cvernon, Author at Marquette Associates

You Get a Dividend, You Get a Dividend, You Get a Dividend!

As January closes, it is not uncommon for New Year’s resolutions to go up in smoke; one publication has suggested that as many as 80% of commitments for change are gone come February.¹ Regardless, many such resolutions target weight loss in the New Year, and an obvious winner in this game would seem to be Weight Watchers. However, January’s performance for this stock appears surprisingly unrelated to news of increased subscribers. Instead, it appears that the influential figurehead Oprah Winfrey had an unanticipated — and unconventional — impact on Weight Watcher’s January performance.

Since Oprah took a 10% stake and joined the board of directors at Weight Watchers in late 2015, her $43 million investment has grown to exceed $400 million. Compare that 847% growth to the S&P’s 39% increase and the Oprah effect cannot be denied. Her powerful speech at the Golden Globes on January 7th incited social media to explode with excitement over a theorized 2020 run for the presidency. Weight Watchers shares jumped over 12% the Monday following her speech and an additional 9% the next day; the stock continued to climb through January, though this was likely due to more typical reasons such as the company’s strong growth outlook. Once news broke on the 25th that Oprah was officially not planning to run for president, shares tumbled 7% intraday and ended the month down 5% from their January peak.

An announcement from a board member regarding a lack of intent to run for president is certainly not a typical cause for a depression in stock price, and this situation is only a recent example of the growing importance of a company’s brand. Stock prices are no longer solely affected by their fundamentals; a seemingly unrelated blip in the news cycle can now blow up on social media and essentially override a company’s true fundamentals to impact its share price. While an event like this can be unpredictable, it forces management across all industries to have a stronger brand awareness, which is ultimately a good thing as it can lead to increased responsiveness to consumer feedback. As it relates to portfolio management, actively managed funds that can successfully account for this trend are more likely to outperform both their peers and respective indices. As capital markets unfold in 2018, this is a pattern that bears watching.

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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.

2018 Market Preview

Each year, investors face numerous questions that can impact their portfolios, and 2018 is no different. How will tax reform further impact the capital markets? How much – and often – will the Fed raise rates in the coming year? Can international equities continue to outperform their U.S. counterparts? Should we be concerned about the levels of dry powder in the private equity market? These topics among many others are covered in the following articles as we offer our annual market preview newsletters. In the links below, readers will find a preview newsletter for each asset class that we cover, as well as a general U.S. economic preview. Each article contains insightful analysis and key themes to monitor over the coming year, themes which will underlie the actual performance of the asset classes covered. We hope that this set of articles can assist you and your committees as you plan for 2018. Should you have any questions about any of the content, please feel free to contact myself or any of the authors or consultants here at Marquette. We also have a webinar recording available by request if you would like to hear a high-level presentation of the topics presented in these articles. Happy New Year!

U.S. Economy by Jeffrey Hoffmeyer, CFA, Lead Analyst, Asset Allocation

Fixed Income by Ben Mohr, CFA, Senior Research Analyst, Fixed Income

U.S. Equities by Samantha T. Grant, CFA, CAIA, Senior Research Analyst, U.S. Equities & Rob Britenbach, CIPM, Research Analyst, U.S. Equities

Non-U.S. Equities by David Hernandez, CFA, Senior Research Analyst, International Equities

Real Estate by Jeremy Zirin, CAIA, Senior Research Analyst, Real Assets

Infrastructure by Jeremy Zirin, CAIA, Senior Research Analyst, Real Assets

Hedge Funds by Joe McGuane, Senior Research Analyst, Alternatives

Private Equity by Derek Schmidt, CFA, CAIA, Senior Research Analyst, Private Equity

Alpha Returned in 2017, But What About 2018?

Equity hedge strategies were the best performing hedge fund strategy in 2017, as alpha was generated on both the long and short side. This chart shows that net alpha bounced back nicely from 2016, as the 2017 environment was much better for active management. Alpha was generated on the short side during the first half of the year, but trailed off as the bull market continued to move higher.

Another factor that helped equity hedge strategies was the decline in correlations during the year. An environment with lower correlations among stocks is positive for active managers, particularly those who maintain both long and short positions.

