Author: Marquette Test

High Yield Primary Market Indicative of Credit Cycle

Recent events have raised investors’ concerns about how much runway we have left for a risk-on fixed income portfolio. This week’s chart explores high yield bond issuance ratings and use of proceeds as indicators of where we are in the credit cycle.

Recent events have raised investors’ concerns about how much runway we have left for a risk-on fixed income portfolio. First, the ECB made an unprecedented move towards negative deposit rates for banks to deposit funds with the central bank, thereby incentivizing more lending with the aim of further stimulating Europe’s economy and containing the risk of deflation. Second, while the Fed maintains its dovish stance, swaps indicate that the market anticipates Yellen to raise rates by July 2015. Third, the TXU bankruptcy’s $20 billion in defaulted loans increased the bank loan default rate to 4.64%, but it is expected to drop back to the 1% to 2% average next quarter. Lastly, as of May 2014, 2nd lien bank loans were 4.58% of all bank loans outstanding, which for the first time since the housing bubble is above the long-term average (since January 2004) of 4.51%.

This week’s chart explores high yield bond issuance ratings and use of proceeds as indicators of where we are in the credit cycle.

The lowest quality bonds, CCC-rated, reached a peak of 32.9% as a percentage of all high yield issues in 2007, just before the housing bubble burst. For the first quarter of 2014, this figure was only 15.2%, roughly at 2004 levels. This segment of the capital-raising pipeline is very telling because it shows whether there is an atypical amount of the most speculative rated companies accessing capital to meet the demand of investors reaching for yield, which was the case in 2007. Based on the current data, this trend does not appear to be resurfacing.

Another key insight can be gleaned from how the proceeds of newly issued high yield bonds are used. More specifically, the greater the amount of proceeds used for LBOs (as opposed to less risky actions such as refinancing debt or repurchasing equity), the more heated the market. LBOs as a percentage of new high yield issues reached a peak of 33.7% in 2007, just before the housing bubble burst. However, the same data point was only 2.6% for the first quarter of 2014, which equates to 2003 levels.

Collectively, these two metrics peaked before spreads blew out during the 2008 credit crisis and deserve careful observation as the credit rally continues. Fortunately, based on current levels, they indicate that we have perhaps another few years to go before another major market correction.

Commodities Start Positively in 2014

This week’s Chart of the Week examines how the commodities markets have fared since the start of the year. After three years of negative returns driven by relative unattractiveness to equities and fixed income, coupled with declining inflation, commodities began 2014 on a strong foot.

This week’s Chart of the Week examines how the commodities markets have fared since the start of the year. After three years of negative returns driven by relative unattractiveness to equities and fixed income, coupled with declining inflation, commodities began 2014 on a strong foot.

Commodities, as measured by the Dow Jones UBS Total Return Commodity Index, enjoyed four months of consecutive gains and, despite May’s pullback, have advanced by 6.4% so far this year. The strongest growth came from the livestock complex, as the DJ UBS Livestock sub-index benefited from improving supply fundamentals and climbed 12.2% in the first five months of the year. Agriculture has also been strong this year with a gain of 11.9%.

Industrial metals have been the weakest area in 2014. The DJ UBS Industrial Metals sub-index increased by only a modest 0.9% through the end of May. China’s economy, no doubt, has had a negative impact on base metals — concerns over slowing growth in the Chinese economy have weighed on the industrial metals complex. Precious metals have fared slightly better this year with a gain of 1.6%.

Although commodities in aggregate remain below their 2010 levels, their upward momentum thus far provides a positive outlook for investors with commodities exposure.

Playing Politics Helps Emerging Market Investors

After a very disappointing year in 2013 emerging market equities got off to a rough start in 2014, underperforming U.S. stocks by 2.2% during the first quarter. However, emerging markets stocks have recently started to show signs of life, up over 5% since the end of March and outperforming U.S. markets. So why the outperformance?

After a very disappointing year in 2013, emerging market equities got off to a rough start in 2014, underperforming U.S. stocks by 2.2% during the first quarter. However, emerging markets stocks have recently started to show signs of life, up over 5% since the end of March and outperforming U.S. markets. This may come as a surprise to some as the economic data out of China has remained weak and there have been only modest improvements in the current account balances of the “fragile five” (Indonesia, India, Turkey, South Africa, and Brazil). So why the outperformance?

