Category: Chart of the Week

Will Strong Deal Activity Continue in 2018?

M&A activity got off to a fast start in 2018, as over 7,000 deals worth $1.3 trillion in value were announced during the first quarter. A common theme among these deals were complex cross-border transactions. The number of transactions greater than $10 billion doubled to a Q1 record of eighteen versus eight last year.

Health care and media/content related deals dominated the quarter and are expected to continue throughout the year. The largest announced deal was the $55 billion merger between Cigna and Express Scripts, a vertical merger of healthcare providers. Other announced deals in the quarter included Comcast’s $31 billion bid for British broadcaster Sky; Keurig Green Mountain’s $19 billion acquisition of Dr Pepper Snapple Group and French insurer AXA’s $15 billion takeover of XL Group.

The biggest risk to M&A deals going forward? Government intervention remains the elephant in the room. Markets became alarmed following the Department of Justice’s (DOJ) antitrust suit in 4Q 2017 around the Time Warner/AT&T deal. The trial between the companies and the DOJ started on March 19th and is expected to continue over the next few months, with many in the media space following it very closely. Government intervention continued in 2018 as the Trump administration blocked Broadcom’s $117 billion hostile bid for Qualcomm, citing national security concerns. Companies now must spend time analyzing how the U.S. government will view any potential deal. Deal activity will likely remain strong in 2018 if companies feel the U.S. government will remain on the sidelines.

As it relates to investments, the fast start of M&A activity in 2018 has given merger arbitrage hedge funds a diverse set of transactions to invest in. A typical merger arbitrage hedge fund will buy shares of the target company and short the acquiring company by borrowing shares with the hope of repaying them later with lower cost shares. If the deal goes as planned, the target company’s stock price should eventually rise to the agreed per-share transaction price and the acquirer’s price should fall to reflect what it is paying for the deal. Deal spreads widened out in February as equity market volatility returned and concerns about government intervention continued to grow. Despite healthy deal activity, merger arbitrage funds have been carefully analyzing deals and how the current administration is likely to view them, thus adding another dynamic to the traditional merger arbitrage strategy.

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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 Do Higher Interest Rates Mean for Higher Yielding Equity Sectors?

It looks like interest rates will dominate both fixed income and equity markets in 2018. Potentially higher interest rates have not only negatively affected bond markets, but have also wreaked havoc in certain sectors of the equity markets. Particularly hard hit:

  • Consumer Staples, down 7.1%;
  • Telecom, down 7.0%;
  • Real Estate, down 6.7%, and
  • Utilities, down 4.7 %.

Predictably, these are the worst performing sectors in the S&P 500 through April 13, 2018. The S&P 500 was down 0.1% over the same period.

Given the stubbornly low interest rate environment after the Global Financial Crisis, investment firms created a plethora of high dividend indices and strategies to respond to the world’s demand for yield. Investors who were not comfortable taking a bet on long duration bonds often invested in high dividend yield strategies to capture yield premiums over the 10-year bond and S&P 500. After a few years, high yielding sectors were often among the best performers in the market. For instance, in 2014 the Telecom sector returned 29.0%, trouncing the return of every other sector and the S&P 500 index.

Dividend-oriented ETFs saw $40B in net inflows which was in stark contrast to equities which have seen outflows over the same time period. However, there have been periods of outflows, namely during the Taper Tantrum in the summer of 2013 and in December 2015 after the Fed’s first interest rate hike.

However, the interest rate outlook is very different today versus three years ago. The global economy is strong and the U.S. is embarking on an interest rate normalization process. Since year-end, the yield on the 10-year bond increased 0.4% from 2.4% to 2.8% and the S&P 500 Dividend Aristocrats index, a proxy for high yielding stocks, yields 2.5%, which is lower than the yield on bonds. As fixed income’s yield prospects have improved, the interest in bond-proxy sectors has waned and investors are starting to withdraw assets. Although outflows are not as extreme as in December 2015, the return prospects of bond-proxy sectors could be challenged further as rates continue to rise.

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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 the Worst Over, or Still Yet to Come?

