Author: cvernon

A Tale of Two Markets

Leveraged loans have been the asset class of choice this year, with fixed income investors drawn to the floating-rate nature of these securities in a rising rate environment. Investors have piled into the asset class since the beginning of 2021 at the expense of other segments of the market, including high yield bonds. High yield bonds are typically the first to show signs of deterioration in stressed credit markets and tend to be subject to more volatile trading patterns. Below the surface, however, the overall quality of the loan market has deteriorated relative to high yield and changes at the issuer level have impacted the perceived safety of the asset class. Investors who have flocked to loans may need to pause and consider that it could be the loan market — not high yield — that signals trouble on the horizon.

This newsletter provides background on leveraged loans and analyzes historical and recent performance and flows, shifts in quality, and seniority and covenants.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Inflation: Expectations Matter

The announcement of another 75 basis point rate hike at last week’s FOMC meeting reaffirmed the Federal Reserve’s unwavering commitment to reducing inflation. One of the key variables the Fed watches to help it determine the path of rates is expected inflation. Inflation can become a self-fulfilling prophecy if consumers start pricing future inflation into their decision-making and businesses start making anticipatory adjustments to their prices and behavior. To combat this, the Fed strives to anchor expectations around a 2% target inflation rate. When long-term inflation forecasts deviate from that 2% target it means inflation expectations are not well-anchored, i.e., people believe that a short-term rise in inflation could lead to higher price levels longer-term.

Inflation expectations have moved further away from the 2% target over the course of 2022, something the Fed recognizes as a potential roadblock in navigating the current inflationary environment. Indeed, Fed Chair Jerome Powell stressed the importance of “expeditiously continuing to raise rates” to “ensure that longer-term inflation expectations remain well-anchored” at the June FOMC press conference.¹ With higher-than-anticipated August CPI figures, however — headline inflation of 8.3% and core inflation that reaccelerated to 6.3% — inflation expectations may remain higher for longer. Headline inflation is moving in the right direction, but core inflation, which remains well above Fed targets, tends to be stickier and may further complicate the Fed’s task. While there are no crystal balls, longer-term inflation expectations will continue to bear monitoring as investors search for potential indicators of a market bottom.

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¹ Lee, J., Powell, T., & Wessel, D. (2022, June 27). What are inflation expectations? Why do they matter? The Brookings Institute. Retrieved September 28, 2022.

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Livestream Videos: 2022 Investment Symposium

The presentations by our research team from Marquette’s 2022 Investment Symposium livestream on September 23rd are now available. Please feel free to reach out to any of the presenters should you have any questions.

View each talk in the player above — use the upper-right list icon to access a specific presentation.

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. Past performance is not indicative of future results. For full disclosure information, please refer to the end of each presentation. Marquette is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Marquette including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.

Midterm Madness

If inflation, rising rates, and a war in Europe were not enough to keep markets interesting this year, 2022 is also a midterm election year. Based on data over the last nine decades, midterm election years — while only marginally more volatile than non-election years overall — tend to exhibit a distinct performance pattern throughout the year. On average, returns during midterm years tend to be flat to slightly negative through the first three quarters as investor confidence is dampened by uncertainty around the outcome of the election. Historically, returns start to pick up as November draws near and tend to finish strongly, with fourth quarter returns in midterm years significantly stronger than non-midterm years. This holds true regardless of which party wins the House and Senate and whether or not there is a change of control, suggesting investors value predictability more so than a specific party controlling Congress. While each year is unique, and this analysis does not consider the deluge of other macroeconomics issues plaguing 2022, it is interesting historical context. Come November 6, there may be one less source of uncertainty in markets.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Go Green or Go Home

Accelerating energy innovation is proving to be a key driver of decarbonizing the economy and mitigating climate change and may also expand the opportunity set for infrastructure-focused investors. President Biden signed the Inflation Reduction Act of 2022 (“IRA”) into law on August 16th, 2022. The legislation is projected to raise $737 billion in revenue, require total investments of $437 billion, and reduce the deficit by more than $300 billion.¹ The IRA bill aims to help offset long-term inflationary pressure via targeted spending in clean-energy renewables and decarbonization initiatives over the next decade-plus. In addition, the bill will utilize tax credits and government subsidies to encourage household and commercial renewable energy purchases, clean-energy manufacturing, and decarbonization of domestic industries. As private equity and infrastructure investors digest the impact of the new legislation, we expect electric utilities and clean hydrogen production to be key beneficiaries of an increase in capital deployment. Infrastructure-focused strategies can provide exposure to these tailwinds while being ESG-friendly and more broadly helping to diversify a portfolio, provide a hedge against inflation, and generate attractive long-term risk-adjusted returns.

