Chart of the Week Archives — Page 38 of 76

Equities Close to a Key Resistance Level

This week’s chart looks at price action of the Value Line Geometric Index. Originally launched in 1961, the Value Line Geometric Index provides exposure to North American equities. It is comprised of over 1,600 companies from the NYSE, Nasdaq, Toronto Stock Exchange, and various over-the-counter markets. The index is equally weighted, and thus can provide insight into the health or breadth of the overall equity market relative to more commonly referenced market cap weighted indices. Market cap weighted indices, by design, are disproportionately driven by their larger market cap weighted components. Thus, an examination of equally weighted indices can shed light on trends often missed when focused solely on the actions of market cap weighted indices.

As seen in the chart above, the Value Line index has historically encountered resistance at the $500 price level. The index traded near this key resistance level in 1998, 2007, and 2015. More recently, the index was able to break out above this resistance level beginning in December 2016. Following the 2016 election, the index saw broad market participation as a result of the current administration’s pro-growth narrative and late cycle fiscal stimulus effects. A host of factors contributed to the recent retracement of the index below this $500 level starting in mid-2018 including concerns over rising interest rates, slowing global growth, trade/tariff effects, and various political uncertainties.

From a technical analysis standpoint, if the index can maintain a sustained breakout above this level then this would be a bullish signal for equities. However, a failure to retest and breach this level could signify further downside risk and warrant a cautious stance within equities.

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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.

Did the Fourth Quarter Wake Up a Sleeping Bear?

Like past bull markets, this most recent one since 2009 has had relatively little daily volatility, which we define here as moves greater than two standard deviations from the mean daily return. Specifically, we look at two standard deviations to the downside during a calendar year basis as compared to its historical average over the last few market cycles. This means the S&P 500 would’ve fallen about 2.2% or more in a single day. The last three bull markets are roughly visualized through the valleys in this negative volatility, which is indicative of the smooth ride up investors have had.

Not surprisingly, the majority of total positive and negative two standard deviation moves have been on the negative side at about 60% of the time since 1990, or in days, about seven trading days per year. In 2018, investors experienced significantly more downside volatility than in recent years; however, within the context of bear market years, this move is not so bad. While this is an interesting story from the data, ultimately macroeconomic and geopolitical developments will undoubtedly determine if this bull market has any life left.

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Brexit Contributes to Global Uncertainty

Political instability increased dramatically in 2018 and the Brexit looms as a major contributor to the uncertainty in 2019. The UK is scheduled to leave the European Union (EU) on March 29th, 2019 however there is no current plan in place for the exit. On Tuesday, January 15th, the UK government resoundingly rejected Prime Minister May’s Brexit plan, 432 votes to 202. May had negotiated this agreement with the EU in an attempt to organize an orderly departure.

On Wednesday January 16th, a day after her plan’s defeat, Prime Minister May survived a vote of no confidence, 325 votes to 306. With her leadership role intact, May must develop an exit plan that the UK leadership will pass, and the EU will approve. This must be done with the clock ticking and as we move closer to March 29th, the possibility of a “no deal” Brexit increases. This is an outcome neither the UK nor the EU want, and if this occurs, volatility in equity markets is likely to spike. To avoid this, we may see a vote to delay the exit and should the UK fail to reach an agreement perhaps we may see a second referendum. Ultimately, as is usually the case with these types of issues, markets will welcome any resolution that clears up the uncertainty surrounding the event.

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U.S. Credit Market Health Check

This week’s chart looks at two key indicators of the health of the U.S. credit market. The first, on the left, shows a growing portion of covenant-light (“cov-lite”) bank loans relative to full-covenant bank loans.¹ The second indicator, on the right, shows a growing portion of loan-only bank loan issuers, which remove the benefit of a credit cushion for bank loan investors.² Recent studies by Credit Suisse show that recovery rates for cov-lite issuers are 10-15% worse than non-cov-lite issuers, and recovery rates for loan-only unitranche issuers are 15% worse than non-unitranche issuers. As such, there is some structural deterioration in the bank loan market, but the general consensus is that this should not be a 2019 story, but 2-3 years out. This means that there is not a very high concern of a credit crunch in 2019, but potentially in 2020-2021 if prices get to frothy levels again by then.

That said, defaults remain low, so at least for now, there is no sign of immediate trouble. And spreads have widened out over the last couple of months to be wider than average excluding 2008 and 2009 levels, showing that there has been some release in pressure and the market is perhaps pricing in some of these concerns. Most bank loan strategies are now focused on quality credit selection, avoiding deals with high leverage and unreliable assets or unreliable earnings. That said, as this cycle wears on, we would certainly want to remember that despite their senior secured nature, bank loans are still sub-investment grade debt and should be balanced with a healthy core bond allocation.

