Author: Marquette Test

Labor Market Churn

The Bureau of Labor Statistics (BLS) release of the U.S. unemployment rate each month generates a significant amount of attention; however, this headline number provides only a static view on the health of the labor market. Since reaching a high of 10.1% in October 2009, the unemployment rate is currently 9.2% through June 2011 and remains at elevated levels following the “Great Recession” of 2007-2009.

The Bureau of Labor Statistics (BLS) release of the U.S. unemployment rate each month generates a significant amount of attention; however, this headline number provides only a static view on the health of the labor market. Since reaching a high of 10.1% in October 2009, the unemployment rate is currently 9.2% through June 2011 and remains at elevated levels following the “Great Recession” of 2007-2009.

An alternate method to gauge the health of the labor market involves analyzing the total number of job openings, hires, and separations each month. The BLS refers to this as the Job Openings and Labor Turnover Survey (JOLTS). The JOLTS survey shows the level of activity taking place in the labor market, generally referred to as “churn”. Labor market churn, the movement of workers from one job to another, shows how fluid the job market is with higher levels generally corresponding to a healthier job market. Hires and separations have remained below pre-recession levels and have shown little improvement during the past two years.

It has been estimated that approximately 125K jobs need to be created every month just to keep up with the pace of population growth. In order to bring unemployment down, a significantly higher amount of job growth per month will be needed for a sustained period of time. In May 2011, the number of hires was roughly 12% higher than the low in experienced in October 2009, but remains well below pre-recession levels.

Dispersion of Commodity Returns

For all the press coverage of rising gold and oil prices, commodity prices during the first half of 2011 showed a tremendous degree of dispersion across different sectors. Silver saw the greatest increase in value as it rose by more than 12%, but wheat fell by more than 26%, thus creating a spread between best and worst of almost 40%.

For all the press coverage of rising gold and oil prices, commodity prices during the first half of 2011 showed a tremendous degree of dispersion across different sectors. Silver saw the greatest increase in value as it rose by more than 12%, but wheat fell by more than 26%, thus creating a spread between best and worst of almost 40%. Despite hitting a price of $1,600 / ounce earlier this week, gold rose by less than 6% through the first 6 months of 2011; in fact, only 6 of the 14 commodities on the chart actually increased in price. The main take away from this chart? Commodity investors must have a keen understanding of their underlying exposures, as the large dispersions of individual commodity returns can lead to vastly different results across products and strategies.

Is the Market Expecting a Debt Default?

With the August 2nd deadline fast approaching investors are increasingly wondering whether the U.S. might actually default on its debt obligations. In an effort to gain some insight into what the market is expecting, this chart looks at the pricing of Credit Default Swaps (CDS) on U.S. Government debt over the last year.

With the August 2nd deadline fast approaching investors are increasingly wondering whether the U.S. might actually default on its debt obligations. In an effort to gain some insight into what the market is expecting, this chart looks at the pricing of Credit Default Swaps (CDS) on U.S. Government debt over the last year. CDS only pay off in the event of a default and are often used by bondholders to hedge against the risk that a bond in their portfolios defaults. As a result rising CDS prices offer a good indication that the market expects a higher probability of default. What is most notable is the jump in CDS prices on 1 Year Treasuries, while at the same time, CDS on 5 and 10 Year Treasuries remain largely unchanged. Given the jump in CDS on shorter duration Treasuries the market seems to be indicating that, if there is a default, it is likely to occur in the next year. However, the lack of movement in CDS prices for 5 and 10 Year Treasuries indicates that the markets are assigning little overall risk of a default (because if a default occurred all Treasury bonds would suffer losses so we would expect to see a jump in spreads for CDS of all maturities). Lastly, to put these numbers in perspective, CDS on 5 year Greek debt trades at 2,320, CDS on 5 year French debt trades at 107, and United Kingdom debt trades at 75. So while there is considerable amount of concern over the debt ceiling deadline in Washington, the markets appear to be pricing in little risk of default.

Revival of U.S. Exports?

This chart depicts the ratio of U.S. exports of goods and services over U.S. imports of goods and services going back to 1960. This measure only looks at goods and services and does not factor in income receipts & payments with other nations.

This chart depicts the ratio of U.S. exports of goods and services over U.S. imports of goods and services going back to 1960. This measure only looks at goods and services and does not factor in income receipts & payments with other nations. Until the mid 1970’s the ratio was consistently above 1.0. Over the years, multiple factors, including globalization, demographics, and the U.S. transitioning away from a manufacturing economy into a service-oriented economy have led the U.S. to become a net importer.

