Flash talk by Nat Kellogg, CFA at Marquette’s 2017 Investment Symposium
We recap a year of surprises and market reactions including Brexit, the 2016 U.S. election, and France’s 2017 presidential election in this session. The lesson to be learned from a year of exciting politics is similar to market performance: forecasting is difficult if not impossible and solely making decisions based on current events can lead investors down an uncertain path.
Opening keynote from Marquette’s 2017 Investment Symposium on the sharing economy with April Rinne, Global Authority on the New Economy: “Access Over Ownership” and the Sharing Economy
Over the past two decades there has been a steady decline in the number of companies listed on U.S. stock exchanges. In 1996, during the dot-com peak there were more than 8,000 public companies, but this has declined to just over 4,300 as increased regulation and consolidation has more than offset the number of IPOs and corporate spinouts. Over 2,000 companies were delisted between 1997-2003 as the maturity, composition, and fundamentals of these businesses were not able to attract institutional capital and thus failed to meet the listing standards of U.S. exchanges.
Meanwhile, the perception of the private equity industry continues to evolve as more capital and managers gravitate towards the space. There are over 7 million businesses in the U.S. and the number of private equity-backed companies has steadily increased to now over 7,100 companies. Investors continue to be attracted to the return potential, alignment, and innovation within the private markets. With nearly $1 trillion of dry powder in the private equity industry and near record fundraising we are almost certain to see the number of private equity-backed companies increase over the next decade.
Furthermore, it will not be surprising to see investors shift more of their allocations into private equity. Private markets offer a larger and growing opportunity set, and further upside than the fully valued equity markets. With both the number of managers and investment options increasing, we are likely to see a widening range of returns produced by the industry which will make manager selection even more critical for investors.
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.
Contrary to popular opinion, not all shopping centers and retail stores are headed to the graveyard. Although some such retailers are already dead or heading in that direction, our chart of the week shows that while the absolute number of net store openings has dropped, they are still positive and expected to outpace store closings. Additionally, the overall composition of retailers has changed over the years. Today, store openings are less flashy than they used to be and companies are more cautious in their plans for growth. We are seeing strength in the retail space from discounters such as TJ-Maxx; “fast-fashion” retailers like Zara and H&M; beauty brands such as Ulta and Sephora; and fitness companies like Soulcycle and Orange Theory Fitness.
So what does all this mean for real estate investments? The majority of retail exposure for real estate funds in the NCREIF-ODCE index is typically in community and regional centers with heavy foot traffic. This includes grocery-anchor malls and areas where store openings remain positive with minimal exposure to the large mall anchor stores that dominate the headlines. These investments should flourish in today’s market, as real estate investment managers anticipate future shopping patterns of the ever changing consumer.
One of the biggest challenges investors face today is navigating the current equity environment as valuations are well above their historical averages. The P/E ratio for the S&P 500 climbed over 45% during the past five years resulting in several new all-time high index levels. Given the length of the current bull market many have begun to prepare for a correction over the past few years, yet we are still waiting.
In early 2016 equity markets appeared to be in trouble as earnings repeatedly disappointed. Instead, stocks ultimately rallied with Trump’s pro-growth agenda, as investors anticipated increases in infrastructure spending and lower taxes. But with the failure to pass any major legislation so far, it seemed these gains were in danger of being wiped out. However, this time it was earnings to the rescue, as they climbed more than 10% over the trailing 12 months. This allowed stocks to rise even higher while stabilizing valuations.
While earnings are unlikely to continue growing at this pace, during 2013 and 2014 they did average a more reasonable 6.5%. If earnings can maintain that level once again markets may be able to postpone a correction and further sustain the current bull market. Should they fall, however, there may not be other factors to support valuation levels and hold off significant losses.
Hurricanes Harvey and Irma substantially impacted the lives and infrastructure of all that was in their paths. They also directly impacted certain investments, namely catastrophe bonds, (“cat bonds”). Catastrophe bonds can help diversify a bond portfolio’s rate, credit and currency risk with non-correlating nature risk. Cat bonds are issued by insurance companies that pool property and casualty policies. They pay coupons to the bondholder using the policy premiums received. However, when a natural disaster occurs, the principal of a cat bond can be used to pay insurance claims on the pool of policies. Historically, annual cat bond returns average 5% to 10%.
This week’s chart shows the Swiss Re Cat Bond Index on the top compared to the Credit Suisse High Yield Bond Index on the bottom. Hurricane Harvey caused only a negligible 0.3% decline in the cat bond index followed by a 0.5% rebound, since the most severe damage came from flooding. Flooding is generally not covered by cat bonds, as cat bonds primarily cover hurricane damages associated with wind. However, Hurricane Irma caused a 16% initial decline, as the index has roughly 20% exposure to Florida hurricanes. Moreover, the state of Florida requires that all homeowners hold hurricane insurance.
Hurricane Irma qualifies as one of the top 10 costliest natural disasters ever recorded, with damage estimates ranging from $50 billion to $100 billion. It is akin to the 2008 housing crisis for the corporate credit and equity markets. The bottom chart shows the high yield bond index declining during the 2008 housing crisis by 33% peak-to-trough, which was over twice the initial decline of the cat bond index due to Hurricane Irma. With recent damage estimates adjusted downwards from an initial overshoot, the Swiss Re Cat Bond Index has already rebounded by 10% only a few days after Irma struck. This makes its net decline 6% to-date as the index continues to recover, showing inherent resilience in the cat bond market. Our thoughts are with those affected by these recent disasters.
