cvernon, Author at Marquette Associates

Is Either Side Winning the U.S.–China Trade War?

Given everything that’s going on in the markets it is easy to get confused about what’s happening in our trade war with China, especially since the U.S. has engaged several other countries with tariffs, or at least threats of them. For all the back and forth that has occurred, the current situation isn’t overly complicated. So far, the U.S. and China have both implemented a 25% tariff on $50B worth of imports from one another. The U.S. is threatening an additional tariff on $200B worth of Chinese goods, which is now undergoing the mandatory review process. In response, China is planning to retaliate with tariffs on $60B should the U.S. enact this additional tariff. This would put a tariff on nearly all goods exported from the U.S. to China.

This potentially means the U.S. has the upper hand, since if these tariffs are implemented China will be left with little room to escalate things further, at least through traditional means. However, this doesn’t mean things will be resolved quickly or that the U.S. economy won’t feel any pain. In fact, the U.S. has already seen some impact as this week the Trump administration was forced to provide $4.7B in relief from the USDA to help farmers make up some of the losses from the trade conflict. At this point there’s no serious talk about a deal, so while many may be hoping for a quick resolution to the trade dispute things could get worse before they get better.

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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.

Looming Maturity Wall for Emerging Markets Debt

This week’s chart looks at the looming maturity wall for emerging markets debt. The chart shows the amounts coming due for U.S. dollar-denominated emerging markets debt issued by both sovereigns and corporates. The green portion represents publicly traded bonds, while the blue portion represents bank loans.

The table in the top right shows that the total face value of hard currency sovereign bond debt, as represented by the JPMorgan EMBI Global Diversified index, is $539 billion. The total face value of hard currency corporate bond debt, as represented by the JPMorgan CEMBI Broad Diversified index, is $456 billion. “Hard currency” is generally defined as U.S. dollar-denominated.

The 2018 bar represents the amounts maturing for the rest of 2018, a relatively small amount. However, the amounts maturing in the next five years are substantial. As the dollar continues to strengthen relative to emerging market currencies due to the Federal Reserve’s rate hikes, emerging market issuers may find it more difficult to pay the interest and principal — or even refinance their debt. This is because they earn their tax revenue in local currencies but must pay interest and principal in dollars. The trade weighted U.S. dollar broad index, an index of the U.S. dollar versus a basket of foreign currencies, rose 6.9% so far in 2018 and has risen 31.9% since 2011.

We continue to recommend emerging markets debt as a long term strategic asset class, because fundamentals in terms of GDP growth, debt-to-GDP leverage and current account balances are stronger than five, ten and twenty years ago. However, developed central banks such as the Federal Reserve, Europrean Central Bank and Bank of Japan are converging and will eventually tighten together, thereby raising their rates and strengthening their currencies — relative to emerging market rates and currencies. Thus despite the long-term merits of the asset class, given the looming maturity wall and tightening by the world’s major central banks, it will not be surprising to see elevated volatility from EMD in the short-term.

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Tech Sector Bubble?

Our Chart of the Week examines the concentration in market cap over time among the five largest stocks in the S&P 500 relative to the total market cap of the index. With growth outperforming value in the current market cycle, it’s not surprising to see the largest stocks by market cap today populated entirely by growth stocks. The strong performance among FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google/Alphabet) have propelled the weighting of these securities within market cap weighted indices over recent years and caused market participants to question how long this historic run can last and if we are currently in a technology sector bubble. With names such as Facebook and Netflix pulling back earlier in the year and Apple hitting a $1 trillion market cap milestone last week, fears of a technology bubble have only continued.

As of June 2018, the largest five stocks in the S&P 500 occupied 15.9% of the total market cap of the index. This concentration is high relative to the current market cycle, but it is important to note that we are still below the March 2000 high of 18.5%. Additionally, the largest five stocks in the S&P 500 have occupied greater than 20% of the total S&P 500 market cap in prior periods such as during the 1970’s.

The technology sector does trade at a premium to the broader market today. However, the sector generates high return on equity, strong earnings growth, and multiple expansion is not as excessive as during the dot-com peak. While the recent rise in technology stock weighting as a percentage of total market cap warrants monitoring, today’s concentration is not without precedence.

