Category: Chart of the Week

De-risking at a Lower Price

In 2023, managing uncertainty and risk is top of mind as markets continue to grapple with inflation, a potential recession, and ongoing geopolitical conflict. Increasing allocations to investment-grade fixed income may be one way investors can better position their portfolios to navigate the current environment.

The chart above illustrates return outcomes for two portfolios based on a Monte Carlo simulation of portfolio returns over a forward-looking ten-year investment horizon. As a baseline, the 60-40 portfolio consists of a 60% allocation to U.S. equities (the S&P 500) and a 40% allocation to investment-grade fixed income (the Bloomberg U.S. Aggregate). Alternatively, the 50-50 portfolio shifts an incremental 10% from equities to IG fixed income. Benefitting from today’s elevated yields and lower volatility inherent to fixed income, the 50-50 portfolio projects a greater concentration of outcomes centered around the 7% target rate of return with less volatility than the 60-40 baseline portfolio. Although the expected return decreased slightly, portfolio risk decreased by roughly 1.5 percentage points, creating a more favorable risk-adjusted return. As described in Marquette’s latest white paper, The 60/40 Portfolio Revisited: Back from the Dead?, the rise in yields in 2022 has made fixed income a more attractive investment relative to prior years and reduced the expected return differential between stocks and bonds. For many investors, the 60/40 portfolio seems poised to meet their long-term risk and return goals, but for those looking to remove additional risk from their portfolios, the new yield environment makes further de-risking more of an option than it has been over the past decade.

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Disclosure > Hypothetical Performance

 

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 Short Rebate: A Headwind Becomes a Tailwind

Investor focus over the last year has centered on the Federal Reserve and rising interest rates. Since March 2022, the federal funds rate has increased 450 basis points, with further rate hikes expected in the next six months. While the Fed’s intent is to lower inflation and create price stability, higher rates have widespread implications for the economy and markets. While many have focused on the challenges for investors, hedge funds, particularly those that have the ability to short stocks and bonds, are also set to benefit from the increase in rates.

To establish a short position, a hedge fund must first borrow the security from other asset owners, providing cash collateral to the security lender to protect against potential default. During the borrowing period, the hedge fund that borrowed the stock must pay the lender any dividends or interest received, but is also entitled to receive back any interest that accrues on the required collateral. The return earned on the collateral, known as the short rebate or stock loan rebate, can meaningfully contribute to a hedge fund’s return, particularly for funds with meaningful short portfolio allocations.

For the past 15 years, the short rebate, estimated as the federal funds rate less a fee charged for borrowing a security (typically between 25 and 75 basis points), had been less than the dividend yield on the S&P 500, equating to a headwind to returns for short sellers. However, with short rebates now firmly in positive territory, hedge funds can benefit from higher expected returns in a segment of their portfolio that has been challenged since the Global Financial Crisis. While overall hedge fund returns will still be dependent on manager security selection and exposure management, the short rebate flipping from a headwind to a tailwind is just one of the reasons that the go-forward environment should be more favorable than it has been for relative hedge fund outperformance.

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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.

The Fed’s Effective Proxy Battle

The Federal Reserve’s sharp tightening of interest rates over the last year has made financial market conditions significantly more restrictive. However, financial conditions may be even tighter than generally recognized based on the fed funds rate alone. The San Francisco Federal Reserve Proxy Rate is a measure that uses public and private borrowing rates and spreads to better reflect broader monetary policy. The proxy rate represents the fed funds rate that would typically be associated with current market conditions, assuming financial markets are driven solely by this rate.

As of the end of January, the proxy rate was 6.1%, notably above the effective fed funds rate of 4.3%. The higher proxy rate indicates that broader monetary policy is tighter than what is implied by the fed funds rate alone. The proxy rate also started increasing in November 2021, while the Fed did not begin raising rates until March 2022, showing that broader financial market conditions have actually been tightening for more than a year. With markets extremely sensitive to Federal Reserve policy decisions, but the long-term health of the economy dependent on cooling price pressures, a higher proxy rate may be a hidden positive for markets.

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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.

Debt is the New Equity

Real estate debt investors, relative to equity investors, are generally more insulated against downside risk with underlying properties secured as collateral. Mechanically, a debt investor is effectively lending money to a borrower who may require bridge or rescue financing to close on prospective property acquisitions or development deals. Lending to borrowers at higher interest rates allows for higher returns, as well as consistent cash yields.

