Author: cvernon

“Renew” Your Opinion on Policy Bets

During election season, investors are often tempted to position their portfolios based on expectations related to potential changes in government policy. That said, market dynamics in the wake of various political events can be confounding and notoriously difficult to forecast. There is perhaps no better example to support this statement than performance of the energy space over the last seven years.

When Donald Trump assumed the presidency in 2017, his administration sought to rescind many environmental regulations and attain energy independence via the use of fossil fuels. His term saw the approval of multiple controversial oil pipelines, a large expansion of oil and gas leasing, and support for energy development on federal land. Since coming to office in 2021, however, Joe Biden has aimed to reverse many of the energy policies of his predecessor, as well as promote an agenda focused on the reduction of greenhouse gas emissions and the development of renewable energy sources. Based on this information, many readers might have expected robust performance of traditional energy companies during the Trump presidency, as well as more challenged returns for clean energy stocks. The policies of the Biden administration, on the other hand, might have been expected to lead to a reversal of these dynamics. Readers may be surprised to learn, however, that the Energy sector of the S&P 500 Index returned -29.6% during Trump’s term in office, compared to 136.1% since Biden assumed office. Conversely, the S&P Global Clean Energy Index returned 305.9% in the four years of Trump’s presidency but has notched a -54.0% gain during the Biden term.

There are many factors that can help explain these and other surprising performance trends. First, markets tend to be forward-looking in nature, meaning current prices of financial assets usually reflect investor expectations of what is to come in the (sometimes distant) future. Additionally, exogenous shocks can roil securities markets and lead to dynamics that would have otherwise been unexpected based on prevailing conditions and the agendas of those in political office. For instance, the COVID-19 pandemic upended supply chains and the 2022 Russian invasion of Ukraine led to increases in the prices of certain commodities, and these developments were largely conducive to positive performance from traditional energy companies despite a renewables-focused U.S. president. Finally, there is the question of natural business and economic cycles, which have tended to ebb and flow regardless of which party controls the White House. All of this is to say that market timing around an election or any other major political event can be a most difficult exercise. Given the upcoming presidential election in the U.S., investors should remain diversified across the asset class spectrum in order to capture market gains and insulate their portfolios against losses, both of the expected and unexpected kind.

Airline Stocks: Just Plane Challenged

Although travelers have happily bid farewell to pandemic-related restrictions and returned to the skies en masse, airline stocks seem to have missed the memo on bouncing back to pre-COVID levels. To that point, the Dow Jones U.S. Airlines Index has returned roughly -35% since the start of the pandemic. This cumulative performance figure is despite a surge in the index in the wake of vaccine announcements in late 2020, as well as the fact that that this summer may be the busiest travel season the U.S. has ever seen. These dynamics can be observed in this week’s chart.

The dichotomy between booming travel numbers and lackluster airline stock performance can be attributed to several challenges facing the industry. Specifically, while increased passenger volumes boost revenues for major airlines, these businesses continue to grapple with profit margin pressures stemming from soaring operational costs. For instance, higher oil prices (now $80 per barrel compared to roughly $55 before the pandemic) have proved to be a significant headwind for airlines. Additionally, ongoing issues including pilot and crew shortages, escalating wages, operational inefficiencies, and higher maintenance expenses have further constrained airline profitability in recent time. Spending on corporate travel has also been somewhat tepid over the last few years as well, which has presented problems for airlines that offer premium upgrades such as business class seating.

In conclusion, the challenges faced by airlines will likely persist into the near future, though robust passenger volumes are certainly a cause for optimism. As it relates to investor exposure to these types of stocks in general, four major airlines (American, Delta, Southwest, and United) are constituents of the S&P 500 Index, and these carriers comprise roughly 0.2% of the benchmark. In other words, adequate diversification should mitigate the impacts of the headwinds described above at the portfolio level.

Credit Check

Interest in private credit has grown considerably in recent years and the asset class has moved from a relatively small or non-existent allocation in institutional portfolios to a multi-trillion dollar market accessed by a wide variety of investors. Demand for private credit remains high, but the rapid growth of this space has sparked debates about potential bubbles and whether underwriting standards have diminished given intense competition among lenders. However, recent survey results indicate that underwriting standards may actually be more conservative today than in prior years, highlighting increased caution with regard to both borrower leverage and required levels of equity within borrower capital structures.

