Author: mgyurcsik

Fueling the Future: The Evolving Economics of Oil

Oil prices may have made headlines on Monday – closing above $50 a barrel for the first time since late May – but the economic outlook for fossil fuels remains uncertain. The International Energy Agency (IEA) reports that global energy investment fell by 12% in 2016, a second year of decline experts attribute to reduced spending on upstream oil and gas investments. Meanwhile, clean energy spending reached 43% of total global energy supply investment in 2016, a record high. While the IEA and large oil companies predict a greater than 10% rise in oil demand by 2040, a recent report by Bloomberg suggests that shifts in the energy economy could dampen such estimates.

This week’s Chart of the Week illustrates the hypothetical effects of technological advances, electric cars, and alternative energy sources on the IEA and oil industry’s demand predictions. Transportation – which alone accounts for about 60% of oil use – has enjoyed technological advances which have led to increasingly efficient engines, less fuel waste, and shorter trips due to better navigation systems. Concurrently, Bloomberg predicts more than 20 million sales of electric cars by 2030 due to shifting consumer preferences and aggressive policies in China, India, and Europe. Lastly, alternative energy sources such as biofuels and natural gas could supplant oil demand as clean energy investments continue to gain traction and popularity. These variables combined could drastically impact the economics of oil over the next several decades.

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Passive’s Influence on U.S. Small-Cap

This week’s chart examines the percentage of active and passive ownership within the large, mid, and small-cap segments of U.S. equities. The longstanding trend of increased investor usage of passive strategies over time has been well documented. Since January 2000, the percentage of passive investments has grown from 15% to represent nearly 47% of total U.S. equity mutual fund and ETF assets through June 2017. While true that the bulk of passive assets are directed towards informationally efficient areas of the market such as U.S. large-cap, the overall percentage of passive ownership within each market cap segment varies.

As seen in the above chart, passive investments comprise a greater percentage of the small-cap segment than those for mid or large-cap. Critics of passive investing argue that these investments have the potential to distort the price discovery mechanism of the market should passive assets become too large a percent of total invested assets. The reason for this being that strong passive flows provide support or pressure to index constituents depending on the direction of asset flow regardless of a company’s fundamentals. Given the higher overall percentage of passive ownership in small-cap, the impact of passive investing is arguably greater in this market cap segment.

The situation is further compounded for active managers in small-cap since approximately one-third of stocks in the Russell 2000 index do not generate earnings. Active managers generally have a quality bias thus tend to underweight companies that exhibit no earnings, have low trading volume, or short operating histories. Strong passive flows provide support to this segment of small-cap that is underrepresented by most active small-cap managers. Active small-cap managers in aggregate have been able to generate greater consistency of value-add over their index than active managers within the mid and large-cap market segments despite the higher percentage of passive assets. The reason for this discrepancy is likely because of informational inefficiencies which remain among small-cap companies. If the strong inflow trend continues in passive products, small-cap managers may experience greater difficulties outperforming their index in the future.

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Growing Bond Market in China

Our chart this week shows the five largest bond markets in the world. We will focus on China and highlight a few reasons why the Chinese bond market is projected to overtake Japan in the next few years.

For starters, up until last year capital controls put in place by the Chinese government were designed to limit foreign investment. As a result of some newly implemented reforms since then, international investors have slowly been allowed direct access to the Chinese domestic bond market. For example, on July 3, 2017 Beijing and Hong Kong opened a trading link which will allow investors based in Hong Kong to trade directly in the Chinese bond market.

Additionally, in March Citigroup announced the inclusion of Chinese onshore bonds in several of its market indices and more recently Bloomberg announced similar plans. Inclusion in multiple market indices will aid in growth while increasing foreign investment.

Finally, new rules recently implemented in China require the country’s 22 provinces to borrow in the local government bond market instead of seeking out bank financing which had previously been the preferred route. This change should also contribute positively to the continued expansion of China’s bond market and will offer greater access to more investors.

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Quantitative vs. Fundamental Strategies: Who Has the Edge?

How do performance trends differ between quantitative and fundamental strategies? This week we explore those differences amongst U.S. large, mid, and small cap equities over the past business cycle.

Quantitative and fundamental strategies first differ in their approach to selecting stocks. Quantitative strategies rely on mathematical models weighing a varying amount of factors while fundamental strategies rely on solid company standing, outlook, and a more human touch through proprietary analyst research.

