Chart of the Week Archives — Page 39 of 76

Can Hurricanes Drive Inflation Higher?

Given the most recent hurricane to hit the U.S. — Hurricane Florence — our chart of the week examines the impact of U.S. hurricanes on the Consumer Price Index (“CPI”), a common measure of inflation. The chart shows the change in CPI over the 5-month period following landfall of each hurricane, as well as the cumulative damage of each storm in billions of dollars. Is it possible that the amount of damage caused by each hurricane, along with the subsequent interruption to economic activity could push prices higher as supply chains are disrupted?

Overall, the chart above shows that as impactful from a humanitarian sense these storms are, they really don’t have a meaningful impact on inflation. In most cases, inflation (as measured by the change in CPI) actually contracts in the months following a hurricane, but for all the storms shown here, inflation is positive 5 months after landfall. Although the storms become the focal point of news stories for weeks before and following landfall, their damage is small compared to the size of the U.S. economy, and their impact is mostly local as opposed to national. Furthermore, despite the disproportionate amount of media coverage devoted to hurricanes, the changes in CPI are more likely due to other economic factors which affect the U.S. economy more broadly.

So while there is no denying the damage and disruptions that hurricanes can cause, their impact on inflation is immaterial to the overall economy and economic measures.

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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.

“Cash Rich” S&P 500 Companies Accelerating Buybacks in 2018

S&P 500 companies have become “cash rich” as the combination of tax reform and a decade of strong economic growth has resulted in very healthy corporate balance sheets. Accordingly, we have seen the level of cash allocated to corporate stock buybacks steadily increase as corporate leaders continue to have confidence in their companies’ future growth prospects.

During the first half of 2018, the level of S&P 500 planned corporate buybacks has picked up substantially, with announcements exceeding $600 billion through July, which already exceeds the annual levels over the prior decade. Tax reform has significantly improved the profitability of companies, reducing their corporate tax rate from 35% to 21%, with much of that improved cash flow being redeployed into funding business expansions, R&D efforts, acquisitions, and most notably stock buybacks.

However, these numbers are announced buyback approvals and corporations are not always compelled to execute on announced buybacks. If their stock continues higher or growth prospects weaken, they may wait for a more reasonable valuation before executing the buyback. If buybacks are executed prior to growth prospects decelerating and/or a decline of the stock price the capital used on buybacks could prove to have been capital destructive.

It remains unknown how much of these buyback approvals will actually be deployed by S&P 500 companies in today’s high valuation environment. Only time will tell if this corporate buyback activity is well timed or capital destructive.

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Does Shorter Duration Pay Off When Interest Rates Rise?

With the Fed poised to further raise rates this year as well as next, it is insightful to investigate how a bond’s duration can impact its return in a rising interest rate environment. Typically, a bond’s duration is used to gauge its price sensitivity to changes in interest rates. As most investors know, bond prices are inversely related to interest rates; the longer the duration, the greater the sensitivity to interest rate movements. In the event of rising rates, all else equal, a bond with a higher duration will decline more in price.

As a simple illustration of how duration can affect bond prices in times of rising interest rates, we compare the performance of short bonds — measured by the Barclays 1–3 Year Govt/Credit Index — and long bonds — measured by the Barclays Long Govt/Credit Index. At this point, the Federal Reserve is likely to announce two more interest rate hikes in 2018, with each hike expected to be 25 basis points. The respective durations for the two indices used in the analysis are approximately 1.9 and 14.9, respectively. Assuming a parallel shift in the yield curve and keeping other economic variables constant, the index values will decrease by 0.95% (short bonds) and 7.45% (long bonds), given the 0.5% increase in interest rates by the end of 2018. If this is true, does this mean that short duration bonds always outperform long duration bonds when interest rates goes up?

On average, the annualized cumulative return over seven interest rate rising periods since 1976 on the Barclays 1–3 Year Govt/Credit Index is 4.69% and 3.4% for the Barclays Long Govt/Credit Index. The correlation with interest rates is also consistently high for short duration bonds at 87% as opposed to 24% for long duration bonds.

At this point, the numbers suggest that short duration bonds tend to outperform when interest rates rise. However, the last two periods in the chart show the opposite trend — long bonds have actually outperformed their shorter duration counterparts. How so? A primary reason is how the shape of the yield curve changed during the last two interest rate increases, as not all rate increases are parallel shifts of the entire curve. The shifts in the yield curve for the periods 1994–1995 and 1999–2000 were indeed parallel whereas the last two periods featured rises on almost exclusively the short end of the yield curve. Rates were anchored on the long end during these periods due to demand from foreign investors looking for greater yield than offered by their home countries, particularly in Europe and Asia.

