Author: cvernon

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.

Recession Redefined

The National Bureau of Economic Research (NBER) is widely considered the official judge on what is and is not a recession. The academic organization’s traditional definition of a recession is a “significant decline in economic activity that is spread across the economy and lasts more than a few months.” This definition can be subjective and, to help avoid the need for revisions, the committee does not typically call the start of a recession, or the end of a recession, until well after the fact.

Another commonly accepted definition of a recession is at least two consecutive quarters of negative GDP growth. Given the last two GDP prints of -1.6% in the first quarter and the advance estimate of -0.9% in the second quarter, the U.S. economy would be in a technical recession. Recently, both the White House and Federal Reserve Chairman Jerome Powell have argued that this interpretation does not accurately reflect the current state of our economy, specifically given the still-strong labor market.

Another economic indicator to consider is consumer spending, specifically the contribution to GDP from Personal Consumption Expenditures (PCE). Consumer spending comprises 70% of GDP and is traditionally a much less volatile component than investment and net exports, the primary contributors to the year-over-year declines in the first half of the year. The strength of the U.S. consumer will dictate the country’s path from here, as healthy balance sheets and a hot labor market contend with decades-high inflation and rising rates. PCE contributed a positive 1.2% and 0.7% to first and second quarter GDP, respectively. In only one of the last eight recessions over the last 50 years — the relatively mild downturn in 2001 — has PCE not turned negative. One month into the third quarter, the highly-regarded Atlanta Fed GDPNow tracker is projecting positive PCE and overall GDP growth for the quarter. The current macro situation is complex, with a healthy U.S. consumer facing a number of headwinds, and, in this case, understanding those underlying dynamics is just as important as the “are we or aren’t we” debate.

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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.

The Currency Conundrum

The U.S. dollar is the strongest it has been in a generation. The U.S. dollar index is up almost 11% this year against a basket of global reserve currencies with the greenback reaching parity with the euro last week for the first time since 2002. Like many things in financial markets, interest rates tend to be one of the most significant drivers of currency valuation, specifically the interest rate differentials between global central banks. As the Federal Reserve has pivoted to a more hawkish stance to tame decades-high inflation, other central banks, including the ECB and BOJ, have been slower to respond. When capital can flow freely, investors tend to flock to higher-yielding assets as interest rates rise, which leads to appreciation of the higher-interest rate country’s financial account and increases demand for the domestic currency — in this case, the U.S. dollar.

The Japanese yen is down roughly 16% year-to-date and is the worst performing major currency relative to the U.S. dollar. In an effort to fight decades-long deflation, the Bank of Japan has committed to holding down short-term interest rates, resulting in significant currency devaluation. Japan is the largest foreign holder of U.S. Treasuries, with $1.3 trillion as of January 2022. As the U.S. dollar strengthens, it becomes more expensive for Japan to continue to purchase on-the-run Treasury issuances, which could put further upward pressure on U.S. rates at the same time the Fed is lifting the benchmark fed funds rate and engaging in quantitative tightening. The question of what will happen when the two largest buyers of U.S. Treasuries — the Federal Reserve and the Bank of Japan — both remove liquidity from the market is another unknown that could add to market volatility in the near term.

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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.

Halftime Market Outlook: A Mixed Bag

Last week, we hosted our “Halftime” Market Insights Webinar. As the host, my job was to introduce the analyst for each section and then summarize his or her comments before moving to the next speaker. After the fourth section, I found myself using the term “mixed bag” for the third time; it was at that moment that I knew I had my title for this letter!

Of course, “mixed bag” is an overused and unoriginal cliché to describe a perspective that features both positive and negative elements. If we focus solely on the first half of the year, it is hard to find much good news at all between negative economic growth, historically high inflation, and hefty losses in both the equity and bond markets. Even the good news is rooted in how bad things are…after all, how much longer can inflation stay above 9%? Could the equity market REALLY drop another 20% the second half of the year? Alas, our “mixed bag” descriptor admittedly relies on the assumption that conditions should improve at least somewhat for the remainder of the year, though likely not enough to reverse the damage inflicted during the first half. On an absolute and relative basis, growth and return figures should be better, but it is naïve to think that all of the bad news is behind us.

In this edition:

  • Inflation expectations
  • Consumer and business sentiment
  • The S&P 500’s worst six-month start to a year since 1970
  • Recession probability
  • The Agg’s worst start to a year ever
  • Bonds go back to being bonds

Read > Halftime Market Outlook: A Mixed Bag

 

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.

2022 Halftime Market Insights Video

This video is a recording of a live webinar held July 20th by Marquette’s research team, featuring in-depth analysis of the first half of 2022 and risks and opportunities to monitor in the coming months.

Our Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real estate, infrastructure, private equity, and private credit, with presentations by our research analysts and directors.

Sign up for research alerts to be notified when we publish new videos and invited to future webinars.
For more information, questions, or feedback, please send us an email.

Oil Prices Aren’t All They’re Cracked Up to Be

Americans are paying more at the pump this summer than they ever have in the past. The national average in June for regular gasoline was $4.929/gallon. The only other time gasoline averaged more than $4 per gallon nationally was in June and July of 2008 when prices were $4.054 and $4.062, respectively.¹ Crude oil peaked at $140/barrel then. Why are we paying almost $5 per gallon at the pump when crude oil is only about $100/barrel today? The answer lies in the crack spread.

Crude oil is “cracked” to produce gasoline and distillates like heating oil and diesel in a 3:2:1 ratio, meaning for every three barrels of crude, two barrels of gasoline and one barrel of distillates are produced. The crack spread measures the difference between the purchase price of crude and the selling price of the finished products and is a proxy for refinery profits. Crack spreads have spiked over temporary periods in the past, though the median over the last 20 years has averaged just over $11/barrel. The prior peak occurred in August 2005 when Hurricane Katrina took much of the U.S. refining capacity offline, but, like most spikes, was short-lived as refining capabilities were quickly brought back online. The only sustained period of higher crack spreads occurred in 2012 — a year filled with hurricanes, refinery outages, and tensions in the Middle East — when spreads averaged in the mid-$20s throughout the year. At the end of June 2022, the 3:2:1 crack spread hit a new peak of $47.653/barrel, and this bout of elevated spreads may have more staying power.

The green revolution has had some negative externalities. There has been a retreat from refining as companies are reluctant to invest in fixed assets. Throughput has decreased by roughly 500,000 barrels/day to 16.7 million barrels with refineries operating above 90% capacity. Many refiners have closed or converted to producing biodiesel amid fears that refining assets would be stranded during the energy transition. While there is no easy fix to any component of inflation, gasoline dynamics are even more complicated, and until additional resources are committed to refining, higher crack spreads and higher gasoline prices may be here to stay.

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¹Source: U.S. Energy Information Administration

 

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.