Author: Marquette Test

Foreclosure Trends

There has been much discussion in the media about the improving conditions of the U.S. housing market. As the graph through April 30, 2011 indicates, the rate of new foreclosures is decreasing, the rise in number of significantly delinquent loans has tapered off, and residential construction spending appears to have bottomed out.

There has been much discussion in the media about the improving conditions of the U.S. housing market. As the graph through April 30, 2011 indicates, the rate of new foreclosures is decreasing, the rise in number of significantly delinquent loans has tapered off, and residential construction spending appears to have bottomed out.

Unfortunately, the data does not indicate that all of the U.S. housing market problems are behind us. According to Lender Processing Services, foreclosure inventories on March 31, 2011 reached 8 times historical norms. Additionally, the average days payments were delinquent for properties in foreclosure was 549 compared to 251 in early 2008. As home prices continue to decrease, lenders appear to be showing an increased willingness to modify loans or ignore delinquency in their efforts to spread out the realization of their losses on the sale of foreclosed properties. While this is good news for some delinquent borrowers, it should serve as a reminder of the fragility of the U.S. economy amid the exuberance over strong corporate profits.

The Taylor Rule

The Taylor rule, proposed by John Taylor, is a formula for determining the target Fed Funds rate. In the Taylor Rule, the Fed Funds rate baseline is set to the target nominal rate (target real rate plus target inflation), and then adjusted based on economic conditions. The rule states that the Fed Funds rate should be raised when inflation is higher than target inflation (“Inflation Gap”), and lowered when economic output is lower than potential output (“Output Gap”).

The Taylor rule, proposed by John Taylor, is a formula for determining the target Fed Funds rate. In the Taylor Rule, the Fed Funds rate baseline is set to the target nominal rate (target real rate plus target inflation), and then adjusted based on economic conditions. The rule states that the Fed Funds rate should be raised when inflation is higher than target inflation (“Inflation Gap”), and lowered when economic output is lower than potential output (“Output Gap”). The equation for the Taylor rule is shown below:

Target Fed Funds = Inflation + Target Real Rate + a1(Inflation Gap) + a2(Output Gap)

Though the rule itself is relatively simple, there are many different interpretations of how to implement it. There are of course multiple measures of inflation, and multiple measures of the output gap. In the chart, we use the Core Personal Consumption Expenditures (PCE) deflator, one of the measures favored by the Fed, as our measure of inflation. To measure the output gap, we use the CBO real potential GDP series, a trend line estimate, less actual real GDP.

The other two important components of the Taylor rule are the “weights” placed on the inflation gap and the output gap. These are the terms a1 and a2 in the formula. The larger the weighting, the more the prescribed Fed Funds rate moves in response to changes in inflation and output. In his original formulation, Taylor proposed weights of 0.5 for both inflation and output.

While the Fed does not explicitly follow the Taylor rule, it has proved to be a reasonable approximation of Fed policy. However, the Fed has indicated that it places more “weight” on the output gap than Taylor originally suggested. The graph shows the “original” Taylor rule, as well as an “alternate” Taylor rule with more weight placed on the output gap. In normal times these rules track fairly closely, however, when the output gap is large the alternate rule prescribes a much lower Fed Funds rate than the original rule. This formulation currently suggests a negative Fed Funds rate. Because the Fed Funds rate is up against a zero lower bound, this explains why the Fed engaged in unconventional monetary policy actions such as quantitative easing.

The graph projects out the target Fed Funds rate based on both formulations of the Taylor rule. Real GDP is projected using Bloomberg consensus estimates, and a constant 1.5% inflation rate based on the PCE deflator is assumed. This inflation rate is lower than the 2% target, but higher than the recent reading of 0.9%. Given these assumptions, the alternate rule does not imply an increased Fed Funds rate until 3Q 2012. This is roughly in line with the futures market, which suggests a greater than 50% chance of an increased Fed Funds rate in 2Q 2012.

