Category: Chart of the Week

Higher Yields, Higher Returns

As bond yields are much higher today than they were only three years ago due to nine Federal Reserve rate hikes since the Great Recession, fixed income investors are encouraged by the higher yields that are expected to produce higher returns in the future. The Fed’s nine rate hikes, having raised the fed funds rate from the range of 0.00%–0.25% only three years ago to 2.25%–2.50% today, are expected to provide a general boost to annualized bond returns over the next five years.

Our chart of the week looks at the relationship between current yields in the bond markets and the expected future annualized returns for the next five years. We focus on the Bloomberg Barclays Aggregate Index (“Agg”) as that is the most common bond benchmark used by investors. The chart plots the starting yield of the Agg over the last five decades, from the 1970s to today, on the x-axis. The y-axis then shows the corresponding annualized returns of the Agg over the next five years.

We can see that there is a very linear relationship: the higher the yields at each starting point, the higher the returns for the next five years. As rates declined from the 1980s through the 1990s and 2000s to today in the 2010s, this relationship held true. There are a few outliers in the 1970s, however, as the Federal Reserve under Volcker at the time hiked rates to counter stagflation. But excluding some of these outliers in the 1970s, the chart shows a very strong linear association that higher returns over the next five years are a direct result of higher rates today.

There are secular forces at play, particularly the rising retirement trend across the world’s most powerful economies (Japan, China, U.S., and Europe) that may keep our current low-rate “new neutral” phenomenon a persistent reality for some time. However, the countering forces are new technologies that provide for more productivity. On the balance, fixed income investors are expected to benefit from generally stronger annualized returns over the next five years versus the last 10 years since the Great Recession.

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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.

Will Opportunity Zones Encourage Investment and Economic Growth?

In an effort to attract capital and encourage long-term investments in low-income urban and rural communities, Congress reformed the Tax Cuts and Jobs Act of 2017 to establish Opportunity Zones nationwide, which could offer a tax break for investors. The chart above shows the number of Opportunity Zones in each state. Congress had tried similar approaches in the past with Empowerment Zones and Renewal Communities, but this most recent effort is receiving unparalleled levels of attention for its generosity to investors and lack of governmental supervision.

Under this program, investors can re-invest their unrealized capital gains into a Qualified Opportunity Fund within 180 days of realization to receive numerous tax benefits. These benefits include potentially excluding up to 15% of invested gains from taxation (10% if held for 5 years, 15% if held for 7+ years). An investment held for longer (at least 10 years) is permanently excluded from taxation. In addition, capital gain taxes can potentially be deferred until 2026.

Given the infancy of the program, many have pointed out flaws within the initiative, stating there is a disconnect between the social benefits from the investments — which will be difficult to measure — and the size of the potential tax costs, which are uncapped. However, it will be for some time until it can be determined whether the program is effective and advantageous for investors, given Congress has asked the IRS to begin reporting on the program’s operations in 2022. Ultimately, this program bears watching as it could be an attractive opportunity for investors and asset managers while also encouraging growth in depressed areas of the country.

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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 Reduce Equity Allocations After Yield Curve Inversion?

The yield curve plots the relationship between U.S. bond yields and their maturities, and typically slopes upward: the longer you hold the security, the higher the return given various risks through time such as inflation, opportunity cost, and economic uncertainty. The yield curve, however, can be inverted when high demand for long-term Treasuries drives the price up and the yield down resulting in a downward sloping curve. Yield curve inversion often signals a pessimistic view of the economy in which investors look for protection against slow economic growth and higher-than-expected inflation. Furthermore, the previous four instances of curve inversion have been followed by a market correction, though it can sometimes be years before a market correction follows inversion.

Last Friday, the 10-year Treasury yield fell below short-term yields with maturities ranging from 1-month to 1-year in response to disappointing Eurozone data, geopolitical risks around Brexit, and Fed Chairman Jerome Powell’s remark on a global economic slowdown. Shortly after the yield curve inverted — especially after the negative yield spread emerged between 3-month and 10-year Treasuries (regarded as the Fed’s most sensitive measure of market sentiment) — the equity market sold off and the S&P 500 total return fell by 1.89%. This immediate reaction led some investors to believe the correction was already unfolding.

