), inflation would reduce the effective debt load relative to future GDP totals. In theory, an inflation rate of 3%–4% would stoke at least nominal GDP growth, which would have many of the same benefits discussed under economic growth. 
   Historically, governments have turned to this option, but coordinating monetary and fiscal policy to this end can ruin the public’s confidence in a central bank, and playing with inflation is akin to playing with economic fire (Argentina and Turkey are good recent cautionary tales, with inflation exceeding 100% in both countries for a time).

None of these three “solutions” are straightforward to execute, but as the debt rises higher, the need for dramatic action rises as well. The market may eventually force policymakers to take swift action, which can be very painful—unfortunately, governments rarely take painful proactive steps in these situations. The Eurozone crisis of 2011 is a great example; Italy’s debt situation hadn’t changed meaningfully in many years, but in 2011, a scare around Eurozone government debts, centered on Greece, led to a spike in Italian government bond yields. Seemingly overnight, the market was demanding structural change in Italy before funding new bonds, so the government had to raise taxes and reduce spending at a time when its economy was floundering. We believe the U.S. should act now to avoid pain later, but the current state of congressional politics does not offer much hope for meaningful action—especially when there is no immediate crisis to force Congress to act.

Unchecked debt levels will inevitably put pressure on interest rates, economic growth and, ultimately, on returns generated by financial markets. That impact is hard to see or feel; it is usually overwhelmed on a year-to-year basis by cyclical factors, but it is always there, nonetheless. Debt and deficit issues in the U.S. have contributed to our broadly cautious long-term outlook for equity returns and have influenced our decision to be more conservatively positioned in today’s environment.

Note: All commentary sourced from Brown Advisory as of 12/31/23 unless otherwise noted. Alternative Investments may be available for Qualified Purchasers or Accredited Investors only. Click here for important disclosures, and for a complete list of terms and definitions.

STATE OF THE U.S. CONSUMER

U.S. Consumer spending has been the foundation of post-pandemic economic growth and contributed to the economy’s surprising resilience in 2023. Household spending drives more than 60% of U.S. GDP, and nearly four years after COVID-19 appeared, that spending isn’t letting up. Pandemic stimulus and lockdowns boosted the personal savings rate to 33% in 2020 and raised excess savings to a peak of $2.1 trillion; the purchasing power of households soared following these temporary incentives, partly mitigating the impact of higher interest rates. At the start of 2024, unemployment was historically low, wage growth was outpacing inflation, jobs were being added at twice the 100,000 monthly gains needed to keep the economy growing, and job openings still exceeded unemployed workers by a healthy margin.

Consumer staples stocks missed this wave and performed poorly relative to other S&P 500^® Index sectors in 2023. Investors tend to view this dividend-heavy sector as a bond proxy, and as short-term yields rose to 5%, there was a rotation out of these rate-sensitive stocks into higher-yielding and risk-free U.S. Treasuries. On the other hand, consumer discretionary stocks performed quite well; traditionally, this sector performs well early in a cycle of economic improvement (and sector performance benefited greatly from the fact that Amazon and Tesla are both considered consumer companies in the Index).

When one throws in the increase in net worth for many consumers (thanks to rising equity valuations and real estate prices), the overall picture for U.S. consumers has been extremely healthy. However, headwinds are emerging; the typical consumer is now draining their pandemic savings with the resumption of student loan payments, higher mortgage and credit card rates, and higher prices across the board.

Depletion of excess savings: Excess savings in the U.S. fell from $2.1 trillion to $500 billion as the economy normalized from March 2020 through November 2023 (see chart below).

Shifting Spending Patterns

As the economy has transitioned from its “pandemic footing” to become more normalized, consumer behavior has unsurprisingly been in flux. We moved through a period of “revenge spending” on discretionary items by consumers angry about their lives being constrained, and, more recently, we are seeing consumers trade some of this spending on goods, in favor of spending on experiences such as restaurants, travel and leisure (Royal Caribbean and DraftKings each had terrific years in 2023). Meanwhile, consumers are increasingly opting for cheaper, “private label” products in essential categories (staple foods, cleaning supplies, etc.) as they choose price over brand loyalty. Private label products have also improved greatly in recent years, making them more competitive with established brands that can carry prices from 15% to 30% higher.

