Author: cvernon

Real Estate Position Paper – 2018 Update

This real estate position paper seeks to establish a fundamental understanding of the asset class. More specifically, the various styles, benefits, risks, mechanics, and benchmarks relevant to commercial real estate investments are examined, with an emphasis on quantitative and qualitative illustrations. Recommendations and guidance towards the investment manager search process and making an allocation to the asset class are also included.

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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.

Italy Looks to Increase Its Budget Deficit

The yield on Italian 10-year government bonds has risen this year as investor concern about the country’s fiscal policies mounts. This week Italy approved its 2019 budget targeting a 2.4% deficit to gross domestic product — a larger number than markets anticipated and a higher targeted deficit than 2018’s 1.8%. The Italian coalition government is targeting higher spending to implement a monthly income for low-income citizens and reduce the retirement age despite its high public debt to GDP ratio, 131% in 2017. The European Union will provide its formal comments on the proposed budget in the coming weeks and this will likely create some short-term market movements.

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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.

A Shining Light for China?

On September 25, MSCI, Inc. — a leading global provider of research-based indices and analytics — announced its plans to consult on a further weight increase to China A-shares in the MSCI Global Investable Market Indexes. The changes under consideration include quadrupling the weighting of Chinese A-share large companies in its global benchmarks, adding mid-cap names, and including ChiNext as an eligible stock exchange segment. This consultation follows the successful implementation of an initial 5% inclusion of China A-shares in the MSCI China and related composite indices (such as the MSCI Emerging Markets Index) in May and August 2018.

Let’s unpack the full proposal, piece by piece. The first change would be an increase to the inclusion factor of China A-share large cap securities from 5% to 20% over two phases. Specifically, MSCI would target a 7.5% increase coinciding with their May 2019 semi-annual index review and another 7.5% bump up with their August 2019 quarterly index review. Second, MSCI would increase the list of eligible Chinese stock exchange segments by adding the ChiNext board of the Shenzhen Stock Exchange during the May 2019 review. The ChiNext board, where most technology firms make their debut, represents 20% of the total China A-shares opportunity set and has a larger free-float adjusted market capitalization than Shenzhen main and SME boards. Lastly, China A-share mid cap securities would be included with a 20% inclusion factor as part of the May 2020 semi-annual index review.

MSCI’s rationale for the suggested expansion of A-share inclusion is largely driven by the incremental improvements in market accessibility implemented by China. Since the announcement of MSCI China A shares inclusions in July 2017, the daily trading limit and number of new accounts opened has significantly increased within the Stock Connect program, which is an investment channel between Hong Kong, Shanghai, and Shenzhen that allows international and mainland Chinese investors to trade securities in each other’s markets. There has also been a considerable drop in the number of trading suspensions. For example, the number of large cap trade suspensions in the MSCI China A International IMI Index has decreased from 16 to zero over the past 15 months.

The above chart depicts the pro-forma country weights should these changes be implemented. As indicated, Chinese A-shares’ portion of the index would increase from 0.7% to 3.4%. The anticipated net effect would be a slight increase in China’s overall representation in the MSCI Emerging Markets index by 1.0%.

While MSCI’s consultation may or may not lead to changes in the MSCI indices, this proposal indicates growing confidence in market liberalization within China. And, if implemented, these moves will increase foreign investor inflows into China’s $7 trillion stock market. Chinese markets have been able to handle increased trading volumes. This reaffirms our view that institutional investors will increasingly have exposure to China’s local markets over medium to long term.

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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.

Are Small-Cap Equity Opportunities Disappearing?

In 1996, there were more than 8,000 companies listed on U.S. stock exchanges. Today, that figure is less than half. This sharp decline can be largely attributed to the disappearance of many small-cap stocks within the U.S. equity market. Small companies are staying private longer due to rigorous regulatory requirements and prohibitive costs associated with going public. As a result, true small-cap exposure is becoming harder and harder for investors to obtain in traditional equity markets.

Given the strong returns of small-cap equities, many investors have made significant allocations to small-cap equity funds. The inefficient nature and relatively large universe of smaller stocks has historically provided a wide opportunity for investments in companies that are commonly overlooked or underfollowed. When looking at the number of small-cap companies in the Russell 2000 and Russell 3000 index over the past decade, it reaffirms there are fewer attractive small-cap opportunities within the U.S. equity market for investors.