In the last few months investors were quickly reminded of the volatile nature of equities as these markets suffered steep declines. While there are several possible explanations — ranging from high valuations to geopolitical concerns — many are wondering if we were simply due for a correction or if this a sign of more to come. This week’s chart looks at the historical inter-year drawdowns for the S&P 500 to see how the recent pullback compares.

Since 1983, the S&P 500 index has only had five calendar years with a negative return. Despite this, 28 out of the last 35 years had an intra-year drawdown of more than 7% with the median max drawdown around 10%. Year to date, 2018’s largest drawdown was 10.2%. While this is significant, especially in comparison to the remarkably calm 2017, this is not out of the ordinary. Additionally, even with this drop in the index, the total return for the year is nearly flat thanks to dividend yields.

It is difficult to predict what happens next given the current volatility. Many geopolitical risks remain and though valuations have come down, they are still elevated in comparison to historic levels. However, this drawdown is similar in magnitude to many previous years and the historic average, suggesting that the worst may be over. Even with drawdowns of this size most years have delivered positive equity returns, meaning this could an opportunity to enter the market or invest additional 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.

Can Low Interest Rates Justify High Stock Valuations?

Given the persistence of above-average equity market valuations in recent years, a proclamation oft-heard from the financial press and market pundits alike is that today’s low interest rates justify these higher valuations. Intuitively, it is easy to see how the rationale behind such statements originated. At the most basic level, the intrinsic value of stocks (and most assets) is the present value of their discounted future stream of cash flows, where the required rate of return (“discount rate”) reflects the riskiness of those cash flows. For instance, discount rates for stocks are higher than those for bonds due to the greater uncertainty of cash flows to equity owners. Because of this framework, and noting that lower discount rates will result in higher present-day asset valuations, it can be easy to empathize with the notion that lofty stock prices today, relative to their fundamentals, are “justified.”

To investigate the validity of such claims, this week’s chart examines the historical relationship between interest rates and equity valuations, defined as the cyclically-adjusted P/E (CAPE) ratio. If the theory holds true in practice, we would expect to see periods of heightened equity valuations coincide with low interest rates. As seen above, there are indeed periods where this relationship is observed — including today and in the late 1920’s prior to the Great Depression. However, there are also periods where the opposite is true — such as the 1910’s and during much of the 1940’s — when low interest rates accompanied low valuations. Likewise, long interest rates reached what were then all-time highs in the late 1960’s, but valuations were also heightened, challenging the assertions that are repeated today. Based on what history has shown us, we would caution against the use of long interest rates as a reliable gauge of the reasonableness of equity market valuations.

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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.

Treasuries vs. Dollar Purchasing Power

Our Chart of the Week reviews the link between the 10-year U.S. Treasury Yield and the Trade Weighted U.S. Dollar Index. The Trade Weighted U.S. Dollar Index measures the value of the U.S. dollar relative to a broad group of currencies circulated throughout the globe, lending insight into the global purchasing power of the dollar.

The left axis displays the yield on the 10-year U.S. Treasury and on the right axis, the price of the Trade Weighted Dollar Index. Higher U.S. interest rates is one factor that can lead to a stronger dollar, as foreign investors look to place their monies into higher yielding U.S. government securities. This relationship holds true from the beginning of 2016 through October of 2017 at which point we see the two diverge. In the 4th quarter of 2017, we saw a pick up in the U.S. 10 Year Treasury yield as Congress passed favorable tax legislation.

An additional factor that helps to explain exchange rate movement is the current account balance which measures the balance of trade through the amount of country exports less imports. We saw dollar weakness as the current account deficit rose to $128.2 billion in the 4th quarter of 2017, the highest level since the end of 2008.

As equity volatility picked up in February 2018, we saw an inflection point in the data. Equity volatility can be measured through the VIX-CBOE Volatility Index, which measures the market’s expectations of 30-day volatility for the S&P 500 Index. The VIX increased from a level of 11 at the end of 2017 to a current level of 22.5; the long-term average is 20.

Historically speaking, the correlation between these two economic variables has been positive, but the two trends have diverged more recently. As economic and political developments occur, including the U.S. Federal Reserve’s normalization of short term interest rates, discussions of potential trade wars and other developments, we will continue to monitor the correlation between the U.S. 10 Year Treasury Yield and the Trade Weighted Index, with the expectation that a positive correlation will re-emerge in the coming 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.

