Category: Chart of the Week

Driving Toward a Green Future

Innovation and structural change were hallmarks of 2020 as the spread of COVID-19 accelerated technological advancements across many areas of the global economy. The electric vehicle (“EV”) space is one area of innovation that has especially captured the attention of global investors. While battery-powered and alternative energy vehicles have been available in some form since the early 19th century, it was not until significant developments in rechargeable lithium-ion battery technology were made in the 1970s that meaningful capital began to flow to the space. Since then, interest in EV technology has ebbed and flowed with oil prices, but the recent global push toward green energy has revitalized enthusiasm in the space.

For the three years ended 2019, the NYSE FactSet Global Autonomous Driving and Electric Vehicle Index, which tracks developed and emerging market companies that specialize in self-driving and EV innovation, underperformed the broader MSCI ACWI Index — up an annualized 8.8% versus the ACWI up 10.2%. Since then, over the 14 months from the start of 2020 through February 2021, the Global Autonomous Driving and Electric Vehicle Index is up 63.1% versus the MSCI ACWI Index up 16.3%.

To dive deeper into the different components of the electric vehicle landscape, we look at the newly-created Bloomberg Intelligence Electric Vehicle Basket, a group of 60 global companies expected to benefit from and contribute to the success of EV development. These 60 companies, equal-weighted, have outperformed the MSCI ACWI by 10.3% over the trailing three months ended February 28th. Of the four unique sub-groups,¹ Raw Materials has outperformed by the widest margin, returning 46.3% since December. This cohort includes a diverse group of specialty chemical and mining companies that produce the inputs for a variety of industries, many of which, including those tangential to EVs, have seen increased demand over the last few months. The Battery and EV Component groups have also outperformed the broader MSCI ACWI Index. EV Vehicle Manufacturer stocks have struggled more recently amid profitability concerns given the cost of inputs and headwinds to EV adoption, particularly in the U.S. Despite the push from lawmakers, still limited charging infrastructure and a lack of consistency in charging connectors across manufacturers are issues for consumers. While we expect these and other points of friction will be resolved and EV market share will continue to grow over the next several decades, in the near term, market momentum can push innovation themes ahead of expected earnings or scalability. Investors should exercise caution when allocating to a burgeoning segment of the market and always maintain portfolio diversification.

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¹A fifth Bloomberg exposure, EV Charging, included only one company and was included in the EV Components categorization for this analysis.

 

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.

GDP Growth Hits Highs vs. Bond Yields

The gap between U.S. GDP growth and bond yields is expected to rise to the highest level since the 1970s amid unprecedented amounts of fiscal and monetary stimulus and an accelerating vaccination roll-out. The chart depicts nominal U.S. GDP growth rates year-over-year less the 10-year U.S. Treasury yield over the last 60 years. Beyond 2020, we profile the U.S. Congressional Budget Office (“CBO”) forecasted nominal GDP growth rate for 2021 and 2022, minus the forecasted 10-year U.S. Treasury yield from the Treasury forwards market, which projects a 25 basis point rise each year over the next four years.

The quarterly GDP growth rate is much more volatile than bond yields. It can decline precipitously in a recession much faster than bond yields as well as rebound much faster than bond yields in a recovery. The ratio has spiked down several times in the past: during the early 1980s and early 1990s recessions, following the dot-com bust of 2000 and the housing bust of 2008, and most recently after the COVID panic of March 2020. This is because the GDP growth rate reflects actual economic growth, measured year-over-year quarterly, while bond yields reflect the market’s anticipation of economic growth over a longer time period. While this gap is expected to reach its highest level in roughly 50 years as the economy rebounds from the depths of COVID, it is then expected to moderate back to pre-pandemic levels, as the CBO forecasts GDP growth to normalize throughout 2021 and 2022 after the initial recovery. Therefore, despite the spike in this ratio it is not a fundamental concern for investors and is not suggestive of a coming market downturn.

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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.

Sustainable Investing Among Equity Asset Classes

Sustainable investing continues to grow in both size and relevance among institutional investors and asset managers. As a matter of background, sustainable investing is a term that encompasses three broad approaches: ESG Integration, Socially Responsible Investing, and Impact Investing. As elaborated on in Marquette’s Sustainable Investing video series, the definitions of each of these terms are:

  • ESG Integration: Returns-focused investing that incorporates long-term sustainability factors (Environmental, Social, Governance) into the investment process.
  • Socially Responsible Investing (SRI): Investments driven first by ethical values.
  • Impact Investing: Investments with the specific intent to create and measure social and/or environmental impacts alongside financial returns.

