Category: Chart of the Week

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.

Are Housing Prices Drying Up Our Savings?

The demand for apartments has been robust over the past several years, particularly within the Millennial generation, which has contributed to strong rent growth for the sector. From a demographics perspective, Millennials are delaying life choices such as homeownership and marriage; as a result, homeownership rates are at historical lows. However, there is much more to the story than just demographics driving down homeownership rates. In fact, as illustrated in the table above, the growth in home prices has exceeded its long-term average by 2.9 percentage points. Concurrently, family income growth is down, below its long-term average by 1.9 percentage points, making it increasingly more difficult to own a home in today’s market.

Even more concerning is how much housing costs are contributing to core CPI, illustrated in the graph above. As of October 2017 (the most recent data point available), housing inflation contributes 78% of the total core inflation rate, compared to historically averaging approximately 50%. The combination of increasing home prices coupled with decreasing family income growth is the perfect storm for Millennials looking to purchase a home today. Spending more on housing not only means spending less on other consumer goods and services, but it makes it difficult for the average Millennial — especially those with student debt obligations — to save for the future.

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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.

Are Equities Oversold?

After an extended period of historically low volatility and steady gains in U.S. equity markets, the first significant pullback for U.S. equities since February 2016 has transpired over the last week. Through February 8th, the DJIA and S&P 500 each traded below their January 26th all-time closing highs by 10.4% and 9.7%, respectively. In 2017 the DJIA posted a record 71 new closing highs while the S&P 500 notched 62 new closing highs, its second highest in history. The upward trend continued into January 2018 with both DJIA and S&P continuing to record 11 and 14 additional new closing highs.

With the sharp return of volatility to a bull market that is already long in duration, investors are rightfully feeling a bit jittery right about now. The catalyst for the recent sell-off began with last week’s employment report showing faster than expected wage growth. This created concern that inflation could rise faster than expected. Under this scenario, the Fed would be forced to raise short-term rates at a quicker pace than what is currently being priced into the market. Only time will tell if this was simply a long overdue pullback as part of a normally functioning market, or the start of further price deterioration. While the bull market is long by historical standards and valuations are near the upper end of their historical ranges, economic and corporate fundamentals do not appear to signal warning signs. With such uncertainty, it can be helpful to look towards technical signals for clues.

This week’s chart looks at a popular technical indicator, the Relative Strength Index (RSI). This indicator measures the degree of recent gains and losses for a security or index over a specified period, typically 14 days, to identify overbought or oversold conditions. Its calculation captures both the speed and magnitude of price movements. RSI values range between 0 and 100, however RSI values of 70 or above are generally considered overbought and likely to experience a trend reversal. Likewise, RSI values of 30 or below are generally considered oversold and likely to experience a trend reversal to the upside. RSI values can remain in overbought or oversold territory for extended periods of time, so it is not until that value crosses these threshold levels again that a bottom or top is considered as being potentially formed. At the January 26th close, the DJIA’s RSI measured 88.7 and had been in overbought territory since late 2017. With the recent pullback, the DJIA’s RSI quickly dropped to 29.5 as of February 5th. The following three trading days produced large price swings, but ultimately these indices have continued to trade lower. Currently at 30.4, RSI for the DJIA is thus far holding above the oversold threshold. While a technically oversold level may foreshadow a future potential uptrend, investors should not place too much weight on any one indicator.

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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.

You Get a Dividend, You Get a Dividend, You Get a Dividend!

As January closes, it is not uncommon for New Year’s resolutions to go up in smoke; one publication has suggested that as many as 80% of commitments for change are gone come February.¹ Regardless, many such resolutions target weight loss in the New Year, and an obvious winner in this game would seem to be Weight Watchers. However, January’s performance for this stock appears surprisingly unrelated to news of increased subscribers. Instead, it appears that the influential figurehead Oprah Winfrey had an unanticipated — and unconventional — impact on Weight Watcher’s January performance.

Since Oprah took a 10% stake and joined the board of directors at Weight Watchers in late 2015, her $43 million investment has grown to exceed $400 million. Compare that 847% growth to the S&P’s 39% increase and the Oprah effect cannot be denied. Her powerful speech at the Golden Globes on January 7th incited social media to explode with excitement over a theorized 2020 run for the presidency. Weight Watchers shares jumped over 12% the Monday following her speech and an additional 9% the next day; the stock continued to climb through January, though this was likely due to more typical reasons such as the company’s strong growth outlook. Once news broke on the 25th that Oprah was officially not planning to run for president, shares tumbled 7% intraday and ended the month down 5% from their January peak.

