Author: cvernon

One Year Later, What’s Next?

Welcome to our inaugural quarterly client newsletter! As a way of introduction, I am Greg Leonberger, Director of Research here at Marquette. I have had the privilege of meeting many of you over the years, and for those that I have not worked with previously, please accept this virtual introduction; my hope is to meet many more of you in person once in-person meetings resume. As I embark on this newsletter series, the goal each quarter is relatively simple: provide you with our views on capital markets, the economy, emerging risks as well as opportunities, and hopefully stitch in a few anecdotes to make for a more engaging connection with our readers.

Highlights from this edition:

  • One year anniversary of the equity market trough in 2020
  • COVID-19: lingering uncertainty, vaccine progress, economic recovery
  • Equities update: value and small-cap outperformance, valuations, TINA
  • Fixed income: reflation trade and interest rates, spreads
  • Alternatives: opportunities in real estate, hedge funds, and private markets
  • Inflation worries: money supply and commodity prices

Read > One Year Later, What’s Next?

 

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.

Q1 2021 Market Insights Video

This video features an in-depth analysis of the first quarter’s performance by Marquette’s research analysts and directors, reviewing general themes from the quarter 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 here.
For more information, questions, or feedback, please send us an email.

PE Pursues Buy-and-Build

Add-on investments, a company acquired by a private equity firm to be added to one of its platform companies, have steadily increased in importance and popularity over the past two decades. In 2020, 71.7% of U.S. PE deals were add-ons, compared with 43.2% in 2002. After a dip in total deal count in 2020 amid the COVID-19 pandemic, we expect 2021 will see the highest number of add-on deals on record. These buy-and-build strategies can take different forms. Some involve large-scale roll-ups in which a platform company acquires a large number of smaller, often founder-owned companies. Others include more opportunistic M&A transactions that allow portfolio companies to pursue specific product or operational goals. The growth of add-ons across two decades of various market cycles can be attributed to a number of advantages: multiple arbitrage, giving larger firms access to out-of-reach market segments, helping portfolio companies enter new geographical markets, and doubling down on more profitable end markets.

The holding period for add-ons has also evolved. Historically, private equity has held platform investments that included add-ons longer than other portfolio companies. In recent years, the median exit times for portfolio companies with and without add-ons have converged to roughly five years. We attribute this to both private equity becoming more skilled at executing these buy-and-build strategies as well as buyers being increasingly willing to pay for the unrealized potential of recently-completed add-on acquisitions.

Print PDF > PE Pursues Buy-and-Build

 

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.

Weak Dollar, Strong EM

For U.S.-based investors, the movement of the dollar has a direct and indirect impact on emerging market equity returns. The direct impact is straightforward. Purchasing foreign-listed equities requires conversion to the local currency. On top of the change in the price and any dividends of the underlying stock, a weakening U.S. dollar creates a positive currency return, while a strengthening U.S. dollar generates a negative currency return.

The movement of the dollar also has an indirect impact on emerging market returns. This week’s chart looks at the performance of the MSCI EM Local Currency Index and the U.S. Dollar Index (DXY). The local currency index removes any direct currency impact, isolating price performance of the underlying stocks. The DXY measures the U.S. dollar versus a basket of trade partner currencies. Since 2000, the correlation of monthly returns between the local currency index and the dollar index is -0.40, meaning historically they have moved in opposite directions.

There are several reasons why a weak dollar is supportive of emerging market equities. A weaker U.S. dollar is generally positive for overall economic growth and emerging economies typically benefit from strong global growth. Many developing economies are also reliant on dollar-issued debt. A weaker dollar lowers the cost of borrowing, a positive for emerging markets companies and equity markets. The U.S. dollar weakened throughout most of 2020, with the DXY down 10% between February and December. Over that same time frame, emerging markets equities returned 19%. So far in 2021, the dollar is up modestly, with emerging markets pulling back more recently. Looking forward, we expect the historical relationship between the two to persist, positioning emerging market equity investors to benefit should the dollar weaken further.