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¹ Covenant-light means that the bank loan issuer is subject to few restrictions, also known as covenants, in managing its business. For example, covenants could be maximum leverage (debt divided by cash flows) or minimum coverage (cash flows divided by interest expenses). The rise in cov-lite deals has been a reality since 2005 and they appear to be here to stay. One reason for their rise is due to the standardization and syndication of bank loans as a public security, thereby making them become more like high yield bonds, which have very little covenants, and less like private credit.

² This means that, in the event of bankruptcy, the bank loan investors do not have a high yield, junior subordinated debt tranche beneath them for the losses to eat into after the equity tranche. The bank loan investors will see immediate losses right after the equity tranche in this case.

Nowhere to Hide in 2018

As we enter 2019, we look back on what was a pretty poor year for investors. There was just nowhere to hide in 2018 as a volatile 4th quarter turned all major indices negative. The downward catalyst occurred when Federal Reserve Chair Jerome Powell said interest rates were “a long way” from what he considered neither stimulative nor restrictive.

For the year, the S&P 500 lost 4.4%, the Russell 2000 lost 11%, and emerging markets (as measured by the MSCI EM index) lost 14.6%. These losses came mostly as volatility spiked with the CBOE Volatility Index up 132% in 2018. Strong market fundamentals have largely been overshadowed by fear as global growth concerns, trade, and rising interest rate worries continue to pressure markets. This broad market correction has been historically unusual, but years with broadly poor returns from a majority of indices are typically followed by a positive year as investors find value in market opportunities.

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Equities Continue Their Wild Ride

It has been a wild ride since the equity market peaked on September 20th. Almost three months later, the S&P 500 is down 14.0%, marking the second market correction this year. Corrections occur when the market falls more than 10% from its market peak. Investors have been caught off-guard by this year’s volatility given last year’s slow and steady rise. While we predicted that 2018 would most likely be more eventful than 2017’s record-breaking tranquility, we could not predict to what extent. Year to date, we have seen market movements in excess of 1% in one out of every five days this year, and four of the five largest Dow Jones Industrials Average point drops ever despite strong positive economic data within the United States.

Market pauses occur frequently. Since 1920, the S&P 500 has on average experienced a 5% pullback 3 times a year, a 10% correction once a year, and a 20% bear market decline every 3 years.¹ What’s important is that corrections are merely temporary movements and have little impact on returns over the long-term. Since the bottom of the market in 2009, the S&P 500 has returned over 350% cumulatively and 15% annualized. The chart above shows the S&P 500’s cumulative returns after every correction this market cycle.

Markets are constantly under pressure from external events; recent history includes 2010’s Sovereign Debt Crisis, the 2011 U.S. debt downgrade, and fear of slowing Chinese growth in the winter of 2016. Today, market returns are almost flat since February’s market correction. Returns have eventually rebounded after each correction (including the global Financial Crisis) due to the underlying fundamentals of the economy and not elements of fear.

We acknowledge that while global growth did not meet investors’ expectations in 2018, the United States continues to meet or even exceed expectations. Third quarter GDP came in at 3.5%, unemployment is a low 3.7%, personal income is up, corporate earnings are strong, and inflation is a healthy 2.2%. The fundamental backdrop is still positive for the U.S. and is a stark contrast to the market’s performance quarter-to-date. While the recent volatility can be uncomfortable, waiting for market performance to realign with economic fundamentals can be rewarding over the long-term.

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¹ Fidelity Investments, Viewpoints, November 5, 2018

What Do Higher Rates Mean for Asset Class Returns?

Higher interest rates coupled with signs of a global slowdown and roughly two months of market volatility — including several periods of a selloff — have clouded an otherwise positive picture of the U.S. economy. Despite this, many investors are still worried future increases in interest rates will hinder the economy, given growth in the U.S. and other regions is likely to slow down next year.

An analysis of the performance of different asset classes during U.S. rate hike cycles since the 1990’s suggests the opposite — these cycles were largely positive for investors. In fact, during the most recent hike cycle (Jan-16 to Nov-18), annualized returns for both private and public markets (excluding real estate) were well above their 1-year annualized rates of return before the initial hike began. The orange bars, which illustrate the various asset classes’ 1-year returns before the hike cycle, are well below their annualized returns during the cycle, as depicted by the colored columns. U.S. equities (S&P 500) outperformed other asset classes, gaining almost 12% during this period. U.S. buyout, non-U.S. equities and fixed income gained roughly 6%, 4%, and 1%, respectively. Real estate appears as the outlier with this most recent cycle, but comes on the heels of a considerable run for real estate after the Great Recession.

When looking at 1-year annualized returns after a hike cycle occurred for the prior three rising-rate regimes in 1994, 1999 and 2004, the data paints a similar picture. As illustrated in the graph, annualized returns 1-year after the hike cycle ended (when the effect of an increase/decrease in interest rates will be felt on a wide scale) were on average higher than returns during the cycle. This is depicted by the gray bars (1-year returns after the hike) being on average well above the returns during the hike cycles.

