Category: Chart of the Week

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.

Hike! The Herald Fed Sings

The trajectory of rate hikes by the Federal Reserve has had a meaningful impact on asset values this year. Historically, rising interest rates have aligned with higher risk-adjusted returns for real estate investors, with an average 12.8% annual total return of the NPI during past periods of Fed hikes. Although higher borrowing rates increase the cost of capital for property buyers, rate hikes typically coincide with a strong economy and easy credit. Economic strength can lead to mark-to-market rent growth opportunities and strong tenant demand within in-favor sectors, and open credit markets may allow investors to increase their purchasing power, thereby expanding the pool of real estate buyers.

This year, the Fed has raised rates to specifically target heightened inflation. During periods of price pressure and subsequently higher rates, property owners tend to increase rents in order to keep pace with growing maintenance and replacement costs. Owners and investors also benefit from supply-demand dislocations when construction, financing, and labor costs rise, placing downward pressure on new supply and ultimately increasing demand for rentals. Historically, rent growth in the U.S. has averaged 3.0% in a rising Fed policy environment, compared to 1.7% and 1.4% in steady and declining rate environments, respectively.¹ While the ultimate impact to real estate valuations from this period of higher inflation, rates, and economic uncertainty is still unknown, the asset class does benefit from its ability to effectively pass through costs, providing a hedge against macro headwinds.

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¹Federal Reserve, Hines Research 1990–2021Q4 for U.S. markets, CoStar, Property Market Analysis, Colliers

Fixed Income Indexing: A Commitment to the Bottom

The equities market has experienced a tectonic shift from active to passive investing, with passive investors benefiting from index strength and meaningful fee savings. In fixed income, however, investing in indexing strategies tends to be a commitment to the bottom. The Bloomberg Aggregate Index — the standard index for broad fixed income investing — tends to underperform most active strategies. While there may be shorter time periods where active managers trail the index, over longer time periods the index generally falls within the bottom quartile of universe performance and often in the bottom decile.

Due to the size of and inefficiencies within the fixed income market, there should be many opportunities for managers to take active risks and generate excess returns. Two common active management strategies for aggregate mandates are core and core plus, differentiated by the level of active risk and return objectives. Core strategies should be expected to outperform the index by 50–100 bps and core plus by 100–150 bps over a full market cycle. The vast majority of active managers outperform the index. In the core plus universe, the index’s rolling 5-year return was in the bottom quartile 14 of the last 20 years and in the bottom decile in 10 of those years. In the core universe, where the level of active return is lower, the index on a rolling 5-year basis was in the bottom quartile in 11 of 20 years.

To be fair, there are times when indexing pays. Many fixed income managers are “active” by systematically overweighting corporate and structured credit while underweighting Treasuries and agency mortgages to create a yield advantage. Outyielding the benchmark works well until it doesn’t. During risk-off periods of spread widening, the index tends to be one of the better performers within the universe. The two best examples of this are 2002 and 2008, when markets experienced a precipitance of spread widening due to the dot com bubble bursting and the sub-prime mortgage crisis, respectively. Those periods erased years of prior active management outperformance, though having a yield advantage remained beneficial longer-term, with those active managers outperforming in subsequent years.

While active is often the preferred method of accessing the fixed income market, an aggregate indexed strategy may be helpful as a risk management tool and indexed options may help investors take more tactical positions within fixed income sub-asset classes. Overall, investors should make sure they understand the risks and benefits of investing in active versus passive within fixed income and work with their consultant to create a portfolio that best serves their needs.

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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.

 

Rising Stars are a Bright Spot in 2022

While 2022 has been an exceptionally challenging year, with both equities and fixed income down meaningfully, there are a few bright spots within the high yield space. The number of rising stars, which are below investment grade securities (high yield) that have been upgraded to an investment grade rating, has already hit 2021 levels with two months remaining in the year. Fallen angel securities — previously investment grade businesses that have fallen to high yield or “junk bond” status — remain relatively low. The increase in rising stars over the last two years comes after a big increase in fallen angels in 2020, and has been driven in part by a recovery in economic activity following the pandemic and better financial discipline of management teams. Many companies used the period of incredibly low interest rates to shore up balance sheets and push out debt maturities. A company’s credit rating changing from high yield to investment grade is significant, especially when facing a slowdown, as it allows the company to better access funding in the capital markets. The number of rising stars is a good trend in credit and quality overall in high yield has improved. Paired with the most attractive yields in years, the forward outlook looks promising in credit.

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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.