In 2008, the number of small-cap companies (market cap less than $500M) in the Russell 2000 index (small-cap benchmark) were 1,307. Just a decade later, that number has fallen 54% to just 603 companies. A similar trend can be seen in the Russell 3000 index (total market benchmark) with small-cap companies declining from 46% of the index in 2008 to just 20% of the index in 2018.

While attractive small-cap opportunities still exist in the U.S. equity market, true small-cap exposure is becoming more difficult for investors to obtain within their portfolios. If this trend persists, we expect investor capital to continue to seek out private market alternatives for this small-cap exposure.

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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.

U.S. Petroleum Production Surges

U.S. crude oil production peaked in November 1970 at just over 10 million barrels per day. That record stood until this year, when U.S. production surpassed its previous high, and with OPEC’s recent decision to keep production constant, there are perhaps more opportunities for additional U.S. production to fill in the demand gap. As a matter of background, petroleum is the sum of crude oil (used for gasoline, jet fuel, diesel, and heavy applications such as asphalt and tar) and hydrocarbon liquids (most common examples are natural gas, propane, and butane).

Natural gas drilling has increased substantially since the passing of the Energy Policy Act (“EPAct”) of 2005 and has been a significant driver of the increase in petroleum production and exports. Furthermore, this legislation loosened regulation and put incentives in place to drive growth in crude oil and natural gas production in the United States, with the goals of reducing reliance on foreign sources and providing a buffer against high energy costs. This has driven 7.4% and 5.7% annualized growth of U.S. natural gas and crude oil production over the past 13 years, respectively. Historically crude oil production has driven overall petroleum output for the United States, but since the EPAct of 2005, natural gas has had a significant influence on the domestic energy markets. Natural gas’ share of the overall U.S. petroleum output has risen from 15.4% in January 1973 to 28.9% in June 2018.

Overall U.S. petroleum production has increased by roughly 8,000 barrels per day since the passing of the EPAct of 2005, resulting in a 519.6% increase in U.S. petroleum exports, and a 23.1% decrease in U.S. petroleum imports over the same period. With Brent Crude oil exceeding $80 per barrel in September, the active count of U.S. rigs is likely to increase as greater profit opportunities return to the petroleum market.

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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.

Can Hurricanes Drive Inflation Higher?

Given the most recent hurricane to hit the U.S. — Hurricane Florence — our chart of the week examines the impact of U.S. hurricanes on the Consumer Price Index (“CPI”), a common measure of inflation. The chart shows the change in CPI over the 5-month period following landfall of each hurricane, as well as the cumulative damage of each storm in billions of dollars. Is it possible that the amount of damage caused by each hurricane, along with the subsequent interruption to economic activity could push prices higher as supply chains are disrupted?

Overall, the chart above shows that as impactful from a humanitarian sense these storms are, they really don’t have a meaningful impact on inflation. In most cases, inflation (as measured by the change in CPI) actually contracts in the months following a hurricane, but for all the storms shown here, inflation is positive 5 months after landfall. Although the storms become the focal point of news stories for weeks before and following landfall, their damage is small compared to the size of the U.S. economy, and their impact is mostly local as opposed to national. Furthermore, despite the disproportionate amount of media coverage devoted to hurricanes, the changes in CPI are more likely due to other economic factors which affect the U.S. economy more broadly.

So while there is no denying the damage and disruptions that hurricanes can cause, their impact on inflation is immaterial to the overall economy and economic measures.

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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.

 

 

“Cash Rich” S&P 500 Companies Accelerating Buybacks in 2018

S&P 500 companies have become “cash rich” as the combination of tax reform and a decade of strong economic growth has resulted in very healthy corporate balance sheets. Accordingly, we have seen the level of cash allocated to corporate stock buybacks steadily increase as corporate leaders continue to have confidence in their companies’ future growth prospects.

