Category: Chart of the Week

What Does the Labor Shortage Mean for Inflation?

Employers have faced a number of challenges throughout the COVID-19 pandemic — most recently, a labor shortage. As of the end of June, the Bureau of Labor Statistics reported a record high of more than 10 million job openings (including either newly created or unoccupied positions where an employer is taking specific actions to fill those positions), and as of the end of July, 8.7 million people looking for employment (people who are without work, currently available for work and seeking work), creating a disconnect in the labor market.

While this is not the first time job openings have exceeded the number of people looking for work, the imbalance is more meaningful now as companies attempt to fulfill pent-up demand caused by the pandemic with sharply less labor availability. To help combat this shortage, states have started to cut unemployment benefits, though these actions so far seem to have had minimal effect. Employers must now find a way to incentivize workers to apply to openings and accept offers. This is likely to put upward pressure not only on wages but on consumer prices. In order to protect profitability, companies will have to pass on the additional costs to the consumer, adding to inflationary pressures. While many signs point to higher inflation being transitory, the labor shortage — which could continue even after extra unemployment benefits expire, given demographic trends and a shift toward the gig economy — could be a longer-term issue. We will continue to monitor inflation, its underlying drivers, and the potential impacts to our clients’ portfolios carefully.

Print PDF > What Does the Labor Shortage Mean for Inflation?

 

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.

Where is Inflation Headed?

Despite a number of commodity prices, including lumber, corn, and pork, retreating from recent highs, inflation remains a key focus for investors, especially as the Delta variant rages on and vaccination rates slow. Our chart this week looks at what the data can tell us about where inflation is headed.

Actual inflation, as measured by year-over-year growth in the headline Consumer Price Index (CPI), is shown in green in the chart above. CPI ran hot in 2008 just before the Global Financial Crisis (GFC), fell into negative territory in 2009, and then peaked twice before turning a corner, declining in 2011 and normalizing from 2012 to 2014.

The market’s expectations for average annual inflation are shown above in purple and teal, over the next two and five years, respectively. The breakeven inflation rate measures the difference in yield between U.S. Treasury bonds and Treasury Inflation-Protected Securities (TIPS) of the same maturity. This difference is the return that the TIPS provide to protect from inflation, or the inflation rate where an investor would be indifferent between owning the two instruments.

What do these three lines tell us? First, actual CPI does loosely follow, on a lag, the two-year and five-year breakeven rates. Both breakeven rates fell and recovered ahead of CPI in 2008 and 2009. The difference between the two-year breakeven and five-year breakeven also provides critical information. In the post-2008 GFC recovery, the five-year breakeven remained higher than the two-year breakeven from 2009 to 2011, with the market expecting inflation to rise and be higher on average over the next five years than over the next two years as the global economy continued to recover. In 2011, the five-year breakeven fell below the two-year breakeven, showing that the market began to forecast that average inflation over the next five years would be lower than average inflation over the next two years. Actual CPI peaked not long after that, declining and normalizing from 2011 to 2014.

What could these indicators mean for inflation going forward? Actual CPI is again running hot at 5.4% in both June and July. However, the two-year breakeven, despite characteristically falling faster than the five-year breakeven at the height of the COVID panic in 1Q20, is already higher than the five-year breakeven, a leading indicator of CPI peaking and something that didn’t happen after the GFC until 2011. Additionally, both the two-year and five-year breakeven appear to be plateauing. Both breakeven rates have been fluctuating around 2.5%, meaning the market believes annual inflation will settle around an average 2.5% over both the next two and five years, supporting the idea that heightened near-term inflation is more transitory. While this market-based data does have its limitations, it is a helpful input as we look to help our clients prepare for the future.

Print PDF > Where is Inflation Headed?

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Chinese Equities Sold Off in July

In 2020, China was a top performer in the global equity market, returning 29.5%. In 2021, however, Chinese equities have struggled relative to peers. In July, the MSCI China Index lost 13.8%, dragging the broader MSCI Emerging Markets Index to a 6.7% loss for the month.

On July 23rd, the Chinese government, as part of its efforts aimed at boosting a declining birth rate, announced that private for-profit education companies were no longer allowed to make a profit. Among other restrictions, these companies are now required to transform into non-profit entities. As a result, two of the largest education companies — New Oriental Education and TAL Education — were down 73.5% and 75.9%, respectively, in July. This dramatic change is a recent event in a series of regulatory actions that have been taken by the Chinese government over the last nine months. Previous changes predominately impacted internet-based businesses.

Chinese equities have sold off as investors assess the risks of the new regulatory climate and the potential impact to future profitability of several key industries. From here, the market will likely remain jittery on Chinese stocks, especially within regulated industries. However, this is not a new phenomenon. We have seen the Chinese government increase regulations in the past after periods of unchecked growth. The online gaming industry, for example, came under pressure in 2018 when the Chinese government imposed a curfew for minors as a means of limiting gaming consumption. In those past instances, the market recalibrated to the new regulatory environment and the resulting winners and losers were identified. We anticipate a similar outcome in this case.

Print PDF > Chinese Equities Sold Off in July

 

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 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.

Print PDF > What Might an Earnings Peak Mean?

 

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.

Print PDF > Private Equity Staying Rational with Fund Sizes

 

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.

Print PDF > PE Tapping Public Market Strength

 

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.

Print PDF > Welcome Back…to the Grind

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.

Print PDF > The Lumber Experience

 

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.

Print PDF > Russell Reconstitution: AMC Bought Tickets to the Russell 2000

 

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.

Print PDF > Can Private Equity Outperformance Persist?

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.