Based on a survey conducted by Proskauer capturing responses from 178 senior-level private credit executives, lenders have reduced the maximum level of leverage they are willing to underwrite in private credit deals in recent years. In 2021, more than 68% of lenders to U.S. corporate borrowers were willing to underwrite deals with more than 6.0x leverage, as measured by borrower debt-to-EBITDA. That figure increased to over 82% of U.S. lenders in 2022 but has since fallen sharply, with now just 45% of lenders willing to underwrite highly leveraged deals. Today, more than 55% of private credit lenders cap deal-level leverage at 6.0x, indicating a shift towards more cautious standards in the current interest rate environment. At the same time, borrowers are now requiring more subordinated equity exposure in the deals they underwrite. Deal equity, often provided by private equity sponsors, represents the amount of equity subordination in a borrower’s capital structure and offers a degree of downside protection for the lender if stress arises for the borrower. In 2021 and 2022, those lenders requiring less than 35% equity in deals represented 18% and 22% of Proskauer survey respondents, respectively. However, the proportion of lenders willing to lend with less than 35% deal equity fell to 13% in 2023 and currently sits at approximately 12%. Conversely, lenders requiring at least 45% equity in deals increased from 25% to 55% over the last three years, again highlighting the trend towards more conservative deal structures.

In summary, given elevated interest rates, lenders are prudently reducing the amount of leverage they are willing to support for corporate borrowers and are also requiring more deal equity. These efforts are largely aimed at enhanced downside protection and reflect increased caution among lenders in response to broader economic conditions. At the asset class level, private credit remains an attractive opportunity set for investors, offering attractive yields, portfolio diversification, and downside protection.

The Capital Structure Shuffle

In the years following the Global Financial Crisis, issuing new debt was an easy decision for companies looking to raise capital given an environment of historically low interest rates. That said, decisions related to the composition of corporate capital structures are now less straightforward due to seismic shifts in monetary policy that have taken place in recent time. To that point, this week’s chart compares the yield-to-worst of the Bloomberg U.S. Corporate Bond Index, a proxy for the cost of debt, to the earnings yield of the S&P 500 Index. The earnings yield is calculated by dividing earnings-per-share by the price of the index and is used as a proxy to determine the costs companies face when it comes to new equity share issuance (i.e., the lower the earnings yield, the cheaper it is to sell shares and vice versa). As readers can observe in the chart above, this yield now sits below the yield-to-worst of the fixed income index.

Companies generally prefer issuing debt over equity due to the tax shield associated with this financing (i.e., interest expenses are typically tax-deductible), which still renders debt the more cost-efficient option for many companies in the current environment. Further, equity issuance is often viewed negatively by market participants due to the dilution of per-share earnings that arises as a result.  There are, of course, additional factors beyond the costs of debt and equity that CFOs must consider when making decisions related to capital structure dynamics. That said, in light of the trends outlined above, many companies may begin to view equity issuance as a more attractive option when it comes to raising capital.

Impact of SEC Rule Changes for Money Market Funds Regulatory Update

Over the past year, the SEC has been phasing in regulatory changes for money market funds resulting from adopted amendments to Rule 2a-7. These amendments were passed on July 12, 2023, in response to the stress that money market funds faced at the start of the pandemic in March 2020 when investors rapidly pulled more than $130 billion dollars from money market funds. As a result, the Treasury and Federal Reserve had to step in to provide emergency liquidity facilities to shore up the short-term funding market. The changes primarily focus on institutional prime and tax-exempt money market funds, which have historically been more susceptible to investor runs.

This regulatory update summarizes these changes as well as which fund types are impacted.

A Jolt from JOLTS?