Print PDF > Weak Dollar, Strong EM

 

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.

Where’s the Blowout?

A typical real estate cycle has four phases: recovery, expansion, hypersupply, and recession. Typically, the recession phase is marked by rising cap rates (a real estate valuation measure, calculated as the ratio of net operating income to market value), which then compress over the growth phases of the cycle as property values rise. However, the current cycle, which began shortly after the onset of the COVID-19 pandemic, has been atypical. Although we experienced a period of economic contraction, cap rates did not rise as they have in previous recessions. Two contributing factors may have been lower interest rate expectations in 2020 and the impact of government stimulus measures that helped occupiers navigate weaker market conditions. Now with cap rates at historic lows and interest rates expected to rise through 2021, real estate investors are asking whether a “blowout” (an increase in cap rates) is on the horizon.

Historically, cap rates have been driven by the interaction of (1) changes in U.S. government bond yields, (2) the real estate risk premium (the cap rate spread above U.S. treasuries), and (3) the expected-long term growth of rental income (net operating income (NOI)). In previous cycles, cap rate compression was in part driven by favorable liquidity conditions and falling treasury yields. Today, yields are rising, with 10-year rates already up meaningfully off the mid-2020 bottom. With NPI cap rates essentially flat, this means the real estate risk premium has compressed. Accordingly, rent growth is becoming a bigger driver of capital appreciation and more important to investors. Over the short term, we expect investors will favor properties with the highest rent or NOI growth potential and rotate out of properties where growth is more limited. This should benefit industrial warehouse and apartment properties in select markets to the detriment of more challenged retail and potentially office properties. As a result of this asset rotation, the cap rates of properties in high demand may continue to compress, while cap rates of more challenged properties may see the “blowout” the broader real estate market has so far avoided.

Print PDF > Where’s the Blowout?

Sources utilized: Cornerstone Real Estate Advisors, “Cap rates and RE cycles,” and Principal Real Estate Investors, “Interest rates are rising, should real estate be concerned?”

 

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.

Will Skyrocketing Money Supply Boost Inflation?

As the economic recovery continues, investors are rightly concerned with inflation, especially given the recent surge in M2 money supply,¹ as shown in the purple line in the left chart. M2 has soared amid unprecedented levels of monetary and fiscal stimulus infusing markets and households with cash. While an economy awash with cash may lead to concerns about runaway inflation, certain key economic recovery dynamics point to a less drastic trajectory and potentially more muted, transitory inflation.

Juxtaposing M2 with core PCE inflation,² shown as the green line in the left chart, we see that the two have not always been perfectly correlated. While an increase in the M2 rate has typically led to an increase in the core PCE rate, there are imperfections in the relationship. Inflation so far in the economic rebound has stayed low as the surge in M2 has been offset by a drastic decline in the velocity of money,³ shown as the orange line in the right chart. The velocity of money dropped off last year as money supply surged while consumer spending was down during the pandemic, though velocity has generally been in decline since 2000 amid the longer-term trends of aging demographics, greater debt, and weaker physical investment prospects relative to financial investment prospects. The increased money supply has so far not led to increased transactions, GDP per dollar spent, or inflation. The gray line in the right chart depicts M2’s annual rate of change normalized by annual GDP, showing that M2 increases from the 1990s, 2000s, and 2010s have been relatively stable as a proportion of overall GDP. In this context, while the surge over the last year is still evident, it is much less extreme.

From here, as the economy continues to reopen, consumer spending on goods and services is expected to raise demand for input materials. This, along with COVID-related supply shortages, may boost inflation temporarily. However, we expect supply chains will normalize and supply overall will adjust, reducing inflationary pressures. More importantly, in order for a pickup in inflation to be sustained over the longer term, economic participants would have to boost real asset purchases over financial asset purchases, counter to trends over the last 20 years. As the Fed eventually tapers its bond purchases and increases rates, the markets will be expected to absorb at least some of the greater money supply. M2 is ultimately expected to shrink relative to GDP as the economy rebounds, with velocity expected to correct upwards.

