Author: cvernon

The Lasting Effects of a Temporary Trade Stoppage

In late March, one of the busiest waterways in the world came to a standstill after the Ever Given, a 1,300-foot container ship, became lodged in the Suez Canal. Nearly 30% of the world’s daily shipping container freight passes through the Suez Canal, and with supply chains already disrupted amid the COVID pandemic, the timing could not have been worse. While only a one-week stoppage, with approximately 7% of the world’s oil and 12% of global goods trade flowing through the canal, it is estimated that each day lost delayed more than $9 billion worth of goods.¹

In this Chart of the Week, we analyze the impact that the Suez Canal closure had on maritime shipping costs and the contribution to inflation. The chart above shows the daily price movement of the Shanghai Containerized Freight Index (SCFI). As one of many proxies for global trade and ocean freight health, the SCFI reflects the weekly shipping spot rates of Shanghai container exports along 15 major trade routes, including Shanghai to the United States (east and west coasts), Europe, South Africa, and South America. In contrast to the highly-cited China Containerized Freight Index (CCFI), the SCFI focuses solely on exports in these 15 individual trade routes, rather than nationwide import and export container transport, which would include more contractual and futures rates. Rates surged throughout 2020 amid increasing demand for goods over services and tighter supply. The blockage, which may take months to fully recover from, combined with pent-up demand and economic re-openings has exacerbated the imbalance and sent SCFI spot shipping costs up another 20% over the last month. Rising inflation has been an increasing concern for investors this year and, given current dynamics, we do not expect the contribution from higher global shipping rates to abate anytime soon.

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¹Lloyd’s List Intelligence

 

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 SPAC Explained

The SPAC once again rose to prominence in 2020 and momentum has continued to build this year. By mid-March 2021, the number of SPACs raised had already eclipsed the total raised in 2020. SPACs, special-purpose acquisition companies, are shell companies set up to raise money to acquire another, existing company. SPAC vehicles have been around for decades but have recently risen in popularity as experienced investors and management teams have chosen this route to decrease the risks associated with a traditional initial public offering (IPO).

In this newsletter, we explain how SPACs work and are structured, typical attributes of SPAC sponsors, who benefits from the SPAC structure, why SPACs have seen such exponential growth recently, and how private equity interacts with and influences the SPAC industry.

Read > The SPAC Explained

For more Marquette coverage on SPACs, reference our recent research, What’s Next for SPACs? and The Year of SPACs.

 

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.

When Do Rising Rates Matter the Most?

The first quarter of 2021 saw the 10-year Treasury yield nearly double, which had a profoundly negative impact on growth-oriented and higher-valuation stocks. Generally, higher interest rates are expected to lead to lower equity returns and vice versa, all else equal. While the pace of change in the 10-year during the first quarter was enough to rattle investors, data from the last decade does not support an overall negative correlation between the movement in interest rates and equity returns. Since the Global Financial Crisis (“GFC”), monthly returns of the S&P 500 Index and monthly changes in the 10-year Treasury yield have exhibited correlations ranging from modestly negative to strongly positive. This is in stark contrast to the correlations from previous decades, when equity returns and interest rate movements tended to be strongly inversely related, as conventional wisdom would suggest. Roughly 75% of the monthly correlation observations from 1970 to the beginning of the Global Financial Crisis were negative, compared to less than 14% from the GFC to the present day. While many variables likely contributed to this disconnect, the absolute level of interest rates may be the most important factor.

Though it is difficult to precisely quantify the impact, the extremely low yield environment of the past decade has clearly been a boon to stock prices. During periods of low rates, investors tend to shun conservative assets like bonds and turn to equities for yield, otherwise known as the “TINA” effect (i.e., market participants believe “there is no alternative” to stocks in low-rate climates). This phenomenon manifests itself in the form of the equity risk premium (the S&P 500 earnings yield less the 10-year Treasury yield), which has indicated the relative attractiveness of equities for nearly two decades. Low rates also benefit stock price valuations, calculated as expected future cash flows of companies pulled forward to the present day using a discount factor based on the risk-free interest rate. When yields are low, the denominators in those present value calculations are also low, leading to higher valuations. So, despite rates ticking up during various periods in the last decade, stock prices largely continued to rise as rates stayed extremely low on an absolute and historical basis. It is also worth noting that during exogenous shocks like the GFC and COVID-19, both yields and equity prices saw dramatic decreases, contributing to the positive correlation over the last several years.

At higher absolute levels of interest rates, however, the data show a stronger negative correlation between yield changes and equity price movements. The idea that the absolute level of interest rates helps determine the extent to which movements in yields impact equities begs the question: Is there an inflection point at which increases in rates are more likely to lead to diminished equity returns? While there are many factors at play, a quadratic regression on the correlations observed from 1970 through today implies that negative correlations begin at a 10-year Treasury yield of around 5.8%. For investors, this may help allay concerns about the impact of future rate hikes, with the 10-year still below 2%. That said, the era of easy money that has persisted for more than a decade may be drawing to a close, and investors should consider the implications of increasingly restrictive monetary policy going forward.

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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.

What’s Next for SPACs?

The ferocious appetite for Special Purpose Acquisition Companies (SPACs) continued its momentum throughout the first quarter of 2021. Investors could not get enough of this asset class as a record amount of capital flowed into the space. Through March, 2021 has already seen more SPAC IPOs than all of 2020, with over 300 new deals coming to market. Similarly, gross proceeds thus far through April are already over $100B, well past the $83B that was raised throughout 2020. The space has gotten so hot that sports celebrities like Shaquille O’Neal, Colin Kaepernick, and Alex Rodriguez have all put their names on SPACs that have recently hit the market.

Can this momentum continue? The Securities and Exchange Commission (SEC) might have something to say about it. Earlier this month, the SEC issued new accounting guidance that would classify SPAC warrants as liabilities instead of as equity instruments, as they are currently classified. Warrants are given to capital providers like hedge funds that put up the capital for SPACs before an IPO, to offer the capital provider more upside once the company goes public. SPAC IPOs have since slowed, as affected SPACs would have to restate their financials if this becomes law. With this risk on the table, investors may begin to look elsewhere to put their capital to work, dampening this SPAC market frenzy.

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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.

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.

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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.

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.

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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.

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.

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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.

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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.