Category: Chart of the Week

Spreads Largely Pricing in a Full Recovery

Spreads for industries that were beat-up during the early 2020 COVID panic — energy, retail, and transportation — as well as for industries that proved more stable — financials, technology, and utilities — are now generally tighter than pre-pandemic levels in the bank loan and high yield markets. From here, spreads could tighten further as issuer fundamentals continue to improve, widen in a correction, or be volatile, blowing out and tightening back in throughout the economic recovery.

While a lot of progress has been made on the vaccination front, there is still more work to do. The fully vaccinated rate in the U.S. is currently 39%, not yet at 70% herd immunity. Globally, the fully vaccinated rate is only 5%, not even close to 70% herd immunity. While this leaves the economic recovery vulnerable, markets are forward-looking. In the bank loan and high yield markets, maturities have been pushed off, which is a positive, thanks to the large volume of issuance over the past year. Leverage levels of bank loan and high yield issuers are currently high, but due to decline, another positive, as earnings rise in the economic recovery. Use of proceeds from bank loan and high yield issuances¹ and aggressive issuance² are at benign levels, and defaults have been declining — more positive indicators. On the negative side, equity valuations are already at all-time highs and continuing to rise.

In summary, fundamentals are attractive, but valuations are not. We could potentially see spreads tighten further, but uncertainty is high, and we could also see a correction given the high valuations and frothy sentiment. While further spread tightening will be accretive to returns, it will limit short-term future price appreciation for fixed income strategies. Overall, this is a dynamic that bears watching, particularly as economic growth accelerates and the pandemic continues to fade.

Print PDF > Spreads Largely Pricing in a Full Recovery

¹ Such as towards refinancings (a sign of conservativism) versus acquisitions and LBOs (a sign of frothiness).
² Such as CCC bank loan and high yield issuance and 2nd lien bank loan issuance.

 

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’t Buy a Thrill

In the spring of 1973, the lyrical geniuses Walter Becker and Donald Fagen of the musical group Steely Dan released the song “Reelin’ In the Years.” The third and fourth lines of the first stanza proclaim:

Well, you wouldn’t even know a diamond if you held it in your hand
The things you think are precious I can’t understand

At first glance, the reproving lyrics underscore the disagreement of value between two parties and one’s inability to recognize an object of high value. Arguably, value is subjective as the intersection of what the most pessimistic seller and most optimistic buyer are willing to accept. Fagen and Becker could have been students of economic policy, prophesizing the creation of Bitcoin more than 35 years later and critical of inflation, which would reach 6.2% in 1973 and 11.1% in 1974.¹ While I am hesitant to put Fagen and Becker in the same category as Keynes, Smith, and Friedman, I do believe their words inspire a debate on the meaning of value.

Gold has historically been accepted as an alternative to cash and a hedge against inflation. As expected, inflation has been on the rise this year, with the Consumer Price Index up 4.2% YoY in April, the highest in 12 years.² At the same time, contrary to conventional wisdom, gold has underperformed. Through May 14th, 2021, gold is down 3.4% YTD and up only 2.6% over the past year. Alternatively, the cryptocurrency Bitcoin is up over 50% YTD and over 350% over the past year. While there are a number of different factors behind Bitcoin’s latest rally, its status as “digital gold” may be one of them, with its finite supply and detachment from central bank policy particularly attractive right now.

The discussion around cryptocurrencies and inflation is a complicated one, given the nascency of the asset class and the limited data available given the general lack of inflation over the last several years. Making long-term decisions based on short-term information does not typically lead to beneficial outcomes. With that said, it is often hard to grasp the magnitude of innovation at its earliest stages. As the debate over the value of Bitcoin and the value of gold as an inflation hedge continues, we recommend investors be prudent and diligent in accounting for new data and information while weighing it against past lessons in uncertain periods.

Print PDF > Can’t Buy a Thrill

¹ World Bank, 1960–2019 data. “Inflation, consumer prices (annual %) – United States.”
² Cox, J. 12 May 2021. “Inflation speeds up in April as consumer prices leap 4.2%, fastest since 2008.”