While SRI and Impact Investing are more targeted strategies driven by underlying initiatives and/or beliefs, ESG integration has allowed portfolio management teams of more traditional approaches to consider social and environmental issues in a more tangible way than in the past. As ESG factors are more ingrained in the investment processes, there will be more investment options that contribute, directly or indirectly, to some of the ideals sought after in SRI and Impact portfolios. As shown in the above chart, investors have options across the global equity universe for both ESG integrated funds as well as dedicated SRI/Impact Investing funds. The proportions of each are likely to expand as sustainability investing trends accelerate globally.

Along with this growth comes an increased emphasis on measurable impact and standardized reporting, both of which have been a challenge in the sustainable investing space. We have started to see investment managers adopt the United Nations Sustainable Development Goals (UN SDGs) as a framework for expressing the sustainable intent or reach of their portfolio. For instance, there is a growing contingent of investment managers that have mapped their portfolio holdings to one or more SDGs based on whether the firm’s product or service aided or harmed the stated end goal. We have also seen many investment managers become signatories of the UN Principles for Responsible Investment (PRI) over the last three years. The UN PRI are comprised of six foundational principles that work to support and encourage ESG investing. Another sustainable investing reporting metric that has become more readily available is carbon intensity measures. While there have been many positive developments in recent years, investors should be cognizant of potential greenwashing — disingenuous or misleading attempts to present strategies as more ESG-focused than they actually are.

Overall, sustainable investing is moving in the right direction as more allocators and investment managers realize that returns need not be sacrificed in pursuit of positive change. In fact, a fundamental concept of sustainable investing is that firms with better ESG practices tend to fare better over the long run due to a reduced likelihood of litigation, increased diversity, and capitalization on emerging sustainable technologies, among others. Marquette continues to monitor these developments and stands ready to assist clients in pursuing their sustainable investing goals.

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eVestment Universes
U.S. Large-Cap: “US Large Cap Equity” 1,129 Products
U.S. Mid-Cap: “US Mid Cap Equity” 289 Products
U.S. Small-Cap: “US Small Cap Equity” 640 Products
International Large-Cap: “EAFE Large Cap Equity” 219 Products & “ACWI ex-US Large Cap Equity” 142 Products
International Small Cap: “EAFE Small Cap Equity” 101 Products & “ACWI ex-US Small Cap Equity” 67 Products
Emerging Markets: “All Emerging Markets Equity” 654 Products

 

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 the Most Attractive Segment of the Private Equity Market?

As private equity matures further as an asset class, median private equity returns will continue to move closer to the public markets. Nevertheless, as a result of active management and private market inefficiencies, the top quartile to median spread for private equity is still more than 2x greater than it is for public market-oriented managers. When we take a closer look at fund performance within private equity, there is significantly more upside as well as performance variability for smaller buyout funds as compared to larger buyout funds. As seen in this week’s chart, funds that are less than $1B in size had a median Net IRR of 13%, a 1st quartile range of 21–37%, and a 4th quartile range of -10–6% whereas funds greater than $6B in size had a median Net IRR of 9%, a 1st quartile range of 17–23%, and a 4th quartile range of 2–8%.

This performance dispersion is largely driven by smaller funds sourcing opportunities outside of intermediated processes, leveraging a repeatable and focused operational playbook to professionalize and grow portfolio companies quickly, and a growing list of paths to liquidity, including larger funds with an increasing amount of dry powder that are sourcing investments out of smaller managers’ funds. With that said, larger funds buy companies that are typically more mature, have built-out teams, and are capable of weathering business shocks with greater success, which accounts for the tighter band of outcomes at the larger end of the market.

Due to COVID and an inability to meet with potential investors in person, first-time funds and emerging managers which typically fall in the “small” fund size had difficulty raising capital in 2020. This dynamic is expected to have two significant effects on the 2021 private equity ecosystem: 1) first-time funds and emerging managers fundraising is likely to be more active in 2021 and 2) dry powder has been further concentrated in larger funds, which should create an increasingly attractive exit environment for smaller funds.

