Category: Chart of the Week

What Might an Earnings Peak Mean?

S&P 500 earnings growth of nearly 30% year-to-date has completely eclipsed that of the last 10 years. This is in stark contrast to the previous two years, when 18% and 31% market gains were almost entirely driven by multiple expansion. The 2021 rebound in earnings follows last year’s sharp COVID-induced decline and has some investors wondering what an almost inevitable slowdown from here could mean.

As of the end of June, FactSet analysts had estimated second quarter earnings to be up 63.1% year-over-year. Of the 345 S&P 500 constituents that have reported so far, approximately 87% have surprised to the upside. Despite this strength at the bottom line, many of these companies have seen their stock prices fall post-reporting, implying true expectations, following the historic 41% run over the last year, were actually higher. Reopening optimism started to drive stocks, and multiples, higher in late 2020, ahead of earnings growth, and now investors are trying to determine how much future earnings growth is already priced in. We saw something similar after the Global Financial Crisis in 2009 and 2010. As the economy began its initial recovery, strong returns in 2009 preempted 40%+ earnings growth, and a sharp correction in multiples, in 2010. Importantly, in the years that followed, despite a slowdown in earnings growth, the market continued to post positive annual returns until the late-year drawdown in 2018.

This year, we may see earnings growth peak in the second quarter, but it isn’t necessarily cause for concern. Company earnings are expected to remain stable as regions continue to reopen and overcome supply and demand shocks. And, more importantly, active investment managers who have struggled to keep up with a sentiment-driven market could see an improved stock picking opportunity set. To the extent optimistic exuberance is in the rearview, stocks should be more driven by company-specific fundamentals than by macro-centric tailwinds, a positive for many of our recommended managers.

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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.

Private Equity Staying Rational with Fund Sizes

Despite strong fundraising numbers in recent years, private equity managers in the U.S. have stayed consistent with subsequent fund size step-ups. Through the first half of 2021, 72% of private equity managers launched funds with increased size targets, in line with the average over the last decade. The median fund size step-up in the first half of the year was 48%, modestly above the 40% average increase over the last decade, but in line with the industry average over the last five years.

Fund size is a critical factor for private equity investors to consider, as it can push a manager outside their strategy, require additional resources, require purchasing larger businesses that are more efficient, and/or take managers longer to deploy. That said, modest fund size growth is healthy for a private equity organization, allowing for internal growth, giving existing investors the ability to scale their allocations, and creating opportunities to bring new investors into the fund. Risks related to increased fund size can be mitigated by managers via scaled resources, targeting more portfolio companies, reducing the amount of co-investment offered, and/or reducing leverage — all things we look for in our due diligence process. We believe modest growth is healthy and to be encouraged if done responsibly, but we do carefully evaluate the magnitude of a fund size increase relative to our assessment of a manager’s capacity and strategy.

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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.

PE Tapping Public Market Strength

Private equity exits are set to break record numbers in 2021. In 2020, there were 947 exits worth $367 billion, and in 2019 there were 1,111 for a total $323 billion. Already this year, in the first half of 2021, there have been 676 exits for $356 billion. At this pace, the year is on track to surpass both the previous highs of 1,328 exits in 2015 and $421 billion in exit value in 2018.

Along with the number of exits increasing overall, the percentage of exits via IPO has increased significantly this year. In 2019, the fear of a recession kept private companies from wanting to go public. Once a private company hits the market, PE sponsors keep their shares, now subject to public market dynamics, for an average of three years. Risk of a looming recession or lack of confidence in the public market can deter private company owners from pursuing this path. Alternatively, the increased use of public market exits year-to-date may represent private owners’ more bullish outlook on the market. We will continue to look to leading indicators like private market sentiment to help inform our own market expectations and client 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.

Welcome Back…to the Grind

Uncertainty lingers in the office sector against a backdrop of extended office closures across the U.S. Average occupancy rates have dropped over the past year and net absorption further declined in the first quarter of 2021. The national average vacancy rate for the office sector rose to 16% in Q1 2021, up 100 basis points quarter-over-quarter and 370 basis points year-over-year.¹ The ongoing rate of deterioration in office fundamentals has been somewhat surprising given the rebound in the labor market as the economy has reopened. Although office rents have been sticky so far, questions remain about the longer-term demand for office space, with some property owners offering leasing concessions in primary markets hit hardest by vacancies.

The second half of the year should provide some clarity with the COVID-19 vaccine rollout in full swing and more and more employees expected to return to work. The long-term extent of remote working on office demand is the biggest outstanding question. Average days in the office has fallen from 4.6 days a week to 3.6 days a week.² Employers are re-evaluating office space needs, looking to balance a flexible work environment with the benefits of workplace collaboration and productivity. Rising new supply combined with more than a year of minimal leasing activity will also continue to put downward pressure on office rents and occupancies in the near term. From here, we may see office demand stabilize, setting the stage for an uptick in leasing activity, or we may realize we are facing a new normal. We will continue to look for and recommend to our clients real estate managers that we believe are best positioned to navigate this evolving dynamic.