For alpha generation to continue in 2018, correlations between stocks will need to stay low, with meaningful sector dispersion. Coupled with the continued effort to remove global monetary stimulus, we would expect managers to benefit from these conditions.

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Will the Fed Prevent the Yield Curve from Inverting?

The U.S. Treasury yield curve is flatter today than it was at the end of the Great Recession in 2009. This week’s chart examines how flat the curve is now, and the potential for further flattening, possible inversion, or potential steepening. The 10s minus 2s steepness shown in the chart is the 2-year Treasury yield subtracted from the 10-year Treasury yield.

In general, a steep yield curve signifies a growing economy and a bullish market, as long-term bonds must provide greater yields to keep up with future growth. On the other hand, an inverted yield curve signifies a shrinking economy and a bearish market, as investors buy long-term bonds as safe havens, thereby driving their prices up and lowering their yields. As we can see from the chart, the yield curve inverted prior to the 2000 tech bubble burst and prior to the 2008 Great Recession.

With the Tax Cut now signed and underway, we would theoretically expect the yield curve to steepen as the market expects stronger economic growth. However, in the fourth quarter of 2017 — as the legislation gained momentum through Congress and was ultimately signed into law by Trump — the yield curve flattened instead. This is a possible sign that much of the tax stimulus may have already been priced into assets.

Previous Fed Chairs Greenspan and Bernanke both said the economy would be fine after the yield curve inverted in 2000 and 2008, respectively. Going forward, we may expect that the new Fed Chair Jerome Powell will be more cautious in preventing inversion.

Prospects for curve steepening still exist, as inflation — which rose recently — may continue to rise as the economy benefits from the Tax Cut. Rising inflation would then be expected to raise the long end of the yield curve. However, we continue to see the mitigating effect of overseas reach for yield, as U.S. rates across the curve still outyield rates from the rest of the developed markets. Non-U.S. pensions, insurers, and banks continuing to buy long U.S. bonds may drive up prices and keep yields low on that segment of the curve.

Given the flat yield curve, we recommend maintaining an allocation to core bonds for yield, diversification, and principal protection, as well as the inherent moderate duration position.

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Oil Market Disruption for 2018 is Closer to Home

Iran, one of the largest exporters of oil, rang in 2018 with a wave of political demonstrations across the country. Citizens gathered to protest Iran’s spiraling economic conditions, which include a 12% unemployment rate, high inflation, and elevated prices of basic goods such as eggs and dairy products. While energy analysts monitor such geopolitical events with due concern, the consensus is that the Iran riots have not caused a significant disruption of supply to the global oil market.

Instead, analysts are pointing to elevated oil production in the U.S., and the subsequent decline in imports. As depicted in this week’s Chart of the Week, net imports of oil to the U.S. dropped more than 65% in the past decade due to rising domestic production. Numerous U.S. shale drillers have pledged to expand exploration if crude oil prices hold above $60, driving imports down even further.

This rise in U.S. oil production has proved a headache for the Organization of Petroleum Exporting Countries (OPEC) and its affiliates, which have actively restrained output since 2016 in hopes of buoying prices. These cutbacks have successfully reduced oil inventories in these countries and the output restraint is set to remain in place through the end of this year. However, global supplies remain high and OPEC’s plan depends on continued compliance from its members. These factors coupled with U.S. production momentum could keep oil prices in check through 2018.

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How Will Tax Reform Impact Asset Class Returns?

On December 20, 2017, Congress passed the final version of the Tax Cut and Jobs Act (H.R. 1). This tax reform bill is estimated to be a $1.5 trillion tax cut and represents the most significant reform to the U.S. tax code since the 1986 tax cut passed under President Reagan. This newsletter will address the most important changes as it relates to the economy, markets, and our client portfolios.

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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 nor 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.

Is the Private Equity Market Overvalued?

Most institutional investors generally expect lower future returns at this point of the economic cycle as valuations remain inflated across all asset classes. Nevertheless, investors still seek attractive opportunities which provide potential for stronger relative returns. We continue to see robust fundraising in the private equity industry as investors are attracted to the current fundamentals as well as the long-term excess returns the industry has generated.

