Category: Chart of the Week

What Have the Last Two Downturns Taught Us About Private Equity?

While each economic downturn is certainly unique, we can look back over the Dot-Com Crisis and the Global Financial Crisis to see how private equity markets performed relative to public equity markets. In both cases, the private equity market1 bottomed 3–6 months later than public markets (due to the lag in reporting), but with a less significant trough. Returns within private equity markets also recovered more quickly as they recovered 1.5–2 years sooner than public markets and generated significant relative outperformance.

The lack of liquidity combined with lagged and overall less frequent reporting works to most investors’ advantages in volatile markets as there is a “smoothing” effect that often generates less fear and the lack of liquidity limits the ability to sell at what may be the worst time for value creation. Quarterly valuations are provided on a 2–3 month lag which provides the benefit of future knowledge on where markets are headed. Perhaps most critical for investors to understand is that throughout an economic downturn — such as the one we are currently experiencing — private equity portfolio allocations will likely rise due to this lag in reporting, but these levels are temporary as markets are correlated to some degree. Unfortunately, some investors look at this temporarily higher allocation (which are predominantly due to the denominator effect) and choose to reduce their private equity program investment; often these liquidations are done at a significant discount. Historically, selling or pulling back on investing has been a big mistake as these investors have missed out on four of the best vintages over the last 25 years.

The primary concern in this downturn is that with a significant portion of the U.S. economy essentially closed, many small businesses do not have sufficient liquidity to weather substantial losses of revenue. However, we would caution that performance will vary by industry and geography as some businesses are operating at relatively high levels in this environment and should be positioned to accelerate as the economy returns to a more normal state. Across the private equity asset class, investor allocations are also higher as reflected by the strong fundraising in recent years, which means the industry is well capitalized to support many businesses throughout this downturn. This significant “dry powder” that private equity firms have at their disposal is likely to be deployed to support existing portfolio companies as well as towards new opportunities that arise from a less competitive landscape as many less well-capitalized businesses will inevitability fail throughout this downturn.

The previous two downturns proved private equity is not immune to public equity market corrections, but the asset class has historically recovered quickly and resumed its place as a return-enhancing component of investor portfolios. Although the denominator effect may drive private equity allocations above intended targets in the context of an overall portfolio, these differences are only temporary in nature and private equity investors are best served to maintain their allocations rather than selling at a steep discount in the secondary market. From a long-term perspective, making consistent allocations and maintaining exposure has best served portfolio returns, and we do not expect that pattern to change in the current 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.

Another Unprecedented Surge in Initial Weekly Jobless Claims Due to COVID-19

As mentioned in last week’s chart, the number of Americans filing for unemployment over the past few weeks overwhelmed the system and created a backlog of claims that were unable to be processed right away. This week’s data updates that picture and shows another colossal jump in claims: over 6 million people filed for unemployment last week.

In this chart, we focus on 2020 data to show the scale of these numbers. Claims between the week of March 23rd and the week of March 16th more than doubled, and the jump from 2020’s weekly average before the pandemic set in to last week is more than 30 times higher.

The data from last week shows that the backlog of claims had an overwhelming effect. Businesses have been suffering and this has caused unemployment numbers over the past two weeks alone to total nearly 10 million Americans. As companies continue to lay off Americans as a result of stay-at-home orders and COVID-19 concerns, the initial unemployment claims have skyrocketed. Congress also passed a stimulus package that increased the incentive for people to see the process of filing for unemployment through, including unemployment benefit extensions and expansions in paid benefits. With the projected timeline for when businesses will be able to re-open being pushed further and further out, the hope is that COVID-19 cases will slow and companies will be able to take full advantage of increased consumer demand.

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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.

What Does the Coronavirus Pandemic Mean for Future Real Estate Returns?

This week’s chart examines forward-looking returns for private real estate based on historical spreads to the 10-Year Treasury Yield and the NCREIF-ODCE Index (proxy for core private real estate). Real estate valuations (spread-to-Treasuries) are currently above 300 bps as a result of COVID-19. Spreads of this magnitude have only been seen four times, each of which has been followed by strong 3- and 5-year returns. For example, during the Global Financial Crisis, real estate spreads-to-Treasuries surpassed 300 bps in the fourth quarter of 2009 which were followed by 12.2% and 12.4% returns for the NCREIF-ODCE Index in the subsequent 3 and 5-year periods, respectively.