While we mostly focus on economic data and the business cycle to inform our understanding of financial markets, it is important to remember that politics can play a role as well, particularly in emerging markets. This week’s chart looks at the impact of two recent political events on financial markets.

First, the blue line on this chart shows the cumulative price performance, on a quarter-to-date (“QTD”) basis, for the Sensex Index, the main stock market index in India. As the chart shows, improved equity market performance has coincided with the recent Indian election in which Narendra Modi and the BJP party recently won a sweeping victory. Mr. Modi has an impressive record of reform and growth from his days as the Chief Minister of Gujarat and has been elected with a mandate to improve economic growth by cutting red tape and loosening restrictive labor markets.

Second, Gazprom (the largest energy company in Russia) shares have rallied recently ahead of Putin’s much anticipated visit to Beijing. This visit culminated on May 23rd with the announcement that Russia had signed a $400 billion, 30-year pact to supply China with natural gas. Gazprom is the largest natural gas producer in Russia and is likely to be the largest direct beneficiary of the agreement.

India represents 7.08% of the MSCI Emerging Markets index and Gazprom represents 1.27% of the MSCI Emerging Markets index and is the sixth-largest holding in the index. As a result, these recent political developments have had a meaningful effect on the performance of emerging market investors’ portfolios and serve as a reminder that political — as well as economic — developments can drive equity market returns.

Tackling Unemployment: Significant Job Growth Still Needed

This week’s Chart of the Week takes a closer look at the current employment situation compared to pre-recession numbers. Recently, the U.S. hit a new high water mark for the number of private sector employees, though the total amount of workers employed is still behind by approximately 900k jobs when compared to its previous high set in November 2007. Considering that over 8.5 million jobs were lost during the recession, with total employment falling at one point to about 138 million, the economy has come a long way.

This week’s Chart of the Week takes a closer look at the current employment situation compared to pre-recession numbers. Recently, the U.S. hit a new high water mark for the number of private sector employees, though the total amount of workers employed is still behind by approximately 900k jobs when compared to its previous high set in November 2007. Considering that over 8.5 million jobs were lost during the recession, with total employment falling at one point to about 138 million, the economy has come a long way.

However, there are two additional factors that should be taken into account when discussing the improvement in employment. The first is population growth. To achieve the same unemployment rate as November 2007 (4.9%), total employment would need to increase by about 2.5 million to 148.1 million. The second, and much larger factor, is the difference in participation rate, which measures the labor force as a percentage of the total population over 16. Prior to the recession, the participation rate was 66%, and it has been steadily declining since then to 62.8%. To look at it another way, the civilian population has grown by almost 14.5 million people but the labor force has only grown by about 1.5 million. All else being equal, if the participation rate today was 66% unemployment would be at 10.8%. At this level, nearly 10 million jobs would need to be added to reach the pre-recession unemployment rate.

There is much debate whether or not this participation rate is the new norm. The decrease has mainly been attributed to students staying in school longer. If this trend reverses as job prospects improve and tuition costs grow, the participation rate, and in turn the unemployment rate, could increase substantially. On the other hand, as more baby boomers leave the workforce to retire, there will be continued downward pressure on the participation rate. Depending on how these factors are viewed, the condition of employment and the economy can vary greatly.

Growing Debt in China

This week’s chart of the week examines the difference in private non-financial sector debt levels as a percentage of GDP for the United States and China. Private non-financial sector includes non-financial corporations (both private-owned and public owned), households and non-profit institutions serving households. Rising debt levels are a concern to any economy, as higher debt as a percentage of GDP is a potential drag on growth.

This week’s chart of the week examines the difference in private non-financial sector debt levels as a percentage of GDP for the United States and China. Private non-financial sector includes non-financial corporations (both private-owned and public-owned), households, and non-profit institutions serving households. Rising debt levels are a concern to any economy, as higher debt as a percentage of GDP is a potential drag on growth.

