Topic Tags: Interest Rates

The Short Rebate: A Headwind Becomes a Tailwind

Investor focus over the last year has centered on the Federal Reserve and rising interest rates. Since March 2022, the federal funds rate has increased 450 basis points, with further rate hikes expected in the next six months. While the Fed’s intent is to lower inflation and create price stability, higher rates have widespread implications for the economy and markets. While many have focused on the challenges for investors, hedge funds, particularly those that have the ability to short stocks and bonds, are also set to benefit from the increase in rates.

To establish a short position, a hedge fund must first borrow the security from other asset owners, providing cash collateral to the security lender to protect against potential default. During the borrowing period, the hedge fund that borrowed the stock must pay the lender any dividends or interest received, but is also entitled to receive back any interest that accrues on the required collateral. The return earned on the collateral, known as the short rebate or stock loan rebate, can meaningfully contribute to a hedge fund’s return, particularly for funds with meaningful short portfolio allocations.

For the past 15 years, the short rebate, estimated as the federal funds rate less a fee charged for borrowing a security (typically between 25 and 75 basis points), had been less than the dividend yield on the S&P 500, equating to a headwind to returns for short sellers. However, with short rebates now firmly in positive territory, hedge funds can benefit from higher expected returns in a segment of their portfolio that has been challenged since the Global Financial Crisis. While overall hedge fund returns will still be dependent on manager security selection and exposure management, the short rebate flipping from a headwind to a tailwind is just one of the reasons that the go-forward environment should be more favorable than it has been for relative hedge fund outperformance.

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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 Fed’s Effective Proxy Battle

The Federal Reserve’s sharp tightening of interest rates over the last year has made financial market conditions significantly more restrictive. However, financial conditions may be even tighter than generally recognized based on the fed funds rate alone. The San Francisco Federal Reserve Proxy Rate is a measure that uses public and private borrowing rates and spreads to better reflect broader monetary policy. The proxy rate represents the fed funds rate that would typically be associated with current market conditions, assuming financial markets are driven solely by this rate.

As of the end of January, the proxy rate was 6.1%, notably above the effective fed funds rate of 4.3%. The higher proxy rate indicates that broader monetary policy is tighter than what is implied by the fed funds rate alone. The proxy rate also started increasing in November 2021, while the Fed did not begin raising rates until March 2022, showing that broader financial market conditions have actually been tightening for more than a year. With markets extremely sensitive to Federal Reserve policy decisions, but the long-term health of the economy dependent on cooling price pressures, a higher proxy rate may be a hidden positive for markets.

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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.

Real Estate Is Where the Heart Is

Core real estate investments experienced a sharp post-pandemic rebound, with the NFI-ODCE¹ benchmark returning 22.1% over the year ended September 30, 2022, more than double the index’s pre-pandemic 5-year average of 8.5%. In the fourth quarter, however, momentum shifted, with macroeconomic uncertainties impacting property level underwriting, cap rate assumptions, and asset pricing. Uncertainty has increased within the asset class due to inflation, rising interest rates, and geopolitical conflict, though real estate continues to offer long-term thematic tailwinds for institutional investors.

This newsletter explores a few crucial factors currently impacting real estate markets, as well as opportunities outside of core real estate that may be relatively better positioned amid these challenges.

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Debt is the New Equity

Real estate debt investors, relative to equity investors, are generally more insulated against downside risk with underlying properties secured as collateral. Mechanically, a debt investor is effectively lending money to a borrower who may require bridge or rescue financing to close on prospective property acquisitions or development deals. Lending to borrowers at higher interest rates allows for higher returns, as well as consistent cash yields.

Commercial mortgage-backed securities (CMBS)¹ — the public form of real estate debt — have seen market yields rise materially amid higher interest rates. Debt is en vogue again as yields are back to levels that can contribute meaningfully to portfolio returns. 2022 was a year of re-pricing due to the impact of higher interest rates. Public real estate markets quickly embedded a recession risk-premium into pricing while private market valuations trailed. If the economy enters a recession this year, debt is likely to perform relatively well based on conservative underwriting and performance that is not directly tied to a property’s net operating income growth. CMBS excess spreads have also widened out relative to corporate bonds to account for real estate-specific downside scenarios. As shown in the chart, CMBS yields are currently comparable to the yield of corporate bonds rated at least two full ratings lower. Though market risks remain, higher rates and wider spreads have created a potentially attractive relative value landscape for CMBS opportunities.

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¹Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate. 

 

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 60/40 Portfolio Revisited: Back from the Dead?

In response to an inquiry concerning rumors of his demise in 1897, American writer and satirist Mark Twain quipped, “The report of my death was an exaggeration.” This quote may also apply in the case of the 60/40 portfolio and a white paper published by Marquette Associates in late 2021. The piece, entitled, “Is the 60/40 Portfolio Dead Forever?” examined the challenges faced by the popular model consisting of a 60% allocation to diversified equities and a 40% allocation to a broad basket of fixed income securities. These challenges included elevated equity valuations and the prospects of rising interest rates and slowing economic growth. Indeed, both stocks and bonds struggled mightily last year due to these and other headwinds, with 2022 one of the worst on record for the 60/40 portfolio. That said, and amid a strong start to 2023, there are reasons for optimism when it comes to the viability of the model to again generate attractive risk-adjusted performance.

This white paper provides historical context for the 60/40 portfolio, details its current outlook, and outlines ways in which investors can augment the model to achieve desired return targets.

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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.