Given the compelling upside opportunity of investing in smaller funds and an expected increase in the number of these funds raising capital in 2021, these managers represent an attractive area of the private equity market to be allocating capital towards. Given the greater performance variability of smaller funds, allocations to funds at this size should be focused within a program that allows for a number of high-quality commitments, such as those provided by fund-of-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. Opinions, estimates, projections, and comments on financial market trends constitute our judgment and are subject to change without notice. Past performance does not guarantee future results. 

Federal Debt Rises but Federal Interest Expense Drops

Due to the unprecedented fiscal and monetary stimulus that the federal government has provided the U.S. economy during the COVID-19 pandemic, our federal debt has been rising precipitously. As we can see from this week’s chart, the federal debt as a percentage of GDP (left chart, purple bars) skyrocketed in 2020. In the meantime, interest rates have declined, shown using the bellwether 10-year U.S. Treasury yield (left chart, orange line). Rates have declined because of haven asset-seeking from investors, driving up Treasury prices and driving down yields, as well as from developed market foreign investors seeking relatively higher yields here versus low to negative yields in their markets.

Because of the decline in rates over 2020, the federal gross interest expense on U.S. Treasury securities (right chart, purple bars) has been declining. The federal gross interest expense rate (right chart, green line), based on dividing the federal gross interest expense dollar amount by the total federal debt outstanding dollar amount, has been declining along with the 10-year U.S. Treasury yield (right chart, orange line), but there has been a lag. This lag comes from newly issued, on-the-run bonds having lower yields versus existing bonds that are off-the-run, on which the Treasury is paying interest. These two charts emphasize that despite the rise in federal debt, our government is benefitting from a decline in the interest costs due to lower interest rates. This should help mitigate the total costs of supporting the U.S. economy as we recover from the COVID pandemic.

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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.

Should Investors Be Concerned About Stagflation?

The coronavirus pandemic has disrupted everyday life and caused a devastating impact on the global economy. At the peak of the outbreak, the U.S. unemployment rate reached 11.1% and real GDP growth fell by 9.0%, which marked the second worst economic crisis since the Great Depression. On the bright side, the COVID relief programs and expansionary economic policies projected an air of optimism; as of January 2021, the unemployment rate came down to 6.3% and real GDP growth has started to recover since cratering during the first half of 2020. However, these figures are still at concerning levels, and an emerging fear is that the magnitude of economic stimulus may create a surge in inflation, in spite of middling economic growth. This week’s chart examines the nature of stagflation and how the markets perform under this condition.

The term “stagflation” comes from “stagnation” and “inflation” and can be identified as a period of slow economic growth, high unemployment, and high inflation. An example of stagflation was in the 1970s as shown in the chart. The inflation and unemployment rates (blue and orange lines) stayed in a 10–15% range when the economic growth (purple line) was slow or negative. The typical cause of stagflation is an external shock that breaks the inverse relationship between the inflation and unemployment rate; the high inflation usually indicates that the demand for goods and services is high, the economy is expanding and unemployment is low. In this case, the supply shock of oil was the main contributing factor for driving prices higher, discouraging consumption, and resulting in a recession. Stagflation is not only detrimental to the economy but also difficult to address. For example, contractionary policies such as increasing interest rates to reduce inflation may make unemployment even worse.

As shown at the bottom of the chart, the U.S. stock, international stock, bond, real estate, and commodity markets held up well during stagflation in the 1970s. The S&P GSCI commodity index returned 54.3% per year and the other markets returned 25% to 28% per year. The international stock market outperformed the U.S. stock market. The commodity market performed best but highly fluctuated with a 0.72 correlation with inflation.

The economic crisis from the pandemic coupled with the aid to boost the economy may seem like a recipe for stagflation. However, impending stagflation is unlikely. The current inflation of 1.3% is well below the central bank’s 2% target, oil prices are stable, the personal consumption expenditure is down but has recovered to 96% of its pre-pandemic level, vaccines are becoming more accessible and IMF projections are generally positive (dotted lines). As the economy further re-opens later this year, the threat of stagflation should dissipate as attention turns toward renewed economic growth.

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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 Big Squeeze

A group of small-cap stocks made big waves last week as retail day traders collaborated online to drive up certain stock prices in order to “squeeze” hedge funds with short positions. The influence of the retail investor has been building for over a year, facilitated by reduced trading fees, new brokerage platforms, and the time and money freed up by COVID lockdowns, but the Reddit-documented campaigns to manipulate GameStop and others brought forth entirely new dynamics.

