Author: Marquette Test

2015 Market Preview

January 2015

Similar to previous years, we offer our annual market preview newsletter. Each year presents new challenges to our clients, and 2015 is no different: U.S. equities are at all-time highs, uncertainty reigns for international equities, and to everyone’s surprise, interest rates fell dramatically in 2014…but are poised to rise from historic lows over the next year. In the alternative space, real estate remains a solid contributor to portfolio returns, and private equity delivered on return expectations, though dry powder is on the rise. Hedge fund results were mixed, but have shown to add value in past rising interest rate environments. Further macroeconomic items that bear watching for their potential impact on capital markets include the precipitous fall in oil prices, the strengthening U.S. dollar, job growth, and international conflicts.

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Economic Impact of Falling Oil Prices

The economic impact of falling oil prices has been a common discussion point for investors over the past few months. Who benefits? Who doesn’t? In this week’s Chart of the Week, we look at what different oil prices mean to various parties.

The economic impact of falling oil prices has been a common discussion point for investors over the past few months. Who benefits? Who doesn’t? In this week’s Chart of the Week, we look at what different oil prices mean to various parties.

Oil prices fell by more than 40% in 2014 as a result of strong production and OPEC’s refusal to support prices. Brent crude, the international benchmark for oil, began the year at $110, which is significantly less than the level necessary for certain countries like Venezuela and Iran to balance their budgets. Earlier this week, Brent crude fell to less than $47. According to the Financial Times, an oil price of $90 is necessary for Saudi Arabia to balance its budget, while Kuwait would be happy with levels above $50. In the U.S., the outlook for operators of shale oil developments will be heavily dependent on their cost structures — an oil price of $115 is needed for high-cost producers to break even, but low-cost producers can break even with prices as low as $40. A major beneficiary of the slippery slope in oil prices is the airline industry. With oil at the level of $95, they would see a boost to 2015 operating profits of approximately $15 billion.

The takeaway is that the economic impact of the slide in oil prices is not the same for all market participants. As such, this environment presents interesting tactical opportunities for domestic and international investors with exposures to governments and corporations.

Booming Biotech Still a Buy?

The Nasdaq Biotech Index enjoyed another great run in 2014, returning 34% for the year and over 220% since 2011. By comparison, the Nasdaq Index has gained 13% and 75%, respectively, over the same time periods. Currently, the Nasdaq Biotech Index is nearly 60% above its long-term average price-to-book (“P/B”) ratio, and while there’s an argument that most U.S. equities are currently overvalued, the Nasdaq Index is only about 13% above its long-term average P/B ratio.

The Nasdaq Biotech Index enjoyed another great run in 2014, returning 34% for the year and over 220% since 2011. By comparison, the Nasdaq Index has gained 13% and 75%, respectively, over the same time periods. Currently, the Nasdaq Biotech Index is nearly 60% above its long-term average price-to-book (“P/B”) ratio, and while there’s an argument that most U.S. equities are currently overvalued, the Nasdaq Index is only about 13% above its long-term average P/B ratio. As a comparison, the S&P Biotech Index is about 36% above its long-term average P/B ratio, while the S&P Index is only 23% higher.

These elevated valuation metrics even have biotech bulls questioning if a bubble is emerging in response to so much growth. Though these fundamentals alone may indicate that biotech is on the verge of a correction, there is still hope for the sector. Healthcare spending is a large portion of U.S. GDP and is expected to grow with our substantial aging population. As technologies and research methodologies improve, so do drug research possibilities and opportunities. Some of the prior rises in price may be explained by positive news that is not yet quantifiable or on positive trial data that is not yet able to be capitalized. Because of the lengthy trial and FDA approval processes, along with the current maturation of the sector, many revenue-generating drugs and technologies should come to fruition in the coming years, thus providing optimism for further positive returns from biotechs.

Fundamentals suggest that biotech has already experienced the majority of its run, is overvalued, and would not be an ideal investment for the faint of heart. However, the sector bears watching in the coming year as investors keep an eye out for progressing FDA phase data or new drug releases. Ultimately, in spite of current valuation data, biotechs should continue to deserve a healthy allocation within a well diversified U.S. equity portfolio.

Lower Oil Prices a Tailwind for Airline Stocks

Our chart of the week examines how the fall in the price of oil – despite its recent impact on the overall stock market – has benefitted the airline industry and should continue to do so in the near future.

Our chart of the week examines how the fall in the price of oil – despite its recent impact on the overall stock market – has benefitted the airline industry and should continue to do so in the near future.