The 1Q11 ratio was 0.78, off of a recent high of 0.82 in 2Q09. The lowest number ever recorded was 0.63, set in 4Q05. Throughout time this ratio has been susceptible to prolonged movements, both up and down. Prior to the low set in 2005, the ratio dipped below 0.7 during one other time period: the mid-1980’s. From here, the measure climbed above 0.9 and even approached 1.0. The ratio hovered around 0.9 in the late 1980’s and first half of the 1990’s before its steady decline through 2005. Could the recent dip in the ratio signal a downward trend for the U.S.? Or is there a long-term trend at play similar to the recovery in the ratio that occurred in the late 80’s/early 90’s? Obviously, only time will tell. Factors that can help the U.S. continue to narrow the trade gap include a depreciating U.S. dollar, energy discovery/efficiency at home, and China becoming more of a consumer economy rather than an export-dependent economy.

Will the Debt Ceiling be Raised?

There has been much discussion over the past several months regarding increasing the debt limit. Currently, the Treasury Department projects that the U.S. will exhaust its borrowing authority under the current debt ceiling on August 2, 2011. If politicians cannot come to an agreement in the coming weeks, the government could default on its legal obligations.

The chart above illustrates the debt ceiling and the amount of gross debt as a percentage of GDP. The debt ceiling ($14.3 trillion) is the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. The total debt outstanding is the sum of the debt held by the public and intergovernmental holdings. Total GDP through 1Q11 was approximately $15.0 trillion. The debt to GDP ratio is currently at 95%, a 46% increase from the pre-crisis ratio (65%); the significant increase is an indication of the amount of stimulus enacted to save the financial system from collapse.

There has been much discussion over the past several months regarding increasing the debt limit. Currently, the Treasury Department projects that the U.S. will exhaust its borrowing authority under the current debt ceiling on August 2, 2011. If politicians cannot come to an agreement in the coming weeks, the government could default on its legal obligations.

Much of the debate in recent months is based upon political posturing between democrats and republicans. There have been nearly 100 instances since 1940 that Congress has permanently raised, temporarily extended, or revised the definition of the debt ceiling; debt as a percentage of GDP has averaged approximately 59% over that timeframe. The U.S. debt ceiling reached $1 trillion in 1980 and has risen by a considerable amount since that point. It is worth noting that the last time debt to GDP was over 100% was WWII, but the years after the run up in debt featured a period of sustained economic growth. In theory, the temporary stimulus that has entered the system will allow for increased economic growth going forward so that growth will allow for the percentage of debt to GDP to fall. Growth alone will not solve the overarching problem of debt, though, so policy makers need to work together to ensure fiscal responsibility while fostering economic growth.

Changing Composition of the Barcap Agg?

As many commentators have pointed out, over the past two years the BarCap Aggregate has seen a large increase in its benchmark allocation to treasuries. Since December 2008, treasuries as a percentage of the Agg have grown from 21% to 33%. This highlights a drawback of any bond benchmark based on issuance.

As many commentators have pointed out, over the past two years the BarCap Aggregate has seen a large increase in its benchmark allocation to treasuries. Since December 2008, treasuries as a percentage of the Agg have grown from 21% to 33% (see first image above – click on thumbnail for larger version). This highlights a drawback of any bond benchmark based on issuance. Issuance based benchmarks by their nature drive allocations not based on expected risk and return, but based on the funding needs of underlying issuers. One of the primary drivers of the increase in treasuries as a percentage of the Agg has been the large federal deficits caused by the 2008 recession necessitating higher treasury issuance. Historical and projected deficits are shown in the second image above (click thumbnail for larger version).

The federal deficit picture shows why the Treasury component of the Agg may stabilize, albeit at a higher level. While the Federal budget remains challenged and the political environment uncertain, through GDP growth alone the Federal deficit will decrease from its peak.

A more important concern for investors is how the change in the composition of the Agg affects the risk and return profile of their fixed income portfolios. If treasuries increased in market weighting in the Agg, clearly other sectors decreased in weighting. The change in sector weighting in the Agg for major sectors is shown below:

 

Treasury

Credit

MBS

Agency

Securitized
Chg. In Mkt

11.02%

1.16%

-6.49%

-2.59%

-3.10%

Source: Barcap; changes since December 2008

As treasuries have increased as a percentage of the Agg, MBS, agency bonds, and securitized products (ABS and CMBS) have decreased. This is due to a combination of decreases in issuance, especially for securitized products, and Fed purchases (MBS). Notably, the percentage weight to corporate bonds has remained constant on relatively strong issuance, and the weight to credit as a whole has actually increased.

