Category: Chart of the Week

To Inflation and Beyond

Real estate as an asset class is not immune to the effects of inflation and rising rates, but certain sectors within real estate can help investors manage through the volatility. Typically, inflation manifests itself within commercial real estate in the form of higher prices for construction materials, labor, and land. Since the onset of the pandemic, the Producer Price Index for Construction Materials, which measures the average price change of building materials over time, has skyrocketed by over 50% as of June 30, 2022.¹ These rising development costs and value-add expenditures create a headwind for real estate valuations, diluting the value of incremental rental income. However, as inflationary pressures continue to weigh on economic growth, real estate should be well positioned as a solid, though imperfect, inflation hedge. Multifamily and hotel properties benefit from the flexibility of shorter-duration leases that allow property owners to reset rents in line with market levels. Moreover, value-add and opportunistic managers are well positioned to enter deal flow at attractive unlevered price points, extracting value from industrial and retail investments that benefit from guaranteed rent increases and tenant pass-through costs. Real estate investments are an important part of alternatives allocations at Marquette as they can help diversify a portfolio and hedge against inflation while providing attractive risk-adjusted returns.

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¹Bloomberg, Bureau of Labor Statistics, Federal Reserve Bank of St. Louis, CBRE-EA, Clarion Partners Investment Research, June 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.

Recession Redefined

The National Bureau of Economic Research (NBER) is widely considered the official judge on what is and is not a recession. The academic organization’s traditional definition of a recession is a “significant decline in economic activity that is spread across the economy and lasts more than a few months.” This definition can be subjective and, to help avoid the need for revisions, the committee does not typically call the start of a recession, or the end of a recession, until well after the fact.

Another commonly accepted definition of a recession is at least two consecutive quarters of negative GDP growth. Given the last two GDP prints of -1.6% in the first quarter and the advance estimate of -0.9% in the second quarter, the U.S. economy would be in a technical recession. Recently, both the White House and Federal Reserve Chairman Jerome Powell have argued that this interpretation does not accurately reflect the current state of our economy, specifically given the still-strong labor market.

Another economic indicator to consider is consumer spending, specifically the contribution to GDP from Personal Consumption Expenditures (PCE). Consumer spending comprises 70% of GDP and is traditionally a much less volatile component than investment and net exports, the primary contributors to the year-over-year declines in the first half of the year. The strength of the U.S. consumer will dictate the country’s path from here, as healthy balance sheets and a hot labor market contend with decades-high inflation and rising rates. PCE contributed a positive 1.2% and 0.7% to first and second quarter GDP, respectively. In only one of the last eight recessions over the last 50 years — the relatively mild downturn in 2001 — has PCE not turned negative. One month into the third quarter, the highly-regarded Atlanta Fed GDPNow tracker is projecting positive PCE and overall GDP growth for the quarter. The current macro situation is complex, with a healthy U.S. consumer facing a number of headwinds, and, in this case, understanding those underlying dynamics is just as important as the “are we or aren’t we” debate.

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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 Currency Conundrum

The U.S. dollar is the strongest it has been in a generation. The U.S. dollar index is up almost 11% this year against a basket of global reserve currencies with the greenback reaching parity with the euro last week for the first time since 2002. Like many things in financial markets, interest rates tend to be one of the most significant drivers of currency valuation, specifically the interest rate differentials between global central banks. As the Federal Reserve has pivoted to a more hawkish stance to tame decades-high inflation, other central banks, including the ECB and BOJ, have been slower to respond. When capital can flow freely, investors tend to flock to higher-yielding assets as interest rates rise, which leads to appreciation of the higher-interest rate country’s financial account and increases demand for the domestic currency — in this case, the U.S. dollar.

The Japanese yen is down roughly 16% year-to-date and is the worst performing major currency relative to the U.S. dollar. In an effort to fight decades-long deflation, the Bank of Japan has committed to holding down short-term interest rates, resulting in significant currency devaluation. Japan is the largest foreign holder of U.S. Treasuries, with $1.3 trillion as of January 2022. As the U.S. dollar strengthens, it becomes more expensive for Japan to continue to purchase on-the-run Treasury issuances, which could put further upward pressure on U.S. rates at the same time the Fed is lifting the benchmark fed funds rate and engaging in quantitative tightening. The question of what will happen when the two largest buyers of U.S. Treasuries — the Federal Reserve and the Bank of Japan — both remove liquidity from the market is another unknown that could add to market volatility in the near term.

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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.

Oil Prices Aren’t All They’re Cracked Up to Be

Americans are paying more at the pump this summer than they ever have in the past. The national average in June for regular gasoline was $4.929/gallon. The only other time gasoline averaged more than $4 per gallon nationally was in June and July of 2008 when prices were $4.054 and $4.062, respectively.¹ Crude oil peaked at $140/barrel then. Why are we paying almost $5 per gallon at the pump when crude oil is only about $100/barrel today? The answer lies in the crack spread.