During the first half of 2018, the level of S&P 500 planned corporate buybacks has picked up substantially, with announcements exceeding $600 billion through July, which already exceeds the annual levels over the prior decade. Tax reform has significantly improved the profitability of companies, reducing their corporate tax rate from 35% to 21%, with much of that improved cash flow being redeployed into funding business expansions, R&D efforts, acquisitions, and most notably stock buybacks.

However, these numbers are announced buyback approvals and corporations are not always compelled to execute on announced buybacks. If their stock continues higher or growth prospects weaken, they may wait for a more reasonable valuation before executing the buyback. If buybacks are executed prior to growth prospects decelerating and/or a decline of the stock price the capital used on buybacks could prove to have been capital destructive.

It remains unknown how much of these buyback approvals will actually be deployed by S&P 500 companies in today’s high valuation environment. Only time will tell if this corporate buyback activity is well timed or capital destructive.

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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.

 

Emerging Markets Equity — Reason for Concern?

After a strong 2017, emerging markets (“EM”) equities have struggled to keep pace with their U.S. counterparts in 2018. Year-to-date through August 31, 2018, the MSCI Emerging Markets equity index has underperformed the S&P 500 by 17.1%. EM equities gave up an 8.3% gain in January with a streak of weakness from February through August.

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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.

Does Shorter Duration Pay Off When Interest Rates Rise?

With the Fed poised to further raise rates this year as well as next, it is insightful to investigate how a bond’s duration can impact its return in a rising interest rate environment. Typically, a bond’s duration is used to gauge its price sensitivity to changes in interest rates. As most investors know, bond prices are inversely related to interest rates; the longer the duration, the greater the sensitivity to interest rate movements. In the event of rising rates, all else equal, a bond with a higher duration will decline more in price.

As a simple illustration of how duration can affect bond prices in times of rising interest rates, we compare the performance of short bonds — measured by the Barclays 1–3 Year Govt/Credit Index — and long bonds — measured by the Barclays Long Govt/Credit Index. At this point, the Federal Reserve is likely to announce two more interest rate hikes in 2018, with each hike expected to be 25 basis points. The respective durations for the two indices used in the analysis are approximately 1.9 and 14.9, respectively. Assuming a parallel shift in the yield curve and keeping other economic variables constant, the index values will decrease by 0.95% (short bonds) and 7.45% (long bonds), given the 0.5% increase in interest rates by the end of 2018. If this is true, does this mean that short duration bonds always outperform long duration bonds when interest rates goes up?

On average, the annualized cumulative return over seven interest rate rising periods since 1976 on the Barclays 1–3 Year Govt/Credit Index is 4.69% and 3.4% for the Barclays Long Govt/Credit Index. The correlation with interest rates is also consistently high for short duration bonds at 87% as opposed to 24% for long duration bonds.

At this point, the numbers suggest that short duration bonds tend to outperform when interest rates rise. However, the last two periods in the chart show the opposite trend — long bonds have actually outperformed their shorter duration counterparts. How so? A primary reason is how the shape of the yield curve changed during the last two interest rate increases, as not all rate increases are parallel shifts of the entire curve. The shifts in the yield curve for the periods 1994–1995 and 1999–2000 were indeed parallel whereas the last two periods featured rises on almost exclusively the short end of the yield curve. Rates were anchored on the long end during these periods due to demand from foreign investors looking for greater yield than offered by their home countries, particularly in Europe and Asia.

Overall, the chart shows that short duration bonds provide a more predictable return when rates rise, however a non-parallel shift in the yield curve can influence their relative performance vs. longer duration bonds. For institutional investors, if nothing else this serves as a reminder that trying to time interest rates and changes to the shape of the yield curve is an utterly difficult task to consistently get right, so investors are best served maintaining and re-balancing their bond allocations as dictated by their investment policy statements.

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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.

Infrastructure Position Paper – 2018 Update

Infrastructure is a relatively new asset class to institutional investors and over the last twelve years has emerged as a sustainable addition to client portfolios. The following paper examines the asset class in great detail, from its early beginnings in the 1980s to its current day role in an institutional portfolio. In particular, the nuances of infrastructure — as well as its unique characteristics — are discussed in an effort to cultivate a thorough understanding of the asset class. Recommendations and guidance towards the manager search process and making an allocation to the asset class are also included.

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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.