 

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 Lasting Effects of a Temporary Trade Stoppage

In late March, one of the busiest waterways in the world came to a standstill after the Ever Given, a 1,300-foot container ship, became lodged in the Suez Canal. Nearly 30% of the world’s daily shipping container freight passes through the Suez Canal, and with supply chains already disrupted amid the COVID pandemic, the timing could not have been worse. While only a one-week stoppage, with approximately 7% of the world’s oil and 12% of global goods trade flowing through the canal, it is estimated that each day lost delayed more than $9 billion worth of goods.¹

In this Chart of the Week, we analyze the impact that the Suez Canal closure had on maritime shipping costs and the contribution to inflation. The chart above shows the daily price movement of the Shanghai Containerized Freight Index (SCFI). As one of many proxies for global trade and ocean freight health, the SCFI reflects the weekly shipping spot rates of Shanghai container exports along 15 major trade routes, including Shanghai to the United States (east and west coasts), Europe, South Africa, and South America. In contrast to the highly-cited China Containerized Freight Index (CCFI), the SCFI focuses solely on exports in these 15 individual trade routes, rather than nationwide import and export container transport, which would include more contractual and futures rates. Rates surged throughout 2020 amid increasing demand for goods over services and tighter supply. The blockage, which may take months to fully recover from, combined with pent-up demand and economic re-openings has exacerbated the imbalance and sent SCFI spot shipping costs up another 20% over the last month. Rising inflation has been an increasing concern for investors this year and, given current dynamics, we do not expect the contribution from higher global shipping rates to abate anytime soon.

Print PDF > The Lasting Effects of a Temporary Trade Stoppage

¹Lloyd’s List Intelligence

 

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

When Do Rising Rates Matter the Most?

The first quarter of 2021 saw the 10-year Treasury yield nearly double, which had a profoundly negative impact on growth-oriented and higher-valuation stocks. Generally, higher interest rates are expected to lead to lower equity returns and vice versa, all else equal. While the pace of change in the 10-year during the first quarter was enough to rattle investors, data from the last decade does not support an overall negative correlation between the movement in interest rates and equity returns. Since the Global Financial Crisis (“GFC”), monthly returns of the S&P 500 Index and monthly changes in the 10-year Treasury yield have exhibited correlations ranging from modestly negative to strongly positive. This is in stark contrast to the correlations from previous decades, when equity returns and interest rate movements tended to be strongly inversely related, as conventional wisdom would suggest. Roughly 75% of the monthly correlation observations from 1970 to the beginning of the Global Financial Crisis were negative, compared to less than 14% from the GFC to the present day. While many variables likely contributed to this disconnect, the absolute level of interest rates may be the most important factor.

Though it is difficult to precisely quantify the impact, the extremely low yield environment of the past decade has clearly been a boon to stock prices. During periods of low rates, investors tend to shun conservative assets like bonds and turn to equities for yield, otherwise known as the “TINA” effect (i.e., market participants believe “there is no alternative” to stocks in low-rate climates). This phenomenon manifests itself in the form of the equity risk premium (the S&P 500 earnings yield less the 10-year Treasury yield), which has indicated the relative attractiveness of equities for nearly two decades. Low rates also benefit stock price valuations, calculated as expected future cash flows of companies pulled forward to the present day using a discount factor based on the risk-free interest rate. When yields are low, the denominators in those present value calculations are also low, leading to higher valuations. So, despite rates ticking up during various periods in the last decade, stock prices largely continued to rise as rates stayed extremely low on an absolute and historical basis. It is also worth noting that during exogenous shocks like the GFC and COVID-19, both yields and equity prices saw dramatic decreases, contributing to the positive correlation over the last several years.

