Author: Marquette Test

Growth in Direct Lending

This week’s chart shows the significant growth in direct lending over the last decade, as indicated by the number of funds and amount of capital raised.

Direct lending is defined as a loan made by a private entity to a small – medium size company which generally carries a floating interest rate. The loans have a 3 to 5 year term and are in most cases held to maturity. For some perspective, this space was largely dominated by commercial banks and proprietary trading desks at investment banks leading up to the global financial crisis of 2008 when private lenders had little market share. The landscape has changed since then as banks now face significant regulatory pressure as a result of the Basel III and Dodd-Frank bills, which call for higher risk-based capital charges for non-rated loans and an increase of 25% or more in Tier 1 capital ratios by 2018, making the practice of direct lending an increasingly inefficient use of bank balance sheet capital.

This week’s chart shows the significant growth in direct lending over the last decade, as indicated by the number of funds and amount of capital raised.

Direct lending is defined as a loan made by a private entity to a small–medium size company which generally carries a floating interest rate. The loans have a 3- to 5-year term and are in most cases held to maturity. For some perspective, this space was largely dominated by commercial banks and proprietary trading desks at investment banks leading up to the global financial crisis of 2008 when private lenders had little market share. The landscape has changed since then as banks now face significant regulatory pressure as a result of the Basel III and Dodd-Frank bills, which call for higher risk-based capital charges for non-rated loans and an increase of 25% or more in Tier 1 capital ratios by 2018, making the practice of direct lending an increasingly inefficient use of bank balance sheet capital.

As a result, banks today are virtually inactive in this area and direct lending by private investment managers has emerged as a natural structural replacement. On the demand side, the current low global interest rate environment is fueling increased appetite for this strategy as investors continue to search for yield and diversification in their portfolios.

China Commits to Financing a Green(er) Economy

Earlier this month China and the United States jointly pledged to ratify the Paris climate change agreement, a monumental step for the world’s two largest polluting economies. Executing a dramatic reduction in greenhouse gas (GHG) emissions will require creative financing, and China is looking towards green bonds to support their commitment.

Earlier this month China and the United States jointly pledged to ratify the Paris climate change agreement, a monumental step for the world’s two largest polluting economies. Executing a dramatic reduction in greenhouse gas (GHG) emissions will require creative financing, and China is looking towards green bonds to support their commitment.

Green bonds are financial instruments that raise capital for specific projects with targeted environmental benefits. Apple made headlines in February of this year by issuing the largest green bond from a U.S. corporation. The tech giant sold $1.5 billion in green bonds earmarked for clean energy projects, green buildings, and resource conservation efforts.

Despite the large issuance from Apple, China has surpassed the United States as the largest issuer of green bonds. The country seeks to attract global investors to help finance the Chinese economy’s transition away from polluting industries and towards advanced technology and services.

China approved more than $17.4 billion of sales of green bonds so far this year — over 40% of the market — after issuing its first green bond less than two years ago. However, some of the domestic green bonds being issued do not meet international standards and require additional scrutiny by prospective investors.

For example, some of the Chinese green bonds are tagged to fund clean coal projects. While clean coal might represent environmental progress in pollution-afflicted China, internationally these bonds conflict with the majority of environmentally-friendly investment mandates, as well as the Green Bond Principles, which serve as the gold standard in green bonds.

China is currently responsible for over 20% of GHG emissions, closely trailed by the United States at just under 18%. As both countries seek financial support for their climate change commitments, investors must be wary of products that aren’t as green as they seem.

Look Out For Falling Angels

Over the past year, many bonds from energy and metal/minerals issuers which previously held investment grade ratings were reduced to junk bond status, commonly known as fallen angels. These include Freeport-McMoRan, the largest copper producer in the world and Chesapeake Energy, the second-largest gas producer in the U.S. This week’s chart examines this unprecedented phenomenon. Fallen angels now account for a mind-boggling 42% of the energy and metal/minerals constituents in the Credit Suisse High Yield Index. With this influx of fallen angels, energy and metal/minerals now make up about 21% of the high yield index, up from 15% in February.

Over the past year, many bonds from energy and metal/minerals issuers which previously held investment grade ratings were reduced to junk bond status, commonly known as fallen angels. These include Freeport-McMoRan, the largest copper producer in the world and Chesapeake Energy, the second-largest gas producer in the U.S. This week’s chart examines this unprecedented phenomenon. Fallen angels now account for a mind-boggling 42% of the energy and metal/minerals constituents in the Credit Suisse High Yield Index. With this influx of fallen angels, energy and metal/minerals now make up about 21% of the high yield index, up from 15% in February.