Ahead of the Game

Heightened inflation and pressure on central banks to raise rates were common themes around the world in 2022. As rate hiking cycles weighed on equity markets, emerging markets that were quicker to respond to elevated inflation with higher rates earlier on began to stand out as a relative bright spot. Inflation is receding in these countries and a lack of headwind from continued rate increases could position emerging markets for strength relative to developed markets. The relative differences in central bank policy are reflected in earnings estimates for the two asset classes. Emerging markets estimates were the first to be revised lower and are now up off November 2022 lows. Developed markets, on the other hand, with the delayed impact of higher rates and a fairly resilient consumer, are only starting to see downward revisions now. This week’s chart compares earnings revisions for emerging markets and developed markets. Figures above zero indicate the revisions ratio — upward revisions less downward revisions as a percentage of earnings estimates — is higher for emerging markets and figures below zero mean that the revisions ratio is higher for developed markets. With emerging markets earnings revisions potentially on an upward track, along with multiples at historically attractive levels, the asset class may be set up for relative strength from here.

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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.

2023 Market Preview: Trail Guide to 2023 Asset Class Performance

As winter takes hold in the northern hemisphere, there are those that choose to escape to warmer climates and those that embrace the season and choose the mountains. Anyone familiar with downhill skiing knows that every ski trail is marked with a shape and color to designate its difficulty. For those unfamiliar with these ratings, the North American system looks like this:


Of course, weather and trail conditions can also impact a trail’s difficulty and must be accounted for when turning down the mountain: environment and terrain matter. Similarly, investment prognostications must recognize the current setting. By now, the environment is all too well known: high inflation, aggressive Fed policy, Russia–Ukraine war, labor supply shortages, and a potential recession. These topics have been covered extensively in recent letters and continue to loom over markets as we start 2023. At a high level, general consensus is that the majority of rate hikes from the Fed are behind us (two are expected for 2023 at time of writing), and inflation will continue to normalize in 2023, thus further supporting the thesis of fewer rates hikes from the Fed over the next year. If a recession comes to fruition, expectations are for it to be short-lived and shallow which reduces the long-term threat to markets.

With this backdrop in mind, we turn our attention to an asset class by asset class outlook for the coming year, assessing the degree of difficulty for each to deliver positive returns in 2023. In some cases, the difficulty will change as the year goes on — similar to trails that are “Most Difficult” for the first half and become more palatable as the journey goes on…which brings to mind a certain trail in Utah that the author found himself on last year that literally had him over his skis…but I digress. Tighten your boots and click into those skis!

Read > Trail Guide to 2023 Asset Class Performance

Download > 2023 Market Preview Report with 100+ additional charts and data, organized by asset class

Watch >  2023 Market Preview Video recording of our research team’s live webinar analyzing last year’s performance as well as trends, themes, opportunities, and risks to watch for in 2023

 

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. Marquette is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Marquette including our investment strategies, fees, and objectives can be found in our ADV Part 2, which is available upon request.

2023 Market Preview Video

This video is a recording of a live webinar held January 19 by Marquette’s research team, featuring in-depth analysis of the final months of 2022 and a look ahead at risks and opportunities to monitor in the year ahead. Our Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real estate, infrastructure, private equity, and private credit, with presentations by our research analysts and directors.

Download > 2023 Market Preview Report with 100+ additional charts and data, organized by asset class

Read > 2023 Market Preview: Trail Guide to 2023 Asset Class Performance

 

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Hike! The Herald Fed Sings

The trajectory of rate hikes by the Federal Reserve has had a meaningful impact on asset values this year. Historically, rising interest rates have aligned with higher risk-adjusted returns for real estate investors, with an average 12.8% annual total return of the NPI during past periods of Fed hikes. Although higher borrowing rates increase the cost of capital for property buyers, rate hikes typically coincide with a strong economy and easy credit. Economic strength can lead to mark-to-market rent growth opportunities and strong tenant demand within in-favor sectors, and open credit markets may allow investors to increase their purchasing power, thereby expanding the pool of real estate buyers.

This year, the Fed has raised rates to specifically target heightened inflation. During periods of price pressure and subsequently higher rates, property owners tend to increase rents in order to keep pace with growing maintenance and replacement costs. Owners and investors also benefit from supply-demand dislocations when construction, financing, and labor costs rise, placing downward pressure on new supply and ultimately increasing demand for rentals. Historically, rent growth in the U.S. has averaged 3.0% in a rising Fed policy environment, compared to 1.7% and 1.4% in steady and declining rate environments, respectively.¹ While the ultimate impact to real estate valuations from this period of higher inflation, rates, and economic uncertainty is still unknown, the asset class does benefit from its ability to effectively pass through costs, providing a hedge against macro headwinds.

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¹Federal Reserve, Hines Research 1990–2021Q4 for U.S. markets, CoStar, Property Market Analysis, Colliers

An Investor’s Holiday Wish List

Hopefully not another year of coal
In the spirit of holiday fun — and an effort to put 2022 investment returns behind us — we have put together our investor wish list for 2023. We have broken the wish list into two categories: the “must-haves,” which carry the most weight and are most observable, and the “stocking stuffers,” which may not be headline grabbers but are nonetheless impactful across economies and markets. Predictably, the “must-have” items focus on a reversal of the major trends that drove the markets this year; we “must have” a better outlook across at least some of these topics. The “stocking stuffers” category is a variety of topics that either directly impact the major trends from 2022 or are more targeted with their impact on specific asset classes. And while we recognize this is not an exhaustive list, we feel strongly that if these wishes come true we can all feel better about market returns in 2023.

This year’s must-haves:

  • Lower inflation
  • Less aggressive Fed policy leads to fewer interest rate hikes in 2023
  • Avoid a deep recession
  • Resolution of geopolitical conflicts

And stocking stuffers:

  • Broad-based earnings in the U.S. stock market
  • A weaker U.S. dollar
  • Credit defaults start to flatline
  • Slowdowns in hiring and wage growth
  • Favorable news out of China
  • History repeats itself

Read > An Investor’s Holiday Wish List

 

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.