Though the impacts from COVID-19 have not yet been fully felt in the private real estate market, it is clear that challenges lie ahead, particularly in the sectors that have been hit the hardest. For example, assets with short lease durations and heavier operating business components, such as hospitality (daily), and co-working office (monthly), as well as assets that rely on foot traffic, such as entertainment, food & beverage, and destination retail will be more affected by the pandemic. Further complicating matters, the lack of transaction volume, comparable sales, leases, and loan originations have made it nearly impossible for appraisers to adjust valuations at this point in time.

Beyond the aforementioned troubled sectors, the impacts from COVID-19 will ultimately vary by property type, geography, and risk profile. The following table highlights the potential near-term and long-term impacts of each property sector:

Impacts of Coronavirus Pandemic on Real Estate Property Sectors table

While global growth is being impacted in the near-term, we still expect a recovery to take hold once the disruption fades; we still maintain the view that the recovery is delayed, not derailed. However, the true impact of this on real estate returns will not be known for a while. Although longer-term forward-looking returns appear promising at this point, there is a relatively high degree of uncertainty because the ultimate impact on the aforementioned sectors (which should be the biggest headwind for real estate) will remain unknown until the coronavirus outbreak is contained and the economy begins to function at a normal level again.

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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.

Initial Weekly Jobless Claims Surge Due to COVID-19

This special second edition Chart of the Week shows weekly initial jobless claims going back to 2007. Last week’s number came in at an unprecedented 3.3 million people, a near 12x increase from the previous week and 5x the previous largest jump in unemployment. Perhaps more alarming is that this number might not tell the whole story of the unemployment picture.

Ten states saw more than 100,000 people file for unemployment this week; however, due to low staffing and budgets, many claims could not be properly processed and included in the data. Granted, the number is likely higher as multiple states — Illinois included — have issued a stay-at-home order for non-essential employees due to COVID-19. The restaurant, airline, retail, and hotel industries have been hit especially hard with many Americans depending on a stimulus package to tide them over until the virus can be effectively tamed. Many small businesses have been forced to let employees go as they have been unable to generate cash flow.

On a more positive note, Amazon, CVS, and Walmart have been looking to hire thousands of employees as they receive increased demand from customers looking to purchase more goods as a result of being at home. If the virus is contained, the hope is that jobs will pick back up and companies will re-hire relatively quickly, though the question on when that might happen is one that is yet to be answered.

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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.

No Reservations

This week’s chart examines the demand for restaurant reservations, both in the U.S. and across the globe, measured by reservation booking activity on OpenTable, a service that allows users to book restaurant reservations online or through its app. Overall reservation booking activity started to slow noticeably at the beginning of March and then cratered as state after state closed schools, urged citizens to work from home, and then eventually closed all restaurants and bars for dine-in service. This is a compelling “real-time” indication of the scope and scale of the economic slowdown caused by the coronavirus.

While restaurants are only one small piece of the economy, they are an excellent gauge of discretionary consumer spending and provide employment to over 14 million restaurant workers across the United States. Although OpenTable’s largest market is here in the U.S., their data also indicates a similarly severe slowdown in global activity. The longer quarantines across the country (and around the globe) last, the more painful the effects on the restaurant industry, and the broader U.S. economy, will be.

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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.

Market Volatility Moves in Both Directions

The last week in the markets has seen a huge increase in market volatility. This week’s chart examines the largest daily moves (the ten worst and ten best) in the S&P 500 index since 1950, in an effort to provide some historical context to the recent volatility. As the chart shows, the recent market moves are not unprecedented, but they are historic. Over a course of just six trading days, the S&P 500 had three of its worst — and one of its best — days in the last 70 years. Beyond just the magnitude of the market moves, this week’s chart attempts to highlight a few important reminders for investors.