Many investment grade strategies, as well as their institutional investors, have been forced to sell these fallen angels because of investment policy guidelines, temporarily depressing prices and thus presenting cheaper than normal buying opportunities. Furthermore, the shift of bonds from investment grade to high yield has created a unique challenge for the team dynamics of investment managers. Investment grade research analysts are losing issuers to cover since many of them have been downgraded while high yield research analysts are now responsible for covering more issuers. Some investment managers are even transferring investment grade analysts to high yield positions because they are already familiar with the bonds that have become fallen angels.

Marquette recommends that investors maintain their high yield bond allocations. Because of these temporarily depressed prices and the change in name coverage within investment management teams, inefficiencies and opportunities have been created in this cross-over section of the bond market. However, there are risks. We should continue to see an increase in the default rate for high yield energy and metals/minerals issuers. Given lower commodity prices across the globe, while costs have been reduced for pumping oil or mining for metals, the energy and metal/minerals industries have yet to make any significant improvements. Many companies are still filing for bankruptcy, even though oil prices are beginning to slightly rebound. Ultimately, the current opportunities should outweigh these risks, but volatility in the high yield market will likely remain elevated for the foreseeable future.

Low Productivity and Its Impact on Global Growth

Productivity is the change in output per hour worked and serves as a key indicator of real economic growth. Not surprisingly, it is one of the critical macroeconomic variables analyzed by the Fed when deciding whether or not to raise interest rates. Lower levels of productivity can result from economic policy and shocks, changing demographics, and slower gains from technological innovations.

Productivity is the change in output per hour worked and serves as a key indicator of real economic growth. Not surprisingly, it is one of the critical macroeconomic variables analyzed by the Fed when deciding whether or not to raise interest rates. Lower levels of productivity can result from economic policy and shocks, changing demographics, and slower gains from technological innovations.

This week’s chart shows the productivity changes of the three largest developed market currency blocks: the United States, Japan, and the Eurozone. The graph illustrates that all three are currently struggling to produce meaningful productivity gains. In the U.S., output per hour worked has now contracted for three consecutive quarters. Most of the U.S. contraction can be accounted for by lower energy prices, but the more important theme is the lower levels of productivity across the developed world and their likely contribution to stagnating global growth. If this trend continues, it will be serve as yet another headwind for stronger growth across the globe.

Is Higher Debt Among Companies Something to Worry About?

As the Federal Reserve maintains interest rates at all time lows, corporate balance sheets continue to benefit from this accommodative environment, as the low rate environment combined with a bull market has allowed corporations to add leverage to their balance sheets at an alarming rate. With borrowing costs so low, corporations have used this debt to finance stock buybacks, dividend growth, and M&A deals.

As the Federal Reserve maintains interest rates at all time lows, corporate balance sheets continue to benefit from this accommodative environment, as the low rate environment combined with a bull market has allowed corporations to add leverage to their balance sheets at an alarming rate. With borrowing costs so low, corporations have used this debt to finance stock buybacks, dividend growth, and M&A deals.

The growth of net debt among the S&P 500 constituents has hit levels not seen in the past 10 years, rising significantly against EBITDA levels. Thus, corporations’ operational cash flows are not expanding quickly enough to keep pace with their growing debt loads. This type of imbalance in past cycles has led companies to cut back on spending and hiring.

While consumers have deleveraged since the 2008 housing crisis, corporations have taken advantage of the low rates and subsequent cheap financing. If the Federal Reserve begins to raise rates or economic growth continues to slow, corporations could struggle to cover interest payments on their outstanding debt, which would likely translate to subpar returns for both equity and debt investors.

Are U.S. Equities Headed for a Correction?

So far this year several macroeconomic issues have threatened to negatively impact financial markets. Yet U.S. equities have shrugged off all of these headlines and outperformed most peoples’ expectations. This week’s Chart of the Week takes a closer look at this strong return for the S&P 500 through July. Year-to-date, all of the positive performance has come from valuation appreciation. As a result, the trailing 12-month P/E ratio is now over 20, which is near its highest level over the last ten years. EPS, on the other hand, has actually fallen during the year, which is in stark contrast to the previous ten years when EPS growth was the main driver of price return. This phenomenon can be observed across the cap spectrum and in both value and growth indices.

So far this year several macroeconomic issues have threatened to negatively impact financial markets. Yet U.S. equities have shrugged off all of these headlines and outperformed most peoples’ expectations. This week’s Chart of the Week takes a closer look at this strong return for the S&P 500 through July. Year-to-date, all of the positive performance has come from valuation appreciation. As a result, the trailing 12-month P/E ratio is now over 20, which is near its highest level over the last ten years. EPS, on the other hand, has actually fallen during the year, which is in stark contrast to the previous ten years when EPS growth was the main driver of price return. This phenomenon can be observed across the cap spectrum and in both value and growth indices.