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¹ Cushman & Wakefield, KPMG, The 2021 KPMG CEO Outlook Pulse Survey, Clarion Partners Investment Research, June 2021.
² TA Realty, Defining Themes of 2021

 

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 Lumber Experience

“The lumber experience,” as coined by Federal Reserve Chair Jerome Powell, has become the poster child for transient inflation. After a brief pullback during the early days of COVID, lumber prices moved up sharply in 2020 to an unprecedented peak in May 2021. In the two months since, prices have been cut in half to roughly $790 per thousand board feet. While still nearly double pre-pandemic levels, the move is clearly meaningful.

Lumber embodies the different moving pieces of the inflation debate, impacted by easy monetary policy, fiscal stimulus, pandemic-related supply chain issues, and evolving consumer preferences spurred by COVID. Lumber, like other commodities, is priced based on the balance between supply and demand. The lumber market had initially braced for a COVID-related housing pullback that never came. Instead, increasing housing and renovation demand, fueled by record-low interest rates, extra cash, and newfound time at home, combined with restricted supply amid pandemic-related shutdowns led to a more than 250% increase in prices. Then, supply and demand adjusted. Sawmills ramped production and consumers put off purchases. Homebuilding permits fell to a seven-month low. This change in behavior is counter to conditions typical of runaway inflation and should help ease the worst of those concerns.

While it is unlikely lumber falls back to pre-pandemic levels given the severe housing shortage in the U.S., the correction, along with that in other commodities like copper, soybeans, and corn, does help the Fed navigate the thin line between fostering economic growth and managing inflation. In June, the Fed indicated we could see rate hikes start in 2023, up from previous expectations of 2024, though some analysts think this will be pulled forward again into 2022. The path of rates is important to markets — as we saw with the rate increases in 2018 and the rise in the 10-year earlier this year — and we will continue to look to leading indicators, like lumber prices in this case, to help inform our outlook and client 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.

Russell Reconstitution: AMC Bought Tickets to the Russell 2000

The last Friday in June brings a unique set of challenges for investors managing to the indices of FTSE Russell as the entire family of domestic index products is rebalanced at the end of the second quarter to reflect changes in the U.S. equity markets over the last year. The annual rebalance updates the market capitalization and style profiles of the indices, which then drives shifts in the underlying sector and industry weightings within the benchmarks. After an unprecedented year in equity markets, the most recent reconstitution is worth a deeper look.

While the Russell Reconstitution impacts all Russell indices, the Russell 2000 index ― which tracks small-cap equities within the U.S. ― tends to undergo the most significant overhaul year to year, as newly-public companies are included for the first time and the previous year’s winners move up the market capitalization spectrum. The chart above details the changes in sector weightings for the Russell 2000 Value, Core, and Growth indices resulting from the annual rebalance. The most notable shifts can be seen in the Consumer Discretionary and Health Care sectors, particularly within the Value and Core indices.

The move in Consumer Discretionary is at least in part a product of the meme stock short squeeze earlier this year. While many of the stocks that saw significant price appreciation in recent months (e.g., GameStop) graduated up in market capitalization to the Russell 1000 index, others, like AMC Entertainment, were left behind on the May 7th rank day. A unique aspect of this year’s rebalance is the speculative nature of the trailing 6-month period. On May 7th, AMC Entertainment had a market capitalization of $4.3B, comfortably within the bounds of the small-cap universe as defined by Russell. Since then, the stock is up over 400% to a market capitalization of nearly $30B. It is expected that AMC will remain in the Russell 2000 and Russell 2000 Value indices despite its increased size, making it the largest position in both of these cap-weighted indices, at roughly 0.8% and 1.6%, respectively. This is a double-edged sword for active managers, as performance relative to the small-cap benchmarks may look overly positive or negative, depending on AMC’s path from here.

The changes in the Health Care sector present a different challenge to active managers. The Russell 2000 Value index has historically included a minimal allocation to Biotechnology, an industry synonymous with binary outcomes and companies with little revenue and few tangible products. This year’s rebalance led to a more than 5% increase in the Value benchmark’s weight in Health Care, with Biotechnology making up roughly 70% of that addition. Many small-cap value managers generally avoid biotech due to its inherent risks and do not consider the space an area of expertise. That said, ignoring the now third largest industry in the Russell 2000 Value index may no longer be an option. Relative performance is an important tool in evaluating active managers and understanding what that benchmark represents is imperative. We look forward to seeing how managers adapt to the latest changes.

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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.

Can Private Equity Outperformance Persist?

North American private equity managers have consistently outperformed the Russell 3000 as well as other broad equity indices over the last 20 years.¹ Key value drivers that have contributed to this outperformance include information asymmetry, a longer-term strategic focus, use of leverage, improved management and governance, and effective value creation plans. But for private equity managers to continue to achieve these outsized returns, they must first find the right opportunities and then be able to effectively monetize their investments.