While it is impossible to determine at this point if the correction is already here, investors should take comfort knowing that the equity market eventually rebounds from these corrections and shows resilience after the yield curve inverts. Our chart above shows the subsequent 3-month, 6-month, 1-year, 2-year, and 5-year returns of the S&P 500 index after the primary inversion data point — the spread between the 2-year and 10-year Treasury yields — first went negative (thus inverting). For example, after the 10s/2s yield inversion on December 27, 2005, S&P 500 annualized total returns after 1 year, 2 years and 5 years were 15.6%, 10.7% and 2.2% respectively. Over longer time periods after yield curve inversion, such as 7 or 10 years, equity returns more closely resemble their long-term averages. The other primary takeaway from the chart is that shorter-term equity returns — 3, 6, or 12 months — feature significant disparity from the last four yield curve inversions, indicating each instance is different in terms of magnitude and timing after initial 10s/2s inversion. Thus, we do not recommend that investors reduce their equity allocations in an attempt to time the potential correction after inversion, and over the longer-term, equities are still expected to be positive contributors to portfolio returns, even if the yield curve is temporarily inverted.

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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.

Will Correlations Between Private Equity Strategies Continue to Converge?

Private equity and venture capital allocations have together benefited private capital investors as they have individually provided outperformance at different points throughout an economic cycle. While both are loosely correlated to public equity performance, venture capital investments have many similarities to growth allocations whereas private equity buyout investments have characteristics similar to value allocations. Buyout returns often depend on lower purchase prices and leverage to generate excess returns, while venture returns tend to be less price sensitive and a reflection of accelerating growth.

The lower correlation between the two assets classes was present for more than a decade, spanning from the 1990’s to the early 2000’s. During this period, an investor would naturally hedge against the heightened volatility in venture by investing in both asset classes to offset this risk. However, since the mid-2000’s these two asset classes have become much more correlated as they both have benefited from a strong, 10-year plus growth-oriented environment coupled with low fixed interest rates.

While correlations have tightened over the past decade, the “growthy” economic backdrop that has fueled this relationship will undoubtedly come to an end. When this occurs, we believe these two asset classes will provide a nice complement over time to investment portfolios in generating a higher overall return with less 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.

ESG Assets Continue Their Dramatic Rise

The demand for — and supply of — ESG investment opportunities has surged over the past several years. This week’s chart depicts the rise in U.S. based ESG assets. After doubling in size between 2012 and 2016, the value of sustainable, responsible and impact investing assets grew by another 38% from 2016 to 2018. These investments now account for more than ¼th of total U.S. assets under professional management.

From the demand side, signatories to the Principles for Responsible Investment, a set of investment principles that enables the incorporation of ESG considerations into investment practices, grew in combined assets from less than $6 trillion in 2006 to over $81 trillion by the end of April 2018. In response, the supply of ESG strategies in the market continues to increase as well, with investment firms offering ESG products in both the traditional and alternative asset classes.

Regulatory changes, new research, and shifting investor demographics continue to foster increased interest in ESG investing, and plan sponsors should be prepared to adapt their investment options to accommodate the changing landscape.

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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.

Brexit – Deal or Delay?

With merely 21 days left before Britain is due to leave the European Union, global investors are keenly watching their daily news feeds in hopes of clarity on the likely outcome – deal or delay. Note that hard exit was excluded from the list of options. Many economists and leading global financial institutions, like JPMorgan, Credit Suisse, and RBC, have lowered that probability to less than 10%1,2 in response to Prime Minister Theresa May’s compromise on February 28th that allows MPs to vote on a short delay and to rule out a no deal exit in the short term.

So what has exactly transpired since the initial divorce deal’s failed vote and May miraculously passing the no-confidence vote on January 25th? There have been several debates within the Parliament chambers on revisions necessary to secure a positive vote, including an option to remove the 21-day wait period required before voting on an international treaty and amendments to the Irish backstop. As of March 6th, a revised deal between Britain and the European Union has yet to be accepted, with recent talks being characterized as difficult and inconclusive. Albeit too early to know, there’s a strong likelihood that one of the following scenarios will occur: 1) May’s top lawyers will come to compromise with EU and present a palatable deal to Parliament by March 12th, or 2) MPs will vote no on the revised deal and agree to an extension on March 14th.

In this week’s chart, we show FRED’s Economic Policy Uncertainty Index for the United Kingdom3 along with U.K.’s Economic Sentiment Indicator over the last three years. As depicted, indecision over the Brexit outcome remains and drives the uncertainty index into the 450 range, up 56 points from January month-end. At the same time, sentiment within the world’s fifth largest-economy continues to wane as both consumers and many businesses hedge their stakes and prepare for the worst-case scenario, a disorderly Brexit.

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1. Bloomberg, “Things Are Looking Up for the Pound, Strategists Say”, March 4, 2019.
2. Business Insider, “The City of London is finally starting to believe that the UK will avoid a no-deal Brexit”, March 3, 2019.
3. Baker, Scott R., Bloom, Nick and Davis, Stephen J., Economic Policy Uncertainty Index for United Kingdom [UKEPUINDXM], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UKEPUINDXM, March 7, 2019.

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 Assets Flow to Water Infrastructure Opportunities?