At higher absolute levels of interest rates, however, the data show a stronger negative correlation between yield changes and equity price movements. The idea that the absolute level of interest rates helps determine the extent to which movements in yields impact equities begs the question: Is there an inflection point at which increases in rates are more likely to lead to diminished equity returns? While there are many factors at play, a quadratic regression on the correlations observed from 1970 through today implies that negative correlations begin at a 10-year Treasury yield of around 5.8%. For investors, this may help allay concerns about the impact of future rate hikes, with the 10-year still below 2%. That said, the era of easy money that has persisted for more than a decade may be drawing to a close, and investors should consider the implications of increasingly restrictive monetary policy going forward.

Print PDF > When Do Rising Rates Matter the Most?

 

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’s Next for SPACs?

The ferocious appetite for Special Purpose Acquisition Companies (SPACs) continued its momentum throughout the first quarter of 2021. Investors could not get enough of this asset class as a record amount of capital flowed into the space. Through March, 2021 has already seen more SPAC IPOs than all of 2020, with over 300 new deals coming to market. Similarly, gross proceeds thus far through April are already over $100B, well past the $83B that was raised throughout 2020. The space has gotten so hot that sports celebrities like Shaquille O’Neal, Colin Kaepernick, and Alex Rodriguez have all put their names on SPACs that have recently hit the market.

Can this momentum continue? The Securities and Exchange Commission (SEC) might have something to say about it. Earlier this month, the SEC issued new accounting guidance that would classify SPAC warrants as liabilities instead of as equity instruments, as they are currently classified. Warrants are given to capital providers like hedge funds that put up the capital for SPACs before an IPO, to offer the capital provider more upside once the company goes public. SPAC IPOs have since slowed, as affected SPACs would have to restate their financials if this becomes law. With this risk on the table, investors may begin to look elsewhere to put their capital to work, dampening this SPAC market frenzy.

Print PDF > What’s Next for SPACs?

 

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 Pursues Buy-and-Build

Add-on investments, a company acquired by a private equity firm to be added to one of its platform companies, have steadily increased in importance and popularity over the past two decades. In 2020, 71.7% of U.S. PE deals were add-ons, compared with 43.2% in 2002. After a dip in total deal count in 2020 amid the COVID-19 pandemic, we expect 2021 will see the highest number of add-on deals on record. These buy-and-build strategies can take different forms. Some involve large-scale roll-ups in which a platform company acquires a large number of smaller, often founder-owned companies. Others include more opportunistic M&A transactions that allow portfolio companies to pursue specific product or operational goals. The growth of add-ons across two decades of various market cycles can be attributed to a number of advantages: multiple arbitrage, giving larger firms access to out-of-reach market segments, helping portfolio companies enter new geographical markets, and doubling down on more profitable end markets.

The holding period for add-ons has also evolved. Historically, private equity has held platform investments that included add-ons longer than other portfolio companies. In recent years, the median exit times for portfolio companies with and without add-ons have converged to roughly five years. We attribute this to both private equity becoming more skilled at executing these buy-and-build strategies as well as buyers being increasingly willing to pay for the unrealized potential of recently-completed add-on acquisitions.

Print PDF > PE Pursues Buy-and-Build

 

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.

Weak Dollar, Strong EM

For U.S.-based investors, the movement of the dollar has a direct and indirect impact on emerging market equity returns. The direct impact is straightforward. Purchasing foreign-listed equities requires conversion to the local currency. On top of the change in the price and any dividends of the underlying stock, a weakening U.S. dollar creates a positive currency return, while a strengthening U.S. dollar generates a negative currency return.

The movement of the dollar also has an indirect impact on emerging market returns. This week’s chart looks at the performance of the MSCI EM Local Currency Index and the U.S. Dollar Index (DXY). The local currency index removes any direct currency impact, isolating price performance of the underlying stocks. The DXY measures the U.S. dollar versus a basket of trade partner currencies. Since 2000, the correlation of monthly returns between the local currency index and the dollar index is -0.40, meaning historically they have moved in opposite directions.