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A “Halftime” Review of Asset Allocation for 2018

As of June 30th, the Russell 3000 index was up only 3.2%, a far cry from its 10-year annualized return of almost 9%; the MSCI ACWI ex-U.S. — a broad proxy for international stocks — has been even more disappointing, down 3.8% compared to its 2017 return of 27%. Furthermore, most bond strategies are negative for the year, thus dispelling the notion of diversification. However, the year is only halfway complete and as we have seen repeatedly in the capital markets, fortunes can change rapidly and unpredictably. In an effort to formulate explanations and expectations, the following newsletter investigates the disappointing performance from the first half of the year, as well as potential outcomes for the remainder of 2018.

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The Impact of Puerto Rico on Hedge Funds

With the first half of 2018 behind us, our chart of the week touches on one of the more profitable positions for distressed credit hedge funds. Funds invested in Puerto Rican debt due to its misunderstood fiscal story, bondholder protections and a better credit situation than many stressed sovereigns. Following the devastation left from Hurricane Maria and President Trump’s comments on wiping out Puerto Rico’s debt, bondholders saw prices plunge in the latter half of 2017. That late year sell-off led to those bond positions contributing the most significant losses to many distressed strategies.

Thus far, 2018 has seen a recovery of Puerto Rican bond prices for hedge funds. The chart above highlights Puerto Rico General Obligation 2035 bonds. Many hedge funds believe the bonds were oversold last year following the hurricane, and recent revisions to Puerto Rico’s fiscal plan now projects greater primary surpluses, which has caused bond prices to rise. Also, Puerto Rico’s recovery from Hurricane Maria is now making progress which has also given comfort to bondholders. Negotiations for other Puerto Rican bonds will continue throughout 2018, with managers expecting to see more volatility during the remainder of the year.

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Do Rising Rates Mean Lower Returns for EM Equities?

Rising rate environments are typically thought to put downward pressure on equity returns. Specifically for emerging market (“EM”) equities, the common perception is that higher interest rates in the United States will drive EM returns lower and investors away from EM securities. However, in looking at the annualized returns of the MSCI Emerging Markets Index over historical periods of rising rates, this may not be the case.

This week’s chart of the week shows the annualized return of the MSCI Emerging Markets Index in rising rate environments and the Fed Funds Rate at the start and end of those periods. Only one of the time periods — January 1994 to February 1995 — was negative, and the average return for the time periods examined is 14%. In the most recent period — from December 2015 through June 2018 — the MSCI Emerging Markets Index has returned over 11% annually. Contrary to common belief, in periods when rates are rising, EM equities seem to perform well.

What explains this performance? For one, economic fundamentals for EM economies have been strong. The annual real growth rate of GDP for developed markets has averaged 1.9% over the past 5 years, while the same measure for emerging markets has averaged 4.9%. The more recent poor EM performance is mostly due to an appreciating dollar, which makes exports from EM countries cheaper to purchase in the U.S. Longer term, however, the data suggests that EM returns could be positive as rates climb higher in the U.S.

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Goodbye Telecommunications Services Sector and Hello Communications Services Sector!

On November 15, 2017, S&P Dow Jones Indices, a leading provider of financial market indices, and MSCI Inc., a leading provider of research-based indices and analytics, conducted their annual review of the Global Industry Classification Standard (GICS). As a result, the pair decided to broaden and rename the Telecommunications Services sector to the Communications Services sector. The thought process is that over the past several years consumers and businesses have fundamentally transformed the way in which they communicate and access content.

In some ways, this trend started when Comcast, a cable company, announced its intention to purchase a stake of NBC Universal, a television network and content provider, in 2007. The latest example of the convergence between communications and media is the on-going asset fight between Fox, Comcast, and Disney for Sky PLC, a European satellite broadcaster. Moving away from traditional communications and media companies, firms like Alphabet through its Google search engine and YouTube, Facebook through its ever-expanding social media platform, and Netflix through its direct-to-consumer streaming content, have changed the way the world communicates and accesses content. The lines have officially blurred and S&P along with MSCI decided to take action.

