Category: Chart of the Week

Could Conflict Spur an Energy Revolution?

Now one month into the Ukrainian crisis, investor concerns about the knock-on effects of war, higher energy costs, and generally prolonged, heightened inflation have hit a crescendo. Europe’s natural gas benchmark, the Dutch TTF, has been extremely volatile, at one point spiking to more than ten times last spring’s levels. The European Union relies heavily on Russian natural gas. According to the International Energy Agency, in 2021, the EU imported 155 billion cubic meters of natural gas from Russia, comprising roughly 45% of European Union gas imports and close to 40% of total gas consumption. Russia’s invasion of Ukraine has underscored the risks of Europe’s dependence on Russian gas imports and prompted the European Commission to take action.

Beyond halting approval of Nord Stream 2, a set of offshore natural gas pipelines from Russia to Germany, at the outset of the conflict, the European Commission has now vowed to curtail the EU’s usage of Russian natural gas, with a target of reducing imports by two thirds by the end of the year. To make up the difference, the Commission will increase gas and liquefied natural gas (LNG) imports from other countries and phase in alternative gases like hydrogen and biomethane. The U.S. has answered this call, with the Biden administration authorizing additional exports of LNG from two major facilities on the U.S. Gulf Coast. The Commission is also looking to accelerate the transition to renewable energy. In particular, the EU will accelerate its “Fit for 55” rule, deploying a massive campaign of electrification, expansion of renewables and electricity storage, development of green hydrogen tech, and investment in energy efficiency measures. While these longer-term initiatives will take several years to come to pass, the composition of energy sources, at least in Europe, should have a stronger, greener future as a result.

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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 Impact of Russia’s Invasion on Bond Indices

Russia’s invasion of Ukraine has meaningfully altered the emerging market landscape. At the start of the year, Russia and Ukraine combined had comprised almost 5% of the hard-dollar index, JPMorgan EMBI Global, and the hard-dollar emerging market corporate index, JPMorgan CEMBI, with 3–4% in Russia and roughly 1% in Ukraine. In local markets, represented by the JPMorgan GBI-EM, Russia was approximately 7% of the index, while Ukrainian local bonds were scheduled for index inclusion at the end of March.

Since the invasion in February, Ukrainian debt, already stressed, has fallen further, and now represents less than 0.5% of the hard-dollar indices. Its inclusion in the local index is on hold until further review due to market disruptions. Foreign sanctions and self-imposed capital restrictions have pushed Russian dollar debt to distressed levels, with Russia unlikely to pay external debts in hard dollars. Local bonds are still trading near par, though a weakening currency has reduced the value to international investors. At present, Russia represents no more than 1% in the hard-dollar or local indices and will be removed by JPMorgan entirely at month-end as sanctions have made the debt illiquid and uninvestable. Belarus is also facing removal from JPMorgan’s ESG indices for its role in the conflict.

Managers face a tough decision regarding holdings in Russia. The local bond market is frozen for international trading. Although local bonds are trading near par in the domestic market, many managers are pricing holdings at zero. External debt is distressed but the market continues to function and there have been bright spots, with Russian energy giant Gazprom redeeming a bond, priced down to 50 cents on the dollar, at par on March 7th. With the write-down already taken and the removal from indices, Russian debt could be a source of upside in a recovery scenario, though uncertainties and risks certainly remain. Prudent risk management and process consistency remain key factors for Marquette as we analyze and recommend funds to clients.

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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.

Trouble With the Curve?

Short-term interest rates have increased dramatically since the fourth quarter of 2021 amid inflationary pressures and concerns surrounding reduced global market liquidity. The 2-year Treasury yield ended February at 1.33%, up from 0.56% at the end of November 2021, and has continued to rise throughout the first few days of March. The yield on the 10-year Treasury has also ticked up in recent months, albeit at a much slower pace than that of the 2-year instrument. As a result, the spread between the 2- and 10-year Treasury yields has contracted significantly since the beginning of the year and currently sits at approximately 23 basis points, its lowest level since March 2020. Current yield curve dynamics could be exacerbated by the Federal Reserve, which, after holding short-term rates near zero for the last two years, is set to begin a hiking cycle later this month. Increases in the federal funds rate, though likely modest (25–50 basis points per increase), could number as high as seven in 2022 and result in additional yield curve flattening.