The Sixth Fed Hike and Rising LIBOR

The Federal Reserve announced its sixth rate hike on Wednesday, with the target fed funds rate now 1.5% – 1.75%. The decision to increase rates was based on low unemployment and low inflation. Our chart this week takes a closer look at LIBOR (more formally known as the London interbank offering rate) and its relationship with the fed funds rate. As a matter of background, LIBOR is primarily used as the base rate upon which the floating rates for bank loans and private credit are set. For example, a bank loan with an L+400 rate means that it yields 400 basis points over LIBOR. As LIBOR rises, the bank loan’s yield rises.

As the chart shows, LIBOR demonstrates a strong correlation with the fed funds rate, which is the short-term interest rate controlled by the Federal Reserve. The blue line shows the rate hikes over the last three years. The purple line shows the corresponding rise in the three-month LIBOR, which is the most commonly used maturity of LIBOR for bank loans and private credit. On average, the three-month LIBOR is approximately 50 basis points higher than the fed funds rate; thus, LIBOR is currently around 2.0%.

The gray section on the right shows the fed funds rate (blue line) as projected by the fed funds rate futures curve. By applying the 50bp difference to the LIBOR curve, we can project LIBOR to approximately 2.5% for December 2018 and 3.0% for both December 2019 and December 2020. This means that we could expect a bank loan with an L+400 rate to yield about 6.5% in December 2018 and about 7.0% as of December 2019 and December 2020.

However, we must note that LIBOR is expected to be phased out by the end of 2021. In addition, the London Stock Exchange has been working on a new short-term benchmark interest rate that would replace LIBOR, and plans to launch this replacement rate in April. Marquette will continue to monitor and provide guidance on these LIBOR developments, as they will undoubtedly have an impact on how interest rates and the credit market are measured.

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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 Will Drive Inflation Higher in 2018?

Driven by the rising price of oil, the unknown ultimate impact of the tax cuts, strong global economic growth and potential infrastructure spending, investors are asking whether inflation might finally rise. This week’s chart examines market-implied inflation versus actual realized inflation. The orange line shows the market-implied core personal consumption expenditures (“PCE”). The blue line shows the actual realized core PCE. PCE is based on surveys of what businesses are selling, while CPI, or consumer price index, is based on surveys of what households are buying. For this analysis, core excludes the more volatile food and energy components.

The orange line — market-implied inflation — is calculated by subtracting 50bp from the 10-year breakeven inflation rate. The 10-year breakeven inflation rate is the 10-year nominal Treasury yield minus the 10-year TIPS yield, which shows the inflation that would equilibrate the two securities. The 10-year breakeven inflation rate is then the market’s expectation for CPI based on how the market prices Treasuries and TIPS. To convert this CPI to PCE, we subtract 50bp, which is the historical average difference between CPI and PCE.

The market-implied core PCE was low in late 2015 and into 2016 because of the shale crisis, Third Avenue’s high yield hedge fund meltdown, and a general sentiment that inflation would not rise. Actual inflation was higher than market-implied during this time. In the first half of 2017, the unwinding of the “Trump trade,” the health care bill’s initial failure and North Korean missiles over Japan drove both market-implied and actual inflation lower. As the tax cut gained momentum in the second half of 2017, both market-implied and actual inflation rose in unison and have continued to rise so far in 2018. Because we are now at full employment, further inflation will have to be wage-driven, not employment-driven.

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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 This the End of a Low Volatility Regime?

For most of 2017, we were fixated on the unusually low volatility environment. Despite a number of geopolitical challenges, markets continued their sanguine march to higher heights. A month ago, we reviewed the latest U.S. equity market correction (defined as a market decline of at least 10%). At the beginning of the year, the S&P 500 Index had not had a negative month since October 2016 and January 2018 was already off to a strong start. However, cracks started to appear at the end of January as generally positive news (i.e. higher wage growth and low unemployment) precipitated February’s market decline and the first U.S. equity market correction since January 2016.

