cvernon, Author at Marquette Associates

And the Winner is… Commodities?

Through the end of May, 2018 has featured volatility and uncertainty across financial markets leading to some disappointing performance. Fixed income investments struggled as the yield curve rose with both core bonds and high yield slightly negative year to date. Broad U.S. equities are only up 2.5% after a rocky start to the year while international equities are negative following an exceptionally strong 2017. All this, along with fears about inflation, led to a surprising result: commodities are the best performing asset class in 2018. Despite this, the asset class is still by far the worst performer over both a 5 and 10-year period.

This week’s chart shows how difficult it is to time the market and why maintaining a consistently well-diversified portfolio is so important. The argument could be made that commodities were due to outperform (i.e. buy low and sell high) given their recent struggles. However, in 2014 commodities were down over 33%; investors hoping for a nice rebound the following year were in for a shock as commodities fell another 32.9% in 2015. On the flip side, last year emerging market (EM) equities was the top performing asset class, but those looking to chase this return now find themselves in the worst performing asset class YTD. There is little correlation between returns year to year and therefore we encourage clients to stick with long term allocations and avoid portfolio decisions based solely on recent returns.

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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.

Being on Guard for Curve Inversion

Our chart for this week examines the shape of the U.S. Treasury yield curve. With the 10-year Treasury yield recently rising above 3%, the yield curve is now as flat as it was in 2007, just before it inverted as a precursor to the 2008 financial crisis. An inverted yield curve shows that the market does not expect future interest rates to be as high as today’s interest rates, and may signify an economic downturn — going hand-in-hand with an equity and credit correction — to come.

The horizontal axis shows the maturities of U.S. Treasury bonds while the vertical axis shows their yields. Each line is a cross-sectional snapshot — rather than a time-series — of the U.S. Treasury yield curve. The bottom-most line is the spot curve, which shows the current¹ U.S. Treasury yield curve. The next line up is a Treasury forward curve that shows where the market expects the yield curve to be at the end of 2018. The next line up after that shows the forward curve for one year later, at the end of 2019; and the highest line shows the forward curve for the end of 2020.

As we can see, the market expects the curve to pivot at the long end, and rise at the short end, suggesting further flattening.

While it is comforting to know that the Federal Reserve now has in its toolbox the ability to cut rates to support the economy, it is a concern how easily the curve could invert, say, if the Fed hikes only a few more times coupled with a drop in the long end of the curve. This drop could be due to a resurgence of geopolitical tensions or slower growth expectations.

The Fed continues to have the dual mandate of minimizing unemployment while containing inflation. As inflation and inflation expectations continue to rise, we may see the Fed continue its rate hikes in order to rein in the economy, making inversion that much more likely. Because of this, we encourage investors to be on guard for curve inversion, which means taking moderate risk in portfolios, remaining diversified and maintaining a suitable amount of duration. We will continue to monitor the likelihood of curve inversion in the quarters to come — in the context of key metrics such as valuations, fundamentals and technicals — to help ensure that our clients’ portfolios are well-positioned.

¹ Data as of May 18, 2018

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Growing Demand for “Other” Real Estate Sectors

This chart examines the most recent property type sector breakdown within the NFI-ODCE¹ including apartments, industrial, office, retail and other. While the actual “other” sector only represents 4% of the NFI-ODCE index exposure and typically includes land, parking and self-storage, what’s not that apparent is the “other” allocations within apartments and office.

Over the past several years, NCREIF has been trying to capture and measure “other” subtypes such as student housing and medical office, life sciences, manufactured housing and senior living under a field labeled for usage, but the reporting among ODCE managers has been inconsistent across the board. For example, a manager may report a student housing asset as “apartment” with a classification for garden, high rise or low rise, while at the same time submit the asset under the “usage” field making it unclear how much student housing is represented within the apartments sector.

With that said, managers have started and are likely to increase their exposures to these “other” property types given their unique risk-adjusted return profiles in this mature market cycle. For example, medical office and life science tenants tend to be much stickier and sign longer-term leases compared to traditional office tenants making them a more attractive tenant to have. The question going forward will be whether or not these “other” sectors develop into more mainstream standalone sectors and how much they will represent within the ODCE over the coming years.

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¹The NCREIF Fund Index – Open End Diversified Core Equity (“NFI-ODCE”) – is an index of fund-level investment returns reporting on both a historical and current basis.