An announcement from a board member regarding a lack of intent to run for president is certainly not a typical cause for a depression in stock price, and this situation is only a recent example of the growing importance of a company’s brand. Stock prices are no longer solely affected by their fundamentals; a seemingly unrelated blip in the news cycle can now blow up on social media and essentially override a company’s true fundamentals to impact its share price. While an event like this can be unpredictable, it forces management across all industries to have a stronger brand awareness, which is ultimately a good thing as it can lead to increased responsiveness to consumer feedback. As it relates to portfolio management, actively managed funds that can successfully account for this trend are more likely to outperform both their peers and respective indices. As capital markets unfold in 2018, this is a pattern that bears watching.

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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.

Alpha Returned in 2017, But What About 2018?

Equity hedge strategies were the best performing hedge fund strategy in 2017, as alpha was generated on both the long and short side. This chart shows that net alpha bounced back nicely from 2016, as the 2017 environment was much better for active management. Alpha was generated on the short side during the first half of the year, but trailed off as the bull market continued to move higher.

Another factor that helped equity hedge strategies was the decline in correlations during the year. An environment with lower correlations among stocks is positive for active managers, particularly those who maintain both long and short positions.

For alpha generation to continue in 2018, correlations between stocks will need to stay low, with meaningful sector dispersion. Coupled with the continued effort to remove global monetary stimulus, we would expect managers to benefit from these conditions.

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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 the Fed Prevent the Yield Curve from Inverting?

The U.S. Treasury yield curve is flatter today than it was at the end of the Great Recession in 2009.  This week’s chart examines how flat the curve is now, and the potential for further flattening, possible inversion, or potential steepening. The 10s minus 2s steepness shown in the chart is the 2-year Treasury yield subtracted from the 10-year Treasury yield.

In general, a steep yield curve signifies a growing economy and a bullish market, as long-term bonds must provide greater yields to keep up with future growth. On the other hand, an inverted yield curve signifies a shrinking economy and a bearish market, as investors buy long-term bonds as safe havens, thereby driving their prices up and lowering their yields. As we can see from the chart, the yield curve inverted prior to the 2000 tech bubble burst and prior to the 2008 Great Recession.

With the Tax Cut now signed and underway, we would theoretically expect the yield curve to steepen as the market expects stronger economic growth. However, in the fourth quarter of 2017 — as the legislation gained momentum through Congress and was ultimately signed into law by Trump — the yield curve flattened instead. This is a possible sign that much of the tax stimulus may have already been priced into assets.

Previous Fed Chairs Greenspan and Bernanke both said the economy would be fine after the yield curve inverted in 2000 and 2008, respectively. Going forward, we may expect that the new Fed Chair Jerome Powell will be more cautious in preventing inversion.

Prospects for curve steepening still exist, as inflation — which rose recently — may continue to rise as the economy benefits from the Tax Cut. Rising inflation would then be expected to raise the long end of the yield curve. However, we continue to see the mitigating effect of overseas reach for yield, as U.S. rates across the curve still outyield rates from the rest of the developed markets. Non-U.S. pensions, insurers, and banks continuing to buy long U.S. bonds may drive up prices and keep yields low on that segment of the curve.

Given the flat yield curve, we recommend maintaining an allocation to core bonds for yield, diversification, and principal protection, as well as the inherent moderate duration position.

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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.

 

Oil Market Disruption for 2018 is Closer to Home

Iran, one of the largest exporters of oil, rang in 2018 with a wave of political demonstrations across the country. Citizens gathered to protest Iran’s spiraling economic conditions, which include a 12% unemployment rate, high inflation, and elevated prices of basic goods such as eggs and dairy products. While energy analysts monitor such geopolitical events with due concern, the consensus is that the Iran riots have not caused a significant disruption of supply to the global oil market.

Instead, analysts are pointing to elevated oil production in the U.S., and the subsequent decline in imports. As depicted in this week’s Chart of the Week, net imports of oil to the U.S. dropped more than 65% in the past decade due to rising domestic production. Numerous U.S. shale drillers have pledged to expand exploration if crude oil prices hold above $60, driving imports down even further.

This rise in U.S. oil production has proved a headache for the Organization of Petroleum Exporting Countries (OPEC) and its affiliates, which have actively restrained output since 2016 in hopes of buoying prices. These cutbacks have successfully reduced oil inventories in these countries and the output restraint is set to remain in place through the end of this year. However, global supplies remain high and OPEC’s plan depends on continued compliance from its members. These factors coupled with U.S. production momentum could keep oil prices in check through 2018.

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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.