Author: cvernon

Life During Wartime: Assessing the Market Impact of the Russia/Ukraine Conflict

Recent days have seen an escalation of political tensions in Eastern Europe, and on February 24th, Russian forces began conducting large-scale military operations in Ukraine. These actions have drawn widespread condemnation from the international community, with NATO repositioning troops along its eastern flank and both the United States and European Union announcing intentions to impose sanctions on a variety of Russian financial institutions. The conflict has also threatened the stability of global markets, particularly those areas of the world economy that are most sensitive to energy and the performance of emerging market countries. The aim of this newsletter is to assess the ramifications of Russian actions vis-à-vis the broad market and determine the potential implications of further escalation of the conflict going forward, including:

  • Equity index performance
  • Index exposure to Russia and Ukraine
  • Commodity market expectations
  • Central bank policy and inflation impacts
  • Historical impact of similar exogenous shocks on equities

Read > Life During Wartime: Assessing the Market Impact of the Russia/Ukraine Conflict

 

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.

What Is at Stake?

A general partner (GP) stake is a direct investment in a general partner’s management company and is typically a passive, minority investment. GP stake investors have purchased interests in hedge fund, real estate, private credit, and venture capital managers, but the most significant adoption of this transaction type has been in the private equity buyout landscape. GP stake investing has increasingly become a topic of conversation due to robust fundraising by dedicated GP stake funds and the maturation of the buyout market, with many firms on the cusp of a generational transition and a desire to raise capital to finance future commitments and build out platforms via product proliferation and team growth.

Investors in GP stakes are attracted to the stable yield of the management fee, the upside potential provided by carried interest, and other strategic benefits that may include better access to co-investment opportunities or a primary allocation to future funds. Managers view a GP stake sale as a more favorable path to raising capital relative to an IPO given the scale required and the complexities of going public.
For limited partners (LPs) investing in funds of managers that have sold a GP stake, or are planning to do so, understanding the manager’s plans for the use of proceeds is critical. The capital is typically used to offer liquidity to existing owners of the management company and/or as a means to reinvest in the firm, either through increased GP commitments in future funds or growth initiatives. In addition to confirming the use of proceeds, LPs ought to diligence the rationale for the sale, percentage of the management company sold, and terms of the agreement between the manager and the GP stake investor.

GP stake sales were a key feature of the private equity marketplace in 2021 and show no signs of dissipating in 2022. While these types of investments historically have been limited to the largest buyout managers, increasingly middle market managers are selling GP interests. As we continue to see buyout funds participating in GP stake sales, as well as an increase in the number of dedicated GP stake funds raising capital, it is important for clients to consider this dynamic when investing in private equity funds.

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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.

Russia & Ukraine: All Eyes on Energy

Escalating tensions between Russia and Ukraine have the world on edge. While the situation continues to evolve and the likelihood of a full-scale war remains unlikely, markets are attempting to price in the risk. This latest geopolitical clash builds on an already tumultuous start to the year for financial markets. In the U.S., the S&P 500 has fallen 8.1% from its all-time high on January 3rd amid concerns about rising inflation and consequential rate increases by the Fed. The latest year-over-year inflation figures for both the U.S. and Eurozone have reached alarming milestones, with the U.S. hitting a new 40-year high and the Eurozone setting a new record going back to 1991. Ballooning energy prices have been the greatest contributor to rising inflation, evident in the delta between consumer inflation and core inflation, which removes more volatile prices like energy- and food-related costs. The friction between Russia and Ukraine is only expected to worsen this dynamic, given Europe’s reliance on Russia for energy.

The European Union imports nearly 40% of its total natural gas consumption from Russia. While global oil prices tend to trade largely in tandem due to OPEC’s influence, natural gas prices are more sensitive to regional access and supply. The Dutch TTF Natural Gas price has historically hovered around $20/MMBtu but has surged more than 300% over the last 12 months, while U.S. Natural Gas is up just 36.9% over the same period. While geopolitical fears may continue to drive up the cost of crude as uncertainty builds, the more immediate impact is to the European energy markets via natural gas prices. In the most direct sense, the impact to global developed markets may be low, with the Energy sector comprising only 2.9% and 3.9% of the S&P 500 and MSCI EAFE indices, respectively, though knock-on effects may be broader, including economic sanctions and additional measures to combat inflation that could ultimately impact growth. Past geopolitical stress events provide little guidance with moving pieces always evolving. Tensions could deescalate and we could see little fallout, as was the case following the 2014 Crimean crisis, or pressures could mount with wide-reaching global implications. For now, we will continue to monitor and help our clients navigate the volatility.

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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.

Navigating Inflation from Up Here

Despite year-to-date turbulence, equity markets remain near all-time highs. While company earnings have more than recovered from the lows of early 2020, valuation multiples are also still well above pre-pandemic levels. Our chart of the week looks back at historical trailing P/E levels of the S&P 500 in different inflationary environments. Historically, in months when consumer prices were up between 6% and 8%, the S&P 500 traded at an average 12X earnings, below its long-term average of 17X. As of January 31st, the S&P 500 traded at 23.7X trailing earnings.