The chart shows how oil prices have steadily declined since June to roughly $56/barrel as of December 16th. Over the same period, U.S. equities — as represented by the S&P 500 — have marched higher, led by stronger than expected earnings and an increasingly favorable jobs market. Given the drop in oil prices, it may not be entirely surprising that airline stocks as a group have been one of the strongest performers in 2014, gaining 34% so far this year. Since one of the largest expenses for any airline is fuel, the recent decline in prices coupled with both the large volume of travelers in the fourth quarter and rise in airline ticket prices should translate to one of the most profitable quarters for a sector already flying high. The nosedive in oil prices may not be the best news for the overall market (seen at the very end of the graph) but should bode well for airlines and the managers who choose to invest in this soaring sector.

Real Assets: The State of Commodities

December 2014 Investment Perspectives

Commodity market investors received a ray of hope in the early months of 2014. After several years of consecutive declines, commodities, as measured by the Bloomberg Commodity Index, began the year on strong footing and posted a gain of 7.1% in the first half of the year. By the end of the third quarter, however, commodities entered negative territory, and the year-to-date return through November for the Bloomberg Commodity Index had fallen to -10.2% (Exhibit 1). In this newsletter, we examine the recent developments in the commodity markets and evaluate their prospects for the coming quarters.

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Impact of Low Oil Prices on Emerging Market Investments

Many investors are concerned that the recent decline in oil prices will pose significant headwinds for investments in emerging markets debt and equity, since many emerging countries are known as significant exporters of oil. In the same vein, the economic slowdown in Europe and China may translate to reduced consumption of emerging countries’ commodity exports. Our Chart of the Week examines the impact of lower oil prices on the potential returns for emerging market investments, specifically debt and equity.

Many investors are concerned that the recent decline in oil prices will pose significant headwinds for investments in emerging markets debt and equity since many emerging countries are known as significant exporters of oil. In the same vein, the economic slowdown in Europe and China may translate to reduced consumption of emerging countries’ commodity exports. Our Chart of the Week examines the impact of lower oil prices on the potential returns for emerging market investments, specifically debt and equity.

While all emerging market countries are exporters in one way or another, they do not all primarily export energy or even commodities. As shown in the bottom right of this week’s chart, Venezuela and Nigeria rely heavily on energy exports and the recent drop in oil prices has been a negative trend for their sovereign and corporate debt as well as the stocks of companies in those countries. In the top right, there are more emerging countries that rely on commodity exports that are non-energy — countries that rely more on mineral and agricultural exports, such as Chile and Brazil. Finally, in the top left, there are even more emerging countries that have much more of their exports in the form of non-energy, non-commodity goods, such as Israel and China, which export mainly manufactured goods. In some cases, the fall in commodity prices is beneficial for commodity importers like India and Turkey.

Based on the chart, there does not appear to be an overreliance on oil – or commodity – exports to support the collective economies of emerging market countries. While some countries will most certainly feel the direct impact of lower oil prices, emerging market investments should not be disproportionately hurt by falling oil prices.

When Will Rates Rise in 2015?

As investors turn the calendar to 2015, one of the big uncertainties for the coming year is Fed policy and its impact on interest rates. In October, the Fed formally wrapped up its quantitative easing program, which saw the size of the central bank’s balance sheet grow from a pre-crisis $800 billion to almost $4.5 trillion. Now, the Fed can once again focus on the more traditional policy tool of manipulating short-term interest rates.

As investors turn the calendar to 2015, one of the big uncertainties for the coming year is Fed policy and its impact on interest rates. In October, the Fed formally wrapped up its quantitative easing program, which saw the size of the central bank’s balance sheet grow from a pre-crisis $800 billion to almost $4.5 trillion. Now, the Fed can once again focus on the more traditional policy tool of manipulating short-term interest rates. Against a backdrop of steadily improving economic fundamentals and low inflation, the Fed has pledged to keep the Fed Funds rates low for a “considerable” period of time. Investors have loosely interpreted such Fed-speak to mean that the first rate hike is likely to occur sometime in the second half of 2015.

For a more precise estimate of the market’s interpretation, we can turn to the futures market for potential guidance. As of November 28, the futures market was predicting that the effective Fed Funds rate will rise from its current level of 0.10% to 0.25% by August of 2015, reaching a level of near 0.50% by the end of 2015. Unfortunately, as our chart of the week shows, the futures market has historically been a poor predictor of future interest rates. Since the 2008 Financial Crisis, futures contracts on the effective Fed Funds rate have serially overestimated the actual level of interest rates. So while 2015 is supposed to finally be the year that interest rates rise off historic lows, the futures market cannot be counted on to accurately predict the timing and magnitude of any increase.