In the chart above, the most striking development is that China’s debt (as a percentage of GDP) is now higher than the U.S. There are a variety of reasons for this, including deleveraging in the U.S. in the wake of the Great Recession, as well as easy credit coupled with massive infrastructure spending in China. Collectively, these trends have driven the relative debt in China higher than the U.S., which is especially worrisome for future growth prospects in China, and by extension, investments in the country. It is not surprising that investor sentiment has cooled regarding China as of late, and investors will closely watch the growing debt level in the coming years.

Drop in Shadow Inventory of U.S. Housing

In this week’s chart we examine the improving housing market and its outlook in terms of pricing stability as it relates to the number of homes in shadow inventory. To be brief, shadow inventory (courtesy of CoreLogic) represents the number of properties that are seriously delinquent, in foreclosure, and/or held by mortgage servicers that are expected to come to market in the future.

In this week’s chart, we examine the improving housing market and its outlook in terms of pricing stability as it relates to the number of homes in shadow inventory. To be brief, shadow inventory (courtesy of CoreLogic) represents the number of properties that are seriously delinquent, in foreclosure, and/or held by mortgage servicers that are expected to come to market in the future. During the recession, experts feared a second major dip in home prices would result from banks unloading the historically high number of distressed homes on their balance sheets.

Since 2009, the number of houses that comprise the shadow inventory has declined from roughly 3M to around 1.7M, thus approaching pre-recession levels. Homes prices, illustrated by the Case-Shiller Index, have continued to rebound from their 2011 lows. This represents a significant improvement in the housing market and as the shadow inventory continues to decrease the chances of a secondary dip in home prices becomes less likely.

Lower Debt Costs in Eurozone

This week’s chart examines the improving financial conditions in the Eurozone’s peripheral countries. Italy, Spain, and Portugal have recently seen their borrowing costs reach significant lows as investors’ confidence strengthens.

This week’s chart examines the improving financial conditions in the Eurozone’s peripheral countries. Italy, Spain, and Portugal have recently seen their borrowing costs reach significant lows as investors’ confidence strengthens. Italian and Spanish 10-Year bond yields fell to 3.1% in late April, the lowest since 1999 for Italy and 2005 for Spain. After its first regular debt auction since a 2011 bailout, Portugal saw its yields drop to 3.7% marking a new post-2009 low.

More than two years removed from the European debt crisis, investor sentiment has improved as economic growth (though small) has returned to the region with participation from the peripherals. The Eurozone’s purchasing managers composite index (PMI) has been in expansion territory for nine consecutive months and hit a post-crisis high of 54 in April. While the Eurozone certainly remains in a fragile state with only a tepid level of growth, investors are encouraged by the improving conditions as well as the commitment of additional support from the European Central Bank if needed.

Growth of Liquid Alternatives

This week’s chart looks at the recent fund flows and the trailing twelve month (“TTM”) percentage growth rate of liquid alternatives as of March 31, 2014. Over the past decade, private investment managers, traditionally associated with less liquid investments such as hedge funds, private equity, and real estate, have expanded their investment focus towards the creation of liquid alternative products that comply with the 1940 Investment Company Act in order to meet the demands of the rapidly growing defined contribution market.

This week’s chart looks at the recent fund flows and the trailing twelve-month (“TTM”) percentage growth rate of liquid alternatives as of March 31, 2014. Over the past decade, private investment managers, traditionally associated with less liquid investments such as hedge funds, private equity, and real estate, have expanded their investment focus towards the creation of liquid alternative products that comply with the 1940 Investment Company Act in order to meet the demands of the rapidly growing defined contribution market.

Within the open-ended mutual fund universe, liquid alternatives have once again topped all other asset classes with the highest organic growth rate over the TTM period, up 39.5% as of March 31, 2014. Although this growth rate is impressive, liquid alternative assets only represent 1.3% ($149B) of the U.S. mutual fund universe, which has over $11 trillion in assets.