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¹ Inflation Reduction Act of 2022, Investopedia

This Exit Closed

Amid public market turbulence, venture capital exit activity and total exit value so far in 2022 are down significantly from peak 2021 levels. The venture-backed exit value in the U.S. came in just under $50 billion in the first half of the year. If this pace continues, 2022 is on track to come in at less than 15% of 2021 levels, returning to an exit value range last seen in 2017.

The number of acquisitions and buyouts as forms of exit are tracking close to 2021 numbers. Firms at the lower end of the market commonly use acquisitions and buyouts as exit strategies. This area of the market has also been more resilient against public market compares. Weakness in the IPO market — potentially on track for its worst year since Dealogic began tracking it in 1995 — is having the greatest impact on the decline in exit value. The IPO market has essentially shut down for venture capital-backed businesses. The familiar macroeconomic headwinds — high inflation, rising interest rates, and the risk of recession — have weighed on venture capital valuations alongside public market equities. Startups that were planning on an IPO are now forced to reevaluate their options. In the meantime, these companies have to rely on the strength of their balance sheets and the financial backing of sponsors. For companies still early in their life cycle and burning cash, liquidity may be a growing concern. Since valuations are down, VC managers are predicting 2022 could in theory be an attractive vintage year and entry point into the VC market. Partnering with VC managers who have experience investing through business cycles and periods of high and low valuations will prove to be important. Overall, with the outlook for the IPO market still uncertain, we are carefully monitoring the impact to the VC landscape and the potential impact to investors.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Hawks and Doves: The Birds of Summer

Inflation, interest rates, and a possible recession are top of mind this summer. Last Friday at the widely-watched Jackson Hole Economic Symposium, Federal Reserve Chairman Jerome Powell signaled that the U.S. central bank will keep raising interest rates and leave them elevated in order to fight inflation. With the Fed not backing off its hawkish stance, concerns around what tighter monetary policy means for economic growth remain front and center.

Looking back to the late 1970s — the last time we saw inflation rising near this pace — a series of rate hikes preceded the 1980 recession and the subsequent ’81–’82 recession. The early 1990s saw an 8-month recession stemming from the restrictive monetary policy of the late ‘80s paired with the 1990 oil price shock. Rates were subsequently increased, though to lower highs, before being cut amid the bursting of the Dot-Com Bubble and then again during the Global Financial Crisis. While the Great Recession was officially over by June 2009, rates were kept near zero until 2015. With only modest rate increases through 2018 followed by a reversal in 2019, rates were quickly slashed to near zero again in early 2020 during the shortest recession on record. This year, to address escalating inflation, the Fed has raised rates by 2.25% over a roughly four-month period — the quickest pace in decades. While rate hikes may have started to weigh on demand, inflation remains near 40-year highs, and more needs to be done to restore price stability. The degree of economic slowdown and impact to the employment market as a consequence of rising rates is one of the biggest unknowns and biggest drivers of markets today. While examining history can add context, inflation dynamics are complex and nuanced, and many have never seen these levels of price increases. Overall, uncertainty in markets remains, with all eyes on the Fed, the September FOMC meeting, and the evolving impact on the U.S. consumer.

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Geopolitics: The Final Frontier

Geopolitical risk has shifted center stage as evolving international dynamics have driven asset allocators to reassess risk exposures and market opportunities. While the Russia-Ukraine conflict has dominated headlines, a number of recent events in the Asia-Pacific region have also led to heightened volatility, directly impacting global markets.

China-Taiwan: Tensions have escalated following House Speaker Pelosi’s visit to Taiwan, with the Fourth Taiwan Strait Crisis now in its fourth week. Taiwan seems to be at the center of a series of ongoing territorial disputes within the first island chain. China’s growing influence and military footprint within the first island chain could create considerable headwinds for investors as trade relations and global supply chains are forced to adapt.

Xinjiang: The situation in Xinjiang continues to draw western criticism, with the U.S., Canada, U.K., and E.U. imposing sanctions on Chinese officials — further stressing diplomatic and economic relations in the wake of the recent Sino-American trade war.