Overall, the chart shows that short duration bonds provide a more predictable return when rates rise, however a non-parallel shift in the yield curve can influence their relative performance vs. longer duration bonds. For institutional investors, if nothing else this serves as a reminder that trying to time interest rates and changes to the shape of the yield curve is an utterly difficult task to consistently get right, so investors are best served maintaining and re-balancing their bond allocations as dictated by their investment policy statements.

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Is Either Side Winning the U.S.–China Trade War?

Given everything that’s going on in the markets it is easy to get confused about what’s happening in our trade war with China, especially since the U.S. has engaged several other countries with tariffs, or at least threats of them. For all the back and forth that has occurred, the current situation isn’t overly complicated. So far, the U.S. and China have both implemented a 25% tariff on $50B worth of imports from one another. The U.S. is threatening an additional tariff on $200B worth of Chinese goods, which is now undergoing the mandatory review process. In response, China is planning to retaliate with tariffs on $60B should the U.S. enact this additional tariff. This would put a tariff on nearly all goods exported from the U.S. to China.

This potentially means the U.S. has the upper hand, since if these tariffs are implemented China will be left with little room to escalate things further, at least through traditional means. However, this doesn’t mean things will be resolved quickly or that the U.S. economy won’t feel any pain. In fact, the U.S. has already seen some impact as this week the Trump administration was forced to provide $4.7B in relief from the USDA to help farmers make up some of the losses from the trade conflict. At this point there’s no serious talk about a deal, so while many may be hoping for a quick resolution to the trade dispute things could get worse before they get better.

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Will Rising Rates Damage Real Estate Returns?

Our chart this week examines the historical¹ total returns of the NCREIF Property Index (“NPI”) during times of rising interest rates. As illustrated in the chart, real estate has historically showed little correlation with interest rates indicating changes in interest rates do not immediately translate to asset prices. In fact, the average annual total return during periods of rising rates is 12.3%; typically rising rates are accompanied by stronger economic growth and/or inflation, both which inevitably draw investors to real assets. It is important to keep in mind, however, that private real estate is valued less frequently than its publicly traded (daily valued) counterparts. This is important because changes in private real estate prices will typically lag changes in interest rates as a result of less frequent valuations.

With interest rates expected to rise further, the spread between the 10-Year Treasury and real estate cap rates will continue to shrink, but strong fundamentals – such as rent growth and economic growth – are much more important than movements in the 10-year Treasury. There is no magic number for the 10-year that would trigger a re-pricing of real estate, but some property types are more susceptible to higher rates such as those with longer-term bond-like leases. Going forward, we believe that a mix of strong fundamentals mixed with stable rising rates will translate into moderate, income-driven returns to core real estate in the mid to high single-digit range.

¹Since inception

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Looming Maturity Wall for Emerging Markets Debt

This week’s chart looks at the looming maturity wall for emerging markets debt. The chart shows the amounts coming due for U.S. dollar-denominated emerging markets debt issued by both sovereigns and corporates. The green portion represents publicly traded bonds, while the blue portion represents bank loans.

The table in the top right shows that the total face value of hard currency sovereign bond debt, as represented by the JPMorgan EMBI Global Diversified index, is $539 billion. The total face value of hard currency corporate bond debt, as represented by the JPMorgan CEMBI Broad Diversified index, is $456 billion. “Hard currency” is generally defined as U.S. dollar-denominated.

The 2018 bar represents the amounts maturing for the rest of 2018, a relatively small amount. However, the amounts maturing in the next five years are substantial. As the dollar continues to strengthen relative to emerging market currencies due to the Federal Reserve’s rate hikes, emerging market issuers may find it more difficult to pay the interest and principal — or even refinance their debt. This is because they earn their tax revenue in local currencies but must pay interest and principal in dollars. The trade weighted U.S. dollar broad index, an index of the U.S. dollar versus a basket of foreign currencies, rose 6.9% so far in 2018 and has risen 31.9% since 2011.

We continue to recommend emerging markets debt as a long term strategic asset class, because fundamentals in terms of GDP growth, debt-to-GDP leverage and current account balances are stronger than five, ten and twenty years ago. However, developed central banks such as the Federal Reserve, Europrean Central Bank and Bank of Japan are converging and will eventually tighten together, thereby raising their rates and strengthening their currencies — relative to emerging market rates and currencies. Thus despite the long-term merits of the asset class, given the looming maturity wall and tightening by the world’s major central banks, it will not be surprising to see elevated volatility from EMD in the short-term.

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Tech Sector Bubble?