With most of these data points coming from the 1970s, this is more of an interesting anecdote than a prescriptive playbook, but does directionally make sense. Higher inflation tends to lead to rising interest rates, as the Federal Reserve looks to maintain price stability. Higher interest rates, in turn, put downward pressure on valuations, as the discount rate used to value a stream of future earnings increases. Companies whose value is largely derived from future growth in earnings see a pullback in the multiple investors are willing to apply to current earnings.

The Fed’s increasingly hawkish tone has already led to a meaningful correction in multiples, with potentially more volatility to come. While perhaps unnerving, the change in backdrop is creating opportunities for stock pickers. Active long-only and long/short managers should be better positioned to navigate market headwinds and add value for investors. While we of course do not have a crystal ball, we are looking forward to active managers hopefully capitalizing on an improved opportunity set this year.

Print PDF > Navigating Inflation from Up Here

 

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.

There Is No Crystal Ball

The Federal Reserve is arguably the most influential financial institution in the world. Their eight meetings a year are highly anticipated, their policy decisions are highly scrutinized, and their economic projections and commentary can move markets. Last month the Nasdaq sold off nearly 9% on concerns of heightened inflation and expected rate hikes by the central bank. The market reversed sharply after the January FOMC meeting on Chair Jerome Powell’s comments about rising inflation and monetary tightening. There are even trading strategies built on predicting market movements after the Fed’s comments and monetary policy surprises. While the monetary policy decisions made by the Fed have a material impact on the economy, their projections are not always accurate, especially when it comes to rate hikes.

Our chart of the week examines the summary of economic projections of GDP, unemployment, inflation, and the number of 25 basis point rate hikes projected for the year over the last eight years. Prior to the COVID pandemic in 2020, the Fed had fairly accurately predicted GDP, inflation, and unemployment, more often than not coming within 0.2% of actual full-year numbers. Ironically, when it comes to interest rate changes — the metric most directly controlled by the Federal Reserve — predictions worsen. While the Fed accurately foresaw no movement in 2014 and 2021 and were on the mark with three rate hikes in 2017, they greatly overestimated hikes in 2015 and 2016 and underestimated rate cuts in 2019 and 2020. Following four rate hikes in 2018, after starting the year predicting three, the Fed quickly reversed course in 2019, cutting rates three times, a sharp contrast to initial expectations for one additional rate increase.

This year the members of the FOMC are predicting three rate hikes, though history has shown us actual results could differ greatly. Monetary policy and economics are never an exact science, and the continually evolving supply and demand dynamics behind inflation make this year all the more challenging. There are simply variables that cannot be predicted. In other words, there is no crystal ball. As the year unfolds, we will continue to keep our clients abreast of policy updates out of the Fed as well as any other developments that could impact the course of rates.

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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.

Any Port in a Storm

The volatile start to the new year has all eyes on the Federal Reserve and its increasing hawkishness. As the Fed prepares to raise interest rates later this year, we look at reverse repurchase agreements and what they mean for the markets.

As part of the Federal Reserve’s efforts to maintain monetary policy and manage liquidity, the New York Fed engages in temporary transactions where reserve balances of excess liquidity are added to or reduced through repurchase (repo) and reverse repurchase (reverse repo) agreements. These operations have a short-term, self-reversing effect on bank reserves. Repurchase agreements involve the Fed purchasing Treasury securities from a counterparty (typically a large institution with excess reserves), with an agreement to resell the securities back at a slightly higher price, representing a small rate of interest. The repo transaction temporarily increases the supply of reserve balances in the banking system and provides liquidity. Reverse repurchase agreements involve the opposite, where counterparties temporarily purchase Treasury securities to be sold back at a later date. Reverse repo transactions help alleviate any undue downward pressure on the effective federal funds rate and set a floor under overnight interest rates by providing a short-term alternative investment for large institutions with excess liquidity reserves.

After a period of dormancy in the beginning of 2021, the Federal Reserve’s overnight window for reverse repurchase agreements saw a rapid rise in demand when the counterparty limit for reverse repos was raised from $30B to $80B in March. This trend continued to accelerate when the limit was again raised to $160B in September, closing out the year at a record level of $1.91T in volume. Low interest rates and the Fed’s quantitative easing efforts presented large institutions with a challenge as to where to invest record levels of excess liquidity reserves. The solution has so far been to make use of the overnight window and earn minimal interest via a risk-free investment in Treasuries.

Time will tell how the Fed will execute its monetary policy changes this year and how markets will respond to that shift. Institutions currently utilizing reverse repurchase agreements may change course once they have higher yielding alternatives, with the impact to the economy and market dependent on where those reserves go. Marquette will continue to carefully follow policy decisions from the Federal Reserve and monitor other indicators, like the demand for overnight repurchase agreements, to help provide clarity during this period of heightened market volatility.