The volatility we have seen thus far in the market is typical for the later stages of an expansion and should not be solely attributed to the Federal Reserve’s tightening policy. It is important to note that interest rate hikes alone will not adversely affect asset class performance, but rather, the economic backdrop of each rate hike cycle will determine the market outcome. Given the uncertainty surrounding the current cycle’s path moving forward, investors should expect continued volatility and watch closely for upward-trending inflation.

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Should Investors Be Concerned About Yield Curve Inversion?

After eight post-recession Fed rate hikes since 2015, the U.S. Treasury yield curve continues to flatten. On Monday, December 3, the yield curve inverted by one basis point between the three-year yield at 2.84% and the five-year yield at 2.83%. The next day, that inversion intensified to two basis points, with the three-year yield at 2.81% and the five-year yield at 2.79%, causing an 800-point correction in the Dow. The bellwether steepness indicator — the difference between the two-year yield and 10-year yield — remains upward sloping, however, but narrowed from 15bp on Monday with the two-year at 2.83% and 10-year at 2.98% to 11bp on Tuesday with the two-year at 2.80% and 10-year at 2.91%.

Based on previous market cycles, an inverted yield curve has predicted a recession six months to two years after inversion. Prior to the 2008 crisis, the first sign of inversion occurred in the 4th quarter of 2005, when the three-year and five-year inverted first, followed by the two- and ten-year inverting in the same quarter, roughly two years before the crisis that began in early 2008. This week’s chart shows the actual yield curve at the end of the day on December 4, along with the predicted yield curve at the end of this year and the next three years based on Treasury forwards. We can see that the market expects the curve to be generally upward sloping for the rest of this year, but to further invert in the front of the curve to the belly, and remain inverted in that region, for the next three years. However, the market still shows the 10s minus 2s to be upward sloping, even in the outer years.

Over the last few quarters, the expectations for the Fed’s hikes declined from one this December plus four more in 2019 to one this December plus only one more in June 2019. With this first sign of inversion, the Fed may pause on a hike for December, but it has communicated the hike so much that it may have to move forward with it or risk a loss of credibility. As 2018 heads to a close, this recent inversion bears watching and will no doubt have an impact on this month’s as well as next year’s capital markets.

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Are Bonds Approaching Moderate Value?

This week’s chart looks at how bonds have fared during the global volatility of the last two months. In summary, bonds have retrenched a bit but have protected principal overall as expected and served as good diversifiers to other asset classes such as equities and alternatives. Spreads have widened moderately and are now showing some value across the board.

The four sections of the chart show the spread versus the average for core bonds, bank loans, high yield bonds and emerging markets debt. The timeframes are from the end of 2008 to today, but the averages are based on the last 20 years excluding 2008 and 2009 as outliers. As we can see, each of the spreads are rising and approaching averages. They are no longer near post-2008 tights anymore. This signifies that there may perhaps be some moderate value in fixed income today.

The fundamentals and the global macro backdrop support a moderate outlook. U.S. and European high yield and leveraged loan default rates remain low. Leverage, coverage, issuance and outstanding amounts do not point to a frothy market. Aggressive issuance is experiencing a shift away from high yield and into bank loans but remains modest overall. As the effect of Trump’s tax cuts continues to be felt through strong corporate earnings and the global tariff escalation continues to evolve, the Federal Reserve has enough optimism about the economy to warrant its continued pace of rate hikes. Collectively, these trends suggest stable if not improving valuation, fundamental and macro factors as we approach the New Year.

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America’s Infrastructure Report Card

Pending a final vote count in Florida, the U.S. midterm election results are in with the Democrats regaining control of the House and Republicans maintaining majority control of the Senate. While a split Congress may lead to gridlock on various policies, one thing both parties should be able to agree on is the need for infrastructure investments in the U.S.

The historical under-investment, coupled with the lack of available public-sector funding, has impaired the government’s ability to deliver public services at adequate levels. The American Society of Civil Engineers (ASCE) estimated that $4.5 trillion needs to be invested through 2025 to upgrade the nation’s infrastructure. In its annual report, the ASCE in 2017 gave an overall “D+” grade for the condition and capacity of infrastructure in the U.S., further highlighting the need for additional investment.

Consequently, governments and public agencies have begun looking beyond the traditional funding methods to private investment in infrastructure via privatizations and public-private partnerships (“PPPs”). As a result, ownership and operation of infrastructure assets has been gradually moving from the public to the private sector on a global level. With this trend, the role of government has shifted from the provider of services to that of a regulator. This has provided a stream of investment opportunities and fueled development of a distinct alternative asset class for institutional investors that complements fixed income, public equities, real estate, and traditional private equity investments, and whose popularity is likely to increase as more investments and hence products come to fruition.

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