The relationships between Treasury yields of different maturities are important considerations for investors and traditionally serve as key indicators of macroeconomic trends. Typically, longer-dated debt instruments have higher yields than short-term bonds due to increased risk and liquidity premiums, resulting in relatively wide spreads and an upward-sloping term structure of interest rates, an indication of solid growth expectations and overall economic health. An inverted yield curve, marked by short-term yields that are higher than long-term yields, is commonly considered a bear signal, as it implies that the nearer term is riskier than the longer term. Each instance of a 2/10 inversion dating back to the 1990s has been followed by a recession in the United States within the next two years.

It is important to note that a narrowing 2/10 spread does not necessarily portend an economic downturn, as most economists expect positive economic growth in 2022 and beyond given solid corporate fundamentals and strong consumer balance sheets. Still, recent sell-offs in equity markets, elevated inflation, and supply shortages stemming from the conflict in Eastern Europe are causes for concern, especially when viewed in tandem with narrowing Treasury spreads. Marquette will continue to monitor the term structure of interest rates, as well as other leading macroeconomic indicators, and advise clients accordingly.

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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.

Collapse of the Russian Ruble

This week, as the crisis in Ukraine continues to evolve, we look at the devaluation of the Russian ruble amid retaliation from the West. In response to Putin’s invasion of Ukraine, allied governments are imposing financial sanctions, companies are pulling back from operations in Russia, and investors are looking to exit Russian investments. As a result, the ruble, now worth less than a penny, has fallen more than 30% over the last week. The pace of the move surpasses even that seen in 2014 when Russia moved to a floating exchange rate amid pressures following its annexation of Crimea, resultant sanctions, and the sharp drop in global oil prices. In 2014, Russia was able to leverage its mountain of foreign currency reserves to eventually help stabilize the ruble. That ability is severely restricted this time following the decision to cut off certain Russian banks from SWIFT, the financial messaging system used by more than 200 countries to link money transfers between the world’s banks.

The sharp devaluation of the ruble could shock Russia’s economy. Inflation in Russia surpassed 9% as of February 25th, above the country’s 4% target. The Russian central bank on February 28th more than doubled its benchmark interest rate to 20% in an attempt to prevent a run on banks. The line the world is walking to manage inflation without negatively impacting growth is now much finer in Russia, with reverberations likely to be felt globally. Inflation, the path of rising interest rates, and geopolitical tensions remain key risk factors for investors this year, and we will continue to keep clients updated on developments and any related portfolio recommendations.

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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.

What Is at Stake?

A general partner (GP) stake is a direct investment in a general partner’s management company and is typically a passive, minority investment. GP stake investors have purchased interests in hedge fund, real estate, private credit, and venture capital managers, but the most significant adoption of this transaction type has been in the private equity buyout landscape. GP stake investing has increasingly become a topic of conversation due to robust fundraising by dedicated GP stake funds and the maturation of the buyout market, with many firms on the cusp of a generational transition and a desire to raise capital to finance future commitments and build out platforms via product proliferation and team growth.

Investors in GP stakes are attracted to the stable yield of the management fee, the upside potential provided by carried interest, and other strategic benefits that may include better access to co-investment opportunities or a primary allocation to future funds. Managers view a GP stake sale as a more favorable path to raising capital relative to an IPO given the scale required and the complexities of going public.
For limited partners (LPs) investing in funds of managers that have sold a GP stake, or are planning to do so, understanding the manager’s plans for the use of proceeds is critical. The capital is typically used to offer liquidity to existing owners of the management company and/or as a means to reinvest in the firm, either through increased GP commitments in future funds or growth initiatives. In addition to confirming the use of proceeds, LPs ought to diligence the rationale for the sale, percentage of the management company sold, and terms of the agreement between the manager and the GP stake investor.

GP stake sales were a key feature of the private equity marketplace in 2021 and show no signs of dissipating in 2022. While these types of investments historically have been limited to the largest buyout managers, increasingly middle market managers are selling GP interests. As we continue to see buyout funds participating in GP stake sales, as well as an increase in the number of dedicated GP stake funds raising capital, it is important for clients to consider this dynamic when investing in private equity funds.

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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.