Valuations have continued to increase across the private equity industry, partly as a result of improving fundamentals of small businesses in the U.S., and partly as a result of an increasingly attractive sellers’ market, with strategic and financial buyers anticipated to deploy capital over the next few years. These valuations, now averaging 10.5x EBITDA, still remain well below the public markets. Throughout this growth cycle private valuations have not inflated as significantly as they have in the public markets. As seen in the chart, over the last decade valuations in private equity have ranged between a 20-40% discount to the Russell 2000. We believe this persistently lower valuation in a relatively expensive market should continue to attract capital from valuation sensitive investors as they rebalance portfolios heading into 2018.

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Shrinking Public Markets and Rising Valuations

Barring a correction in December, most U.S. equity indices are looking at another successful year of double-digit returns. While investors can rejoice in their strong portfolio performances, there is an air of caution as valuations are well above historical averages. This has been an area of concern for the last few years, yet markets continue to outperform and valuations keep rising.

One possible explanation for this is the decline in the total number of publicly traded companies. Since peaking in the mid-1990s, listed companies have fallen by nearly 50% to about 4,300 firms despite the total number of companies in the U.S. remaining about the same. More regulation as well as increased availability of private capital have made businesses less likely to go public. Most retail investors, however, do not have the capability to invest in private markets. With fewer investable options there is more money to go around to these publicly traded firms.

While most of the companies that choose to be public are larger than their private counterparts, this suggests the historic average valuation of about 20x earnings is too low of a benchmark for today’s publicly traded firms. These higher equity valuations may be the new normal and the bull run could continue in 2018.

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Is the U.S. Economy Headed for a Recession?

The U.S. Treasury yield curve, as measured by the difference between 10-year Treasuries and 2-year Treasuries, has flattened significantly over the past several years, decreasing from 2.65% on December 31, 2013 to 0.65% on November 15, 2017. In fact, this is the flattest that the yield curve has been since November 4, 2007, just prior to the onset of the “Great Recession,” and this has sparked concerns about a potential recession on the near-term horizon. A flattening yield curve has typically been associated with concerns about future economic growth, so mounting worries about a potential recession are understandable.

However, these concerns appear to be a bit premature. First, it is important to note that every recession since 1980 (including the “Great Recession”) was precipitated not only by a flattening yield curve, but by an inverted yield curve, meaning that yields on longer-term (i.e. 10-year) Treasuries were below yields on shorter-term (i.e. 2-year) Treasuries. Given that yields on 10-year Treasuries are currently 0.65% higher than yields on 2-year Treasuries, we are nowhere near an inverted yield curve. Second, it is worth noting that it is fairly common for the yield curve to flatten during rate hike cycles when short-term rates tend to rise faster than long-term rates. Given that the Federal Reserve Bank has increased interest rates four times since 2015, a flattening yield curve is not an unexpected occurrence. Finally, it is important to note that the yields on U.S. Treasuries — particularly the longer-end of the curve — have been significantly impacted by the actions of other central banks around the world. In 2013, the Bank of Japan launched a $1.4 trillion quantitative easing program that primarily focused on purchasing longer maturity Japanese government bonds. In 2015 the European Central Bank launched a $1.2 trillion quantitative easing program that primarily focused on purchasing longer maturity European government bonds. These large-scale bond purchase programs drastically lowered interest rates on Japanese and European government bonds, enticing investors from around the world to purchase U.S. Treasuries, which offered significantly higher relative yields. Between December 31, 2013 (when the spread between 10-year and 2-year Treasuries was 2.65%) and November 15, 2017 (when the spread between 10-year and 2-year Treasuries was 0.65%), yields on 10-year U.S. Treasuries actually decreased from 3.03% to 2.34%, while yields on 2-year U.S. Treasuries increased from 0.38% to 1.69%.

While the flattening yield curve is somewhat concerning, it appears that this combination of Federal Reserve rate hikes boosting the short end of the curve and quantitative easing programs from global central banks depressing the longer end of the curve is the primary driver of the flattening yield curve, not concerns about future economic growth in the United States.

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