There are several reasons why a weak dollar is supportive of emerging market equities. A weaker U.S. dollar is generally positive for overall economic growth and emerging economies typically benefit from strong global growth. Many developing economies are also reliant on dollar-issued debt. A weaker dollar lowers the cost of borrowing, a positive for emerging markets companies and equity markets. The U.S. dollar weakened throughout most of 2020, with the DXY down 10% between February and December. Over that same time frame, emerging markets equities returned 19%. So far in 2021, the dollar is up modestly, with emerging markets pulling back more recently. Looking forward, we expect the historical relationship between the two to persist, positioning emerging market equity investors to benefit should the dollar weaken further.

Print PDF > Weak Dollar, Strong EM

 

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’s the Blowout?

A typical real estate cycle has four phases: recovery, expansion, hypersupply, and recession. Typically, the recession phase is marked by rising cap rates (a real estate valuation measure, calculated as the ratio of net operating income to market value), which then compress over the growth phases of the cycle as property values rise. However, the current cycle, which began shortly after the onset of the COVID-19 pandemic, has been atypical. Although we experienced a period of economic contraction, cap rates did not rise as they have in previous recessions. Two contributing factors may have been lower interest rate expectations in 2020 and the impact of government stimulus measures that helped occupiers navigate weaker market conditions. Now with cap rates at historic lows and interest rates expected to rise through 2021, real estate investors are asking whether a “blowout” (an increase in cap rates) is on the horizon.

Historically, cap rates have been driven by the interaction of (1) changes in U.S. government bond yields, (2) the real estate risk premium (the cap rate spread above U.S. treasuries), and (3) the expected-long term growth of rental income (net operating income (NOI)). In previous cycles, cap rate compression was in part driven by favorable liquidity conditions and falling treasury yields. Today, yields are rising, with 10-year rates already up meaningfully off the mid-2020 bottom. With NPI cap rates essentially flat, this means the real estate risk premium has compressed. Accordingly, rent growth is becoming a bigger driver of capital appreciation and more important to investors. Over the short term, we expect investors will favor properties with the highest rent or NOI growth potential and rotate out of properties where growth is more limited. This should benefit industrial warehouse and apartment properties in select markets to the detriment of more challenged retail and potentially office properties. As a result of this asset rotation, the cap rates of properties in high demand may continue to compress, while cap rates of more challenged properties may see the “blowout” the broader real estate market has so far avoided.

Print PDF > Where’s the Blowout?

Sources utilized: Cornerstone Real Estate Advisors, “Cap rates and RE cycles,” and Principal Real Estate Investors, “Interest rates are rising, should real estate be concerned?”

 

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.

Will Skyrocketing Money Supply Boost Inflation?

As the economic recovery continues, investors are rightly concerned with inflation, especially given the recent surge in M2 money supply,¹ as shown in the purple line in the left chart. M2 has soared amid unprecedented levels of monetary and fiscal stimulus infusing markets and households with cash. While an economy awash with cash may lead to concerns about runaway inflation, certain key economic recovery dynamics point to a less drastic trajectory and potentially more muted, transitory inflation.

Juxtaposing M2 with core PCE inflation,² shown as the green line in the left chart, we see that the two have not always been perfectly correlated. While an increase in the M2 rate has typically led to an increase in the core PCE rate, there are imperfections in the relationship. Inflation so far in the economic rebound has stayed low as the surge in M2 has been offset by a drastic decline in the velocity of money,³ shown as the orange line in the right chart. The velocity of money dropped off last year as money supply surged while consumer spending was down during the pandemic, though velocity has generally been in decline since 2000 amid the longer-term trends of aging demographics, greater debt, and weaker physical investment prospects relative to financial investment prospects. The increased money supply has so far not led to increased transactions, GDP per dollar spent, or inflation. The gray line in the right chart depicts M2’s annual rate of change normalized by annual GDP, showing that M2 increases from the 1990s, 2000s, and 2010s have been relatively stable as a proportion of overall GDP. In this context, while the surge over the last year is still evident, it is much less extreme.