Commercial mortgage-backed securities (CMBS)¹ — the public form of real estate debt — have seen market yields rise materially amid higher interest rates. Debt is en vogue again as yields are back to levels that can contribute meaningfully to portfolio returns. 2022 was a year of re-pricing due to the impact of higher interest rates. Public real estate markets quickly embedded a recession risk-premium into pricing while private market valuations trailed. If the economy enters a recession this year, debt is likely to perform relatively well based on conservative underwriting and performance that is not directly tied to a property’s net operating income growth. CMBS excess spreads have also widened out relative to corporate bonds to account for real estate-specific downside scenarios. As shown in the chart, CMBS yields are currently comparable to the yield of corporate bonds rated at least two full ratings lower. Though market risks remain, higher rates and wider spreads have created a potentially attractive relative value landscape for CMBS opportunities.

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¹Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate. 

 

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.

Ahead of the Game

Heightened inflation and pressure on central banks to raise rates were common themes around the world in 2022. As rate hiking cycles weighed on equity markets, emerging markets that were quicker to respond to elevated inflation with higher rates earlier on began to stand out as a relative bright spot. Inflation is receding in these countries and a lack of headwind from continued rate increases could position emerging markets for strength relative to developed markets. The relative differences in central bank policy are reflected in earnings estimates for the two asset classes. Emerging markets estimates were the first to be revised lower and are now up off November 2022 lows. Developed markets, on the other hand, with the delayed impact of higher rates and a fairly resilient consumer, are only starting to see downward revisions now. This week’s chart compares earnings revisions for emerging markets and developed markets. Figures above zero indicate the revisions ratio — upward revisions less downward revisions as a percentage of earnings estimates — is higher for emerging markets and figures below zero mean that the revisions ratio is higher for developed markets. With emerging markets earnings revisions potentially on an upward track, along with multiples at historically attractive levels, the asset class may be set up for relative strength from here.

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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.

Things Are Looking Up: Good News for China

China has been a hot topic over the last year amid market-moving headlines and heightened stock market volatility. U.S.-China geopolitical tensions, zero-COVID policies, real estate market turmoil, and regulatory constraints have all weighed heavily on Chinese equities. Recently, however, things have been looking up. Chinese equities ended last week on a high note, continuing the significant rebound in performance since the end of October. The CSI 300, which tracks the top 300 stocks on the Shanghai and Shenzhen exchanges, is close to bull market territory, up 19% since October 31. Chinese equities as a whole have staged an even more impressive rebound, up close to 55% during the same time frame.

Two major shifts in Chinese policy have contributed to this performance, with the first being the overhaul of strict zero-COVID policies. Beginning in December, Chinese authorities rolled back stringent guidelines by reducing testing and quarantine time for travelers, lessening isolation restrictions for COVID “close contacts”, and scrapping penalties for airlines that carried COVID cases into the country. The second shift is help for China’s struggling real estate sector. According to Bloomberg, close to 150 billion yuan ($24B USD) will be provided in relief in the first quarter to top developers. Additionally, mortgage rates and minimum down payments have been lowered, with the hope of increasing demand for real estate. Along with these shifts in policy, the dollar decline has only helped make Chinese equities more attractive.

Looking forward, despite the recent good news and market rally, Chinese markets are likely to remain volatile, with uncertainties and risks remaining. The reopening of the Chinese economy could add to global inflation pressures, COVID outbreaks have been on the rise in China, and the country has seen its greatest population decline since the 1960s. These dynamics present both risks and opportunities in the market this year and beyond, and developments will be key to emerging markets performance from here.

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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.

Banks to Borrowers: Tighter, Tighter

If recent data points collected by the Federal Reserve are any indication, major financial institutions are bracing for a period of challenged economic activity. The latest edition of the Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices, which surveyed roughly 70 domestic banks and 20 U.S. branches and agencies of foreign banks, found that nearly 40% of these organizations have raised standards for commercial and industrial (C&I) loans to large and middle-market firms over the last several months. According to the survey, these tighter conditions were most widely reported for costs of credit lines, premiums charged on risky loans, covenants, collateralization requirements, and spreads of loan rates over the cost of funds. It is important to note that these tighter conditions are not limited to C&I borrowers, as standards for commercial real estate and credit card loans, as well as home equity lines of credit, are back to levels last seen during the early days of COVID-19. Respondents cited reductions in risk tolerance, decreased secondary market liquidity for commercial and industrial loans, lower competition among lenders, and a less favorable economic outlook as the primary reasons for these higher lending standards.

In a special section of the most recent SLOOS, banks were asked to assess the probability and potential severity of a near-term economic downturn. Roughly 80% of respondents believe there is at least a 40% chance of a U.S. recession in the next 12 months. On a more positive note, none of the banks included in the survey believed the downturn would be severe, with roughly 75% of respondents indicating the recession would likely be moderate and 25% expecting it to be mild. For context, severe recessions have historically resulted in a 3.4% reduction in real GDP and an increase of 3.6% in the unemployment rate, according to Federal Reserve data. Mild and moderate recessions, on the other hand, have seen real GDP decline 0.6–1.1% and increases of 1.1–1.8% in the unemployment rate.