Equities Show Underlying Weakness

After hitting an all-time closing high on January 26th, the S&P 500 officially entered correction territory over the span of nine trading days with a 10% pullback. Since the February 8th low, price levels for the S&P 500 have shown signs of stabilization but have yet to fully recover. Through May 8th, the S&P 500’s year-to-date return was +0.55%. This headline number, however, masks the dispersion of returns among sectors and individual stocks so far this year. Despite the index being slightly positive year-to-date, many individual stocks within the index are in negative territory.

This week’s chart shows the S&P 500 price level along with the percentage of S&P 500 stocks trading above their 200-day moving averages. The 200-day moving average is a popular technical indicator used to gauge price trends in equity markets. This same indicator can also be applied to individual securities within an index to assess the level of participation or breadth.

The chart above highlights the narrow participation of securities within the S&P 500 since the prior all-time closing high. 83% of stocks in the S&P 500 were trading above their 200-day moving averages as of January 26th. This number fell to 56% by May 8th, indicating that price levels are being supported by a smaller percentage of individual stocks within the index. For example, the popular mega-cap acronym FAANG (Facebook, Apple, Amazon, Netflix, and Google/Alphabet) has been a key driver for equity returns this year. These five stocks account for over 11% of the S&P 500’s total weight and as a group have generated an average year-to-date return of +20%. While higher market cap stocks have supported overall equity returns year-to-date, such narrow market participation creates concerns should sentiment change among these stocks.

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Turn Up the Vol-ume

Volatility is a normal and healthy component of any market. While 2017 lacked typical market volatility, 2018 has experienced its share and entered back into a more reactive and “normal” environment. In the first quarter alone, 2018 had almost triple the amount of +/- 1% days than the entire year of 2017. Although a reversal of 2017’s complacent behavior, this market movement is in line with recent history.

Another pivotal trend is the VIX premium over the V2X; the VIX reflects U.S. market volatility while the V2X is an equivalent measure of European markets. Typically, the VIX trades below the V2X (a negative premium), which reflects the average lower volatility of U.S. vs European markets. The first quarter of 2018 marks the first time this monthly average has peaked above 0 in quite some time. This is not exactly surprising given the economic policy uncertainty and rising rate environment in the U.S.

Volatility is back, and though this is a change of pace from 2017, is well within the bounds of normalcy and is likely to continue throughout 2018.

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Will Strong Deal Activity Continue in 2018?

M&A activity got off to a fast start in 2018, as over 7,000 deals worth $1.3 trillion in value were announced during the first quarter. A common theme among these deals were complex cross-border transactions. The number of transactions greater than $10 billion doubled to a Q1 record of eighteen versus eight last year.

Health care and media/content related deals dominated the quarter and are expected to continue throughout the year. The largest announced deal was the $55 billion merger between Cigna and Express Scripts, a vertical merger of healthcare providers. Other announced deals in the quarter included Comcast’s $31 billion bid for British broadcaster Sky; Keurig Green Mountain’s $19 billion acquisition of Dr Pepper Snapple Group and French insurer AXA’s $15 billion takeover of XL Group.

The biggest risk to M&A deals going forward? Government intervention remains the elephant in the room. Markets became alarmed following the Department of Justice’s (DOJ) antitrust suit in 4Q 2017 around the Time Warner/AT&T deal. The trial between the companies and the DOJ started on March 19th and is expected to continue over the next few months, with many in the media space following it very closely. Government intervention continued in 2018 as the Trump administration blocked Broadcom’s $117 billion hostile bid for Qualcomm, citing national security concerns. Companies now must spend time analyzing how the U.S. government will view any potential deal. Deal activity will likely remain strong in 2018 if companies feel the U.S. government will remain on the sidelines.

As it relates to investments, the fast start of M&A activity in 2018 has given merger arbitrage hedge funds a diverse set of transactions to invest in. A typical merger arbitrage hedge fund will buy shares of the target company and short the acquiring company by borrowing shares with the hope of repaying them later with lower cost shares. If the deal goes as planned, the target company’s stock price should eventually rise to the agreed per-share transaction price and the acquirer’s price should fall to reflect what it is paying for the deal. Deal spreads widened out in February as equity market volatility returned and concerns about government intervention continued to grow. Despite healthy deal activity, merger arbitrage funds have been carefully analyzing deals and how the current administration is likely to view them, thus adding another dynamic to the traditional merger arbitrage strategy.

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Is the Worst Over, or Still Yet to Come?