Russia & Ukraine: All Eyes on Energy

Escalating tensions between Russia and Ukraine have the world on edge. While the situation continues to evolve and the likelihood of a full-scale war remains unlikely, markets are attempting to price in the risk. This latest geopolitical clash builds on an already tumultuous start to the year for financial markets. In the U.S., the S&P 500 has fallen 8.1% from its all-time high on January 3rd amid concerns about rising inflation and consequential rate increases by the Fed. The latest year-over-year inflation figures for both the U.S. and Eurozone have reached alarming milestones, with the U.S. hitting a new 40-year high and the Eurozone setting a new record going back to 1991. Ballooning energy prices have been the greatest contributor to rising inflation, evident in the delta between consumer inflation and core inflation, which removes more volatile prices like energy- and food-related costs. The friction between Russia and Ukraine is only expected to worsen this dynamic, given Europe’s reliance on Russia for energy.

The European Union imports nearly 40% of its total natural gas consumption from Russia. While global oil prices tend to trade largely in tandem due to OPEC’s influence, natural gas prices are more sensitive to regional access and supply. The Dutch TTF Natural Gas price has historically hovered around $20/MMBtu but has surged more than 300% over the last 12 months, while U.S. Natural Gas is up just 36.9% over the same period. While geopolitical fears may continue to drive up the cost of crude as uncertainty builds, the more immediate impact is to the European energy markets via natural gas prices. In the most direct sense, the impact to global developed markets may be low, with the Energy sector comprising only 2.9% and 3.9% of the S&P 500 and MSCI EAFE indices, respectively, though knock-on effects may be broader, including economic sanctions and additional measures to combat inflation that could ultimately impact growth. Past geopolitical stress events provide little guidance with moving pieces always evolving. Tensions could deescalate and we could see little fallout, as was the case following the 2014 Crimean crisis, or pressures could mount with wide-reaching global implications. For now, we will continue to monitor and help our clients navigate the volatility.

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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.

Navigating Inflation from Up Here

Despite year-to-date turbulence, equity markets remain near all-time highs. While company earnings have more than recovered from the lows of early 2020, valuation multiples are also still well above pre-pandemic levels. Our chart of the week looks back at historical trailing P/E levels of the S&P 500 in different inflationary environments. Historically, in months when consumer prices were up between 6% and 8%, the S&P 500 traded at an average 12X earnings, below its long-term average of 17X. As of January 31st, the S&P 500 traded at 23.7X trailing earnings.

With most of these data points coming from the 1970s, this is more of an interesting anecdote than a prescriptive playbook, but does directionally make sense. Higher inflation tends to lead to rising interest rates, as the Federal Reserve looks to maintain price stability. Higher interest rates, in turn, put downward pressure on valuations, as the discount rate used to value a stream of future earnings increases. Companies whose value is largely derived from future growth in earnings see a pullback in the multiple investors are willing to apply to current earnings.

The Fed’s increasingly hawkish tone has already led to a meaningful correction in multiples, with potentially more volatility to come. While perhaps unnerving, the change in backdrop is creating opportunities for stock pickers. Active long-only and long/short managers should be better positioned to navigate market headwinds and add value for investors. While we of course do not have a crystal ball, we are looking forward to active managers hopefully capitalizing on an improved opportunity set 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.

There Is No Crystal Ball

The Federal Reserve is arguably the most influential financial institution in the world. Their eight meetings a year are highly anticipated, their policy decisions are highly scrutinized, and their economic projections and commentary can move markets. Last month the Nasdaq sold off nearly 9% on concerns of heightened inflation and expected rate hikes by the central bank. The market reversed sharply after the January FOMC meeting on Chair Jerome Powell’s comments about rising inflation and monetary tightening. There are even trading strategies built on predicting market movements after the Fed’s comments and monetary policy surprises. While the monetary policy decisions made by the Fed have a material impact on the economy, their projections are not always accurate, especially when it comes to rate hikes.

Our chart of the week examines the summary of economic projections of GDP, unemployment, inflation, and the number of 25 basis point rate hikes projected for the year over the last eight years. Prior to the COVID pandemic in 2020, the Fed had fairly accurately predicted GDP, inflation, and unemployment, more often than not coming within 0.2% of actual full-year numbers. Ironically, when it comes to interest rate changes — the metric most directly controlled by the Federal Reserve — predictions worsen. While the Fed accurately foresaw no movement in 2014 and 2021 and were on the mark with three rate hikes in 2017, they greatly overestimated hikes in 2015 and 2016 and underestimated rate cuts in 2019 and 2020. Following four rate hikes in 2018, after starting the year predicting three, the Fed quickly reversed course in 2019, cutting rates three times, a sharp contrast to initial expectations for one additional rate increase.

