Author: cvernon

Higher Yields, Higher Returns

As bond yields are much higher today than they were only three years ago due to nine Federal Reserve rate hikes since the Great Recession, fixed income investors are encouraged by the higher yields that are expected to produce higher returns in the future. The Fed’s nine rate hikes, having raised the fed funds rate from the range of 0.00%–0.25% only three years ago to 2.25%–2.50% today, are expected to provide a general boost to annualized bond returns over the next five years.

Our chart of the week looks at the relationship between current yields in the bond markets and the expected future annualized returns for the next five years. We focus on the Bloomberg Barclays Aggregate Index (“Agg”) as that is the most common bond benchmark used by investors. The chart plots the starting yield of the Agg over the last five decades, from the 1970s to today, on the x-axis. The y-axis then shows the corresponding annualized returns of the Agg over the next five years.

We can see that there is a very linear relationship: the higher the yields at each starting point, the higher the returns for the next five years. As rates declined from the 1980s through the 1990s and 2000s to today in the 2010s, this relationship held true. There are a few outliers in the 1970s, however, as the Federal Reserve under Volcker at the time hiked rates to counter stagflation. But excluding some of these outliers in the 1970s, the chart shows a very strong linear association that higher returns over the next five years are a direct result of higher rates today.

There are secular forces at play, particularly the rising retirement trend across the world’s most powerful economies (Japan, China, U.S., and Europe) that may keep our current low-rate “new neutral” phenomenon a persistent reality for some time. However, the countering forces are new technologies that provide for more productivity. On the balance, fixed income investors are expected to benefit from generally stronger annualized returns over the next five years versus the last 10 years since the Great Recession.

Print PDF > Higher Yields, Higher Returns

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.

Defined Contribution Plan Legislative Update – 2Q 2019

While 2018 saw bipartisan support for retirement savings enhancements, the proposed legislation highlighted in our previous DC Legislative Update did not progress during the lame duck session. However, many are hopeful that 2019 will be the year for major legislative reform surrounding these issues.

In this update, we summarize various pieces of legislation and recent topics of interest for DC plan sponsors:

  • Leadership Change for the House Ways and Means Committee
  • Expanding Retirement Savings Access
  • Student Loan Repayment Programs
  • Fiduciary Duty and Fees
  • Retirement Income Strategies

Download PDF> Defined Contribution Plan Legislative Update – 2Q 2019

As always, your consultant will be able to address any specific questions you may have regarding these changes. For a broader view of Marquette’s approach to defined contribution consulting, see our previous research including A Roadmap for Defined Contribution Plan Sponsors and Defined Contribution Plans: A Look at the Past, Present & Future.

 

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 Opportunity Zones Encourage Investment and Economic Growth?

In an effort to attract capital and encourage long-term investments in low-income urban and rural communities, Congress reformed the Tax Cuts and Jobs Act of 2017 to establish Opportunity Zones nationwide, which could offer a tax break for investors. The chart above shows the number of Opportunity Zones in each state. Congress had tried similar approaches in the past with Empowerment Zones and Renewal Communities, but this most recent effort is receiving unparalleled levels of attention for its generosity to investors and lack of governmental supervision.

Under this program, investors can re-invest their unrealized capital gains into a Qualified Opportunity Fund within 180 days of realization to receive numerous tax benefits. These benefits include potentially excluding up to 15% of invested gains from taxation (10% if held for 5 years, 15% if held for 7+ years). An investment held for longer (at least 10 years) is permanently excluded from taxation. In addition, capital gain taxes can potentially be deferred until 2026.

Given the infancy of the program, many have pointed out flaws within the initiative, stating there is a disconnect between the social benefits from the investments — which will be difficult to measure — and the size of the potential tax costs, which are uncapped. However, it will be for some time until it can be determined whether the program is effective and advantageous for investors, given Congress has asked the IRS to begin reporting on the program’s operations in 2022. Ultimately, this program bears watching as it could be an attractive opportunity for investors and asset managers while also encouraging growth in depressed areas of the country.

Print PDF> Will Opportunity Zones Encourage Investment and Economic Growth

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.