China-India: At the same time, the Sino-Indian border disputes have been ongoing since May 2020, and violent flare-ups persist as one of the most apparent obstacles for Indian and Chinese markets and the BRICS alliance. Developments in Sino-Indian relations could be significant as an increase in trade between China and India would likely generate tailwinds for emerging markets.

Myanmar and Sri Lanka: The conflicts in Myanmar and Sri Lanka may also have broad implications for emerging markets. Myanmar’s internal conflict presents economic and humanitarian issues for neighboring states. China recently announced the China-Myanmar Economic Corridor (CMEC) Plus initiative. While improved stability and infrastructure could bolster global investment, parallels may be drawn to Sri Lanka, where economic conditions deteriorated due to unproductive and unsustainable sovereign debt — approximately 10% of which was Chinese-owned infrastructure loans. Facing default, Sri Lanka relinquished control of Hambantota International Port and 15,000 acres of adjacent land in a 99-year lease to China Merchants Port, a Chinese state-owned enterprise. On August 19th, a Chinese surveillance vessel docked in Sri Lanka reigniting western concerns that Chinese-owned emerging market debt could be leveraged to expand its military footprint.

Taken together, China’s relations with Taiwan, India, and Myanmar and the situation in Xinjiang are additional macro factors that allocators should understand and consider as they evaluate different investment opportunities and risks.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Movin’ Out (Of Their Parents’ Basement)

A previous Chart of the Week published in April entitled “Buy Land, They’re Not Making It Anymore” discussed the fundamentals driving the domestic housing market, including an increase in home valuations and a decrease in the number of new homes built in the United States over the last decade. Data released this week by Anytime Estimate serves to shed additional light on current housing dynamics. One of the most noteworthy aspects of this report is that millennials accounted for roughly two-thirds of first-time buyers in a survey of more than 700 respondents who purchased a home since the start of 2021. Generally speaking, this is good news for the housing market and pushes back against the notion that individuals in this age demographic have avoided home ownership because they prefer to rent. The bad news, according to the Anytime Estimate survey, is that 72% of buyers since 2021 have regrets about their home purchase, with over one-fifth of all buyers indicating complete dissatisfaction with the process and result. To that point, over 25% of respondents claimed they either spent too much money on their home or bought the home too quickly, not giving the purchase adequate consideration. Additional regrets include buying a “fixer-upper” that requires extensive maintenance (24% of respondents), feeling pressured to make an offer (21% of respondents), and purchasing the home sight unseen (17% of respondents).

Regrets notwithstanding (and jokes about millennials thinking buying a home was as easy as purchasing a slice of avocado toast aside), the results of this survey are largely encouraging. Homes tend to be beneficial investments, so recent purchases could allow millennials to build significant wealth over the coming decades. Additionally, many of these first-time buyers have reason to feel good about their purchases given the fact that they likely financed their homes at record low-interest rates. In recent months, the housing market in the U.S. has cooled substantially, which is evident by a buildup in inventories and a pullback in housing starts. This pullback may serve as a welcome respite for interested buyers in the near term. Marquette will continue to monitor dynamics within the market for housing with the conviction that real estate acts as a strong value-add for investors with long time horizons.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

To Inflation and Beyond

Real estate as an asset class is not immune to the effects of inflation and rising rates, but certain sectors within real estate can help investors manage through the volatility. Typically, inflation manifests itself within commercial real estate in the form of higher prices for construction materials, labor, and land. Since the onset of the pandemic, the Producer Price Index for Construction Materials, which measures the average price change of building materials over time, has skyrocketed by over 50% as of June 30, 2022.¹ These rising development costs and value-add expenditures create a headwind for real estate valuations, diluting the value of incremental rental income. However, as inflationary pressures continue to weigh on economic growth, real estate should be well positioned as a solid, though imperfect, inflation hedge. Multifamily and hotel properties benefit from the flexibility of shorter-duration leases that allow property owners to reset rents in line with market levels. Moreover, value-add and opportunistic managers are well positioned to enter deal flow at attractive unlevered price points, extracting value from industrial and retail investments that benefit from guaranteed rent increases and tenant pass-through costs. Real estate investments are an important part of alternatives allocations at Marquette as they can help diversify a portfolio and hedge against inflation while providing attractive risk-adjusted returns.

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¹Bloomberg, Bureau of Labor Statistics, Federal Reserve Bank of St. Louis, CBRE-EA, Clarion Partners Investment Research, June 2022

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.