Within the large cap universe, quantitative funds, on average, were unable to provide much downside protection during the financial crisis. However, over the course of the ensuing bull market these funds were able to outperform the benchmark and eventually their fundamental counterparts. This could perhaps be attributed to quantitative funds having a greater ability to react nimbly to any buy signals generated as a result of massive inflows into the large cap benchmarks in recent years. Strategies within the small cap universe experienced a scenario on the opposite end of the spectrum. Here, quantitative funds were able to offer neither superior upside nor downside protection versus the benchmark; on average these performed worse than the index and over the course of the bull market were unable to outperform enough to recoup those extra losses. As this universe of smaller companies has less analyst coverage, perhaps quantitative strategies struggled to capture enough readily available data from which their models could generate accurate signals. Strategies in the mid cap space exhibit an interesting pattern of their own. Quantitative strategies were able to protect on the downside along with fundamental strategies and were also able to outpace the outperformance of fundamentals.

While these patterns are certainly not guaranteed to persist through the next business cycle, they may offer insight into which universes quantitative strategies have either an advantage or disadvantage, whether it informational or reactionary. As quantitative strategies continually adapt through additions of new factors or tweaks to their models, it will be interesting to see how the two strategy types compare over the next business cycle.

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Will the Yield Curve Invert?

The Chinese yield curve inverted recently. Does this mean that the U.S. yield curve might invert soon? What does inversion mean for investors? Inverted yield curves have been precursors of bad news for the equity market. In the past 20 years, the U.S. yield curve inverted twice, once in 2000 and once in 2006 and the S&P 500 subsequently dropped 48% and 53% following each inversion, respectively. When the yield curve inverts, it usually means that the market is pessimistic about the economy and drives up long bond prices as safe havens, thereby reducing their yields relative to short bond yields, which typically have been driven up by rate hikes.

This week’s chart observes several signals that appear just before the yield curve inverts. First, there are several years of a downward trend in the spread between 10-Year and 2-Year Treasury yields (also known as steepness) and an upward trend in the equity market, as the orange and red arrows show in the chart. Since the last inversion in 2006, we have seen this signal for a while. Second, GDP growth reaches its peak. For the last five years, GDP growth has been stable and at a moderate level, and it is unclear if it has reached a peak or could grow further. Lastly, it takes time for the spread to become negative and the change is not abrupt. Before the inversion, the spread was around 30bps in 2000 and 15bps in 2006. The spread as of May 2017 was around 50bps and still has room to contract.

Overall, there are several signals that suggest that yield curve inversion is coming. However, inversion is unlikely to happen in the near future. The current yield curve is reasonably steep, the market has a positive sentiment about the economy and other economic boosts from the Trump administration may come into play, such as job creation initiatives and tax cuts for businesses and consumers. Yield curve inversion is not yet impending.

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Fed Balance Sheet Normalization

The Federal Reserve recently increased its commentary on how and when to reduce its $4.5 trillion balance sheet, comprised of $2.5 trillion in Treasury bonds and $2 trillion in mortgage-backed securities (MBS). Shown in this week’s chart, that amount grew at a rapid rate from under $1 trillion during the 2008 financial crisis to where it is today. This growth was the result of unprecedented monetary stimulus in the form of large-scale bond-buying to keep the economy afloat by flooding it with cash through the Great Recession.

Recent commentary suggests that the Fed might gradually normalize its balance sheet later this year at an expected rate of $1.5 trillion spread over five years. The minutes released this Wednesday from the latest Federal Open Market Committee meeting show even more clarity on this process: The Fed intends to pre-announce, on a regular basis, caps on the amounts of bonds that it would allow to mature without reinvesting. It would start at very low caps and would then raise these caps on a quarterly basis, depending on how strongly the economy continues to grow. The minutes stated, “Nearly all policymakers expressed a favorable view of this general approach.”

Gradually reducing the Fed’s balance sheet may have a similar effect as hiking rates, which the Fed is expected to continue to do. It may ultimately increase Treasury and MBS yields and put downward pressure on their prices as the Fed reduces its role as a buyer. The market is expected to counter this effect, however, as international demand for Treasury bonds remain strong given the continued low and negative rates in countries such as Germany and Japan. Moreover, the market was able to absorb about $5 trillion of MBS during the housing boom, and is expected to absorb much of the MBS that is not retained in by the Fed. The ultimate effect on interest rates from these two opposing forces is unknown, but at the least they should mostly offset to prevent a rapid increase in interest rates.

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Is It Everything Must Go for the Retail Sector?

The retail sector has been under fire lately as a result of ecommerce trends leading to a large number of retailers filing for bankruptcy or closing stores across the nation. Brick-and-mortar sales are constrained by internet retail, which has increased because of shifting age demographics. Consumers — particularly the millennial generation — increasingly spend their money on experiences rather than goods. Experiential spending — perhaps in an attempt to take the perfect selfie and garner enough likes on social media — is experiencing significant growth.