Crude oil is “cracked” to produce gasoline and distillates like heating oil and diesel in a 3:2:1 ratio, meaning for every three barrels of crude, two barrels of gasoline and one barrel of distillates are produced. The crack spread measures the difference between the purchase price of crude and the selling price of the finished products and is a proxy for refinery profits. Crack spreads have spiked over temporary periods in the past, though the median over the last 20 years has averaged just over $11/barrel. The prior peak occurred in August 2005 when Hurricane Katrina took much of the U.S. refining capacity offline, but, like most spikes, was short-lived as refining capabilities were quickly brought back online. The only sustained period of higher crack spreads occurred in 2012 — a year filled with hurricanes, refinery outages, and tensions in the Middle East — when spreads averaged in the mid-$20s throughout the year. At the end of June 2022, the 3:2:1 crack spread hit a new peak of $47.653/barrel, and this bout of elevated spreads may have more staying power.

The green revolution has had some negative externalities. There has been a retreat from refining as companies are reluctant to invest in fixed assets. Throughput has decreased by roughly 500,000 barrels/day to 16.7 million barrels with refineries operating above 90% capacity. Many refiners have closed or converted to producing biodiesel amid fears that refining assets would be stranded during the energy transition. While there is no easy fix to any component of inflation, gasoline dynamics are even more complicated, and until additional resources are committed to refining, higher crack spreads and higher gasoline prices may be here to stay.

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¹Source: U.S. Energy Information Administration

 

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.

Active Managers: The Mid-Year Report Card

Domestic equity indices suffered significant pullbacks in the first half of 2022 amid increasing investor concerns of a prolonged economic slowdown. Growth benchmarks were hit hardest given the recent focus on rising rates, although core and value indices across the market capitalization spectrum also notched negative returns during the period. These types of broad-based pullbacks are often conducive to active manager outperformance because, in theory, one of the main benefits of active strategies is protection during down markets. Fund managers are usually able to deliver on this proposition by avoiding speculative stocks with uncertain future cash flows that tend to drop precipitously amid corrections, instead gearing toward high-quality business with pricing power and robust earnings that are able to withstand market swoons. That said, the extent to which managers have been successful in notching returns in excess of their respective benchmarks this year has largely depended on investment style.

In the first six months of 2022, most value-oriented active strategies have done a good job protecting capital. Roughly 67% of managers in the large-cap value space have outperformed their relevant benchmarks, while 90% and 78% have done the same in the mid- and small-cap value spaces, respectively. Core strategies have had similar success. Just over half of large-cap core managers have recorded positive relative returns for the year, while 68% of mid-cap core and 78% of small-cap core managers have outperformed their respective benchmarks. The story is different on the growth side, however, where just 26% of active large-cap, 45% of mid-cap, and 36% of small-cap managers have been able to keep pace with or exceed relevant benchmarks. At a high level, performance of growth indices in 2022 has largely been driven by multiple compression rather than changes in earnings growth or company fundamentals, and active managers are more likely to lag in periods when valuation is the primary driver of market returns.

Marquette recommends allocating between active and passive management based on the efficiency of the underlying market. At the top of the market capitalization spectrum, outperformance has been notoriously difficult in recent history, with roughly two-thirds of all active U.S. large-cap managers trailing the S&P 500 on a trailing 10-year basis regardless of investment style. Mid- and small-cap strategies have had more success generating alpha over longer periods of time given the less efficient nature of those segments of the market, with the majority of managers outperforming their respective indices over the last decade. While even the most capable managers experience periods of underperformance, the case for active management within the U.S. equity space is certainly stronger further down the cap spectrum. Marquette will continue to source best-in-class strategies across all asset classes and recommend these strategies for inclusion in client portfolios where appropriate.

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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.

Fair or Free?

While developed economies across the globe are struggling with historical levels of inflation, the European Union and its 27 constituent nations are facing extraordinary economic challenges related to energy costs and security amid the ongoing Russia–Ukraine conflict. Against this backdrop, Germany posted its first monthly trade deficit in more than 30 years. Following the adoption of the euro in 2002, Germany built its economy around the cheap common currency, using its relative cost advantage to grow via exports. The country’s trade surplus expanded over the next several years, hitting a peak of more than 7% of GDP in 2017. Today, in the face of higher prices for vital imports like food and energy, and with supply chain disruptions impacting trade, that trade surplus has collapsed to a deficit. The Russia–Ukraine war has changed longstanding dynamics in the region and will likely have far-reaching implications, with one in four jobs in Germany reliant on the export market. With central banks around the world focused on controlling inflation, the risk of recession has continued to rise, with the outlook in Germany and broader Europe even more challenged following this latest data point.

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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.

Global Equities Still Well Above COVID Lows

Just over two years ago, on March 23rd, 2020, global equities hit their COVID-19-induced bottom. At their lows, the S&P 500, MSCI Emerging Markets Index, and MSCI EAFE Index were down 30%, 32%, and 33%, respectively, year-to-date. Over the next seven quarters, global equities produced mostly positive returns, with the S&P 500 leading the way. From the 2020 trough, the large-cap U.S. index was up an astounding 119% through the end of 2021.