This year the members of the FOMC are predicting three rate hikes, though history has shown us actual results could differ greatly. Monetary policy and economics are never an exact science, and the continually evolving supply and demand dynamics behind inflation make this year all the more challenging. There are simply variables that cannot be predicted. In other words, there is no crystal ball. As the year unfolds, we will continue to keep our clients abreast of policy updates out of the Fed as well as any other developments that could impact the course of rates.

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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.

Any Port in a Storm

The volatile start to the new year has all eyes on the Federal Reserve and its increasing hawkishness. As the Fed prepares to raise interest rates later this year, we look at reverse repurchase agreements and what they mean for the markets.

As part of the Federal Reserve’s efforts to maintain monetary policy and manage liquidity, the New York Fed engages in temporary transactions where reserve balances of excess liquidity are added to or reduced through repurchase (repo) and reverse repurchase (reverse repo) agreements. These operations have a short-term, self-reversing effect on bank reserves. Repurchase agreements involve the Fed purchasing Treasury securities from a counterparty (typically a large institution with excess reserves), with an agreement to resell the securities back at a slightly higher price, representing a small rate of interest. The repo transaction temporarily increases the supply of reserve balances in the banking system and provides liquidity. Reverse repurchase agreements involve the opposite, where counterparties temporarily purchase Treasury securities to be sold back at a later date. Reverse repo transactions help alleviate any undue downward pressure on the effective federal funds rate and set a floor under overnight interest rates by providing a short-term alternative investment for large institutions with excess liquidity reserves.

After a period of dormancy in the beginning of 2021, the Federal Reserve’s overnight window for reverse repurchase agreements saw a rapid rise in demand when the counterparty limit for reverse repos was raised from $30B to $80B in March. This trend continued to accelerate when the limit was again raised to $160B in September, closing out the year at a record level of $1.91T in volume. Low interest rates and the Fed’s quantitative easing efforts presented large institutions with a challenge as to where to invest record levels of excess liquidity reserves. The solution has so far been to make use of the overnight window and earn minimal interest via a risk-free investment in Treasuries.

Time will tell how the Fed will execute its monetary policy changes this year and how markets will respond to that shift. Institutions currently utilizing reverse repurchase agreements may change course once they have higher yielding alternatives, with the impact to the economy and market dependent on where those reserves go. Marquette will continue to carefully follow policy decisions from the Federal Reserve and monitor other indicators, like the demand for overnight repurchase agreements, to help provide clarity during this period of heightened market volatility.

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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.

In Search of Lost Yield

The fixed income space faces several significant challenges in 2022. First, the ability of many bond strategies to generate viable income streams is limited by interest rates that remain at historic lows. Additionally, elevated levels of inflation, which may remain above the Federal Reserve’s long-term target of 2.5% throughout the year, will serve to dilute real returns. To that point, the 5-year breakeven rate, a measure of expected near-term inflation in the U.S., ended last year at 2.9% after reaching a level of 3.2% just a few weeks prior, which represents a record high for the metric since Bloomberg began tracking it in 2002. As displayed in this week’s chart, Treasuries, mortgage-backed securities, and high yield municipal bonds exhibited flat-to-negative inflation-adjusted yields at the end of 2021. Finally, many expect rates to rise this year as the Fed curtails stimulus programs and begins to implement increasingly restrictive monetary policy to combat the rise in price levels. The current landscape begs the question: What can fixed income investors do going forward?

In the coming years, traditional bond investors may need to focus on a wider variety of sectors within the asset class to attain desired yields. Specifically, preferred securities, emerging market debt (EMD), high yield bonds, and senior loans all offer yields that are in excess of the 5-year breakeven rate, even when adjusting for duration. Bank loans may be particularly attractive going forward, as these instruments typically offer floating interest rates that protect investors from increases in short-term yields. Of course, the risks of each of these spaces should be thoroughly considered before any allocation changes are implemented. The EMD space, for example, carries with it significant currency risk, while preferreds exhibit credit risk and are subordinated in the capital structure, providing investors with a lower claim on assets than more senior debt. While all of these sectors are not uncommonly featured in investment portfolios, market participants should investigate the merits and drawbacks of each before creating or modifying target allocations, with a specific focus on duration, credit spread sensitivities, and liquidity terms.

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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.