Bottom Line on the Consumer

Higher interest rates and inflation historically temper consumer spending, but the impact has been less significant during this cycle. Consumers remain confident about their employment, still have some excess savings, and are willing to spend large portions of their income. Mortgages, which make up 70% of consumer debt, are locked in at low interest rates, even as other forms of debt have seen rates adjust more quickly.

But warning signs are appearing, such as those mentioned above. Interest payments are rising as a percentage of personal income; further, personal savings rates have largely reverted to pre-pandemic levels—slightly lower in the U.S., slightly higher in the U.K. and Canada (see chart below). In 2024, we expect softer consumer spending and disposable income growth, and further expect that lower-income households will feel the greatest pinch from inflation and higher rates.

Note: All commentary sourced from Brown Advisory as of 12/31/23 unless otherwise noted. Alternative Investments may be available for Qualified Purchasers or Accredited Investors only. Click here for important disclosures, and for a complete list of terms and definitions.

2024 ASSET ALLOCATION VIEWS

Discussion of 2024-2026 Scenario Analysis

Asset Allocation Scenario Analysis

Our asset allocation stance is largely based on our long-term return and drawdown risk estimates across asset classes. For equities, the key inputs for our long-term return estimates are starting valuations, economic growth expectations (or potential GDP growth) and changes in interest rates. For fixed income, the key input is starting yields (incorporating both base government bond yields and credit spreads), with some influence from the slope of the yield curve and anticipated changes in yields.

The year 2023 brought another tangible increase in bond yields (despite the major decline at the end of the year), and equity market valuations rose broadly during the year—both of these trends reduced the overall long-term appeal of equities vs. bonds. Therefore, we have been utilizing fixed income and credit more extensively than we did when interest rates were far lower.

Equity markets are also generating diverse return streams, by market segment as well as by individual company. Small caps have lagged large caps for some time (small caps tend to be sensitive to interest-rate changes), so our forward view of small caps is more optimistic than that of large caps (which are more fully valued at the moment). We have a similar view about the runway available in emerging markets vs. developed markets. Of course, small-cap and emerging-market investments tend to be more volatile and more cyclical, especially during uncertain times, and we must take this into account with any allocations to those asset classes.

Medium-Term Outlook (18 to 36 Months)

Most major economies fared better than expected while combating inflation and rising rates in 2023. With inflation starting to ease, hopes have risen that central banks may be able to ease interest rates and avoid a recession.

The odds of a soft landing have increased over the past year, but the global economy is far from out of the woods, and most major economies have already slowed to some extent. The full pressure of higher interest rates has yet to be felt; that pressure will mount as old, lower-cost debt is replaced at higher coupons. Geopolitical tensions and weakness across U.S. regional banks are additional threats.

The European and Chinese economies are at risk from several broad factors, including demographic challenges that are already weighing on growth. China’s ongoing real estate and debt situation is also a meaningful concern for investors.

With so much uncertainty, it is more important than ever to prepare our clients’ portfolios for a wide range of scenarios. A good deal of our thinking this year, and last year, has been focused on the interplay between interest rates and inflation, and how those factors will affect the broader economy. How central banks “land” the economy will depend on their aim: how well they estimate the “true neutral” policy rate—in other words, an interest-rate equilibrium point that neither restricts nor stimulates the economy. It is an important balancing act: Recession looms if they err on one side, while renewed and stubborn inflation awaits them if they err in the other direction. We consistently labor to ensure that our clients are as well prepared as possible for this full range of potential market outcomes.

Note: All commentary sourced from Brown Advisory as of 12/31/23 unless otherwise noted. Alternative Investments may be available for Qualified Purchasers or Accredited Investors only. Click here for important disclosures, and for a complete list of terms and definitions.