Finally, this chart is not intended as a forecast, but merely as a template for understanding Fed policy. Any large surprise either to the upside or downside for GDP could impact Fed policy. The more important indicator to watch may be measures of core inflation. The Fed has stated that it favors measures of core inflation (inflation less food and energy), and has described the current commodities led uptick in CPI as “transient.” As long as measures of core inflation remain subdued there is little pressure on the Fed to raise rates until the output gap narrows. Economists should debate why the Fed makes its decisions; investors should only be concerned with how the Fed makes its decisions to determine likely outcomes.

Top Ten Holdings of Domestic and International Equity Indices

This chart illustrates the top ten holdings for the three indices that give investors broad exposure to the U.S. (S&P 500), Non-U.S. Developed Markets (MSCI EAFE) and Emerging Markets (MSCI Emerging Markets). The chart shows the market caps of each of the ten largest companies in the index and are listed from the largest weights (at the bottom) to the smallest weights (at the top).

This chart illustrates the top ten holdings for the three indices that give investors broad exposure to the U.S. (S&P 500), Non-U.S. Developed Markets (MSCI EAFE) and Emerging Markets (MSCI Emerging Markets). The chart shows the market caps of each of the ten largest companies in the index and are listed from the largest weights (at the bottom) to the smallest weights (at the top). Two things stand out. First, investors often believe that by investing in emerging markets they are gaining exposure to smaller companies but, as this chart shows, the largest emerging market firms are multi-national corporations very similar in size and scope to the largest firms in the U.S. Secondly, for both international funds, the relative weights of the companies in the index do not closely match the relative market capitalization of the companies in the index. This is because all of these indices are weighted based on “free float”, which excludes holdings by insiders or other strategic investors. Governments own a significant portion of many of the large multi-national firms in both the MSCI EAFE and MSCI Emerging Markets indices which slightly distorts the weights of these firms in the respective indices.

St. Louis Fed Financial Stress Index

The U.S. economy has strengthened substantially over the past several quarters, and at some point the Fed will have to begin removing excess liquidity and end the special programs it created to support the economy during the crisis. With the Federal Reserve’s second round of quantitative easing (QE2) set to expire in June, there has been much speculation about what will happen once QE2 comes to an end, and when the Fed will begin tightening monetary policy.

In response to the financial crisis and the accompanying recession that began in 2007, the Fed injected massive amounts of liquidity into the U.S. economy and undertook unprecedented actions to help alleviate the stress in the financial markets. The U.S. economy has strengthened substantially over the past several quarters, and at some point the Fed will have to begin removing excess liquidity and end the special programs it created to support the economy during the crisis. With the Federal Reserve’s second round of quantitative easing (QE2) set to expire in June, there has been much speculation about what will happen once QE2 comes to an end, and when the Fed will begin tightening monetary policy.

During periods of economic recovery, the Fed has traditionally used consumer and business spending as well as the level of upward pressure on prices and wages to determine when to begin tightening monetary policy. However, given that the recession the U.S. economy is currently recovering from was largely caused by a financial crisis, the Fed has the added challenge of determining what effect financial market stress will have on the current recovery. In response to this, the Federal Reserve Bank of St. Louis developed the St. Louis Fed Financial Stress Index as a way to measure the overall “stress” in the financial markets. The St. Louis Fed Financial Stress Index combines 18 financial market variables (see table below), each of which captures some aspect of financial stress, into a single index that is compiled on a weekly basis.

This week’s Chart of the Week shows the St. Louis Fed Financial Stress Index from December 31, 1993 through April 15, 2011 (the index was created in December 2009 and was populated with data going back to December 1993). Positive values in the index indicate that financial stress is above the long-term average and negative values indicate that financial stress is below the long-term average. On April 15, 2011 (the most recent date data is available), the St. Louis Fed Financial Stress Index was -0.14, indicating that financial stress is slightly below the long-term average. This is the lowest level the index has reached since October 2007 (i.e. financial market stress is the lowest it has been since October 2007), and the first time the index has posted a negative reading for three consecutive weeks since 2007.