First, market volatility tends to move in both directions. We have color-coded the market moves by event, and it is worth noting that in the wake of the 1987 stock market crash, the Global Financial Crisis, and the recent volatility around the coronavirus, U.S. equity markets have seen some of the worst — and best — days ever. While all this volatility clearly creates opportunities for rebalancing, the market volatility can create a significant amount of short-term timing risk. This is one reason why clients should consider gradual rebalancing over a period of days or weeks to limit the risk of short-term market volatility.

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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.

A Spike in the Cost to Insure High Yield Bonds From Default

As the number of new coronavirus cases outside of China continues to rise and the oil price war between Saudi Arabia and Russia ensues, spreads of credit default swaps have widened hand-in-hand with the spreads of high yield bonds. Our chart this week will examine what this means for investors.

A credit default swap (CDS) is a derivative security that insures against default on a bond. In other words, the price of a CDS shows the market’s projection of the issuer’s likelihood of defaulting. Referred to as a spread, the price of a CDS is tracked in basis points, similar to the spread of a bond. Currently, the broad high yield CDS index, called the high yield CDX,¹ has a spread of 551bp as shown in the gray line. This means that a CDX investor must pay $5.51 per year to insure $100 worth of the high yield bond index from default. This is a near-term high, as the CDX’s spread was as low as 275bp in early January when it cost only $2.75 per year to insure $100 worth of the high yield bond index from default. But it is not as high as the point it reached in mid-February 2016, the peak of the U.S. shale crisis when it cost $5.89 per year to insure $100 worth of the high yield bond index from default.

A high spread for the CDX index means that the market is assigning a higher average likelihood of default to high yield bonds today as a result of the forward economic fallout from lower expected corporate earnings due to the coronavirus as well as the difficulties energy companies will have to endure due to the low price of oil. However, this high CDX spread also suggests attractive prices of the underlying bonds. Shown in the blue line, option-adjusted spreads for high yield bonds have widened to well above long term averages, signifying a compelling opportunity. With the U.S. consumer still on strong footing, high yield issuer fundamentals remaining moderate, and China in recovery mode as their coronavirus cases are declining and capacity utilization is rising, we would encourage investors to consider adding to their high yield allocations through dollar-cost averaging over the next few quarters, in accordance with the adage “buy fear, sell greed.”

Print PDF > A Spike in the Cost to Insure High Yield Bonds from Default

¹Inception of the high yield CDX was in 2012, while inception of the high yield bond index was in 1994

 

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.

Fed Cuts Rates 50bp to Fight Coronavirus Effects

This morning, the Federal Reserve cut short term interest rates by 50bp to defend against the global economic effects of the coronavirus outbreak. The previous three cuts occurred throughout 2019 as a result of combatting the global slowdown due to the U.S.-China tariff negotiations. This latest cut was a surprise for the markets as going into the day Fed Funds futures showed a strong probability of one rate cut in each of the Fed’s March, June, and September Federal Open Market Committee meetings this year.

This week’s chart shows that the rate cut brings the Fed Funds target range upper limit now to 1.25% (not shown is the lower limit now at 1.00%), juxtaposed against the VIX, which is a measure of the S&P 500’s expected volatility that spiked over the last few days.

It is unclear what the ramifications of this central bank action might be on the markets in the short-term, as the Fed’s signal of apparent concern may cause a fear-induced sell-off in the markets. This is what we are seeing so far, as the S&P 500 is off 2.8% for the day while the 10-year U.S. Treasury fell from yesterday’s close of 1.10% to 1.02% at today’s close. However, the longer-term effects should be stimulative as lower rates will make it easier for businesses and consumers to borrow and refinance their debts as well as ease their interest expense burdens.

The hope is that this cut will reduce short-term economic headwinds to the global economy and combat the onset of a recession. While it is impossible to predict when the outbreak will be contained, the number of new cases in source country China is declining and the coronavirus fatality rate remains low at 3%.

The global fatality rate is especially low for individuals not of elderly age. The latest data provided by global insurer Natixis and the Chinese Center for Disease Control & Prevention show that the fatality rate for individuals under 60 years of age is less than 1.3%, with those under age 50 seeing a fatality rate less than 0.4%.