Print PDF > Any Port in a Storm

 

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 Market Preview: New Year’s Resolutions for the Federal Reserve and Investors

Financial markets kick off 2022 against a backdrop of elevated inflation, a(nother) COVID surge, looming interest rate hikes, an undersupplied labor market, and booming equity returns over the last three years. In particular, concerns over rising inflation and higher rates have forced policymakers and investors to look more closely at their respective responsibilities, and we expect notable changes from both parties in 2022. When looked at more closely, these pivots are not much different than some of the New Year’s resolutions that people make each year.

In this letter, Director of Research Greg Leonberger, FSA, EA, MAAA posits:

  • The Fed resolves to lose weight and exercise more
  • Consumers reduce debt and increase savings
  • Can bond investors adopt a more positive outlook for 2022?
  • Will equity markets ever stop smoking?
  • Should equity investors travel more to enhance their return potential?
  • Learn something new to achieve risk and return goals
  • Reduce stress

Read > 2022 Market Preview: New Year’s Resolutions for the Federal Reserve and Investors

Download > 2022 Market Preview Report with 150+ additional charts and data, organized by asset class

Watch >  2022 Market Preview Video with presentations by our research team analyzing last year’s performance as well as trends, themes, opportunities, and risks to watch for in 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. 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.

2022 Market Preview Video

This video coincides with our 2022 Market Preview letter from Director of Research Greg Leonberger, FSA, EA, MAAA and provides analysis of last year’s performance as well as trends, themes, opportunities, and risks to watch for in 2022.

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.

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In Search of Lost Yield

The fixed income space faces several significant challenges in 2022. First, the ability of many bond strategies to generate viable income streams is limited by interest rates that remain at historic lows. Additionally, elevated levels of inflation, which may remain above the Federal Reserve’s long-term target of 2.5% throughout the year, will serve to dilute real returns. To that point, the 5-year breakeven rate, a measure of expected near-term inflation in the U.S., ended last year at 2.9% after reaching a level of 3.2% just a few weeks prior, which represents a record high for the metric since Bloomberg began tracking it in 2002. As displayed in this week’s chart, Treasuries, mortgage-backed securities, and high yield municipal bonds exhibited flat-to-negative inflation-adjusted yields at the end of 2021. Finally, many expect rates to rise this year as the Fed curtails stimulus programs and begins to implement increasingly restrictive monetary policy to combat the rise in price levels. The current landscape begs the question: What can fixed income investors do going forward?

In the coming years, traditional bond investors may need to focus on a wider variety of sectors within the asset class to attain desired yields. Specifically, preferred securities, emerging market debt (EMD), high yield bonds, and senior loans all offer yields that are in excess of the 5-year breakeven rate, even when adjusting for duration. Bank loans may be particularly attractive going forward, as these instruments typically offer floating interest rates that protect investors from increases in short-term yields. Of course, the risks of each of these spaces should be thoroughly considered before any allocation changes are implemented. The EMD space, for example, carries with it significant currency risk, while preferreds exhibit credit risk and are subordinated in the capital structure, providing investors with a lower claim on assets than more senior debt. While all of these sectors are not uncommonly featured in investment portfolios, market participants should investigate the merits and drawbacks of each before creating or modifying target allocations, with a specific focus on duration, credit spread sensitivities, and liquidity terms.

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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.

2021 Smashes VC Records as Late-Stage Deals Reshape the Market

U.S. venture capital deployment in 2021 smashed the previous record set in 2020, as $329.8 billion of funds were infused (+98% from 2020) into over 15,500 deals (+27% from 2020). While this tremendous volume of investment was deployed across the market, late-stage deals in particular raised over $100 million in capital in the last year. In fact, within the U.S. venture capital market, the substantial amount of late-stage venture deployment alone eclipsed the previous overall deployment record by 15%, as $190.8 billion of investments were deployed across 4,704 late-stage deals during 2021.

The growth trajectory of the late-stage venture capital market has been steadily climbing over the past decade as part of a broader evolution of the space, as private market companies have become larger and more durable due to capital availability, increased transparency, and minimal reporting requirements. That being said, the market may have now reached a size at which investors could begin to view early-stage venture capital and late-stage growth equity as distinct asset classes given the different investment considerations associated with each (e.g., duration, risk, returns, etc.) and separate the two within portfolios. Indeed, as late-stage deals become larger in size they become increasingly different investments, as many growth companies that have previously been supported by early-stage venture investors evolve into more established businesses with substantial revenues, proven product-market fits, much shorter duration (five years or fewer), lower loss potential, and valuations that are more aligned with public market peers.

As the venture capital market continues to expand due to new participants and existing investors increasing their allocations to the space, it is worth considering allocation mixes within portfolios with an eye toward having specific and dedicated early- and late-stage venture capital deployment targets.

Print PDF > 2021 Smashes VC Records as Late-Stage Deals Reshape the Market

 

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.