cvernon, Author at Marquette Associates

U.S. Venture Capital Market Environment

As a growing number of participants have entered the private markets, the amount of total dry powder has increased. Venture capital funds, however, do not appear to be driving this significant increase in fundraising. Rather, U.S. venture capital fundraising appears to have remained rational, roughly in-line with the market’s long-term average of $30 billion raised annually, which differs from the more dramatic increases in fundraising within private equity, growth equity, real estate, and private credit.

Dry powder within U.S. venture capital has risen, but remains at a consistent ratio relative to the annual investment level in the industry, currently implying 1.5 years of investment¹ to work through the current levels of dry powder. A key reason for this statistic is the notable level of investments made in the market; in 2017, close to $70 billion was invested, which represents the highest amount since the tech bubble in 2000. Over the last 18 years U.S. venture capital investments have exceeded U.S. fundraising as additional capital has been invested by sovereign wealth funds, corporate venture groups, and family offices.

This increasingly competitive investment environment is forcing managers to work harder to differentiate their capital by providing more strategic value to underlying managers and companies. Market valuations have been high for 4-5 years now, but the early stage venture space hasn’t experienced as much valuation expansion given the inherent business risk. What has changed is a decline in the number of financing rounds, as fewer companies are raising larger amounts of capital and instead are seeking investors who can provide strategic value as many businesses remain private for longer.

We believe it is important to remain disciplined in manager selection as established high-quality managers with broader platforms are positioned to perform well in this environment as they have differentiated capital pursued by many businesses. We believe these managers are more likely to find attractive investment opportunities without overpaying in this competitive environment.

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¹ The ratio of dry powder to annual investment provides an indication of how many years of investment are needed to work through the current level of dry powder. A ratio over 1 implies there is more than a full year’s worth of dry powder based on the most recent annual deployment for the industry. It is important to pay attention to the directional change of this ratio. An increasing ratio is an indicator the investment landscape is becoming more competitive to deploy capital as dry powder is growing faster than investment opportunities.

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.

Value Underperformance in the Current Market Cycle

With the value premium seemingly in decline, value investors have had a lot to complain about over the past ten years. Growth stocks continue to soar despite rich valuations and increasingly lofty expectations. However, we are most likely closer to the end than the beginning of this “pro-growth” trend.

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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.

Are Housing Prices Drying Up Our Savings?

The demand for apartments has been robust over the past several years, particularly within the Millennial generation, which has contributed to strong rent growth for the sector. From a demographics perspective, Millennials are delaying life choices such as homeownership and marriage; as a result, homeownership rates are at historical lows. However, there is much more to the story than just demographics driving down homeownership rates. In fact, as illustrated in the table above, the growth in home prices has exceeded its long-term average by 2.9 percentage points. Concurrently, family income growth is down, below its long-term average by 1.9 percentage points, making it increasingly more difficult to own a home in today’s market.

Even more concerning is how much housing costs are contributing to core CPI, illustrated in the graph above. As of October 2017 (the most recent data point available), housing inflation contributes 78% of the total core inflation rate, compared to historically averaging approximately 50%. The combination of increasing home prices coupled with decreasing family income growth is the perfect storm for Millennials looking to purchase a home today. Spending more on housing not only means spending less on other consumer goods and services, but it makes it difficult for the average Millennial — especially those with student debt obligations — to save for the future.

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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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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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