In summary, we generally expect a more muted and transitory rise in inflation, holding all else equal. Core PCE may rise from the 1.5% at the end of 2020 to a range of 2.0–2.5% for 2021, encompassing the Fed’s projected 2.2%, but could then revert back down close to the Fed’s long-term target of 2.0%, especially with the Fed’s eventual bond purchase tapering and rate hikes.⁴ Once the initial recovery is over and the economy trends back to normal, we could see factors like aging demographics and the trend towards services and tech over old economy sectors bring on more deflationary pressures. Post-recovery, the evidence points to more normal inflationary levels, again holding all else equal.

Print PDF > Will Skyrocketing Money Supply Boost Inflation?

 

¹ M2 money supply is the total value of money — in the form of currency in circulation, demand deposits, and assets that can be quickly converted into cash — that is available in the U.S. economy. M2 is a closely-monitored indicator of money supply as well as future inflation and used by the Federal Reserve to adjust monetary policy. M1 includes cash as well as checking deposits, whereas M2 includes M1 plus savings deposits, other time deposits, and money market securities.
² Core PCE represents inflation in the form of personal consumption expenditures prices excluding food and energy prices. Used as the key inflation metric by the Federal Reserve, it removes the volatility from movements in food and energy to provide more reliable underlying inflation trends.
³ The velocity of money represents the rate that money is exchanged in the economy as well as the amount of GDP generated for every dollar spent. It is calculated as the GDP in billions of dollars divided by the M2 money supply in billions of dollars. If velocity rises, larger and more transactions are happening between participants in the economy. Conversely, if velocity falls, smaller and fewer transactions are happening between participants in the economy.
⁴ Presently, consensus expectations are for the Fed to taper its bond purchases and to hike rates only when the economy has fully recovered back to normal, likely beyond 2021 as part of concluding the monetary stimulus that has been necessary during the pandemic. 

 

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.

Signs of a Market Bottom: One Year Later

This month marked the somber one-year anniversary of the World Health Organization declaring COVID-19 a global pandemic. In addition to the immeasurable human suffering the disease has caused, the toll on both the financial markets and broader economy has also proven historic in magnitude. After the unprecedented market volatility in March 2020, two questions on many investors’ minds were if a market bottom had been reached and if a recession was underway. The S&P 500 hit an all-time high on February 19th, 2020, and subsequently experienced a fast and furious COVID-induced sell-off resulting in its March 23rd bear market trough. Although at that time, investors could not be certain this was the bottom as economic uncertainty remained high while the pandemic was still in its early stages. To help reason through the two questions noted above, we wrote “Signs of a Market Bottom?” which analyzed four broad categories in an attempt to identify markers of a trough: Technical Data, Valuation Data, Economic Indicators, and COVID-19 Data. This information was examined in the context of bear markets that coincided with recessions, which is an important distinction because one can exist without the other. Our analysis indicated that all but valuation data were useful in identifying a market trough.

Given that it has been over a year since the rapid peak–trough-bull market start, the purpose of this paper is to revisit the four aforementioned categories to see which, in hindsight, were relevant in identifying the 2020 market bottom.

Read > Signs of a Market Bottom: One Year Later

 

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.

Retirement Basics Video Series

This video series is intended for plan sponsors and fiduciaries and covers a variety of topics related to creating and managing effective defined contribution investment programs. Co-presented by members of our consulting and research teams, these videos present the basics of retirement plans for trustees and investment staff in an educational format meant to provide guidance and insights on best practices and trends in the industry.

The series includes:

  • Fiduciary Checklist, an overview of the roles and responsibilities of fiduciaries including planning, oversight, communication, and documentation;
  • Defined Contribution Topics & Trends, industry trends and recent developments and guidance from the Department of Labor;
  • Investment Lineup Best Practices, considerations and guidance for selecting investment lineup offerings for retirement plans;
  • Target Date Funds, a deep dive into TDFs, from structure and glidepaths to why target date funds have become so popular; and
  • Stable Value Funds, an overview of stable value, exploring structure, important considerations, and recent litigation.