Components of the St. Louis Fed Financial Stress Index:

Interest Rates:
• Effective federal funds rate
• 2-year Treasury
• 10-year Treasury
• 30-year Treasury
• Baa-rated corporate
• Merrill Lynch High-Yield Corporate Master II Index
• Merrill Lynch Asset-Backed Master BBB-rated

Yield Spreads:
• Yield curve: 10-year Treasury minus 3-month Treasury
• Corporate Baa-rated bond minus 10-year Treasury
• Merrill Lynch High-Yield Corporate Master II Index minus 10-year Treasury
• 3-month London Interbank Offering Rate–Overnight Index Swap (LIBOR-OIS) spread
• 3-month Treasury-Eurodollar (TED) spread
• 3-month commercial paper minus 3-month Treasury bill

Other Indicators:
• J.P. Morgan Emerging Markets Bond Index Plus
• Chicago Board Options Exchange Market Volatility Index (VIX)
• Merrill Lynch Bond Market Volatility Index (1-month)
• 10-year nominal Treasury yield minus 10-year Treasury Inflation Protected Security yield (breakeven inflation rate)
• Vanguard Financials Exchange-Traded Fund

Short Duration vs. Core Bonds in a Rising Rate Environment

April 2011 Investment Perspectives

In today’s low rate environment, interest rate risk has emerged as a primary concern for market participants. Given that the Fed has held interest rates near zero for over two years, many investors are worried about the effect of an increase in rates on their portfolios. As interest rates rise, the discounted value of future cash flows to bond investors falls, causing a drop in the price of bond portfolios.

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Dispersion of Funding Ratios for Public Pension Plans

In aggregate, public pensions are approximately 75% funded (down from a high of 103% in 2000), but there is a great degree of dispersion of funding ratios on a state by state basis.

For all the bad press about the state of public pension plans, the chart above shows that not every state’s pension system is poorly funded. In aggregate, public pensions are approximately 75% funded (down from a high of 103% in 2000), but there is a great degree of dispersion of funding ratios on a state by state basis. Certainly, there are problem states, as shown by the bar on the left, with 11% (as a percentage of total public plan assets) funded at less than 60%. On the other hand, an almost equal percentage is fully funded, thus showing that not every state’s pension system is in need of massive contributions.

Existing Home Sales

While the U.S stock market enjoyed an upward trajectory over the past 18 months, the U.S. housing market continues to experience its ups and downs. Enacted in the beginning of 2009, the American Recovery and Reinvestment Act provided a tax credit to home buyers. At the time, U.S home sales were in a freefall, but this credit helped reignite the market.

While the U.S stock market enjoyed an upward trajectory over the past 18 months, the U.S. housing market continues to experience its ups and downs. Enacted in the beginning of 2009, the American Recovery and Reinvestment Act provided a tax credit to home buyers. At the time, U.S home sales were in a freefall, but this credit helped reignite the market. That was a short-lived phenomenon, however. Following the tax credit’s expiration in 2010, home sales dropped precipitously again. Average sales prices have also been on a steady decline since July 2010, and now stand at their lowest level since 2002. Interestingly, cash sales (33% of all existing home sales) reached a record level in February 2011, as homebuyers and investors take advantage of lower prices.

The real estate market continues to show stress in 2011. The most recent February report showed a sharp drop in existing U.S. home sales, which fell well below consensus expectations. The number of previously owned homes on the market rose 3.5% to 3.49 million. That represents nearly 9 months of supply based on the current rate of sales. Coupled with the “shadow” housing inventory of bank-owned and potentially foreclosed homes, that number increases to nearly 5.3 million homes, or over 13 months of supply.

Without the enticement of the housing tax credit and the increasing stock pile of foreclosures and existing homes on the market, the U.S residential real estate will continue to struggle for the foreseeable future.

Construction Unemployment

Although the broad economy has grown steadily since the beginning of 2009, the construction sector remains mired in a state of recession. Construction employment peaked at the end of 2006 as the housing bubble began its collapse. Currently, the unemployment rate of the construction sector stands at 21.8%.

Although the broad economy has grown steadily since the beginning of 2009, the construction sector remains mired in a state of recession. Construction employment peaked at the end of 2006 as the housing bubble began its collapse. Currently, the unemployment rate of the construction sector stands at 21.8%. This is primarily contingent upon the fact that residential construction is at its lowest annual rate since records began in 1959. Unfortunately for the construction sector, there is little indication that residential construction will pick up in the short term. The National Association of Realtors is forecasting that new housing starts will slowly increase from its current annual pace of approximately 500,000 to 900,000 in the second quarter of 2012, which is substantially less than the historical annual average of 1,500,000.