Periods of higher volatility and market corrections are not unusual at all. In the chart above, we have plotted the CBOE Volatility Index, also known as the VIX. The VIX shows the market’s expectation of 30-day volatility for the S&P 500 Index. Twenty is the average level of the VIX. Since the VIX’s inception, there have been vacillations between periods of high and low volatility, as noted in the chart. Coming off a period of extended low volatility, it is not surprising that current signals suggest elevated volatility in the near future. First, volatility regimes have lasted a little over five years on average; the current period is at the end of its sixth year. Second, the Federal Reserve is embarking on an interest rate normalization process and investors are afraid that the Fed may have to tighten faster due to stronger economic growth and inflation pressures. Excessive Fed tightening could constrain growth and thus equity markets, which explains the market drop in February.

However, higher volatility does not necessarily mean markets will be negative. From December 1996 through January 2003 and from July 2007 through June 2012 — the last two periods of higher volatility — the market posted positive returns. The former period included the bursting of the Tech Bubble and two U.S. recessions while the latter period encompassed the Global Financial Crisis. So while market volatility has risen from extremely low levels over the past six weeks, volatility is part of a functioning and healthy equity market.

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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.

Italian Elections and a Possible EU Exit

With Italy’s general election set for March 4th, this week’s chart examines the probability of a Euro break-up. This time last year European political risks were at the forefront of investors’ minds. The Netherlands, France, and Germany all held elections in 2017, with investors particularly concerned about France, where the anti-EU Marine Le Pen was polling well headed into elections. Ultimately, each country avoided anti-euro leadership and markets welcomed the results.

Now Italy will hold elections and there are several parties and political factions jockeying for leadership. Based on polling, experts expect no clear winner thus leading to negotiations to form a coalition government. Despite this uncertainty, the Sentix Euro Break-up Index has fallen to an all time low. Over the last two years the European economy has improved dramatically with a falling unemployment rate and rising consumer and business confidence readings. With a rosier outlook on the horizon, the idea of leaving the Euro has become less appealing to citizens. In fact, support for the EU has reached a 10-year high according to the most recent European Commission study. All of this means that an Italy EU exit event, or as we like to call it, Quitaly, is unlikely to occur.

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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.

U.S. Venture Capital Market Environment

As a growing number of participants have entered the private markets, the amount of total dry powder has increased. Venture capital funds, however, do not appear to be driving this significant increase in fundraising.  Rather, U.S. venture capital fundraising appears to have remained rational, roughly in-line with the market’s long-term average of $30 billion raised annually, which differs from the more dramatic increases in fundraising within private equity, growth equity, real estate, and private credit.

Dry powder within U.S. venture capital has risen, but remains at a consistent ratio relative to the annual investment level in the industry, currently implying 1.5 years of investment¹ to work through the current levels of dry powder. A key reason for this statistic is the notable level of investments made in the market; in 2017, close to $70 billion was invested, which represents the highest amount since the tech bubble in 2000. Over the last 18 years U.S. venture capital investments have exceeded U.S. fundraising as additional capital has been invested by sovereign wealth funds, corporate venture groups, and family offices.

This increasingly competitive investment environment is forcing managers to work harder to differentiate their capital by providing more strategic value to underlying managers and companies. Market valuations have been high for 4-5 years now, but the early stage venture space hasn’t experienced as much valuation expansion given the inherent business risk. What has changed is a decline in the number of financing rounds, as fewer companies are raising larger amounts of capital and instead are seeking investors who can provide strategic value as many businesses remain private for longer.

We believe it is important to remain disciplined in manager selection as established high-quality managers with broader platforms are positioned to perform well in this environment as they have differentiated capital pursued by many businesses. We believe these managers are more likely to find attractive investment opportunities without overpaying in this competitive environment.

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¹ The ratio of dry powder to annual investment provides an indication of how many years of investment are needed to work through the current level of dry powder. A ratio over 1 implies there is more than a full year’s worth of dry powder based on the most recent annual deployment for the industry. It is important to pay attention to the directional change of this ratio. An increasing ratio is an indicator the investment landscape is becoming more competitive to deploy capital as dry powder is growing faster than investment opportunities.

 

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.