Category: Chart of the Week

A Tale of Two CPIs

With headline inflation hitting a 41-year high, the market has become increasingly skeptical of the Federal Reserve’s ability to combat rising price levels for consumers and producers alike. As market participants await additional action from the Fed, core inflation numbers have broken away from historical trends with core CPI exceeding core services since March last year. Core CPI, which includes all items except food and energy, has historically stayed near 2% and below core services. As the U.S. began to reopen in early 2021, the increased demand for goods amidst supply chain stresses was quickly followed by a rapid rise in core CPI. Recent geopolitical conflicts such as Russia’s invasion of Ukraine and lasting pandemic mitigation measures taken by China have only exacerbated supply chain disruptions as global trade remains stifled. While policymakers were initially confident in the transitory nature of inflation, it has proved more persistent, with the U.S. now entering a period of a wage-price spiral as higher prices and higher wages threaten a prolonged period of elevated price levels. In addition to supply chain matters, employment dynamics within the U.S. have left many sectors of the economy seeking workers, with many companies resorting to wage increases to maintain or expand their workforce. While wage growth has continued to lag inflation, it has contributed to core services significantly, with year-over-year increases reaching levels not seen in over 20 years. While it remains to be seen whether overall inflation has peaked, it is likely that core services inflation will remain for the time being as persistent labor shortages keep upward pressure on wages.

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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.

Buy Land, They’re Not Making It Anymore

Individuals commonly allocate 20–30% of their net worth into a primary residence, which oftentimes accounts for the single largest investment in their portfolio. The market value of one’s home is impacted by variables that include, but are not limited to, supply and demand relationships, property location, borrowing rates, and tax policies. Since early 2020, median home prices have increased over 25%, benefitting homeowners and their portfolios significantly.¹ The appreciation in home prices can partially be attributed to the shortage of homes built over the past decade. Not since the 1930s, when the country’s population was roughly 40% what it is today, have so few homes been built in the United States. The problem is further exacerbated by the average age of a home in the U.S. — 40 years,² well beyond its useful life — and current labor and material shortages that have been lengthening project timelines and delaying starts.

The sudden rise in housing valuations has homeowners and investors wondering if this could be another bubble, akin to the 2008–2009 mortgage crisis. While new home starts will likely remain low in the near and medium-term, rising interest rates may serve to stymie demand. Since the end of 2021, interest rates on a 30-year fixed mortgage have risen nearly 200 basis points to almost 5.0%,³ adding meaningfully to the cost of buying a home and potentially pushing ownership outside the reach of prospective millennial and generation Z buyers. However, opportunity exists in any inefficiently priced market, which is why more and more institutional investors are allocating “dry powder” to the residential real estate market. Ultimately, buyers, sellers, and lenders are justified in asking whether we are on the precipice of another housing crisis or if this is the start of a new normal with additional runway for growth.

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NOTES
¹ Lambert, Lance. “Homeowners struck gold during the pandemic—here’s the breakdown in every state.” Fortune. 23 Dec 2021.
² Jones, David. “Ages of Houses in the US.” BuyersAsk. Last updated 4 May 2021.
³ 4.96% as of April 4, 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.

The Evolving Secondary Market

The private equity secondary market has matured and become more efficient over the last decade, with annual secondary transaction volume scaling from approximately $25 billion in 2012 to roughly $130 billion in 2021. Investors are increasingly turning to the secondary market for liquidity as they look to exit their private equity investments to better manage their overall portfolio allocations. Single asset transactions have been a more recent contributor to the growth of the secondary market, growing from 3% of total secondary transaction volume in 2018 to 25% in 2021, with a large part of this volume driven by the creation of continuation vehicles. These vehicles are quickly gaining in popularity, primarily by managers within the middle and upper end of the private equity market.

Continuation vehicles have become a hotly debated topic within the private equity community. The ability for private equity managers to recapitalize what is often their top portfolio company into a new single fund structure helps raise additional AUM and allows the manager to continue to own the company. However, it can be challenging for Limited Partners (LPs), who often lack the ability to underwrite a single company or are not given enough time to do so. Many institutional LPs are also simply unable to take the concentration risk of investing in a single asset.

As the secondary market evolves, single asset continuation vehicles are expected to become more common. LPs in private equity funds will need to evolve as well to take advantage of these opportunities and remain invested in the best assets over a longer period. This may require LPs to increase their allowable concentration limits, expand underwriting capabilities, or adjust policies in order to roll top investments into continuation 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.

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.