Hedge funds take short positions when they expect stock prices to fall, generally for fundamental reasons. Short positions are inherently more risky than long positions — the downside is theoretically unlimited and short positions will increase in size as the stock moves against you, but prudent long/short managers understand these risks and typically run short portfolios that are more diversified, with smaller position sizes and tighter risk management parameters. Market sentiment and positioning is a key part of their analysis, especially on the short side. Stocks with high short interest have been red flags for many managers well before the term “Gamestonk” existed.

GameStop, AMC, Bed Bath & Beyond, and other stocks being irrationally bid up have fundamentally struggled for years. Outdated business models have led to earnings declines and multiple compression, and the impact of COVID has pulled forward bankruptcy concerns. At the same time, short interest has increased, and profitably — for the three years ending June 30th, 2020, the five stocks in the chart above lost on average 59% of their value. Over the last seven months, through the end of January, the worst performer of the group has almost tripled, and GameStop is up more than 7,000%, despite a largely unchanged fundamental outlook.

A number of hedge funds holding these higher short interest stocks were significantly impacted. At the center of the drama, Melvin Capital was reportedly down more than 50% for the month. While many hedge funds did not have direct exposure, the broader issue for the group and investors is the related de-grossing — long selling and short covering — as managers look to reduce exposure to the volatility. While de-grossing is not unusual (seen most recently in March 2020, September 2019, the fourth quarter of 2018), it has been especially rapid over the last week with hedge funds coming into the year with above average levels of gross and net leverage. While this has a created a tough backdrop for hedge fund alpha, especially coming off a record year in 2020, year to date losses have been modest. Through January, the average U.S. long/short fund was down just 2.3%,¹ relative to the S&P 500 -1.0%.

While Melvin Capital and others have publicly stated that they have fully closed out short positions on GameStop, the damage has been done, and these funds will likely face ongoing investor scrutiny over their risk management processes. But the majority of long/short funds should be able to make up any early year losses, with 2021 set up to be a good year for stock pickers. Prudent managers are re-underwriting their short positions, reducing exposure to potential targets and names with higher short interest, and many are patiently planning for the inevitable next leg. Stocks do not typically remain this severely disconnected from fundamentals for long, and at these valuations could present strong short opportunities.

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¹ Morgan Stanley Prime Brokerage

 

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.

Record Flows: Another Headwind for Active Management

Fund flows, which measure the net movement of assets into and out of investment vehicles like mutual funds and exchange-traded funds (“ETFs”), can provide a window into investor behavior and are often an indication of investor sentiment. Strong inflows can indicate optimism within a particular asset class or investment style, while outflows may suggest pessimism on the part of investors. That said, a robust market is not always supported by investor inflows, as underlying fund flows and market index performance frequently deviate. This phenomenon was on display in 2020 and merits further evaluation.

The S&P 500 index posted a double-digit return in 2020 and closed the year at an all-time high, despite record-breaking outflows from U.S. equity funds. Nearly $241 billion flew out of domestic equity funds in 2020, a figure that is more than four times the previous calendar year record set in 2015. Perhaps unsurprisingly, these outflows centered predominately around actively managed products, a trend that has been persistent since 2014. Active funds saw net outflows in every month of 2020, while passive funds enjoyed bursts of investor interest, with extreme net inflows in both March (after the market bottomed) and November (due to positive coronavirus vaccine news). Investor preference for ETFs over mutual funds is particularly noteworthy. ETFs have risen in popularity as a lower-cost alternative to mutual fund investing and carry little-to-no investment minimum with real-time pricing. In November, passive ETFs saw a staggering net inflow of more than $54 billion, which is $12 billion more than the last monthly record set in December of 2016. This historic net inflow provided a tailwind to an already optimistic investor base and propelled indices like the Russell 2000 index, which tracks the U.S. small-cap market, to post its strongest returning month on record.

Hefty inflows for passive vehicles, like those in November, can have unfortunate implications for active investment managers. Many of these investment professionals are constructing a relatively small basket of securities with the intent to outperform a benchmark, often with less risk, over the long term. Commonly, these managers focus on quality metrics like top line growth, gross margins, earnings, and lower debt levels to drive outperformance. When a wave of inflows hits passive products, we see a “rising tide lifts all boats” phenomenon that is largely detached from underlying stock fundamentals. This can cause a short-term price dislocation and distortion of investor sentiment. Ultimately, the immediate impact of fund flows is temporary, but the continued trend away from active management may pose a greater threat to the asset management industry if portfolio managers fail to improve benchmark-relative performance.