Whether or not these predictions ultimately come to fruition, Marquette recommends remaining invested throughout the economic cycle, as downturns can be notoriously difficult to time. Securities markets also tend to be forward-looking, so much of the pain associated with a possible future recession may already be reflected in the current landscape. As banks and other market participants continue to assess economic conditions, and as markets react, and overreact, to those changing expectations, it is important for investors to maintain diversification across asset classes and remain focused on long-term objectives.

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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.

Pitch Perfect, Slam Dunk?

Some of the key hallmarks of an attractive private equity deal include businesses with a loyal and diversified customer base, recession-resistant and diversified revenue streams, and observable, steady growth in historic asset values. While this may be a mission-critical software company, it may also be the English Premier League or the National Basketball Association. A growing consortium of private equity funds has begun to recognize the inherent value of professional sports and is increasingly purchasing stakes in leagues, teams, media rights, and related real estate. As of August, $6.2 billion had already been invested in 2022, with the full year on track to exceed 2021’s $6.3 billion. Much of this can be attributed to the swell of activity in European football leagues, with the Chelsea Football Club comprising nearly half of the 2022 year-to-date total.¹

From an investor’s perspective, professional sports franchises provide economic exposure to a diverse set of assets, low correlation to broader equity markets, and recurring and predictable revenue streams. The observable growth in asset value has also added to private equity’s interest in the segment. In the 20 years ended 2021, the average cumulative price return for professional sports team franchises in the NHL (+467%), the NFL (+558%), the MLB (+669%), and the NBA (+1,057%) all outpaced the S&P (+458%), according to Forbes, Sportico, and Pitchbook data. While valuations have risen with a limited number of franchises available to buy, the numbers reflect the attractive characteristics of the assets, such as broadcasting rights, streaming, and the opportunity to further monetize a dedicated fan base. While still in the early innings (or first quarter, half, or period), this is a sub-segment within private equity worth a keen eye as investment continues to grow.

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¹How private equity is moving into the big leagues, Buyouts Insider, October 2022.

 

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.

Fueling Some Relief into the New Year

Last summer, gasoline prices retreating was one of the first bright spots at the macroeconomic level. Since then, CPI has generally followed suit, correcting from a peak of 9.1% year-over-year in June to 7.1% in November. Gasoline prices are broadly a product of global supply and demand, with many economic variables at play. As a notable component of the CPI basket, it is no surprise that the price of gasoline usually moves in line with inflation, however, historically, the correlation between the two has increased during times of economic turbulence. Correlations spiked during the Global Financial Crisis in 2008, the oil price shock in 2014, and again in 2020 when COVID hit and oil futures plunged into negative territory. Correlation remained high heading into 2023, with gasoline prices turning deflationary year-over-year. Inflation is expected to continue lower from here as the Fed prioritizes price stability via higher rates. While heightened macro uncertainty remains, and other factors including weather and refinery operations can impact prices for consumers at the pump, experts generally expect overall lower gasoline prices as well, with the EIA forecasting a 12% drop in the average price per gallon in 2023 from 2022. To the extent historically higher correlations hold, the consumer should continue to benefit from some relief when refueling.

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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.

The Adventures in Venture: Navigating the Current VC Environment

After an incredibly strong run in venture capital, public market weakness is beginning to show through in the VC space, with comparisons to the dot-com era emerging. The venture capital ecosystem, however, remains steadfast in the opportunity set due to the advancement of technology and the dry powder available. As of September 30, 2022, global venture capital fundraising activity reached $224 billion, approaching the $265 billion raised in 2021 and not far off the record $298 billion raised in 2018.¹

Technology is almost synonymous with venture capital. Through the third quarter, technology made up 85% of the U.S. deal value in 2022. In the 2000s, the technology space was less developed than it is today. Venture technology investing was mostly in hardware and telecom. Today, the focus is largely on cloud-based software. The speed at which companies across sectors are adopting technology has increased, leading to a lot of white space for innovation. Furthering momentum, COVID-19 pulled forward adoption trends, pushing companies to embrace technology in new ways. Industries like banking, agriculture, and consumer goods, which have historically been more technology-resistant, were forced to pivot in order to survive. Estimates suggest the pandemic accelerated digital adoption trends in these mega industries by 5–10 years.

The amount of dry powder in venture capital today also gives the asset class some stability. Dry powder levels are hitting all-time highs — $585 billion as of March 31, 2022 — providing a buffer to ensure there is still capital available for startups in the coming years. Ongoing investment in VC companies allows innovators to continue innovating, even in times of market stress.

While there may be some similarities with the dot-com period, there are many differences that could support a quicker recovery than the industry saw then. While we cannot predict the future, we can remain disciplined in our due diligence and look to align our clients with the VC managers that should be best positioned to navigate the volatility.

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¹Pitchbook

 

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.