From here, as the economy continues to reopen, consumer spending on goods and services is expected to raise demand for input materials. This, along with COVID-related supply shortages, may boost inflation temporarily. However, we expect supply chains will normalize and supply overall will adjust, reducing inflationary pressures. More importantly, in order for a pickup in inflation to be sustained over the longer term, economic participants would have to boost real asset purchases over financial asset purchases, counter to trends over the last 20 years. As the Fed eventually tapers its bond purchases and increases rates, the markets will be expected to absorb at least some of the greater money supply. M2 is ultimately expected to shrink relative to GDP as the economy rebounds, with velocity expected to correct upwards.

In summary, we generally expect a more muted and transitory rise in inflation, holding all else equal. Core PCE may rise from the 1.5% at the end of 2020 to a range of 2.0–2.5% for 2021, encompassing the Fed’s projected 2.2%, but could then revert back down close to the Fed’s long-term target of 2.0%, especially with the Fed’s eventual bond purchase tapering and rate hikes.⁴ Once the initial recovery is over and the economy trends back to normal, we could see factors like aging demographics and the trend towards services and tech over old economy sectors bring on more deflationary pressures. Post-recovery, the evidence points to more normal inflationary levels, again holding all else equal.

Print PDF > Will Skyrocketing Money Supply Boost Inflation?

 

¹ M2 money supply is the total value of money — in the form of currency in circulation, demand deposits, and assets that can be quickly converted into cash — that is available in the U.S. economy. M2 is a closely-monitored indicator of money supply as well as future inflation and used by the Federal Reserve to adjust monetary policy. M1 includes cash as well as checking deposits, whereas M2 includes M1 plus savings deposits, other time deposits, and money market securities.
² Core PCE represents inflation in the form of personal consumption expenditures prices excluding food and energy prices. Used as the key inflation metric by the Federal Reserve, it removes the volatility from movements in food and energy to provide more reliable underlying inflation trends.
³ The velocity of money represents the rate that money is exchanged in the economy as well as the amount of GDP generated for every dollar spent. It is calculated as the GDP in billions of dollars divided by the M2 money supply in billions of dollars. If velocity rises, larger and more transactions are happening between participants in the economy. Conversely, if velocity falls, smaller and fewer transactions are happening between participants in the economy.
⁴ Presently, consensus expectations are for the Fed to taper its bond purchases and to hike rates only when the economy has fully recovered back to normal, likely beyond 2021 as part of concluding the monetary stimulus that has been necessary during the pandemic. 

 

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.

One Year Ago, Would Anyone Have Predicted This?

What a year it has been. Officially one year after the equity market’s bottom on March 23rd, 2020, all major indices in the chart above have at least recovered back to ending 2019 levels. The groups that were hit the hardest have also rebounded the strongest, with returns over the last year exceeding 100% for some. Small-cap equities stand out, especially in the U.S. — up 121% over the last year and up 33% over the almost 15-month period since 2019. U.S. mid-cap equities are up 101% over the last year, up 25% over the full period, and U.S. large-cap equities are up 83% over the last year for a 26% return over the full period. Small-cap stocks have also outperformed internationally — the MSCI EAFE Small Cap Index is up 91% over the last year and 18% since 2019, while the MSCI EAFE Index is up 67% over the last year and 12% for the full period. Emerging markets, some of the hardest hit by the crisis last year, have more than recovered, up 78% over the last year for a 22% return since 2019. Fixed income returns have been more muted. Investment grade bonds stayed positive in early 2020 as equity markets fell precipitously and are up another 3% since. High yield bonds, bank loans, and emerging market debt were hit harder but still held up better than equities. Each group has recovered those losses but remains in positive single-digit territory over the full period.

From here, we expect returns will likely moderate. As the vaccine roll-out continues we expect further economic re-openings and renewed growth across the globe, but it seems highly unlikely capital markets returns can continue at this pace beyond the initial recovery.

Print PDF > One Year Ago, Would Anyone Have Predicted This?

 

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.