Category: Chart of the Week

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.

Is Velocity Stifling Inflation Amid Record Growth of Money Supply?

Inflation has remained well below 3% in the United States for nearly a decade despite a record economic expansion and supportive monetary policy. Even after unprecedented alterations to the macroeconomic landscape in recent months, investors have not seen the significant price level increases that might have been expected in theory. This puzzling situation may be at least partially explained by the current relationship between money supply and velocity.

When it comes to economic relief efforts in the U.S. during 2020, no entity has been more active than the Federal Reserve, which has increasingly relied on open market operations with short-term interest rates near zero. Since the start of the pandemic, the Fed has purchased $3.5 trillion in Treasuries, corporate bonds, and mortgage-backed securities, and recently announced its intention to press forward with $120 billion per month in additional bond buying. The central bank’s balance sheet has now ballooned to over $7 trillion. As a result, M2 ­— a measure of the total money supply that includes narrow money, cash equivalents, and short-term deposits — spiked by roughly 25% in 2020, a record year-over-year growth figure.¹ The recent M2 surge has been accompanied by a decrease in the velocity of money, calculated as the ratio of quarterly nominal GDP to the quarterly average of M2 money stock. Put simply, velocity denotes the rate of turnover in the money supply and is a gauge of economic health, as higher velocity is usually associated with more robust economic activity. Since the beginning of 2020, money velocity has fallen by more than 20%, indicating a strong preference for saving vs. spending on the part of the American consumer since the outbreak of COVID-19.

The relationship between money supply and velocity has significant implications for security markets going forward, particularly as it relates to inflation. Investors have long been confounded by the absence of inflation in the U.S. since low interest rates and M2 growth should lead to higher price levels all else equal. Part of the reason for the lack of inflation could be lower levels of money velocity, which has largely declined since 2000 amid three significant recessions in the United States. The recent plunge in velocity may signal to central bankers that expansionary efforts could be continued in the near term without the risk of significant price level increases. As the economic recovery continues, however, velocity will necessarily rise, which could lead to interest rate hikes and the tapering of the Fed balance sheet to prevent runaway inflation. Investors should be cognizant of the possibility of restrictive monetary policy in the coming years as the world lifts itself out of recession.

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¹As measured on November 30, 2020

 

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.

Market Recovery: Superpower Showdown

Despite the enormous challenges of 2020, financial markets have rebounded. While baffling at face value, the contrast between market performance and the widespread suffering due to COVID-19 is more understandable in the context of markets as a representation of human ingenuity and resiliency. These two traits are perhaps most recognized in the world’s foremost economic superpowers: The United States and the People’s Republic of China. During the third week of March, both countries saw market drawdowns near 30%; most other equity indices across the world saw similar drops. Since the global market bottom, countries have been racing to make up these losses and charge ahead to new highs. As of December 11th, America’s recovery has been nearly a third stronger than China’s. Globally, the recovery has fallen in between these two world powers.

A dollar invested in American public equities on March 23rd would have grown to $1.72 as of last Friday, December 11th, as represented by the Russell 3000 (representing approximately 98% of the investable U.S. equity market¹). Over this same time span, a dollar invested in China would have driven an increase to $1.54, as represented by the MSCI China Index. This broad market index captures 85% of China’s equity universe and includes the variety of share classes available to both strictly domestic Chinese investors as well as foreign investors.² However, America’s strength in capital markets recovery does not reflect the country’s relative success in managing the virus. In the U.S., the fight drags on, while much of China has returned to business as usual.³ Broadly, capital markets as measured by the All Country World Index (ACWI) — which contains 85% of the global equity markets, including 23 developed countries and 26 developing countries² — has rebounded at a clip between that of the U.S. and China. The good news for investors is that equity markets — regardless of home country — have rebounded from the extreme drops seen in March and April.

As detailed in our previous Chart of the Week, “Main Street Won’t Look Like Wall Street for a While,” the real-world experience of many Americans is one of continued economic hardship. While this desperate situation may soon be addressed with additional stimulus, Americans and people around the globe can also find hope in the fact that markets are forward-looking and humans, by nature, are resilient and resourceful. As a testament to this, one needs to look no further than the rollout of the highly anticipated and historic COVID-19 vaccine, which saw its first doses administered in the U.S on Monday.⁴ The extreme market volatility and large sell-off early in the year and subsequent recovery have further underscored why a long-term investment perspective rooted in a fundamental confidence in continual technological and economic progress is the most effective mindset an investor can have.

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¹ FTSE Russell
² MSCI
³ China is back to normal — the US and Europe are not. Here’s how it succeeded
⁴ First Covid-19 Vaccine Given to U.S. Public

 

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.