Currency Effects on International Equity Returns

One of the most significant challenges that international equity investors have faced this year is the impact of a stronger dollar. From many perspectives, a stronger dollar signals improved economic growth in the U.S. Unfortunately, a stronger dollar also acts as a headwind for U.S.-based investors purchasing international equities.

One of the most significant challenges that international equity investors have faced this year is the impact of a stronger dollar. From many perspectives, a stronger dollar signals improved economic growth in the U.S. Unfortunately, a stronger dollar also acts as a headwind for U.S.-based investors purchasing international equities. In some instances, the impact of the stronger dollar has flipped positive returns denominated in local currency to negative returns when translated to U.S. dollars. In fact, this phenomenon has occurred year to date in 2014: the local currency return for a primary international equity index (MSCI EAFE) is positive (red bar; 4.2%), but becomes negative when denominated in dollars (blue bar; -2.4%).

In our Chart of the Week, we examine the retrospective returns of the MSCI index, denominated in both local currency and U.S. dollars. Based on the chart, two conclusions seem straightforward:

  • The “winner” each year will vary over time, which is not surprising since the U.S. dollar strengthens in some years and weakens in others.
  • Over the long term, the relative strengthening or weakening of the U.S. dollar is more or less balanced out, as the cumulative returns of each index – local and dollar – suggest, shown by the convergence of the two cumulative return streams.

If nothing else, this week’s chart should provide some comfort to investors whose returns have been negatively impacted by a stronger dollar: although the dollar acted as a drag on international returns this year, it is highly unlikely this will be a consistent pattern in the coming years, and should certainly not serve as a worry for long-term international equity investors.

Better Prospects for Future Income?

One of the most notable economic metrics that has not yet recovered from the recent recession is income and wage growth. This is not surprising: given the high level of unemployment, employers have been able to successfully hire without having to pay a material premium in wages. This trend has been supported by the level of wage growth, which has averaged close to 2%, significantly below its pre-recession average of 3.5%.

One of the most notable economic metrics that has not yet recovered from the recent recession is income and wage growth. This is not surprising: given the high level of unemployment, employers have been able to successfully hire without having to pay a material premium in wages. This trend has been supported by the level of wage growth, which has averaged close to 2%, significantly below its pre-recession average of 3.5%.

However, as the unemployment rate has abated, this trend appears to be reversing itself, at least in terms of future wages expectations on behalf of workers. Our chart this week shows the growing level of workers who expect their incomes to actually increase in the coming years (blue line in the graph). Predictably, the number of workers who expect their incomes to decrease is dropping (red line). Collectively, these patterns suggest a growing confidence that wages will increase, which should translate into more disposable income for consumers. Given that the U.S. economy is one driven by consumption, higher wages should translate into a notable tailwind for economic growth.

Improving Diversification Profile for Commodities?

As they are driven more by supply and demand and less by macroeconomic factors, commodities have historically enjoyed low correlations to other asset classes in an investment portfolio, and are often utilized as a source of diversification. However, the correlations between commodities and other asset classes, such as equities, fixed income, and hedge funds tend to be fluid over time and can change significantly over a market cycle.

As they are driven more by supply and demand and less by macroeconomic factors, commodities have historically enjoyed low correlations to other asset classes in an investment portfolio, and are often utilized as a source of diversification. However, the correlations between commodities and other asset classes, such as equities, fixed income, and hedge funds tend to be fluid over time and can change significantly over a market cycle. Our Chart of the Week examines the recent movement in correlations between commodities and the most common constituents of an institutional portfolio: U.S. equities, international equities, bonds, and hedge funds.

The chart above illustrates that in the years leading up to the summer of 2007, rolling 5-year correlations between commodities and other asset classes ranged from as low as -0.07 for fixed income to as high as 0.36 for hedge funds. Correlations spiked after the collapse of Lehman Brothers in September 2008, as macroeconomic conditions took the driver’s seat and pushed correlations to equities and hedge fund strategies upwards over the following years. Recently, though, these correlations have started to retreat towards pre-recession levels, with correlations generally decreasing since July 2013. Given this downward trend, the correlations between commodities and other asset classes make a better case for the asset class and its diversification benefits now than it did a few years ago.