At the current sales pace of existing homes, there is 8.6 months of supply on the market. Most industry analysts consider 6 months a healthy supply of homes. When taking into consideration the shadow inventory of homes (homes in the early stages of foreclosure process not currently listed) the condition is much worse. Additionally, approximately 40% of sales in the past month were either foreclosures or short sales which drive down the median price of existing home and make new homes (new construction) look less attractive from a price point. The road to recovery in the construction sector will be a slow one, but at least there has been some stabilization in the number of construction jobs (5,500,000) since the midpoint of 2010.

Federal Reserve Stock Valuation Model

As investors raise questions surrounding the prospects of both stocks and bonds as we head into the Summer, a useful exercise can be looking at the historical valuation of the two asset classes in relation to one another. A variation of Dr. Ed Yardeni’s Fed’s Stock Valuation Model can be used as a simplistic gauge of the relative valuation between the two asset classes.

As investors raise questions surrounding the prospects of both stocks and bonds as we head into the Summer, a useful exercise can be looking at the historical valuation of the two asset classes in relation to one another. A variation of Dr. Ed Yardeni’s Fed’s Stock Valuation Model can be used as a simplistic gauge of the relative valuation between the two asset classes. Working under the premise that investors must choose to allocate a limited amount of capital between stocks and bonds, the model subtracts the yield to maturity of the 10-Year U.S. Treasury Note from the earnings yield on the S&P 500 Index to develop a spread between the two.

For much of the 1990’s the spread was negative, suggesting that stocks were expensive relative to bonds. Following the burst of the tech bubble that proved stocks were in fact overvalued, the spread turned positive and has remained so ever since. It is thought that when the spread is positive stocks represent a better investment than bonds due to the higher yield. This is not necessarily the case, in an absolute sense, as one must take into account the additional risk equity investors bear. The reasoning that because stocks are inexpensive relative to bonds does not necessarily suggest that stocks are about to experience a period of positive returns. Keeping in mind that this model represents a relative valuation spread between the two assets classes, a positive spread could suggest that both assets classes are overvalued in relation to other investments – stocks just less so than bonds. Thus, while the model cannot pinpoint the overall outlook for either asset class, trends in the magnitude and direction of the spread have proven useful in the past when predicting the relative movement of stocks and bonds.

Charge-Off and Delinquency Rates for Banks

The Fed recently completed its latest stress tests on banks. Based on the results, many banks were given the green light to increase dividend payouts as well as announce share buybacks. With this in mind, our chart of the week looks at the charge off rates and delinquency rates of loans at all commercial banks.

The Fed recently completed its latest stress tests on banks. Based on the results, many banks were given the green light to increase dividend payouts as well as announce share buybacks. With this in mind, our chart of the week looks at the charge off rates and delinquency rates of loans at all commercial banks.

The Federal Reserve calculates these rates based on quarterly reports by all banks. The charge-off rate is defined as the flow of a bank’s net charge-offs during the quarter divided by the average level of loans outstanding. The delinquency rate is the ratio of the dollar amount of a bank’s delinquent loans to the dollar amount of total loans. Loans include real estate, agricultural, commercial & industrial, and consumer.

Prior to the official start of the recession, in the 2nd of quarter 2006, both rates began to increase, serving as a sign of things to come. In 2008, with the financial industry in danger of collapsing, the Fed stepped in and imposed tight restrictions on banks which led to dividends being slashed or all together eliminated. As banks struggled through the crisis, charge-off and delinquency rates climbed through 2009. During the official recession period between the 4th quarter of 2007 and 2nd quarter of 2009, the charge off rate increased by 255% and the delinquency rate increased by 160%. Perhaps as a sign that lending standards have improved and the economy has strengthened, both rates began to fall in 2010 and have been on a consistent decline the last four quarters. However, both rates are still well above pre-recession levels and undoubtedly haunted by continued high unemployment and a struggling housing market.