In the U.S. there are approximately 17,500 private companies with annual revenue greater than $100 million, compared to roughly 2,600 public companies above the same revenue threshold. For every one public opportunity at this level, there are almost seven private opportunities. There are also more than 340,000 private businesses with revenue between $5 and $100 million. As private markets continue to grow and evolve, private companies will be able to access capital with greater ease than they have historically. This, in addition to the disadvantages of going public, should extend the trend of companies staying private for longer. This sets the stage for private equity managers to continue to deliver attractive risk-adjusted returns, with a robust opportunity set and a number of unique investment advantages.

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¹Pitchbook as of Q320, latest data available.
Sources: Capital IQ, Forbes, and PitchBook

 

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.

A Strong Decade for Private Markets, Led by Growth

While it has been a very strong decade for private market returns, not all private market strategies have provided the same level of risk-adjusted returns. Growth-oriented strategies like Growth, Private Equity, and Venture Capital have delivered the highest 15-year horizon IRRs and with lower standard deviation than other lower-returning strategies like Real Estate, Infrastructure, and Oil & Gas. We believe these growth areas are better positioned to generate higher IRRs within closed-ended funds given their large opportunity set, accelerated ability to deploy capital, opportunities to drive operational improvements, and ability to generate attractive exit opportunities.

Asset allocation mix is of increasing importance as investors seeking higher return potential within portfolios look to scale up their illiquid allocations. The last decade shows that not all private markets investments are equal. We believe Growth, Private Equity, and Venture Capital are likely to continue to be the most attractive strategies for investors looking to maximize the returns generated from their illiquid allocations. Manager selection also remains a critical investment decision within private markets strategies, where there is typically a wider range of performance dispersion than in more traditional public market asset classes.

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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 Labor Market Is Healing, but More Slowly Than Expected

GDP growth turning positive in the first quarter, May unemployment down to 5.8% from 14.8% in April 2020, and the S&P 500 reaching a new all-time high in May are all signs of economic recovery. More than 22 million jobs gained over the past 10 years were wiped out by COVID, and as of May, 13 months after the April 2020 bottom, 66% of those jobs have been recovered. While the same degree of recovery took 22 months following the Global Financial Crisis of 2008, the recent increases in payroll have actually fallen short of expectations.

Nonfarm payrolls increased 559,000 in May, falling below expectations for 675,000. This follows an even larger miss in April, when an increase of 278,000 jobs fell well below expectations for 1 million.¹ At the same time, the number of job openings has mounted to 9.3 million,² a record high and 2.3 million more than before the pandemic. Labor supply is not keeping pace with demand. According to the May Consumer Confidence Survey, 46.8% of consumers ­­— up from 36.3% — say that jobs are “plentiful,” and only 12.2% — down from 14.7% — say that jobs are “hard to get.” The labor participation rate is down to 61.6%, the lowest level since 1976, excluding the recent period since the coronavirus outbreak.

From here, vaccination rates, wage growth, and the expected September expiration of additional unemployment benefits will dictate employment trends. Jobs progress will in turn influence how the Federal Reserve approaches raising interest rates and tightening monetary policy. Meaningful progress has been made, and these factors, among others, will continue to shape the economic recovery.

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¹ Bloomberg
² As of April, latest available

 

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.

Volatility in Crypto

Bitcoin has been under pressure over the past month while Ethereum has held up relatively well, resulting in a large discrepancy in returns between the two largest cryptocurrencies. After a surge in prices from late 2020 through early 2021, a number of factors have weighed on Bitcoin more recently. China reiterated its restrictions on cryptocurrencies and proposed punishments for companies involved in mining Bitcoin in the Inner Mongolia region. Mining rigs have a large energy footprint and have since been banned in order to lower China’s overall energy consumption. China accounts for more than 65% of the world’s total Bitcoin mining due to its cheap energy costs. Elon Musk, a prominent voice in the crypto space, also announced that Tesla would no longer accept Bitcoin as a form of payment due to environmental concerns.

Ethereum also dropped in May, but is still up 83% since March, a stark difference from the -19.8% return of Bitcoin. Ethereum has benefited from increased interest in the underlying technology. Decentralized finance focuses on using Ethereum-enabled smart contracts to optimize transactions. The rise of non-fungible tokens or NFTs has also contributed to Ethereum’s gains. NFTs are digital assets, secured by the Ethereum blockchain, that represent unique ownership of virtual items like art and sports memorabilia. NFT trading volumes in the first quarter of 2021 were up 15X quarter-over-quarter.¹

Cryptoassets are an emerging asset class and this level of volatility should be expected. We recommend interested investors remain diligent and only pursue investments that are appropriate for their risk tolerances.

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¹CoinDesk, Nonfungible.com

 

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.