Category: Chart of the Week

Emerging Opportunities Beyond China

Equity performance in China, with the MSCI China Index down 5.5% through the first half of the year, has disappointed amid hopes for a strong post-COVID recovery. While macro data started the year strong, momentum quickly waned, with a cautious consumer and a slowdown in manufacturing. China’s property sector troubles have continued, and U.S./China tensions remain, with the U.S. moving toward stricter regulation and reduced investment in the Chinese technology sector in 2024. Along with human rights concerns and the general unpredictability of the Chinese government, the debate around China’s investability continues on.

Take China out of the emerging markets picture, however, and the story is different. The MSCI Emerging Markets Index excluding China — the largest single country weight in the index at nearly 30%¹ — has outperformed the broader benchmark since late 2021. Latin American countries like Brazil and Mexico — almost 6% and 3% weights in the index, respectively — have benefited from central banks that began their monetary policy tightening cycle earlier. Additionally, as renewable energy trends continue, Latin American regions rich in natural resources should see exports grow. Nearshoring trends have also benefitted emerging market countries such as Taiwan — the second largest country weight in the index at nearly 16% — and Mexico, with the latter exporting nearly as much to the U.S. as China, something not seen since 2003. And in India — the third largest country weighting in the MSCI EM Index at approximately 15% — government reform programs have drawn in significant investor flows.

Looking into the second half of the year, the evolving macro picture in China, including any potential stimulus, will continue to be a driving factor of overall MSCI EM performance. And outside of China, there are a number of interesting trends playing out across the emerging markets space that should present investment opportunities for active managers.

 

¹All country weights as of June 30, 2023

The FTC vs. M&A

Higher interest rates have broadly impacted capital markets, including M&A deal flow given the significant increase in financing costs. Along with that, elevated regulatory risk has been another headwind for the space.

Since her appointment as Chair of the Federal Trade Commission (FTC) in June 2021, Lina Khan has emerged as one of the most aggressive anti-trust leaders the U.S. and Wall Street have seen in some time. For large corporations seeking growth via M&A, the regulatory requirements for FTC approval have increased significantly. Deals that would likely have been approved with ease in prior administrations now face costly lawsuits, injunctions, and other challenges by the Commission. Coupled with higher financing costs, the FTC’s aggressive agenda has significantly prolonged the timeline for deals to close. In the second quarter of 2023, completed M&A deal volumes came in at mere $95 billion, just above the $83 billion of deals closed at the height of COVID in the second quarter 2022. At the same time, the volume of pending deals awaiting regulatory approval has substantially increased, reaching $183 billion in the second quarter.

The FTC’s actions have had a clear impact on the M&A environment, leading to significantly wider deal spreads in 2023 amid increased uncertainty. This is both an opportunity and a risk for hedge funds specializing in merger arbitrage. While deal spreads appear attractive, they come with heightened risks that require expertise to successfully navigate. For investors, selecting experienced managers with a proven track record of success across different regulatory regimes is critical to achieving favorable risk-adjusted returns.

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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.

Credit Trash is Return Treasure

“One man’s trash is another man’s treasure” may be a cliché, but it has never been more applicable to the below-investment grade, or junk, market. As the macroeconomic backdrop has proven to be more resilient than investors feared heading into 2023, one of the primary beneficiaries has been CCC corporates — traditionally the riskiest securities within the high yield and leveraged loan markets. CCC bonds and loans are the least credit-worthy within their respective markets and tend to perform poorly in periods of economic stress. With the economy so far avoiding recession, this segment of the market has posted significant gains year-to-date. CCC bonds and loans were up 11.0% and 8.3% through the first half, respectively, notably outperforming the broader high yield and leveraged loan indices, up 5.8% and 6.3%, and especially the highest-rated, or BB, segments of each market, up 4.5% and 4.6%, respectively.

On top of better-than-feared macroeconomic conditions, other factors have contributed to the junk rally in these markets. Leveraged credit balance sheets, even amongst the lowest-rated issuers, remain well positioned to weather headwinds. High yield issuer leverage is at a 10-year low while leveraged loan issuer leverage levels are at multi-year lows with interest coverage metrics slightly below all-time highs. Defaults are expected to increase, though only to the long-term average of the asset class, assuaging fears of a wave of defaults. Additionally, market technicals have helped fuel this rally as issuance has remained light, causing what supply is out there to benefit from a continual bid due to the elevated yield on these securities. All of this said, CCCs are still typically the riskiest part of the fixed income market, and continued performance hinges on the notoriously-unpredictable economy.

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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.

More Bang for Your… EM Local Currency?