Our Chart of the Week examines the concentration in market cap over time among the five largest stocks in the S&P 500 relative to the total market cap of the index. With growth outperforming value in the current market cycle, it’s not surprising to see the largest stocks by market cap today populated entirely by growth stocks. The strong performance among FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google/Alphabet) have propelled the weighting of these securities within market cap weighted indices over recent years and caused market participants to question how long this historic run can last and if we are currently in a technology sector bubble. With names such as Facebook and Netflix pulling back earlier in the year and Apple hitting a $1 trillion market cap milestone last week, fears of a technology bubble have only continued.

As of June 2018, the largest five stocks in the S&P 500 occupied 15.9% of the total market cap of the index. This concentration is high relative to the current market cycle, but it is important to note that we are still below the March 2000 high of 18.5%. Additionally, the largest five stocks in the S&P 500 have occupied greater than 20% of the total S&P 500 market cap in prior periods such as during the 1970’s.

The technology sector does trade at a premium to the broader market today. However, the sector generates high return on equity, strong earnings growth, and multiple expansion is not as excessive as during the dot-com peak. While the recent rise in technology stock weighting as a percentage of total market cap warrants monitoring, today’s concentration is not without precedence.

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Is it Value’s Turn?

This week we examine factor performance from the Russell 1000, with a focus on the dynamic between growth and value stocks. For the month of July, value finally pulled ahead of growth as a contributor to performance. This is a shift from recent behavior as growth leads on a trailing 7-year basis. Typically, growth and value have operated in a cyclical relationship so value’s shift from detractor in 2Q to a positive contributor in July could signal a reversal in relative performance between the two styles.

Financials, particularly banks, did well in July by posting strong earnings; these tend to be value stocks and contributed to the relative outperformance. While tech has been a very strong performer year to date, some of the FANG stocks, namely Facebook and Netflix, hit potholes in July. Facebook encountered more trust and brand issues surrounding privacy and Netflix battled disappointing subscriber growth. These specific company pullbacks likely hurt the growth factor.

Growth has outperformed value since 2011 and the rolling 10-year outperformance is at a high point, now bumping up against two standard deviations from its long-term average. This paired with value’s recent edge above growth may indicate that growth’s outperformance versus value could be coming to an end.

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The Impact of Puerto Rico on Hedge Funds

With the first half of 2018 behind us, our chart of the week touches on one of the more profitable positions for distressed credit hedge funds. Funds invested in Puerto Rican debt due to its misunderstood fiscal story, bondholder protections and a better credit situation than many stressed sovereigns. Following the devastation left from Hurricane Maria and President Trump’s comments on wiping out Puerto Rico’s debt, bondholders saw prices plunge in the latter half of 2017. That late year sell-off led to those bond positions contributing the most significant losses to many distressed strategies.

Thus far, 2018 has seen a recovery of Puerto Rican bond prices for hedge funds. The chart above highlights Puerto Rico General Obligation 2035 bonds. Many hedge funds believe the bonds were oversold last year following the hurricane, and recent revisions to Puerto Rico’s fiscal plan now projects greater primary surpluses, which has caused bond prices to rise. Also, Puerto Rico’s recovery from Hurricane Maria is now making progress which has also given comfort to bondholders. Negotiations for other Puerto Rican bonds will continue throughout 2018, with managers expecting to see more volatility during the remainder of the year.

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Do Rising Rates Mean Lower Returns for EM Equities?

Rising rate environments are typically thought to put downward pressure on equity returns. Specifically for emerging market (“EM”) equities, the common perception is that higher interest rates in the United States will drive EM returns lower and investors away from EM securities. However, in looking at the annualized returns of the MSCI Emerging Markets Index over historical periods of rising rates, this may not be the case.

This week’s chart of the week shows the annualized return of the MSCI Emerging Markets Index in rising rate environments and the Fed Funds Rate at the start and end of those periods. Only one of the time periods — January 1994 to February 1995 — was negative, and the average return for the time periods examined is 14%. In the most recent period — from December 2015 through June 2018 — the MSCI Emerging Markets Index has returned over 11% annually. Contrary to common belief, in periods when rates are rising, EM equities seem to perform well.

What explains this performance? For one, economic fundamentals for EM economies have been strong. The annual real growth rate of GDP for developed markets has averaged 1.9% over the past 5 years, while the same measure for emerging markets has averaged 4.9%. The more recent poor EM performance is mostly due to an appreciating dollar, which makes exports from EM countries cheaper to purchase in the U.S. Longer term, however, the data suggests that EM returns could be positive as rates climb higher in the U.S.

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