Throughout history, the state of the domestic labor market has typically served as a reliable indicator of the overall health of the U.S. economy. To that point, while the labor market has remained largely robust in the last few years, the most recent Job Openings and Labor Turnover Survey (JOLTS) from the Bureau of Labor Statistics may cause some observers to question the extent to which the employment landscape is deteriorating. Specifically, job openings in the U.S. decreased in April for the second consecutive month according to the report, falling by roughly 300,000 to just over 8 million. This figure represents the lowest level since February 2021 and equates to just over 1.2 job openings per unemployed individual (down from 1.3 in March). As can be seen in this week’s chart, April’s drop is part of a gradual decline in job openings that has been taking place for nearly two years. Interestingly, the rate at which individuals are voluntarily leaving jobs remains at a multi-year low, which could indicate a lack of confidence among labor market participants regarding the prospects of finding more attractive employment elsewhere. Not all of the April JOLTS data was negative, however, as the report stated that layoffs were unchanged on a month-over-month basis and remain low relative to historical averages.

Slowing job growth could indicate a weaker domestic economy, which makes the job of the Federal Reserve more challenging given its commitment to higher rates to combat elevated inflation. While the April JOLTS figures will likely not lead to a rate cut at next week’s FOMC meeting, further softening in the labor market could lead the central bank to weigh the employment picture more heavily when making policy decisions. Marquette will continue to monitor the impact of inflation and labor market dynamics on Fed policy and provide updates to clients accordingly.

Divesting From the Enemy

As some readers may recall, members of the Marquette Research Team presented a flash talk on deglobalization at our 2023 Investment Symposium given the proliferation of trends including onshoring and reshoring over the last several years. Another trend that supports the idea of reduced global integration is the drop in foreign direct investment (“FDI”) that has occurred in recent time. Indeed, according to The Economist and IMF, when compared to the six years leading up to the pandemic, average FDI flows dropped by nearly 20% from 2020 through 2022. A variety of factors have contributed to these dynamics, including supply chain disruptions caused by the COVID-19 outbreak, the Russian invasion of Ukraine, and trade tensions between major economic powers.

It may be of particular interest to readers to examine the extent to which capital flows between certain countries have shifted since the start of the pandemic. Perhaps unsurprisingly, the IMF notes that these shifts have been asymmetrical across geographic regions, with Asian countries bearing the brunt of the overall decline in FDI. For instance, both the U.S. and countries in Europe have materially decreased levels of FDI to China since the start of 2020. These dynamics are outlined in this week’s chart.

The Economist notes that geopolitical alignment has served as a major driver of the recent diverting of capital flows and is also a key factor in cross-border bank lending and portfolio flows. To that point, the upcoming presidential contest in the U.S., as well as other high-profile elections across the globe, may be crucial in determining the flow of capital over the coming years, as well as the extent to which deglobalization trends persist. Marquette will continue to closely monitor the impact of geopolitics on the global economic landscape and provide counsel to clients accordingly.

A Falling Tide Lowers All Boats

The resilience of the American consumer has been an unanticipated phenomenon in the four years since the outbreak of the COVID-19 virus. Massive federal stimulus in the wake of the pandemic provided the means for significant discretionary spending and has been a major contributor to overall economic strength, even as corporate earnings have wavered. Although consumer activity remains elevated relative to pre-pandemic levels, it has fallen from highs exhibited in mid-2022. At the same time, the percentage of Americans concerned with meeting certain financial obligations has ticked up, with roughly 19% of households earning less than $50,000 per year now questioning their ability to make minimum near-term debt payments, according to a recent Federal Reserve survey. This figure represents a level not seen since the onset of the pandemic. Concerns regarding debt payments among high-income households, or those with more than $100,000 in annual income, have also seen a notable increase over the last several months. These dynamics, as well as overall spending patterns for both low- and high-income households, are highlighted in this week’s chart.

It is worth exploring the extent to which consumer behaviors may have changed in light of the elevated concerns detailed above. To that point, recent corporate earnings reports speak to pressures faced by higher-income households by showing “trade down” effects, which occur when high earners increase spending on cost-efficient products. Walmart, for instance, reported an increase in sales in its latest earnings report which was largely driven by upper-income households. As consumer sentiment dropped to a six-month low in May, the retail giant also reported that shoppers continue to prioritize staples, which has helped propel growth in its grocery business. Other retailers like Five Below and Dollar Tree also show evidence of trade down effects and continue to issue warnings that consumers of all types remain under pressure from macroeconomic factors like inflation and higher interest rates.