Local currency emerging markets debt has been one of the standout fixed income asset classes this year. The J.P. Morgan GBI-EM Global Diversified Index — which tracks local currency bonds issued by emerging market governments — is up nearly 5% year-to-date.¹ This compares with the Bloomberg US Agg up 2.5% over the same period. Yields for the emerging markets index peaked in the fourth quarter of 2022 and remain near multi-year highs. Local currency EM debt could stand to benefit for three reasons: higher starting yields, proactive emerging markets central banks, and emerging versus developed GDP growth differentials.

  • Real yields in EM local currency debt are at attractive levels relative to history as well as relative to developed markets. As of June 26, GBI-EM yields were 6.28%. This compares with the U.S. 10-year Treasury yield at 3.72%. This yield differential compensates investors for the higher risk and positions them to benefit from yield compression if global macro headwinds start to abate.
  • Several EM countries such as Brazil and Mexico began their rate hiking cycles much sooner than their developed market counterparts. To the extent that positions these emerging central banks to cut policy rates sooner than the rest of the world, yield compression could benefit total asset class returns.
  • EM local currency debt should benefit from higher GDP growth than is expected in developed markets. Based on projections from the International Monetary Fund, EM economies are projected to grow approximately 4% per annum through 2024. This compares to advanced economies, where real GDP is projected to grow roughly 1.5% through 2024.

In sum, a number of tailwinds could continue to position EM local currency debt for strong relative returns as the year progresses.

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¹Through June 26, 2023

 

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.

The Tides of Trade

As globalization has slowed in recent years, geopolitical and geoeconomic risks have reemerged across global markets. Amid disrupted shipping lanes, upended supply chains, and economic sanctions, all markets — developed or emerging — are vulnerable to some degree. While these risks are nearly impossible to eliminate, they can be managed, and efforts to minimize exposures seem to be driving a trend of regionalization across markets. To help visualize this trend, this week’s chart highlights economies (green) that may benefit from increasing regionalization based on three core constraints.

First, direct geographic access to primary shipping lanes. The OECD estimates that around 90% of all traded goods travel by sea. This suggests that countries with both direct access to shipping lanes (dashed lines) and fewer choke point exposures (blue circles) have competitive advantages over those without access or those vulnerable to bottlenecks. Second, industrial capability. Countries with greater material inputs, labor pools, and facilities inherently have a comparative advantage over those without. Third, foreign exchange purchasing power. Relative to the U.S. dollar or the euro, countries utilizing weak alternative currencies have a comparative advantage in attracting investment and in production costs. This textbook dynamic heavily suggests that denominating costs in relatively weak currencies may be the strongest differentiator between otherwise equal markets.

While there are certainly many other dynamics and constraints at play including multilateral trade agreements and demographics, direct access to shipping lanes, industrial capability, and foreign exchange rates offer three core measures to assess and expand on.

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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.

Bear Scare?

The S&P 500 index — up 9.6% on a year-to-date basis through May — recently entered into a technical bull market, mostly due to a resurgence of growth-oriented areas of the U.S. equity space like Information Technology and Communication Services. At the same time, data related to futures contracts on the index could indicate extremely bearish sentiment on the part of hedge funds and speculators. As of the end of last month, these investors and traders were net short more than 400,000 E-mini S&P 500 futures contracts — the largest such position since Bloomberg started tracking the metric in the early 2000s.

There are several potential explanations for this phenomenon. First, investors may believe the recent run of the S&P 500 is not reflective of the current economic climate and overly dependent on a small basket of securities. To that point, the year-to-date return of the benchmark would actually be negative through the end of May excluding just seven high-performing index constituents (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla). This type of sentiment could lead the index to retract meaningfully should one of these companies stumble. However, this same group of investors has maintained net long positions on similar NASDAQ futures contracts in recent time, which does not support the notion that investors are inordinately bearish on these stocks. Dynamics within S&P 500 futures markets could also be a reflection of hedge funds and other investors having a significant number of high-conviction long positions with fewer alpha short ideas, which could necessitate hedging to lower net exposures and would actually be a bullish indicator. Whatever the reason for this positioning, it is important for investors to remember that no one variable is sufficient when it comes to explaining overall market machinations. Marquette will continue to monitor equity and futures markets and advise clients accordingly based on our findings.

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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.

If They Build It, Buyers Will Come

Stalled sale processes have become the norm in the private equity market due to several factors, including a mismatch between buyer and seller expectations around price and interest rates. Private equity owners have been forced to pivot from the traditional leveraged buyout model, now taking on less debt as they look to create an asset that will be attractive to potential acquirers. One way to do this is to build a better business, including via add-on acquisitions, which have been growing as a proportion of buyout transactions for the last several years. In 2008, add-ons accounted for 50% of deal volume. In the first quarter of 2023, that amount was close to 80%.