Main Street Won’t Look Like Wall Street for a While

The month of November is often a positive one for equity markets, with the S&P 500 Index posting positive returns 62% of the time, and November 2020 was surely one for the record books. The Dow Jones Index, designed to serve as a proxy for the health of the broader U.S. economy, posted its best monthly return since 1987. Smaller companies also rallied in November as the Russell 2000 Index, which tracks U.S. small-capitalization stocks, set its first record high since 2018 and posted its strongest monthly return ever. That said, a stark contrast emerges when these milestones are viewed beside other economic indicators, particularly unemployment.

Down 54.4% from the April 2020 peak, U.S. national unemployment came in at 6.7% for November. This is exceptionally positive news considering the recent figure is only 0.6% above its 15-year average. However, this aggregated unemployment measure does not highlight the significant disparity plaguing the broader employment landscape.

According to the Bureau of Labor Statistics, the labor market can be divided into 22 unique occupation groups, many of which have been hit harder by the COVID-19-induced recession than others. For example — and perhaps not surprisingly — the four groups most affected by the pandemic include those on the frontlines of human interaction, such as Personal Care & Service, Food Preparation & Serving, Transport & Material Moving, and Building Grounds & Cleaning. While it is clear from the chart that these occupations tend to have a slightly higher rate of unemployment than the national figure, the average November unemployment rate for these groups was a significant 10.7%, coming in 4% higher than the current national level and 2.9% higher than the long-term average of the same groups. Conversely, occupation groups including Healthcare Practitioners, Legal, Computer & Mathematical, and Architecture & Engineering have escaped COVID-19 largely unscathed. These groups posted an average rate of 2.4% unemployment in November, which is 4.4% below the current national level and, in fact, 0.2% lower than their own long-term average. The gravity of this disparity takes on new meaning when viewed through the lens of workforce concentration and wealth generation. The least affected occupation groups employ 11.6% of the workforce, while the most affected groups have nearly double the employee base, at 23.0%. To make matters worse, this larger workforce earns substantially less than their COVID-sheltered peers. According to 2019 data, the most affected groups earned a median annual income of $27,800, which is just over the poverty line for a family of four and $12,000 less than the median income for all occupation groups. On the other hand, for those occupation groups nearing full employment, the median worker earned an annual income of $79,900 in 2019, more than two times the national median.

Ultimately, no two recessions are the same, but perspective can be gleaned by looking to the past. Since 1950, the average U.S. unemployment rate has been a low 5.8%, despite 10 unique bear market corrections during that time. However, the subsequent decline from a spike in unemployment can be slow and long. Looking back to the Global Financial Crisis, U.S. unemployment peaked at 10% in October 2009 and took just over six years to recover back to pre-crisis levels. However, unlike other recessions we have seen in recent memory, this one seems to have a discernible cure: a COVID-19 vaccine. With national distribution beginning before the end of the year, many analysts are expecting the economy to return to ‘normal’ by mid-2021. An unprecedented level of stimulus has already been injected into the economy and an additional highly anticipated package expected to arrive early next year are added reasons for optimism. Taken together, there is hope that current unemployment figures will revert to typical levels at a pace not seen in history.

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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.

Is Growth Conceding?

The market’s continued rally following the U.S. election has been a welcome relief, even more so for value investors. Since major media outlets called the presidential race for now President-elect Biden on November 7th, the Russell 1000 Value Index has outperformed the Russell 1000 Growth Index by 6.6%, and at one point by more than 10%. It has been the strongest value run since the dot-com bubble burst in 2001. The Monday following the result, November 9th, was the best single day for value over growth ever.

Presidential elections and other regime changes can often spark a rotation within the market. In this case, in addition to expectations for additional stimulus post the election, the delayed election results lined up with Pfizer’s announcement — and the peer announcements that followed — that its COVID-19 vaccine candidate was found to be more than 90% effective. Stocks generally, but in particular, more cyclical businesses and industries most impacted by the pandemic, rallied and have continued to gain momentum. Banks are up 20% and Energy stocks more than 30%. Technology and Healthcare have lagged despite the Republican gains in Congress that subsequently reduced the risk of sweeping regulatory changes.

The question now is whether value can maintain this momentum. Interestingly, the move is reminiscent of the period following the 2016 election. From the election on November 8th, 2016 to a peak in mid-December, value had outpaced growth by 5%. Financials, along with Energy and Basic Materials, led at that point as well, though for different reasons, set to benefit from expected regulatory rollbacks, tax cuts, and protectionist trade policies. Technology unsurprisingly lagged following Trump’s attacks on Tech bellwethers throughout his campaign. But the high expectations fizzled as Trump’s agenda hit roadblocks. In 2016, value’s advantage lasted roughly a month, with growth back on top by mid-March 2017. Only time will tell how market dynamics will play out this time. Relative to growth, value is trading at some of the most attractive valuations ever. But several of the same trends that led to growth’s dominance over the last decade, and certainly this year, are also arguably stronger than ever.

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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.