U.S. water infrastructure provides and treats around 355 million gallons of water per day to support cooking, bathing, and productivity in virtually all sectors of the economy. The infrastructure in place, however, is in poor condition; the American Society of Civil Engineers (“ASCE”) assigned a “D” and “D+” grade to both drinking water and wastewater infrastructure, respectively. Based on this assessment, the ASCE estimated that a minimum of $123 billion per year over the next 10 years needs to be invested in U.S. water infrastructure. As illustrated in this week’s chart, current annual spending on water infrastructure totals around $41 billion per year, but only one-third of capital needs are expected to be funded over the next ten years, representing an annual funding gap of $82 billion.¹ Consequently, we would anticipate water infrastructure improvement projects and water reuse² as a source of investment over the next several decades.

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1 Value of Water Campaign, ”The Economic Benefits of Investing in Water Infrastructure,” 2017.
2 Water reuse refers to reclaimed or recycled water, which is the process of converting wastewater into water that can be reused for other purposes

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.

Slower Earnings Growth in 2019?

With the Tax Cut and Jobs Act (“TCJA”) now a little over a year old, this week’s chart looks at the effect of the tax cut on companies in the S&P 500. Despite a headline corporate tax rate of 35%, S&P companies in aggregate were paying an effective tax of only 25% over the twelve months leading up to the tax cut. Lowering the headline rate from 35% to 21% has clearly had an effect, as the tax rate for the S&P at the end of the third quarter was down to just 18.4% (a reduction of almost 27% year-over-year). This was one of the main drivers of strong growth in profits for U.S. companies, as the S&P 500 earnings growth peaked at 27% year-over-year in the third quarter (blue dotted line in the second chart). However, as we move into 2019 the positive effects on earnings growth from the tax cuts will fade, and corporate earnings growth in 2019 is likely to be significantly slower than what investors experienced in 2018, which could be a headwind for the equity market as the year progresses.

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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.

 

Can a Government Shutdown Slow the IPO Market?

Companies have been staying private longer, but expectations for Initial Public Offerings (IPOs) in 2019 are high. Uber and Lyft filed their intent to list their shares publicly with the SEC in December. Most recently, other private companies have been exploring if it makes sense to go public at current valuations. Peloton, the popular exercise bike company, has been exploring an IPO this year as its valuation has climbed to more than $4 billion, roughly 3 times as much as its $1.25 billion valuation in 2017. The chart above shows the amount of money raised via IPOs in each calendar year. But what risk does the previous government shutdown have for the IPO market?

The most favorable time for an IPO is typically when the stock market is doing well, volatility is low, and political risks are mitigated. Due to the recent partial government shutdown, the SEC is backlogged with paperwork, which has delayed planned IPOs during this current favorable environment. The risk is that if another shutdown occurs, there could be an extended delay featuring stale financial statements and other administrative delays, which would naturally discourage companies from wanting to go public. The companies that are most at risk are those that are running low on cash and need capital to continue operating. Business owners and venture capitalists are also at risk of not being able to cash out as quickly as they would like. Though the shutdown has caused a delay in listing, it should not prevent the blockbuster companies from listing publicly. Companies like Uber – which has been valued as high as $120 billion – are looking to tap the larger pool of capital in the public markets. Even though the government shutdown has already caused delays of around 30 days, the expectation is that 2019 will ultimately provide a record amount of capital raised through IPOs.

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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.

Can the PG&E Bankruptcy Create Profits for Hedge Funds?

This week’s chart of the week examines the price performance of Pacific Gas and Electric (“PG&E”) Corporation’s public debt and equity. Because of what they provide, publicly traded utilities have long been considered defensive investments due to their relative stability throughout economic cycles.

In the third quarter of 2018 hedge funds began buying shares of this California public utility on the view that PG&E’s liability for 2017 wildfires would be much lower than expected. This buying took place ahead of the deadliest wildfire in California history which many blamed on PG&E electrical lines.  PG&E’s exposure to wildfire liabilities is heightened by the state’s inverse condemnation, a legal standard which holds utilities responsible for all damages caused by their equipment. On January 29th PG&E filed for bankruptcy related to the more than $30 billion in liabilities it faces related to California wildfires in 2017 and 2018.

Many hedge funds that bought both debt and equity of PG&E in the third quarter of last year have seen the equity and debt sell-off over 60% and 18% respectively through January. This price drop has caused some managers to exit their positions. With the company announcing a bankruptcy filing, distressed hedge funds have stepped in to buy up both the equity and debt of the company.  Their rationale for doing so is that the payout of the liabilities will be smaller than originally expected and thus both equity and debt prices can recover enough to deliver a profit relative to the currently depressed prices.

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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.