Add-ons offer several benefits to private equity firms. First, they are an efficient way to expand and diversify a business’s geographical footprint, customer base, and product offering. Second, add-on acquisitions tend to be smaller businesses, and thus typically less expensive than larger platform investments, allowing the private equity manager to average down the total cost of the combined investment. Third, add-ons tend to be accretive, increasing revenue, EBITDA, and EBITDA margins. Taken together, with proper integration, the end business can become a more attractive acquisition target for both large private equity firms and corporations.

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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.

Will the Summer Heat Make the Market Sweat?

With June and the Treasury’s estimated X-date quickly approaching, the debt ceiling issue came to a head over the weekend. While the spending deal reached between President Biden and House Speaker McCarthy still needs to be approved by Congress, it is an important milestone in the U.S. avoiding its first-ever default. While that worst-case scenario would have had catastrophic impacts on the economy, markets — as measured by the CBOE Volatility Index (VIX), known as the fear index — remained relatively calm. The VIX is measured using option activity and gauges the market’s appetite for volatility. Usually, the market and the VIX are negatively correlated, meaning the VIX increases as markets go down. As shown in the above chart, during times of stress, including debt ceiling uncertainty, the VIX tends to be more dynamic, with sharper jumps and falls. With markets having spent the last year heavily focused on inflation, labor markets, and the path of interest rates, which now seem at least near the peak, debt ceiling negotiations were overall taken in stride by equity markets. It is generally accepted that a VIX level above 30 indicates more investor uncertainty, which we have seen reached multiple times over the last few years, though during the month of May, the VIX peaked around 20. As noted, while the House and Senate still need to consider the bill this week, the most likely outcome is the debt ceiling bill is signed into law before the U.S. would have had to default on its debt obligations, removing one more headwind for markets this year.

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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.

Secondaries Not So Secondary Anymore

Secondary market volume has grown from $37 billion in 2016 to a high of $132 billion in 2021. Despite macroeconomic instability, 2022 was still the second-highest year on record at $108 billion. The secondary market was initially dominated by LPs in need of liquidity, selling at a significant discount. Today, the secondary market is more institutionalized and the reasons for selling on the secondary market have expanded — only 10% of sellers are selling for liquidity reasons, while 64% of deals are done for portfolio management. The increase in GP-led transactions has also added to secondary market volume.

As the secondary market has grown significantly, the space has become increasingly undercapitalized. As shown in the top chart above, the ratio of dry powder to deal volume has steadily declined over the last several years, excluding 2020 when COVID hit deal volume. There is estimated to be only about one year of dry powder available to support the growing supply in the secondary market, well below the ratio in the buyout market. The limited amount of capital relative to secondary market volume has resulted in deals trading at significant discounts, as shown in the lower chart. Buyers can be more selective and have the opportunity to purchase high quality assets at a discount. From here, while there are still challenges given the level of macro uncertainty, there is a clear opportunity for investors active in the secondary market.

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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.

Raise the Roof

Investor questions continue to mount as the U.S. nears the Treasury’s estimated debt ceiling “X-date” of June 1. While there are some signs that progress is being made between President Biden and Republican leaders, the two sides still seem far apart on a deal to raise or suspend the country’s debt limit. Failure to do so would result in the U.S. defaulting on its debt for the first time and would have significant economic consequences. According to the Council of Economic Advisors, even a brief default could lead to the loss of half a million jobs, a 0.6% contraction in real GDP, and a 0.3% increase in the unemployment rate. An extended default would be even more dire, with a forecasted loss of 8.3 million jobs, a 6.1% reduction in real GDP, and a 5% increase in the unemployment rate.¹

As shown in this week’s chart, raising or suspending the debt ceiling has become a fairly common occurrence over the last several years, though the process can be political, contentious, and last minute. This week, amid continued talks between staff, President Biden and Speaker McCarthy, along with other congressional leaders, held a meeting both sides described as “productive.” Both parties are seeking a deal to prevent default, though agreeing on the details — future spending cuts, federal aid work requirements, and clawing back unspent COVID funds, among other Republican demands — remains a delicate process. Markets are closely following the debt-ceiling developments and, while the severity of consequences from a default will hopefully lead to a timely resolution, both equity and fixed income should brace for ongoing volatility from here.

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¹Council of Economic Analysis, The Potential Economic Impacts of Various Debt Ceiling Scenarios