cvernon, Author at Marquette Associates

The Yield Curve Inverted a Month Ago… Now What?

The U.S. Treasury yield curve briefly inverted a month ago, when the 10-year Treasury yield fell 4 basis points below the 2-year Treasury yield on August 27th. An inverted yield curve has historically signaled a recession to come, as was the case prior to the 2000 tech bubble and 2008 housing crisis. However, the stock markets in the U.S. have been resilient since this latest inversion. The S&P 500 is up 4.2% and the Russell 1000 is up 6.6% since August 27th. This is not surprising as historically there is roughly a 20-month lag between yield curve inversion and the start of a recession.

It should be noted, however, in this most recent case of inversion there is the additional — and unprecedented — phenomenon of yield-seeking from investors whose domestic yields are currently negative. Foreign countries currently own approximately $6.6 trillion of U.S. Treasuries. In fact, countries with negative interest rates such as Japan and Germany increased their U.S. Treasury holdings by 9.2% and 21%, respectively, over the last twelve months. Foreign holdings of U.S. Treasuries amount to roughly 30% of the total amount of U.S. Treasuries outstanding and as a result, the shape of the yield curve has been warped and therefore may be a less-reliable indicator for recessions. It is true that yield curve inversion typically signals a market’s pessimistic view of the economy. However, given the current demand dynamics from foreign investors, yield curve inversion may be less reliable of a recession prediction signal given the overall state of economic growth and consumer health.

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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 Rise of Co-Investing

Much like the overall private equity ecosystem, the private equity co-investment landscape is undeniably growing and has yet to show any signs of slowing down. Historically, co-investing was implemented for one-off decisions to fill the gap in financing that GPs were unable to obtain. Now, GPs have come to embrace co-investment capital with a more recent phenomenon pushing its way to the forefront. We are now seeing GPs form dedicated co-investment vehicles, which eliminate the need for GPs and LPs to negotiate terms for each transaction. This structure gives co-investors access to a stream of co-investment opportunities with preferential economics.

Co-investing is beneficial to not only the GP, but also to the co-investors (LPs) who benefit from high-quality investment opportunities at favorable economics. Co-investing allows LPs to commit capital alongside preferred GPs and create tactical allocations to a pool of high-quality investments for their portfolios. Additionally, the more appealing fee structure of co-investments, which often have no management fee or carried interest, is fueling demand from institutional investors.

The value of co-investment deals has more than doubled since 2012 (totaling $104 billion in 2017) with the number of LPs making co-investments in PE rising from 42% to 55% over the past five years. In 2017, roughly 20% of the private equity market accounted for this volume. The volume of co-investment deal value in recent years has increased rapidly, illustrating the growing appetite investors have for this space.

Given the competitiveness of the co-investment market, having the right GP relationship is of utmost importance and a major determinant in the success of a program; however, given the size of the maturing private equity co-investment marketplace, we encourage investors to — at the very least — retain the option to pursue co-investments as even a modest allocation to the space can improve the return profile of a private investment program.

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The Infamous September

When it comes to timing the stock market, one oft-heard saying is “Sell in May and go away,” which “warns” investors to try to avoid the underperforming summer months and re-enter the market sometime in October. While this might be little more than an anomaly, it is true that over the last 40 years these months do tend to have weaker performance. Most notable in underperformance is September, the only month to average a loss in the S&P 500.

Given the volatility and global growth trends we’ve seen recently, a disappointing September would hardly be surprising. Pairing this historical weakness with the results of last year’s fourth quarter — when equities were down 13.5% — it is understandable that many investors are nervous about the remainder of the year. Fortunately, performance has been positive with equities up 2.6% month-to-date at the time of writing. But what’s far more important is that despite some concerning headlines, the S&P 500 is still up over 21% year-to-date. Even if we do see some losses this month and 4Q disappoints, investors are still on track for a profitable year in their domestic stock portfolio.

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Catastrophe Bonds

Institutional investors are constantly searching for additional asset classes that may help diversify a portfolio and enhance returns. Catastrophe (“cat”) bonds may be such an asset class that could help diversify a portfolio’s interest rate, credit/equity and currency risk by providing non-correlating natural event risk. Cat bonds are typically issued by insurance companies that pool property and casualty policies. They pay coupons to the bondholder using the policy premiums received. When a natural event occurs — such as a hurricane or an earthquake — part of the principal of a cat bond may be used to pay the insurance claims on the pool of policies. In other words, the investor is paid to assume a part of the risk associated with natural events. Historically, cat bonds average 5% to 10% return annually.

This paper discusses the benefits of cat bonds and the mechanics of how they work, along with their market size. The characteristics of cat bonds and the types of cat bond strategies will also be examined. The paper will provide details about cat bonds’ merits and risks to help investors make informed decisions about whether to consider this asset class. It will conclude with a discussion of recent and long-term performance.

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Plummeting Pound Rebounds as PM Johnson is Thwarted

There has been a flurry of updates on the Brexit saga over the last three weeks, starting with the leak of the Yellowhammer doomsday report on August 18th to Wednesday’s stunning news of British Members of Parliament (MPs) successfully pressing forward on a measure to foil a no-deal Brexit. Throughout that time — and since the Referendum — the pound sterling has taken varying degrees of “pounding” based on these Brexit updates, and this week was no different.