Should Investors Reduce Equity Allocations After Yield Curve Inversion?

The yield curve plots the relationship between U.S. bond yields and their maturities, and typically slopes upward: the longer you hold the security, the higher the return given various risks through time such as inflation, opportunity cost, and economic uncertainty. The yield curve, however, can be inverted when high demand for long-term Treasuries drives the price up and the yield down resulting in a downward sloping curve. Yield curve inversion often signals a pessimistic view of the economy in which investors look for protection against slow economic growth and higher-than-expected inflation. Furthermore, the previous four instances of curve inversion have been followed by a market correction, though it can sometimes be years before a market correction follows inversion.

Last Friday, the 10-year Treasury yield fell below short-term yields with maturities ranging from 1-month to 1-year in response to disappointing Eurozone data, geopolitical risks around Brexit, and Fed Chairman Jerome Powell’s remark on a global economic slowdown. Shortly after the yield curve inverted — especially after the negative yield spread emerged between 3-month and 10-year Treasuries (regarded as the Fed’s most sensitive measure of market sentiment) — the equity market sold off and the S&P 500 total return fell by 1.89%. This immediate reaction led some investors to believe the correction was already unfolding.

While it is impossible to determine at this point if the correction is already here, investors should take comfort knowing that the equity market eventually rebounds from these corrections and shows resilience after the yield curve inverts. Our chart above shows the subsequent 3-month, 6-month, 1-year, 2-year, and 5-year returns of the S&P 500 index after the primary inversion data point — the spread between the 2-year and 10-year Treasury yields — first went negative (thus inverting). For example, after the 10s/2s yield inversion on December 27, 2005, S&P 500 annualized total returns after 1 year, 2 years and 5 years were 15.6%, 10.7% and 2.2% respectively. Over longer time periods after yield curve inversion, such as 7 or 10 years, equity returns more closely resemble their long-term averages. The other primary takeaway from the chart is that shorter-term equity returns — 3, 6, or 12 months — feature significant disparity from the last four yield curve inversions, indicating each instance is different in terms of magnitude and timing after initial 10s/2s inversion. Thus, we do not recommend that investors reduce their equity allocations in an attempt to time the potential correction after inversion, and over the longer-term, equities are still expected to be positive contributors to portfolio returns, even if the yield curve is temporarily inverted.

Print PDF> Should Investors Reduce Equity Allocations After Yield Curve Inversion?

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.

Yield Curve Inversion Intensifies: Will This Time Be Different?

An inverted U.S. Treasury yield curve — one in which long term rates are lower than short term rates — is known by investors to be a predictive indicator of a market correction and subsequent recession to come. On Friday, the yield curve inverted between the one-month to one-year range vs. the 10-year for the first time since 2007, with the one-month to one-year range yielding 2.45%–2.49% vs. the 10-year yielding 2.44%. This is an extension of the inversion between the two-year and five-year, which began last December.

In this newsletter, we put the current yield curve inversion into historical context, examining the indicators of previous inversions and the various market corrections and recessions that have followed. We also look ahead, taking into account current optimism regarding Fed rate cuts and various other indicators in the credit markets, and note how investors can prepare for further changes.

Read> Yield Curve Inversion Intensifies: Will This Time Be Different?

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.

MSCI Plans to Increase China A-Share Exposure

After several years of consideration, in May 2018 MSCI added a small portion of the China A-share market to its Emerging Markets Equity Index using a 5% inclusion factor. After additional consultation following that successful implementation, MSCI recently announced plans to further increase the inclusion factor to 20% in three steps, with the final step occurring in November 2019.

This newsletter explains MSCI’s considerations in increasing the inclusion factor and the process the index will undergo in the next nine months to implement the increase, as well as an explanation of what an A-share is and what their future may hold for investors.

Read> MSCI Plans to Increase China A-Share Exposure

For further coverage on A-shares, reference our video from 2018’s Investment Symposium, “Getting “A” Share of the Chinese Market“, or two previous charts of the week linked above.

 

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 Correlations Between Private Equity Strategies Continue to Converge?

