Stock Market Volatility and Public Equity Portfolios
The fourth quarter of 2018, especially December, saw one of the worst declines in U.S. stock market history. Listed equity markets in Europe and Asia also suffered sizable losses. Such volatility levels drove most public equity portfolios into negative territory for the year, which in turn dragged down the performance of entire investment programs for many investors. While most participants in the discussion indicated that they had been expecting higher equity volatility, very few were able to anticipate such intense sell-off towards the end of the year. A possible explanation for the indiscriminate selling of even high-quality company stocks is that some institutional investors unloaded their exchange-traded-fund (ETF) holdings and other passive strategies.
As for the outlook of the economy, most participants believed that a major slowdown or even a recession could be in store either in 2019 or 2020. Central bank actions, ongoing trade disagreements, Brexit uncertainties, and government dysfunctions were among the main reasons for a neutral to negative outlook. While forward price to earnings (P/E) multiples for both U.S. and world equity are in their mid-teens, a weak macroeconomic environment will limit corporate earnings growth.
Given that stock markets are by and large anticipatory mechanisms, protracted bear markets could finally come after a decade of exuberance. Not everyone will necessarily be unhappy though—active equity managers, for example, may seize this opportunity to prove their abilities to beat passive instruments. But whether the value they add can justify the fees they charge is still to be determined. More and more allocators are now only looking at select active managers who take concentrated risk on a small portfolio of listed equity at long horizons, while most of their public equity portfolios are indexed or put into other passive strategies.
Widening Credit Spreads: Cause for Concern?
Most investors are well aware of the very extended credit cycle in which they operate. However, nobody knows exactly when and in what way this cycle will end. Investors are looking for all kinds of “canaries” for clues. Perhaps the biggest question is how much central banks will pull back on quantitative easing programs and hike interest rates. There are some similarities between the current and previous credit cycles though; for example, like previous times, the yield curve has flattened significantly. As short-term interest rates rise, the net interest margin of banks is being squeezed, which may push some banks to lend more aggressively, in order to maintain their profits. There are also differences that are somewhat unique. For instance, fixed income ETFs were not nearly as prevalent in the last cycle but have since become significant drivers in markets; in some ways, ETFs have taken the place of traditional credit derivatives, such as credit default swaps.
There has been significant build-up in investment grade credit in the past ten years, but less so in the high-yield (below investment grade) category. This may be comforting on face value; however, much of the investment grade issuances have been in the BBB tranche, which is only a notch above high-yield. An economic downturn or slowdown could trigger a wave of downgrades. Because many institutions are only allowed to invest in investment grade fixed income, the downgrades could in turn trigger a sell-off and cause volatility in bond markets. However, this potential development could very well become a buying opportunity for credit, distressed, and hedge fund managers operating in the high-yield space, as some of the will-be-downgraded companies may not be as highly levered as others. From a market perspective, these managers may play the role of liquidity providers in those market conditions.
Credit ratings are of course lagging indicators of credit markets. Credit spreads are far timelier. Some investors also use spreads to gauge the relative attractiveness of credit investments, compared to equity. At the time of the discussion, spreads still seem relatively benign, even in markets like Europe and China, where unfolding events and data to be released could trigger spikes. In China’s case, that could mean underperformance of entire emerging market debt portfolios, given the weight of Chinese credit.
Private Equity: Can Out-Performance Continue?
For many investors, private equity was the best performing asset class in 2018. Looking back further, the entire decade following the global financial crisis has been a good environment for private equity in general. However, performances of top and bottom quartile general partners (GPs) differ substantially. In the meantime, the conventional wisdom on return persistence, that funds that have done well in the past are likely to continue to outperform, no longer seems to hold true for buyouts, according to a recent study in 2016. GPs that do well tend to be specialists of certain industries or businesses. This is partly a result of intense competition. The buildup of "dry powder" is self-evident that there is now far too much capital chasing after a limited number of deals.
Some investors are becoming frustrated with their GPs' slow deployment of capital; there are also those who are no longer content with their role as traditional limited partners (LPs); there is even a suspicion among some LPs that GPs hide good deals from them. But GPs might argue that it simply isn't the right time to buy at these lofty valuations. In any case, more LPs than ever now aspire to co-investment or even direct investment opportunities in private markets. However, not every investor is adequately prepared for this aspiration, in terms of staffing and other resources, as deals could become very labor-intensive.
In venture capital, 2019 may become a landmark year, as some of the most successful "unicorns," such as Uber, Airbnb, and Slack, are planning their IPOs. However, pre-IPO valuations may become less important in the venture world going forward, as a new class of venture-backed companies dubbed "minotaurs," or those that have raised one billion USD or more in venture funding, have entered the scene. Regardless of the mythical creature metaphors, venture-backed companies are staying private longer.
Trends in Private Real Estate
Private real estate portfolios have performed well in 2018, perhaps second only to private equity. Many investors have increased their current allocations to this asset class, moving closer to their target allocations. But as the prospect of a slowdown in the global economy looms, investors may be shifting weight within their real estate portfolios, from opportunity and value-added to core. Regardless, a net capital inflow into global real estate markets is expected in 2019.
Real estate investors are investing heavily in multi-family residential properties. Commercial properties, such as office space, are getting less attention, while investors are somewhat divided and polarized in their opinions on retail space. Affordable housing has been a good investment in countries like Singapore, but less so in the U.S. European real estate investors tend to have higher requirements on energy efficiency and overall sustainability of properties, while U.S. investors tend to be more return-driven. However, nowadays it is a competition among real estate developers to build the most efficient and sustainable properties.
The advent of the sharing economy expressed itself in real estate in the forms of Airbnb and WeWork, most notably. The demand for shared space properties is strong and will most likely remain strong in the long run. Even established companies and large banks are now drawn to their flexibility and shorter lease terms. These business models will require constant reconfiguration of interior space to remain competitive.
Global Investment Outlook and Key Assumptions