To date, hurricane Harvey has caused more than 100 deaths in the United States and at least $70 billion in estimated losses. Without much time for recovery, hurricane Irma, recorded as the most powerful Atlantic hurricane in history, has already destroyed Caribbean islands and is now approaching Florida. As market participants’ sentiment is one of the most important drivers of asset prices, this week’s chart investigates how traders react to such natural disasters, and the impact on S&P 500 sector performance.
In this analysis, trader sentiment is measured by the number of messages about a specific company posted to the StockTwits website and then the PsychSignal algorithm computes their intensity (scaled from 0 to 4, 4 being the most intense), and groups the scores by sector. The mood score is calculated by bullish score minus bearish score. The more positive the score is, the more bullish the traders are toward that specific sector. The mood scores for each stock are averaged over 10 trading days since the outbreak and averaged again across stocks in the sector.
Considering that the maximum score is 4, the chart shows traders are slightly bullish but close to neutral across the board, and it is difficult to discern a profitable pattern based on these readings. If anything, traders tend to be more bearish on basic material and utility companies whose ability to process minerals and supply power can be tapered. On the other hand, traders are more bullish on consumer staples, energy and health care companies, which may see more demand amidst recovery efforts. During hurricane Harvey, traders have been bullish on energy companies and the sector returned 3.6%.
However, the series of natural disasters shown in the graph above reveals that there really is not a predictable correlation between sentiment and sector performance. For example, traders were bearish on basic material companies in 2009 and 2010. However, the sector returned 1.7% and 1.1%, respectively, during the earthquake (2009) and flood (2010) disasters. Traders were bullish on energy companies in 2011 but the sector returned -4.6%. This unclear relationship could be because the members of S&P 500 sector indices are large cap companies that are less influenced by short-term shocks than small cap companies. Also, StockTwits only represents a small portion of market participants and covers topics beyond natural disasters.
According to this analysis, how traders feel about the natural disasters cannot solely predict how the sectors will perform. Traders tend to keep quiet as natural disasters are an unknown factor and considered too risky upon which to make a buy/sell decision. It is interesting to observe how traders feel about natural disasters in terms of asset prices but not indicative of future returns.
The Federal Reserve continues to signal its intention to reduce its $4.5 trillion balance sheet, with the markets anticipating the first move to occur in September. Much of the liquidity, and consequently, asset returns, in the global markets today could be attributed to the substantial bond and other securities purchases made by the major central banks, thereby ballooning their balance sheets.
Our chart this week shows the Federal Reserve (Fed), European Central Bank (ECB) and Bank of Japan (BOJ) balance sheets over time, totaling $14 trillion today. While the Fed has effectively stopped growing its balance sheet since 2014, the ECB and BOJ continue to expand their balance sheets. With the U.S. enjoying the strongest economy relative to Europe and Asia, the Fed will be the first to taper its balance sheet. This move would effectively slow down stimulus in the U.S., with the ECB and BOJ’s balance sheet tapering to follow at some point in the future when their economies have resuscitated. The Fed has been broadly communicating the mechanics of its tapering, and we expect the markets to respond relatively moderately to the first reduction event.
Wage growth continues to be one of the most disappointing parts of the recovery as increases in pay are relatively low despite record levels of employment. However, the growth individuals see can vary significantly. This week’s chart shows how $1000 five years ago would have grown under the different quartiles of wage growth, as well as how costs have increased under inflation. Given the low levels of inflation in recent years, it is of little surprise that costs have not changed much, rising just over 6.5% during this time frame. Workers whose raises were consistent with median wage growth gained an extra $150 for every $1000 earned in 2012, which was enough to beat inflation and increase their purchasing power.
What is most notable though, is that those who received the 75th percentile for wage growth nearly doubled their pay, while individuals at the 25th percentile lost more than 10% before inflation. It is important to consider that many workers will not consistently be at one end or another of the spectrum; a promotion one year could put an individual in the top quartile, while the loss of an important customer could move them to the bottom the next. Still, this shines some light on the different scenarios workers are facing as a quarter of the population lost about 2% or more of their income this past year, while another gained over 14%.
Although it seems like this gives some credence to the complaints about rising inequality, it should be noted that the biggest determinant of wage growth is age. Younger workers just starting out their careers saw the largest raises with those age 16–24 gaining almost 8% this year on average, compared to just 2% for those 55 and older. Not surprisingly, those with higher skills and better education also fared better on average. The industry in which a person works is less important than one might expect, with most sectors having a growth rate between 3–4%. Ultimately, given the wide range of wage growth rates this could affect increases in consumer spending with those on the lower end of the spectrum not able to increase their spending habits. Spending growth is more dependent on those who experience larger gains and if they choose to start saving more, economic growth could suffer.
After several years of trailing the S&P 500, international equities are off to a strong start, returning 17.1% year-to-date through July. Is this the start of a longer term trend? This week’s chart examines the historical performance of the S&P 500 and the MSCI EAFE over the last thirty five years.
Since October 1982 the S&P 500 and MSCI EAFE have taken turns as the leader, each embarking on significant bullish runs. Between 2000 and 2007, international equities (7.2%) outperformed domestic stocks (1.4%). Then between 2007 and 2016, the S&P 500 beat the MSCI EAFE by over 7% on an annualized basis. The data shows that long periods of outperformance have been a common occurrence for both indices.
This year international equities have outperformed. They have benefitted from strong economic and earnings momentum, a clearer political landscape, and positive currency returns. All equities are expensive, but non-U.S. equities appear less expensive than their U.S. counterparts. While we cannot predict the future, the improved backdrop and relatively attractive valuations bode well for international equities.
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