In today’s chart, we show the intraday moves of the USD/GBP spot rate over the last three days. On Tuesday, September 3rd, MPs exerted their legislative muscle and debated the merits of a bill designed to prevent a no-deal Brexit on October 31st. In a sharp early sell-off that morning, the pound nosedived below the October 2016 “Flash Crash” dip and hit a 34-year low. The slump came amid growing fears that Britain could crash out of the European Union sans divorce agreement and the possibility of a snap general election. By that evening, however, MPs had voted 328 to 301 to seize control and presented a formal debate on the proposed legislation, delivering Prime Minister Johnson’s first legislative defeat in the House of Commons and causing the pound to rebound from the intraday low. And we saw the pound continue to rise in conjunction with PM Johnson’s second loss on the following day — MPs voted 329 to 300 in favor of the proposed legislative block on a no-deal Brexit. While it is unknown whether the pound will continue to climb, the MPs’ steps towards ensuring that the worst-case Brexit scenario would be avoided appeared to placate currency traders and the market.

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Investing 101 Video Series

Our Investing 101 video series covers the fundamentals of investing. This series aims to create a knowledge base for trustees, staff, and other investors of the key terms and concepts that they encounter most frequently, with guidance provided by several of Marquette’s research analysts and directors.

The series covers:

Marquette encourages open dialogue with our consultants and research team. For more information, questions, or feedback, please send us an email.

Low Volatility Takes a Bite out of FAANG

FAANG stocks have underperformed the broad market over the past year, a stark change from their previous multi-year run of outperformance. More recently, this high-flying group has been negatively affected by a slowing global economy, the U.S.-China trade war, and antitrust investigations. On the other hand, low volatility equity strategies — heavily allocated to defensive sectors of the market such as utilities, REITs, and consumer staples — are benefiting from concern that we are late cycle, slowing global economic conditions, and falling interest rates. As investors seek to mitigate downside risk within equities, low volatility investments have been the recent winner.

This week’s Chart of the Week shows the growth of $100 for the S&P 500 Low Volatility index, the S&P 500 index, and the NYSE FANG+ index over the past year. As of August 23rd, the S&P 500 Low Volatility index had a trailing one-year return of +15.3%. Over this same time frame, the S&P 500 index returned a meager +1.7% while the NYSE FANG+ index fell by -12.4%.

The basic premise of low volatility investing is winning by not losing. A focus on lower beta, lower volatility stocks provides downside protection and helps with the power of compounding over time. The low volatility trade isn’t entirely a free lunch since popularity in this investment style has driven up valuations. Across defensive sectors, valuations are well above their long-term historical averages and trade at a premium to the broad market. As of July month-end, the S&P 500 Low Volatility index had a trailing P/E ratio of 23x compared to 21x for the S&P 500 index. While valuation levels for low volatility indices are certainly elevated and may have an impact on future price appreciation, their lower beta nature should act to mitigate downside risk relative to the broad market.

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The Good Old Days

It may be tempting for some investors to “time” the market in order to enhance returns in times of market volatility or to avoid exposure on days of anticipated losses in the equity market. However, this strategy can prove detrimental to a portfolio that compounds over time.

This week’s Chart of the Week shows the cumulative effect of missing out on the 5 best days and 10 best days of return for the S&P 500. If $1 were invested in October of 1988 and simply left alone, the investor would have $20.88 as of August 22nd, 2019. However, if out of a sample of 7,771 days, solely the 5 and 10 best days of return were missed as a result of not being invested in the S&P 500, the investor would have $13.95 and $10.50, respectively. Investors may be tempted to time the market in the short-term but making a wrong timing decision can drastically impact returns as shown in the chart above. It is nearly impossible to predict how the market will react on any given day and attempting to move in and out of the market incurs trading costs as well as the risk of losing out on a few crucial days of return. Compounding returns also widen the gap between the lines over time and exponentially affects the dollar value of a portfolio. This illustrates the importance of staying invested, especially through periods of high volatility when large swings in returns are more common.

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All is Not Lost for 2019

Given this week’s volatility driven by (brief) yield curve inversion, the ongoing U.S.-China trade dispute, disappointing economic data from Germany, and overall growing pessimism about future growth, investors’ growing concerns about portfolio returns are entirely justified. However, despite this week’s volatility and mostly negative news, almost all asset classes have delivered positive returns for the year, with the great majority of U.S. equity strategies up double digits. Furthermore, most fixed income strategies have profited from falling interest rates, as shown by positive returns from investment grade as well as below investment grade sectors. And for all the negative news out of the Eurozone and China, international equities — as represented by the ACWI ex-US index — are still up more than 6% through August 15th. While the rest of the year is likely to feature elevated volatility and lower returns, barring a major market correction most portfolios should remain in positive territory, despite what has transpired the first half of August. If nothing else, we encourage investors to take a long-term view of the markets and not overreact in times of market stress, as stepping back and taking a longer-term view of the markets indicates that 2019 has been a profitable year to date.

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