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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.

Bubble, Bubble, Toil, and Trouble

In Shakespeare’s Scottish play Macbeth, three witches prophesize the protagonist’s imminent rise and fall. This week, Deutsche Bank released its mid-January survey highlighting 627 global market professionals’ feelings of the market’s current state. The survey’s arguably most somber statistic showed that 89% of respondents believe there are currently bubbles in the financial markets. As seen in previous events, we know that bubbles have dire consequences for financial markets. In particular, U.S. tech stocks and Bitcoin were the two assets that respondents believe are the most likely bubbles waiting for a correction. As of January 19th, Bitcoin has soared over 320% and the Nasdaq index is up over 43% in the past year. Due to digital currencies’ nascency, particularly Bitcoin, it is almost impossible to glean any insight from past performance.

Moreover, much of Bitcoin’s future value will be driven by its overall acceptance by financial institutions and its finite supply. Alternatively, investors have decades of Nasdaq data and have experienced market bubbles such as the Dot-com Bubble and the Global Financial Crisis. If history is our guide, the Nasdaq’s current PE ratio of approximately 26 is mild relative to a P/E ratio of 70 seen in 2006 and a fraction of its peak of 175 witnessed in 2000.¹ While a P/E ratio is not a perfect gauge for market bubbles, neither is recent strong performance. Since 1975, of the ten years that the Nasdaq has eclipsed a 30% positive return, only two of the years was the index negative the following year, 1981 and 2000.

If the Deutsche Bank survey is correct, this might be the most well-forecasted bubble in financial history, and if we have learned anything from previous financial bubbles, we know they are tough to predict. Macbeth’s witches were able to predict the future down to the smallest details with powers not held by financial market harbingers. Regardless, surveys give investors powerful insight into the mood and sentiment of financial professionals, but it is up to them to plan accordingly. Much has been learned over the past year as 2020 will remain front of mind for investors for years to come. Since the market bottom in March, many asset classes have benefited from a swift and steady rally, posting strong gains in 2020. Furthermore, the market has felt disconnected from the overall economy, which continues to struggle with the fallout of the COVID pandemic and has caused investors to question, “How long can this continue?” Driven by record-low interest rates, investors allocating to risk assets should remain mindful of future return expectations and potential volatility at current valuation levels.

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¹ Bloomberg

 

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.

Glass Half Full?

As we are beginning to see a possible finish line on the COVID-19 front, there is an expectation in the market that vaccine-assisted re-openings globally will bring about a return to pre-pandemic economic productivity levels. The “Great Lockdown” of 2020 caused many countries around the world to enter a deep recession, which, like former hard resets, has impacted societal behaviors (i.e., social distancing) and reframed business operations and outlooks (i.e., increased safety measures and focus on supply chain). It is fair to say that some industries and segments of the market may have been permanently changed by the pandemic, be it in a positive or negative manner. While we welcome the return to normalcy — or even the new normal — it is important for investors to be mindful of a few things with respect to this economic reversal: 1) the market has largely priced in this turnaround story, 2) continued accommodative monetary policy and large fiscal stimulus packages are providing the support to restart the economic engine, and 3) any hiccups in national inoculation plans and vaccine distribution could sidetrack progress.

Hence, our glass is half full when it comes to sustaining global growth expectations in 2021. As shown in today’s chart, the IMF’s estimate of the global GDP growth rate is expected to come in at -4.4% for 2020. This is a less severe contraction than estimated in June 2020, which showed a more dire COVID-19 impact on economic activity. For 2021, the global GDP growth rate is projected to lampoon to +5.2%, due to a wide negative output gap and a gradually immunized workforce. Of note, China is the only country expected to post a positive GDP growth rate for 2020 and 2021, as it continues to show leadership in restoring and maintaining economic activity. As 2021 plays out, the actual growth numbers across the globe versus what has been projected will be followed and reported upon closely and will undoubtedly have an impact on financial markets. Among vaccine roll-out, efficacy, a new administration in Washington, and a host of other geopolitical factors, global GDP bears watching, especially the first half of the 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.