But it’s not all doom and gloom for the retail sector. While the lower quality B/C malls are struggling to survive in this shifting marketplace (illustrated by vacancy rates in this week’s chart), A-Malls and lifestyle centers are still thriving. In fact, the retail sector represented in the NCREIF Property Index (NPI) was the second best performing sector in the first quarter of 2017 (+1.6%) and also posted a strong 1-year return of 7.6%. Real estate managers that are focused on the A-Malls and lifestyle centers should be well positioned as the trends within e-commerce and experiential spending continue to drive change within the retail sector. The higher quality retailers and locations with easy access in densely populated areas are less easily replaced by online shopping.

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U.S. Domestic Barrel Bulge

This week’s chart chronicles monthly U.S. oil production sourced from the seven major land production zones from January 2011 to April 2017. The price of oil experienced volatility over recent years resulting from macroeconomic factors like OPEC’s pump-at-will strategy and the subsequent supply glut that forced U.S. producers to reduce output. However, following OPEC’s production cut agreement in late 2016, U.S. oil production is on the rise, supported by rig productivity gains in both new and legacy wells as well as reduced capital costs. Gains from legacy wells have been particularly significant in the Eagle Ford and Bakken Regions since 2012, while in the Permian region an almost fourfold increase in new rigs from 2015 to 2017 helped solidify the area as the dominant production region. Overall, net imports of petroleum products as a share of consumption dropped from about 49% in 2010 to about 25% in 2015, showing progress towards a more energy independent U.S.

OPEC’s production cuts and a lower global supply signal positive news for U.S. producers. Khalid Al-Falih, the newly appointed Oil Minister of Saudi Arabia, committed to lengthening the OPEC supply cut on May 7th. “I am rather confident the agreement will be extended into the second half of the year and possibly beyond,” said Al-Falih. Lower breakeven costs and reduced supply from OPEC nations could incentivize U.S. producers to further ramp up production going forward.

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Who’s Buying?

Over the last 15 years, the U.S. Treasury market has grown from $3.3 trillion in 2000 to $14.3 trillion at the end of 2016; certainly the Financial Crisis and subsequent stimulus programs have contributed to this massive growth. Throughout this period, foreign demand has constituted a consistent 40–50% of the market for U.S. Treasuries. However, the demand has shifted over the years, and our chart of the week chronicles the evolution of foreign buyers and sellers of U.S. Treasuries from 2000 through 2016. Perhaps most notable is that in 2015, foreign demand began to wane as China and other emerging market nations began to defend their currencies against appreciation and consequently reallocated away from U.S. debt.

On Monday, former Federal Reserve Chairs Bernanke and Greenspan spoke about the Federal Reserve’s balance sheet and the United States debt market. Bernanke believes the Federal Reserve should aim to reduce its balance sheet from $4.4 trillion to somewhere in the range of $2.3–2.8 trillion. Of the Federal Reserve’s $4.4 trillion in assets, approximately $2.5 trillion are U.S. Treasury Securities. From 2019-2026, $250 billion in Treasury securities will reach maturity each year. These securities will have to be rolled over in addition to any further deficit spending. To avoid this constant debt overhang, the administration is considering “ultra-long-term bonds”, which would push the repayment of this debt to beyond 2049. Ultimately, the declining foreign demand for U.S. Treasuries combined with the Trump Administration’s plans to cut taxes and increase spending could make it difficult for the Federal Reserve to reduce its balance sheet without facing higher yield demands at Treasury auctions.

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Encouraging Trends in Global PMI

Our chart of the week highlights the recent trend of expansionary PMI readings seen across major global economic areas. PMI, also known as the Purchasing Managers’ Index, is a monthly sentiment reading which provides information on current conditions within the manufacturing sector. A reading above 50 indicates that the manufacturing economy is expanding, while a reading below 50 points to contraction in manufacturing. PMI covers activity only within the manufacturing sector, but is considered a leading indicator since contractions in PMI have historically preceded recessions.

As seen in the chart above, an increase in the pace of manufacturing growth has taken place globally since the second half of 2016. Although readings in some regions show a slower short-term rate of change, PMI readings remain well within in the expansionary zone of above 50. Given that we are in one of the longest duration bull markets in history and equity valuations are at the upper end of their historical ranges, it is encouraging to see an improvement such as this in the global economic picture. The recent uptick in manufacturing growth may help to provide an added tailwind for the current economic expansion and bull market.

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