cvernon, Author at Marquette Associates

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.

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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.

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.

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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.

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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.

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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

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.

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Can a Government Shutdown Slow the IPO Market?

Companies have been staying private longer, but expectations for Initial Public Offerings (IPOs) in 2019 are high. Uber and Lyft filed their intent to list their shares publicly with the SEC in December. Most recently, other private companies have been exploring if it makes sense to go public at current valuations. Peloton, the popular exercise bike company, has been exploring an IPO this year as its valuation has climbed to more than $4 billion, roughly 3 times as much as its $1.25 billion valuation in 2017. The chart above shows the amount of money raised via IPOs in each calendar year. But what risk does the previous government shutdown have for the IPO market?

The most favorable time for an IPO is typically when the stock market is doing well, volatility is low, and political risks are mitigated. Due to the recent partial government shutdown, the SEC is backlogged with paperwork, which has delayed planned IPOs during this current favorable environment. The risk is that if another shutdown occurs, there could be an extended delay featuring stale financial statements and other administrative delays, which would naturally discourage companies from wanting to go public. The companies that are most at risk are those that are running low on cash and need capital to continue operating. Business owners and venture capitalists are also at risk of not being able to cash out as quickly as they would like. Though the shutdown has caused a delay in listing, it should not prevent the blockbuster companies from listing publicly. Companies like Uber – which has been valued as high as $120 billion – are looking to tap the larger pool of capital in the public markets. Even though the government shutdown has already caused delays of around 30 days, the expectation is that 2019 will ultimately provide a record amount of capital raised through IPOs.

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Can the PG&E Bankruptcy Create Profits for Hedge Funds?

This week’s chart of the week examines the price performance of Pacific Gas and Electric (“PG&E”) Corporation’s public debt and equity. Because of what they provide, publicly traded utilities have long been considered defensive investments due to their relative stability throughout economic cycles.

In the third quarter of 2018 hedge funds began buying shares of this California public utility on the view that PG&E’s liability for 2017 wildfires would be much lower than expected. This buying took place ahead of the deadliest wildfire in California history which many blamed on PG&E electrical lines. PG&E’s exposure to wildfire liabilities is heightened by the state’s inverse condemnation, a legal standard which holds utilities responsible for all damages caused by their equipment. On January 29^th PG&E filed for bankruptcy related to the more than $30 billion in liabilities it faces related to California wildfires in 2017 and 2018.

Many hedge funds that bought both debt and equity of PG&E in the third quarter of last year have seen the equity and debt sell-off over 60% and 18% respectively through January. This price drop has caused some managers to exit their positions. With the company announcing a bankruptcy filing, distressed hedge funds have stepped in to buy up both the equity and debt of the company. Their rationale for doing so is that the payout of the liabilities will be smaller than originally expected and thus both equity and debt prices can recover enough to deliver a profit relative to the currently depressed prices.

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Equities Close to a Key Resistance Level

This week’s chart looks at price action of the Value Line Geometric Index. Originally launched in 1961, the Value Line Geometric Index provides exposure to North American equities. It is comprised of over 1,600 companies from the NYSE, Nasdaq, Toronto Stock Exchange, and various over-the-counter markets. The index is equally weighted, and thus can provide insight into the health or breadth of the overall equity market relative to more commonly referenced market cap weighted indices. Market cap weighted indices, by design, are disproportionately driven by their larger market cap weighted components. Thus, an examination of equally weighted indices can shed light on trends often missed when focused solely on the actions of market cap weighted indices.

As seen in the chart above, the Value Line index has historically encountered resistance at the $500 price level. The index traded near this key resistance level in 1998, 2007, and 2015. More recently, the index was able to break out above this resistance level beginning in December 2016. Following the 2016 election, the index saw broad market participation as a result of the current administration’s pro-growth narrative and late cycle fiscal stimulus effects. A host of factors contributed to the recent retracement of the index below this $500 level starting in mid-2018 including concerns over rising interest rates, slowing global growth, trade/tariff effects, and various political uncertainties.

From a technical analysis standpoint, if the index can maintain a sustained breakout above this level then this would be a bullish signal for equities. However, a failure to retest and breach this level could signify further downside risk and warrant a cautious stance within equities.

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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

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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