Private equity and venture capital allocations have together benefited private capital investors as they have individually provided outperformance at different points throughout an economic cycle. While both are loosely correlated to public equity performance, venture capital investments have many similarities to growth allocations whereas private equity buyout investments have characteristics similar to value allocations. Buyout returns often depend on lower purchase prices and leverage to generate excess returns, while venture returns tend to be less price sensitive and a reflection of accelerating growth.

The lower correlation between the two assets classes was present for more than a decade, spanning from the 1990’s to the early 2000’s. During this period, an investor would naturally hedge against the heightened volatility in venture by investing in both asset classes to offset this risk. However, since the mid-2000’s these two asset classes have become much more correlated as they both have benefited from a strong, 10-year plus growth-oriented environment coupled with low fixed interest rates.

While correlations have tightened over the past decade, the “growthy” economic backdrop that has fueled this relationship will undoubtedly come to an end. When this occurs, we believe these two asset classes will provide a nice complement over time to investment portfolios in generating a higher overall return with less volatility.

Print PDF> Will Correlations Between Private Equity Strategies Continue to Converge?

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.

ESG Assets Continue Their Dramatic Rise

The demand for — and supply of — ESG investment opportunities has surged over the past several years. This week’s chart depicts the rise in U.S. based ESG assets. After doubling in size between 2012 and 2016, the value of sustainable, responsible and impact investing assets grew by another 38% from 2016 to 2018. These investments now account for more than ¼th of total U.S. assets under professional management.

From the demand side, signatories to the Principles for Responsible Investment, a set of investment principles that enables the incorporation of ESG considerations into investment practices, grew in combined assets from less than $6 trillion in 2006 to over $81 trillion by the end of April 2018. In response, the supply of ESG strategies in the market continues to increase as well, with investment firms offering ESG products in both the traditional and alternative asset classes.

Regulatory changes, new research, and shifting investor demographics continue to foster increased interest in ESG investing, and plan sponsors should be prepared to adapt their investment options to accommodate the changing landscape.

Print PDF> ESG Assets Continue Their Dramatic Rise

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 Assets Flow to Water Infrastructure Opportunities?

U.S. water infrastructure provides and treats around 355 million gallons of water per day to support cooking, bathing, and productivity in virtually all sectors of the economy. The infrastructure in place, however, is in poor condition; the American Society of Civil Engineers (“ASCE”) assigned a “D” and “D+” grade to both drinking water and wastewater infrastructure, respectively. Based on this assessment, the ASCE estimated that a minimum of $123 billion per year over the next 10 years needs to be invested in U.S. water infrastructure. As illustrated in this week’s chart, current annual spending on water infrastructure totals around $41 billion per year, but only one-third of capital needs are expected to be funded over the next ten years, representing an annual funding gap of $82 billion.¹ Consequently, we would anticipate water infrastructure improvement projects and water reuse² as a source of investment over the next several decades.

Print PDF> Will Assets Flow to Water Infrastructure Opportunities?

 

1 Value of Water Campaign, ”The Economic Benefits of Investing in Water Infrastructure,” 2017.
2 Water reuse refers to reclaimed or recycled water, which is the process of converting wastewater into water that can be reused for other purposes

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.

Slower Earnings Growth in 2019?

With the Tax Cut and Jobs Act (“TCJA”) now a little over a year old, this week’s chart looks at the effect of the tax cut on companies in the S&P 500. Despite a headline corporate tax rate of 35%, S&P companies in aggregate were paying an effective tax of only 25% over the twelve months leading up to the tax cut. Lowering the headline rate from 35% to 21% has clearly had an effect, as the tax rate for the S&P at the end of the third quarter was down to just 18.4% (a reduction of almost 27% year-over-year). This was one of the main drivers of strong growth in profits for U.S. companies, as the S&P 500 earnings growth peaked at 27% year-over-year in the third quarter (blue dotted line in the second chart). However, as we move into 2019 the positive effects on earnings growth from the tax cuts will fade, and corporate earnings growth in 2019 is likely to be significantly slower than what investors experienced in 2018, which could be a headwind for the equity market as the year progresses.

Print PDF> Slower Earnings Growth in 2019?

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.