In the last few months investors were quickly reminded of the volatile nature of equities as these markets suffered steep declines. While there are several possible explanations — ranging from high valuations to geopolitical concerns — many are wondering if we were simply due for a correction or if this a sign of more to come. This week’s chart looks at the historical inter-year drawdowns for the S&P 500 to see how the recent pullback compares.

Since 1983, the S&P 500 index has only had five calendar years with a negative return. Despite this, 28 out of the last 35 years had an intra-year drawdown of more than 7% with the median max drawdown around 10%. Year to date, 2018’s largest drawdown was 10.2%. While this is significant, especially in comparison to the remarkably calm 2017, this is not out of the ordinary. Additionally, even with this drop in the index, the total return for the year is nearly flat thanks to dividend yields.

It is difficult to predict what happens next given the current volatility. Many geopolitical risks remain and though valuations have come down, they are still elevated in comparison to historic levels. However, this drawdown is similar in magnitude to many previous years and the historic average, suggesting that the worst may be over. Even with drawdowns of this size most years have delivered positive equity returns, meaning this could an opportunity to enter the market or invest additional funds.

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Can Low Interest Rates Justify High Stock Valuations?

Given the persistence of above-average equity market valuations in recent years, a proclamation oft-heard from the financial press and market pundits alike is that today’s low interest rates justify these higher valuations. Intuitively, it is easy to see how the rationale behind such statements originated. At the most basic level, the intrinsic value of stocks (and most assets) is the present value of their discounted future stream of cash flows, where the required rate of return (“discount rate”) reflects the riskiness of those cash flows. For instance, discount rates for stocks are higher than those for bonds due to the greater uncertainty of cash flows to equity owners. Because of this framework, and noting that lower discount rates will result in higher present-day asset valuations, it can be easy to empathize with the notion that lofty stock prices today, relative to their fundamentals, are “justified.”

To investigate the validity of such claims, this week’s chart examines the historical relationship between interest rates and equity valuations, defined as the cyclically-adjusted P/E (CAPE) ratio. If the theory holds true in practice, we would expect to see periods of heightened equity valuations coincide with low interest rates. As seen above, there are indeed periods where this relationship is observed — including today and in the late 1920’s prior to the Great Depression. However, there are also periods where the opposite is true — such as the 1910’s and during much of the 1940’s — when low interest rates accompanied low valuations. Likewise, long interest rates reached what were then all-time highs in the late 1960’s, but valuations were also heightened, challenging the assertions that are repeated today. Based on what history has shown us, we would caution against the use of long interest rates as a reliable gauge of the reasonableness of equity market valuations.

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Treasuries vs. Dollar Purchasing Power

Our Chart of the Week reviews the link between the 10-year U.S. Treasury Yield and the Trade Weighted U.S. Dollar Index. The Trade Weighted U.S. Dollar Index measures the value of the U.S. dollar relative to a broad group of currencies circulated throughout the globe, lending insight into the global purchasing power of the dollar.

The left axis displays the yield on the 10-year U.S. Treasury and on the right axis, the price of the Trade Weighted Dollar Index. Higher U.S. interest rates is one factor that can lead to a stronger dollar, as foreign investors look to place their monies into higher yielding U.S. government securities. This relationship holds true from the beginning of 2016 through October of 2017 at which point we see the two diverge. In the 4th quarter of 2017, we saw a pick up in the U.S. 10 Year Treasury yield as Congress passed favorable tax legislation.

An additional factor that helps to explain exchange rate movement is the current account balance which measures the balance of trade through the amount of country exports less imports. We saw dollar weakness as the current account deficit rose to $128.2 billion in the 4th quarter of 2017, the highest level since the end of 2008.

As equity volatility picked up in February 2018, we saw an inflection point in the data. Equity volatility can be measured through the VIX-CBOE Volatility Index, which measures the market’s expectations of 30-day volatility for the S&P 500 Index. The VIX increased from a level of 11 at the end of 2017 to a current level of 22.5; the long-term average is 20.

Historically speaking, the correlation between these two economic variables has been positive, but the two trends have diverged more recently. As economic and political developments occur, including the U.S. Federal Reserve’s normalization of short term interest rates, discussions of potential trade wars and other developments, we will continue to monitor the correlation between the U.S. 10 Year Treasury Yield and the Trade Weighted Index, with the expectation that a positive correlation will re-emerge in the coming year.

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