Going forward, things may finally start to catch up with the U.S. equity markets. In addition to lower earnings, GDP growth has been weak the last three quarters, falling short of expectations each time. Furthermore, elections often affect markets negatively due to the increased uncertainty associated with a change in president, and with both candidates carrying unprecedented unfavorable ratings, the volatility impact may be magnified. If earnings do not reverse their recent downward trend, U.S. equities could be in for a rough second half of the year.

Expect Near-Term Volatility for U.S. Equities?

This week’s Chart of the Week examines the pattern of monthly declines for the S&P 500 which are 5% or greater. Data going back to 1945 shows the months of August and September to have historically seen the greatest frequency of equity market declines of this magnitude. In fact, nearly one third of all monthly declines that are 5% or greater occurred during August and September. While historical occurrences such as this do not represent an absolute for equity markets, investors are entering a period that has historically produced below average returns.

This week’s Chart of the Week examines the pattern of monthly declines for the S&P 500 which are 5% or greater. Data going back to 1945 shows the months of August and September have historically seen the greatest frequency of equity market declines of this magnitude. In fact, nearly one-third of all monthly declines that were 5% or greater occurred during August and September. While historical occurrences such as this do not represent an absolute for equity markets, investors are entering a period that has historically produced below-average returns.

The old adage of “sell in May and go away” did not materialize in 2016, but it is important to remember just how much ground equities have recovered since the substantial drop in equity markets at the start of the year. With a year-to-date return of +7.7% through the end of July, the S&P 500 has advanced +18.8% from its February 11th low. Additionally, the S&P 500 notched seven new closing highs during the month of July. With equity markets continuing to test new all-time closing highs, the historical pattern of consolidation during the third quarter looks to be increasingly probable in the near term.

Do Rising Interest Rates Mean Higher Cap Rates for Real Estate?

One of the best performing and consistently stable asset classes over the past several years has been real estate. Based on the NCREIF-ODCE Index real estate has returned an annualized 12.7% over the last five years.

One of the best performing and consistently stable asset classes over the past several years has been real estate. Based on the NCREIF-ODCE Index, real estate has returned an annualized 12.7% over the last five years. Much of the sector’s success has been attributed to strong fundamentals which have translated into cap rate1 compression. Although cap rates are at historical lows and unlikely to compress much further, the unusually low interest rate environment combined with the spread between cap rates and risk-free Treasuries continue to make real estate investments look relatively attractive. Going forward, in anticipation of the Fed raising interest rates, we expect the current relatively wide cap rate to Treasury spread will provide a measure of cushion to allow long-term interest rates to rise without drastically impacting cap rates and the overall value of real estate.

 

1Cap rate is the net operating income divided by property value

Global Bonds and Negative Yields

This week’s chart examines the change in yield for global sovereign debt. While we have been in a low interest rate environment since 2008, over the last three years, we have seen negative yielding bonds move from 0% of the developed bond universe to 38%. A staggering number indeed, this has been the by-product of anemic global growth and aggressive monetary policies in Europe and Japan.

This week’s chart examines the change in yield for global sovereign debt. While we have been in a low interest rate environment since 2008, over the last three years, we have seen negative yielding bonds move from 0% of the developed bond universe to 38%. A staggering number indeed, this has been the by-product of anemic global growth and aggressive monetary policies in Europe and Japan.

One of the consequences of a negative rate environment is increased demand for higher yielding assets. Through the second quarter, U.S. high yield and emerging market debt have returned 9.1% and 10.3%, respectively. In addition to attractive yields, these asset classes have benefitted from stability in commodity prices and minimal exposure to the Brexit event. Should these conditions persist going forward, expect investor preference for credit and higher yielding bonds to continue, given this historically low interest rate environment.

What Does the Brexit Mean for the Fed and Interest Rates?

While the Brexit won’t actually take place until at least sometime next year, many investors and economists are concerned about the ramifications this will have on the global economy. The Federal Reserve is no exception. Prior to the vote, the Fed warned about the effects the Brexit might have, and since then has indicated it would hold off raising interest rates due to these risks. M

While the Brexit won’t actually take place until at least sometime next year, many investors and economists are concerned about the ramifications this will have on the global economy. The Federal Reserve is no exception. Prior to the vote, the Fed warned about the effects the Brexit might have, and since then has indicated it would hold off raising interest rates due to these risks. Markets now are giving almost no chance of a rate hike at next week’s meeting and, as shown in the chart above, there is still only a small chance of an increase in September or November. Both the futures market, which is used to calculate the odds above, and most economists give about a 50/50 chance of a hike in December. So while the Fed initially expected to raise interest rates four times in 2016, it seems now there’s a strong chance that there won’t be any.