Keeping the Lights On

While overall fundamentals for U.S. equity benchmarks have remained mostly resilient this year amid a painful repricing of risk assets, earnings growth has actually been concentrated in just a few areas of the market. The blended year-over-year earnings growth rate for the S&P 500 index during the third quarter of 2022 is 2.2% (with roughly half of companies reporting at the time of this writing), though only four sectors of the index have reported growth in earnings for the period. The Energy space stands out especially among these sectors, with its earnings up a massive 134% year-over-year amid strong demand for natural resources and continued commodity price inflation. Were the sector to be excluded from the S&P 500 index, earnings for the benchmark would be down 5.1% on a year-over-year basis, despite the fact that Energy accounts for less than 6.0% of the index. This trend is expected to continue into the fourth quarter, during which total earnings growth for the index is expected to be roughly 0.5%, with a decline of 3.5% excluding the Energy sector. For the full calendar year, S&P 500 index earnings are expected to grow 6.1% and decline 0.6% without Energy stocks.

Examining data below the index level is always important when assessing the health of equity markets and company fundamentals. To that point, simply looking at earnings figures for the S&P 500 index in aggregate obscures the fact that growth-oriented spaces of the benchmark like Communication Services and Information Technology, which are expected to post year-over-year earnings declines of 22.2% and 2.1% in the third quarter, respectively, are experiencing significant headwinds amid ongoing interest rate and inflationary pressures. These trends, however, are expected to reverse beginning in the second quarter of next year when, against tough compares, the Energy space is projected to become a detractor to overall earnings growth for the S&P 500 index while the rest of the benchmark grows earnings at a positive rate. With all of this in mind, investors should continue to employ a prudent approach to diversification across asset classes, geographies, and economic sectors, which will help position portfolios for success as market leadership rotates.

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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.

Chinese Equities Down 17% in October

2022 has been a difficult year for Chinese equities, which are now down 43% year-to-date through October. In comparison, the MSCI Emerging Markets (EM) ex China Index is down 23% over the same period, while the MSCI World Index, a developed markets benchmark, is down 20%. It has been a seesaw year so far as Chinese equities underperformed in the first quarter, down 14% while the EM ex China index lost 3%. In the second quarter, China was one of the few countries to generate a positive return (+3%) as the EM ex China benchmark declined 18%. In the third quarter, the China index was down sharply again – -22% – with the sell-off carrying into October as other markets globally rebounded. China was down 17% in October – the worst month for the country benchmark in 11 years.

Over the course of the year there have been three key challenges to Chinese equities: 1) continuation of the zero-COVID policy, 2) property sector troubles, and 3) geopolitical issues. For most of the year, markets have reacted to various news and events centered on these three topics. More recently, markets turned sharply negative following the country’s Party Congress where President Xi Jinping was elected to an unprecedented third term and further consolidated power within the newly elected governing body. While there were hopes that the focus would shift to the economy following the Party Congress, President Xi went on to reaffirm China’s zero-COVID policy, casting a shadow over future economic growth. Chinese equities fell 8% the day after the Party Congress concluded, ending the month down 17%. Trailing and forward price-to-earnings multiples now sit close to twenty-year lows. From here, markets are likely to remain choppy, presenting both risks and opportunities to investors, until there is additional clarity regarding China’s zero-COVID policy and property sector, as well as broader geopolitical issues and China’s intentions.

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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.

When Not to Quit

One of the oft-touted advantages of investing in private equity is the opportunity to buy in at a discount to public markets. This valuation discount, as measured by EV/EBITDA multiples, has persisted since 2012, widening to nearly 60% in 2020.¹ Since that peak, the discount has narrowed significantly as public market equities have sold off. While this may give some cause to pause, it is interesting to consider what transpired for investors between 2009 and 2012, on the heels of a near-meltdown of the financial system. With equities down sharply into 2009, the denominator effect boosted percentage allocations to private equity within investor portfolios. The instinctive reaction (and in some cases, forced action) may have been to abstain from new private equity investments beginning in 2009 so as not to exacerbate the over-allocation. This may sound familiar to private equity investors in 2022.

With hindsight being 20/20, these corrections to annual capital commitments ultimately resulted in an under-allocation to private equity, and thus underperforming portfolios over the next decade, as public markets and public market allocations snapped back. Furthermore, while private equity will likely not see the type of drawdown that public markets have seen, we do expect valuations to pull back, creating attractive entry points for managers with dry powder to deploy capital. While investors should be mindful of any liquidity constraints and maximum allocations to private markets, those that are able to remain steadfast in their annual commitment pacing schedules may find themselves in a better position once the public markets settle. Marquette believes that a successful private equity program is one that is consistently diversified by vintage year over time and highly selective in terms of manager partnerships.

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¹Pitchbook, as of June 30, 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.