Determining the future trajectory of consumer spending is a challenge for corporations as management teams attempt to right-size budgets and chart paths forward. While the difficulties faced by low-income consumers have been largely recognized for some time, increased trade down effects and concerns about debt payments from high-income consumers are more recent developments. In general, it appears as though consumers are becoming less tolerant of the higher prices many companies pushed through over the last several quarters. Should consumer savings and sentiment continue to fall, discretionary spending may decline as Americans across the income spectrum prioritize staples and lower-cost goods. This may prove to be a headwind for certain industries, including high-end retailers and restaurants.

The Growing Popularity of Continuation Funds

Historically, the private equity secondary market has been used by limited partners (“LPs”) to sell exposures at the end of their lives and as such contained only tail-end exposures. Selling these lingering exposures to private equity funds allowed LPs to clean up their balance sheets and fueled the growth of secondary private equity funds within the broader private equity space. As the market evolved, however, higher-quality assets began transacting as investors started to use secondary markets as a useful portfolio management tool. More recently, general partners (“GPs”) have come to occupy an increasing percentage of the overall market. In 2023, about $110 billion in volume traded in private equity secondaries, with about 50% of the total transaction activity represented by GP-led transactions.

In this newsletter, we provide an overview of continuation funds, including their growth, structure, transaction requirements, and considerations for investors.

The “Fix” Is In!

The strength of the U.S. economy over the last several quarters has surprised many investors, as consensus expectations from the recent past called for a recession due to rapid monetary tightening by the Federal Reserve. That said, consumer spending actually increased in 2023, and the labor market remained mostly strong as well. This divergence between the expected and realized impacts of higher interest rates has led many to look more closely at the channels through which monetary policy is connected to consumers. To that point, this week’s chart highlights one structural trend that has been shielding many U.S. households from the impact of higher interest rates.

Monthly mortgage payments and outstanding mortgage debt are often among the largest liabilities on the household balance sheets of the more than 60% of Americans who have mortgages. In the period following the Global Financial Crisis through the beginning of the most recent hiking cycle, long-term fixed-rate mortgages dominated the residential mortgage market in the U.S., making up more than 90% of originations in 13 out of the last 14 calendar years. As a result, many households have locked in relatively low long-term fixed rates on mortgage debt. As of the end of last year, the effective rate on outstanding mortgage debt in the U.S. was roughly 3.8%, while the market rate for a new 30-year fixed-rate mortgage was just below 7.0%. While this spread between new and existing mortgage rates has adversely impacted an already strained supply of housing and led to higher home prices, it has also stymied the housing channel of monetary policy transmission. Said another way, the high percentage of fixed-rate mortgages in the U.S. cushions consumers from Federal Reserve interest rate increases and, thus, limits the effectiveness of Fed policy. This is exemplified by the fact that the effective rate on outstanding domestic mortgage debt has only increased from around 3.3% to 4.0% during the current hiking cycle.

As a result of these dynamics, the U.S. household mortgage debt service ratio — which is the ratio of monthly mortgage principal and interest payments to disposable household income — has remained low, so more disposable income is available to Americans relative to individuals in other parts of the developed world. Indeed, the ability to lock in fixed rates on mortgage loans at terms of 20 or 30 years is somewhat unique to the United States in a way that is often overlooked. Canadian households, for instance, are already feeling pain from higher interest rates, evidenced by the recent increase in the nation’s mortgage debt service ratio relative to that of the U.S. To that point, Canada has shorter available mortgage terms from traditional lenders, with a maximum of five years prior to refinancing in most cases. This has left many Canadians grappling with the impact of higher rates, as most possess either fixed-rate mortgages with short-term resets or those with variable rates.

As the conversation over explanations for the surprising strength of the U.S. consumer continues, the characteristics of the domestic mortgage market are important to take into consideration. Indeed, higher interest rates have allowed many domestic households to benefit from an increased rate on assets while continuing to pay a low fixed rate on significant liabilities.