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

For more information, questions, or feedback, please send us an email.

One Year Ago, Would Anyone Have Predicted This?

What a year it has been. Officially one year after the equity market’s bottom on March 23rd, 2020, all major indices in the chart above have at least recovered back to ending 2019 levels. The groups that were hit the hardest have also rebounded the strongest, with returns over the last year exceeding 100% for some. Small-cap equities stand out, especially in the U.S. — up 121% over the last year and up 33% over the almost 15-month period since 2019. U.S. mid-cap equities are up 101% over the last year, up 25% over the full period, and U.S. large-cap equities are up 83% over the last year for a 26% return over the full period. Small-cap stocks have also outperformed internationally — the MSCI EAFE Small Cap Index is up 91% over the last year and 18% since 2019, while the MSCI EAFE Index is up 67% over the last year and 12% for the full period. Emerging markets, some of the hardest hit by the crisis last year, have more than recovered, up 78% over the last year for a 22% return since 2019. Fixed income returns have been more muted. Investment grade bonds stayed positive in early 2020 as equity markets fell precipitously and are up another 3% since. High yield bonds, bank loans, and emerging market debt were hit harder but still held up better than equities. Each group has recovered those losses but remains in positive single-digit territory over the full period.

From here, we expect returns will likely moderate. As the vaccine roll-out continues we expect further economic re-openings and renewed growth across the globe, but it seems highly unlikely capital markets returns can continue at this pace beyond the initial recovery.

Print PDF > One Year Ago, Would Anyone Have Predicted This?

 

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.

Driving Toward a Green Future

Innovation and structural change were hallmarks of 2020 as the spread of COVID-19 accelerated technological advancements across many areas of the global economy. The electric vehicle (“EV”) space is one area of innovation that has especially captured the attention of global investors. While battery-powered and alternative energy vehicles have been available in some form since the early 19th century, it was not until significant developments in rechargeable lithium-ion battery technology were made in the 1970s that meaningful capital began to flow to the space. Since then, interest in EV technology has ebbed and flowed with oil prices, but the recent global push toward green energy has revitalized enthusiasm in the space.

For the three years ended 2019, the NYSE FactSet Global Autonomous Driving and Electric Vehicle Index, which tracks developed and emerging market companies that specialize in self-driving and EV innovation, underperformed the broader MSCI ACWI Index — up an annualized 8.8% versus the ACWI up 10.2%. Since then, over the 14 months from the start of 2020 through February 2021, the Global Autonomous Driving and Electric Vehicle Index is up 63.1% versus the MSCI ACWI Index up 16.3%.

To dive deeper into the different components of the electric vehicle landscape, we look at the newly-created Bloomberg Intelligence Electric Vehicle Basket, a group of 60 global companies expected to benefit from and contribute to the success of EV development. These 60 companies, equal-weighted, have outperformed the MSCI ACWI by 10.3% over the trailing three months ended February 28th. Of the four unique sub-groups,¹ Raw Materials has outperformed by the widest margin, returning 46.3% since December. This cohort includes a diverse group of specialty chemical and mining companies that produce the inputs for a variety of industries, many of which, including those tangential to EVs, have seen increased demand over the last few months. The Battery and EV Component groups have also outperformed the broader MSCI ACWI Index. EV Vehicle Manufacturer stocks have struggled more recently amid profitability concerns given the cost of inputs and headwinds to EV adoption, particularly in the U.S. Despite the push from lawmakers, still limited charging infrastructure and a lack of consistency in charging connectors across manufacturers are issues for consumers. While we expect these and other points of friction will be resolved and EV market share will continue to grow over the next several decades, in the near term, market momentum can push innovation themes ahead of expected earnings or scalability. Investors should exercise caution when allocating to a burgeoning segment of the market and always maintain portfolio diversification.

Print PDF > Driving Toward a Green Future

¹A fifth Bloomberg exposure, EV Charging, included only one company and was included in the EV Components categorization for this analysis.

 

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.