As the trend toward liquid alternatives continues to grow, investors should consider the potential implications and effectiveness of the newly designed strategies. ’40 Act funds must comply with restrictions not required by traditional hedge funds such as leverage limits, short-selling, and liquidity. In addition, the standard 1.5% and 20% hedge fund fee structure has to be adjusted within the ’40 Act universe; currently, the average management fee for liquid alternative funds is around 1.5%. Since the significant rise in the formation of liquid alternative products has taken off within the past few years, investors should be cautious before diving into the space as the next decade will be a testing ground for these strategies as to whether or not they deliver on their performance expectations, in terms of both return and diversification.

Real Earnings Trend Upward

This week’s chart illustrates the year over year real average hourly earnings for all employees-inflation and seasonally adjusted.  Most important in the graph is the recent trend since mid-2012: hourly earnings have been increasing at a rate greater than inflation.  The primary reasons contributing to this are an improving labor force and falling inflation.

This week’s chart illustrates the year over year real average hourly earnings for all employees-inflation and seasonally adjusted.  Most important in the graph is the recent trend since mid-2012: hourly earnings have been increasing at a rate greater than inflation.  The primary reasons contributing to this are an improving labor force and falling inflation.  The U.S. has recovered the bulk of the jobs lost during the recession, and as the unemployment rate continues to decline and we work through some of the slack in labor markets, employers will have to pay higher wages to attract and retain workers.  Assuming the Federal Reserve can adequately control inflation in the future, the trend of improving real hourly earnings should continue.  As earnings continue to increase, GDP should benefit as approximately 68% of GDP is driven by consumer spending.

Note:  Real earnings during the 2008-2009 appear inflated, but this is really the result of the CPI declining precipitously during this time.

Active Share: An Increasingly Relevant Measure

The popularity of passive or indexed investment strategies is as high as ever due to low costs, strong recent performance, and compelling research by the likes of Eugene Fama indicating active management is a losing endeavor in aggregate. Nevertheless, as more assets move to passive strategies from active, skillful active management becomes more attractive assuming market pricing is not perfectly efficient

The popularity of passive or indexed investment strategies is as high as ever due to low costs, strong recent performance, and compelling research by the likes of Eugene Fama indicating active management is a losing endeavor in aggregate. Nevertheless, as more assets move to passive strategies from active, skillful active management becomes more attractive assuming market pricing is not perfectly efficient.

While the average active manager underperforms the market after fees, there are both successful and unsuccessful managers within the herd. The above table includes a sample of the results from a research study titled “Active Share and Mutual Fund Performance” by former Yale and NYU professor Antti Petajisto. The results of the study indicate that a specific subset of active mutual fund managers, specifically those with high Active Share, have exhibited persistent relative outperformance on a net-of-fees basis.

Active Share is a measure of how different a portfolio’s positions are from those of the passive index. The results of Petajisto’s study suggest that, on average, managers with high Active Share (i.e., Concentrated or Stock Picker type) outperform active managers with low to moderate Active Share. In fact, managers with both high Active Share and lower portfolio turnover actually outperformed the passive index net-of-fees by an average of 1.26% per annum with only slightly higher than average tracking error. A reasonable interpretation is that managers can be successful if they take active positions in strong companies and maintain conviction over time in those investments, avoiding excessive turnover. Meanwhile, managers with the lowest Active Share, termed Closet Indexers, persistently underperformed despite having the lowest fees and greatest diversification. This is unsurprising because these managers act mostly like the index but still charge fees reflective of active management. It is notable that large-cap stock strategies are more commonly closet indexers than small-cap strategies, and funds with too many assets under management have operational inability to take high active share.

In summary, there is a place in many portfolios for both active and passive management. The data does not indicate that all managers with high Active Share will outperform. Nevertheless, evaluating a manager’s Active Share in combination with other qualitative and quantitative factors can be very useful. Through due diligence, an independent investment consultant can help investors distinguish active managers who are more likely to exhibit talent and conviction. More importantly, if investors in so-called closet index funds were to move 60% of their money to a high Active Share manager and 40% of their money to a passive strategy, they could achieve the same level of Active Share while decreasing fees and increasing expected alpha. Take caution though: only patient investors who are comfortable with short-term tracking error can expect to realize the benefits of Active Share strategies, a virtue not exhibited by all.