As such, the U.S. Treasury yield curve is still upward sloping in both the 2-year vs. the 10-year and the 2-year vs. the 30-year, showing no signal of an impending recession. In contrast, both these measures were downward sloping going into the tech crisis in 2000 and housing crisis in 2008.

However, we may expect persistent short-term volatility as China recently released its Purchasing Managers’ Index (PMI). A PMI below 50 signals a contraction, and China’s latest PMI is at 30, the lowest it has ever been. To preemptively combat this potential economic slowdown, the Fed’s 50bp rate cut should provide a boost to the U.S. and global economy and we would expect central banks around the world to likely follow suit.

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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.

Coronavirus Roils the Equity Markets

U.S. equities recently experienced a sharp three-day sell-off as the market digested the potential for short-term disruptions to economic growth and company earnings due to the Coronavirus (COVID-19). With new health figures coming out daily, it is easy to become alarmed. However, as our Chart of the Week from February 13th highlighted, prior health crises have been proven to be non-events longer-term for equity markets. Similar outbreaks in the past caused short-term sell-offs in equity markets but longer-term saw positive market performance.

This week’s chart shows calendar year returns for the S&P 500 along with the max drawdown that occurred in each respective year. As of February 25, 2020, the S&P 500 has recorded a year-to-date drawdown of 7.6%. The current pullback is undeniably sharp in nature, but it is important to maintain perspective during turbulent times. Over the past 15 years, the average annual max drawdown was 14%. Many years experienced drawdowns near this level, yet still yielded a positive return for the year. On average, equities see a 5% pullback four times per year, a 10% pullback once per year, and a 20% correction once every five years.

While no one knows the full impact that the current outbreak will have to supply chains, trade, or travel, we recommend taking a long-term view to investing. The market had been looking past this current health crisis until the last few days, so a repricing of risk was inevitable. As this is an evolving situation, there is risk that the economic impact could increase and add further pressure to equities. However, the current pullback remains in-line with historical trends.

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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.

Coronavirus and the U.S. Economy: Assessing the Impact

Over the last month, the world has been gripped by fears of the coronavirus and its eventual toll on the global economy. Most economists expect global economic growth to reaccelerate in the second half of the year after the virus peaks. We agree that most of the negative effects will most likely be felt in the first half of 2020.

Since January and February Chinese economic data will not be released for a few weeks, we thought it would make sense to review the current state of the economy in the United States. The table above shows leading indicators for the U.S. economy. Green denotes a healthy measure and red denotes a deteriorating measure. Some of the more stable measures over the past few years have been the 50-year low unemployment rate and inflation, which has been stable at 2%. The more volatile measures have been stock market valuations, the purchasing manufacturer’s index (“PMI”; a gauge of domestic manufacturing activity), and corporate earnings growth. Let’s start with PMI first since stock market valuation and earnings growth are more intertwined. PMIs have been under pressure since the start of the U.S.-China trade war in 2018. In January 2020, PMIs traced their way back into expansionary territory (i.e., above 50), but the coronavirus fallout may cast a cloud over manufacturing in the coming months.

What about the U.S. equity market? Last year, corporate earnings growth was virtually flat in an expensive stock market. Since then, stock market valuations¹ have come off their 2019 high but are still above the 10-year historical average of 16 times forward earnings. We believe meaningfully positive corporate earnings growth will be needed to support such an above-average market valuation. The most obvious way to ensure that is to have a strong U.S. consumer. Consumer confidence has steadily increased throughout this business cycle and right now consumers are as confident as they have ever been. Since the U.S. consumer drives two-thirds of the economy, we will be closely monitoring the consumer for weakening sentiment through measures like retail sales, revolving debt defaults, overall debt level, and other telling data. While we expect some metrics to potentially soften due to the coronavirus, we expect most to be positive by year-end. Ultimately, much like SARS and MERS, the virus’s bark will be much worse than its bite on the U.S. economy and equity market.

Print PDF > Coronavirus and the U.S. Economy: Assessing the Impact

¹ As measured by forward P/E
² FactSet Expected Earnings Growth for 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.