Over the past 10 years, treasuries have been highly correlated with agencies (0.96) and MBS (0.85), and had a lower correlation with credit (0.62). Returns and standard deviations for the past ten years are shown below:

Return

Stdev
Treasury

5.54%

5.09%
Agency

5.36%

3.68%
MBS

5.81%

2.81%
Credit

6.48%

5.85%
If these relative trends continue, and the sector allocation of the Agg continues to have a higher percentage of treasuries passive investors in the Agg will likely not see much difference in expected future returns. However, passive investors will likely see an increase in future volatility, as the standard deviation of treasuries has been much higher than the standard deviation for agencies and MBS. Investors in active core fixed managers are unlikely to experience changes in expectations due to the changing composition of the Agg, as active managers are often perpetually underweight treasuries.

Quantitative Easing and the U.S. Stock Market

In an attempt to stimulate economic growth, the Federal Reserve (the “Fed”) has used multiple monetary policy tools in the past few years: reducing short-term interest rates to virtually zero, introducing numerous facilities to stabilize specific areas of the market, and implementing quantitative easing (“QE”) programs.

In an attempt to stimulate economic growth, the Federal Reserve (the “Fed”) has used multiple monetary policy tools in the past few years: reducing short-term interest rates to virtually zero, introducing numerous facilities to stabilize specific areas of the market, and implementing quantitative easing (“QE”) programs. Announced in late 2008, the first round of quantitative easing (“QE1”) involved the purchase of $100 billion of government sponsored entity obligations and $500 billion of mortgage backed securities. After its effectiveness was reconsidered, QE1 was expanded in March 2009 with the Fed purchasing $1.25 trillion in mortgage backed securities and up to $300 billion of longer term Treasury securities. This massive increase in the Fed’s balance sheet is evident in the chart above, which depicts the securities held outright by the Fed – along with movement of the S&P 500 Index – since 2007. The equity markets rallied more than 50% from the inception of QE1 to its completion; however, once QE1 purchases stopped and the market experienced several troubling issues including riots in Greece and the “Flash Crash” of May 6, 2010, the equity markets experienced a sharp pullback.

In late August 2010, Fed Chairman Ben Bernanke hinted at a second round of quantitative easing (“QE2”) during a speech in Jackson Hole, Wyoming. After the official announcement of an additional $600 billion in longer term Treasury purchases, Chairman Bernanke wrote about QE2 in an op-ed piece for the Washington Post. He noted that QE programs have “eased financial conditions in the past and, so far, look to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action”. He continued, “Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion”. Since the Jackson Hole speech in August 2010, the equity markets rallied nearly 30% through the end of April, 2011.

However, with the culmination of QE2 approaching at the end of June, a recent round of subpar economic news and a decline in the equity markets that erased nearly all of 2011’s year-to-date gains, eyes have turned backed to the Fed to see if additional policy measures will be implemented. During his speech on June 7th, Chairman Bernanke failed to hint of another round of QE as he did in his Jackson Hole speech. Following the speech, several major financial institutions, including Goldman Sachs, JP Morgan, and PIMCO, have stated that the Fed is unlikely to initiate another round of QE, which would leave the markets without ongoing support from the Fed for the second time in nearly three years.

IPO Return Analysis

Last week’s chart addressed the increase in IPOs during 2011. In addition to the number of companies coming to market, the returns of these companies post-offering can also serve as an important metric.

Last week’s chart addressed the increase in IPOs during 2011. In addition to the number of companies coming to market, the returns of these companies post-offering can also serve as an important metric. So far in 2011, stocks that have been public for less than one year, as measured by the Bloomberg IPO index, have returned a positive 4.1%, yet are lagging behind the broad Russell 3000 index which is up 6.7% for the year. While the returns of newly listed companies are often linked to the general direction of the market in which they trade, severe dislocations like the occurrence in 1999 are cause for concern. Although there is some concern about the rapid price increase witnessed for some of the IPOs in 2011, we are still far from the misplaced exuberance of 1999.

Is the IPO Market Back?

As LinkedIn’s highly successful IPO commanded lofty valuations and headlines across the financial press, commentators began drawing parallels to the hot IPO market that preceded the tech collapse at the end of the last decade. Although it has likely been ten years since a new company listing has generated so much buzz, the state of the equity IPO market in the U.S. has a long way to go before reaching the levels seen in the late 1990’s.

As LinkedIn’s highly successful IPO commanded lofty valuations and headlines across the financial press, commentators began drawing parallels to the hot IPO market that preceded the tech collapse at the end of the last decade. Although it has likely been ten years since a new company listing has generated so much buzz, the state of the equity IPO market in the U.S. has a long way to go before reaching the levels seen in the late 1990’s. Through the end of May 2011, 95 new deals came to market raising aggregate proceeds of nearly $30 billion. With a backlog of companies expected to go public in the second half of the year, 2011 is projected to surpass the improved totals recorded in 2010. The offering market has seen a revival since 2008 when only 58 companies went public, but is still a long way from the types of numbers seen in 1999 when 549 companies listed raising over $90 billion.