This year, markets have faced several geopolitical and macroeconomic concerns that have squashed that positive momentum. Russia’s invasion of Ukraine in February and China’s rise in COVID-19 cases combined with its zero-COVID policy have worsened supply chain issues, exacerbated global inflation, and added to mounting economic pressures. To combat inflation, central banks have aggressively raised interest rates, which will likely further dampen economic activity. As a result of these headwinds, the S&P 500, MSCI EM, and MSCI EAFE benchmarks are all down roughly 17–19% year-to-date.¹ Despite these losses, global equities remain well above the COVID-19 trough, with non-U.S. equities still roughly 40+% higher and the S&P 500 77% higher. Looking forward, we expect global equities — particularly in developed countries — to face continued volatility in the second half of the year as central banks continue their fight against inflation, likely at the expense of economic growth.

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¹As of June 29, 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.

Private Equity — Living in the 21st Century

In 2011, venture capitalist Marc Andreessen wrote “software is eating the world,” and added that disruptors were “invading and overturning established industry structures.” Private equity firms were taking notes. Over the past decade, technology investments have steadily grown as a percentage of the global buyout market. In 2021, $284 billion in technology deals were closed, accounting for 25% of total buyout deal value and 31% of total buyout deal count — the largest share of any sector. Of that $284 billion, software deals comprised $256 billion. And while capital has flooded the sector, increasing competition for these businesses and driving up multiples, superior performance has continued, both in terms of lower loss rates and higher upside of outperforming deals.

Additionally, the value creation levers being pulled by private equity firms in the technology space appear sustainable. According to DealEdge, in fully realized global buyout deals between 2010 and 2021 with more than $50 million in invested capital, 71% of the value created in technology deals (excluding software) and 55% in software deals was driven by EBITDA growth, relative to 44% for all other sectors. These compelling return characteristics are due in large part to the operating models of these businesses — asset light, scalable, with high margins, and, in most cases, sticky, recurring revenue.

Despite the sector’s broad appeal, technology has proven to be a domain for specialists within the buyout market. The complexity of these business models, constant evolution in the technology landscape, and the need for expertise to lead these businesses at scale lends itself to investors who focus exclusively on the sector. LPs appear to share this sentiment, with more than $270 billion raised by technology-focused private equity firms in the past five years, equivalent to 13% of total global buyout capital raised during that time.

While technology and software stocks in the public arena have suffered over the last year-plus amid rising rates, private companies have not been subject to the same mark-to-market risk. The sector remains a driving force in innovation and economic value creation, and we expect exciting opportunities for private equity firms to persist.

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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 Apple Becomes the Forbidden Fruit

For much of the last two years, big name tech stocks had been tantalizing fruit for investors willing to pay up for growth. Enter 2022. After peaking on January 4th, the S&P 500 has taken a nosedive, led by those same tech stocks. Since 2018, the Information Technology sector has grown from a 20.1% weight in the S&P 500 to 26.8%, setting it up to now have an outsized impact as equities correct. The largest detractors year-to-date, regardless of GICS sector classification, have business models and value propositions rooted in technological advancement and innovation. The top eight detractors this year are Apple, Microsoft, Amazon, Alphabet, Meta, Tesla, NVIDIA, and Netflix. These eight stocks have cost the index more than 800 basis points year-to-date, almost half of the S&P 500’s -17.6% return.¹

Behind the outsized correction in technology stocks are macro headwinds and rising rates. The instability caused by the Russia/Ukraine war, COVID-related shutdowns in China, ongoing supply chain disruptions, and heightened inflation has led to shifts out of longer-duration growth stocks towards the perceived safety of assets like gold and value stocks. Rising rates are weighing on growth stock multiples and increasing recessionary concerns are reducing confidence in outyear earnings projections. Uncertainty is high and sentiment is weak, and while risks certainly remain, that may eventually help support a market bottom. Up or down, large tech stocks will continue to have a meaningful impact on broader market returns.

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¹As of June 10, 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.

High on Lithium

Electric vehicle (EV) sales have seen significant growth over the past several years. Recently, elevated demand has contributed to a rampant increase in lithium prices, a primary input to the batteries that power EVs. As the global transition to a clean energy economy continues, the demand for lithium is expected to rise exponentially, to the point of creating a supply shortage in the coming years. While the metal itself is not in short supply, there are limitations to the extraction process and investment in the space has yet to catch up with the rise in demand.

In the last two years, lithium prices have soared more than 700% as sales of EVs have hit record-breaking numbers. Demand for lithium, according to McKinsey & Co., is expected to increase more than sixfold to 3.3 million metric tons in 2030 from 0.54 million metric tons in 2021. Supply is currently projected to reach 2.7 million metric tons by 2030, leaving 0.64 million in demand unaccounted for. The lithium mining industry today resembles an oligopoly, with only a handful of companies responsible for the majority of global supply. Going forward, this could change as further investment is made into the space, which could in turn help normalize price levels. While mining is often thought of as the polar opposite of sustainability, lithium mining actually helps further green energy initiatives, and lithium-related investments may serve ESG-focused investors well over time.

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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.