What impact will this have on investors?

On September 21, 2018, the Telecommunications Services sector, the smallest sector at a 2% weight in the S&P 500 will quintuple in size to become the fourth largest sector in the index at the expense of the Information Technology and Consumer Discretionary sectors. This change is much larger than GICS’s creation of the Real Estate sector in 2016, which affected approximately 3% of the index’s market cap. Sleepy firms like AT&T, Verizon and CenturyLink will be grouped in the same sector as Alphabet, Facebook, and Netflix, just to name a few. Most notably, a sector classified as 100% value will be primarily growth-oriented.

The composition change is shown in the above chart; the formerly dominant names of AT&T, Verizon, and CenturyLink of the Telecom sector (shown in green) will now occupy a much smaller percentage of the new Communications Services sector, as shown by the considerably smaller blue boxes in the graph.

Luckily, most investment managers select stocks based on their investment merits and not their GICS sector classification. An investment manager that owns Alphabet (Google), which is currently classified as an Information Technology stock, on September 21^st will continue to hold it on September 22^nd. Much like the creation of the Real Estate sector in 2016, there is no action needed on the part of investors. We will continue to monitor new developments as S&P and MSCI finalize the change over the coming months.

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Is Emerging Markets Debt Oversold?

Almost halfway through the year, emerging markets debt (“EMD”) returns are negative for the year, due to a variety of economic and political events. The most commonly cited explanations include the following:

The ongoing Fed rate hikes, including the first two this year in March and June, and also those expected in September and December as well as two more next year;
As discussed in our chart last week, the European Central Bank (“ECB”) will end its quantitative easing program in October;
The ongoing protectionist sentiment among the U.S., China and other countries that may stifle global commerce and potentially, global growth;
Italy’s two populist parties’ inability to initially form a coalition, which stoked fears of Italy’s exit from the EU — but they have since formed a coalition and selected a prime minister;
A truckers’ strike in Brazil that paralyzed many of the country’s major roads;
Turkish President Erdogan’s claim that higher interest rates cause inflation, and finally;
A run on the Argentine peso that exacerbated further downward pressure on the currency, resulting in a $50 billion emergency IMF loan.

The chart above illustrates how spreads have risen, which has led to higher yields and thus losses for EMD strategies so far in 2018. More specifically, the chart shows the spreads for the hard currency sovereign and local currency sovereign indices versus their averages. The hard currency sovereign index tracks bonds issued by emerging markets countries denominated in U.S. dollars or euros. The local currency sovereign index tracks bonds issued by emerging markets countries denominated in the issuer’s local currency, such as the Brazilian real or Malaysian ringgit.

Looking ahead, it could be argued that tightening by both the Fed and the ECB may slow global growth, raise interest rates, and strengthen currencies in both the U.S. and Europe, none of which would be favorable for EMD returns. However, at this point these moves may already be priced into current yields, and the worst of their impact on returns has already been felt. If so, what’s left are “idiosyncratic” headlines, which should theoretically have less of an impact on future returns.

Ultimately, despite the EMD market’s sensitivity to headlines, EM fundamentals remain strong. Leverage among issuers remains low on an absolute basis and is lower than developed market issuers. GDP growth remains high and is higher than developed market issuers. Furthermore, current account balances and inflation rates are generally improving. These strong fundamentals may suggest an impending reversal in the second half of the year for EMD returns.

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The ECB Ends QE

Late last week the European Central bank (ECB) announced an end to its quantitative easing (QE) program. Over the last three years the ECB purchased 2.4 trillion euros in bonds to help boost the region’s economy. In October of this year the monthly bond purchases will be halved to 15B euro and move to zero at the end of the year. The ECB balanced this hawkish move with a commitment to keep interest rates at current levels at least through the summer of 2019. In addition, the ECB will continue to reinvest its proceeds from current bond holdings for “an extended period of time.”

The ECB’s actions signal confidence in the economic recovery and provide a timeline for markets to adjust. Despite the end of QE, policies remain accommodative and low borrowing costs should persist into the near future. The central bank remains ready to step in should the region’s economy need further support, but has taken the first steps towards a more normal monetary policy.

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