Category: Chart of the Week

Will the Outperformance of Non-U.S. Equities Continue?

After several years of trailing the S&P 500, international equities are off to a strong start, returning 17.1% year-to-date through July. Is this the start of a longer term trend? This week’s chart examines the historical performance of the S&P 500 and the MSCI EAFE over the last thirty five years.

Since October 1982 the S&P 500 and MSCI EAFE have taken turns as the leader, each embarking on significant bullish runs. Between 2000 and 2007, international equities (7.2%) outperformed domestic stocks (1.4%). Then between 2007 and 2016, the S&P 500 beat the MSCI EAFE by over 7% on an annualized basis. The data shows that long periods of outperformance have been a common occurrence for both indices.

This year international equities have outperformed. They have benefitted from strong economic and earnings momentum, a clearer political landscape, and positive currency returns. All equities are expensive, but non-U.S. equities appear less expensive than their U.S. counterparts. While we cannot predict the future, the improved backdrop and relatively attractive valuations bode well for international equities.

Print PDF

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.

Print PDF

The Re-Price is Right

Bank loans provide investors with many advantages, chief among them a floating rate feature that resets on a quarterly basis, benefiting the investor as interest rates rise. They also offer a senior secured top-of-an-issuer’s-capital-structure positioning, meaning that the bank loan investor has first-in-line access to the issuer’s assets should something go wrong. However, recent market dynamics have produced a phenomenon that cuts into bank loans’ attractiveness: re-pricings. A re-pricing is a renegotiation performed by the bank loan issuer with its bank loan investors. Typically occurring in rising rate periods, the re-pricing lets the bank loan issuer reduce the spread that makes up the total coupon it has to pay under its bank loan agreement. An example representative of several recent re-pricings is shown in this week’s chart.

The chart shows two time periods: one year ago (before re-pricing), on the left, and today (after re-pricing), on the right. One year ago, LIBOR, the base rate, was at 1.0%. The spread was 4.0%, making the total coupon, or yield, 5.0%. After the re-pricing on the right, as LIBOR increased from 1.0% to 1.5%–a direct result of the Federal Reserve’s recent rate hikes–the issuer has successfully renegotiated the spread from 4.0% to 3.5%. The total yield then remains at 5.0%. Bank loan issuers get to re-price only if the price of their bank loan exceeds par value, typically 101, and they can initiate re-pricings only after the non-call period ends, which typically lasts six to twelve months after issuance. High yield bonds, on the other hand, have much longer non-call periods, typically five years.

Currently, we are seeing large amounts of bank loan re-pricings. This is because of strong demand for bank loans, including re-priced bank loans, and a lack of supply in the form of new issuance due to low mergers and acquisitions activity, as the issuance of new bank loans is typically how an acquirer finances a take-over. Investors currently have an appetite for re-priced bank loans that is keeping the total yield after the re-pricing approximately equal to the total yield before the re-pricing. This phenomenon explains why bank loan spreads have remained close to their long term averages, as investors have not completely rushed into bank loans, which would have made spreads much tighter. We continue to recommend bank loans as a short-term and long-term allocation due to their moderate spread level, relatively strong yield (currently averaging 5.0%), and the aforementioned floating rate and senior secured features. As M&A activity picks up, we expect more new bank loan issuance, which would reduce the proportion of re-priced loans in the market, thereby raising overall yields on bank loan investment portfolios.

Print PDF

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.

Print PDF

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.

Print PDF

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.

Print PDF

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.

Print PDF

EM and Max Draw Down

Through the end of May, the MSCI Emerging Markets Index has returned 17.3% year-to-date and 27.4% over the trailing 12-months.  This asset class has benefitted from improvements in the macro-economic environment that took place in 2016: stronger commodity prices, more stable currencies, and a better global economic growth outlook. With this change in backdrop, broad company fundamentals have improved including earnings growth and corporate profitability (as measured by ROE). Markets have taken notice and investor sentiment has shifted, resulting in positive fund flows into the asset class.

With all these good vibes in mind, this week’s chart looks at the annual max drawdown of the MSCI Emerging Markets Index. For every calendar year, even those with very strong returns, the index has experienced a double digit max drawdown. For example, in 2006, the max drawdown was 24%, but the calendar year ended with a 32% gain. Thus far, the max drawdown in 2017 is just 3%. Based on history, investors should not be surprised to see a double digit pullback in EM this year. Even if that occurs, a strong 2017 return is possible, as these types of swings have been par for the course in this asset class.

Print PDF

A Car Wash for Brazil?

Many EMD strategies hold overweight positions to Brazilian sovereign and corporate bonds, in both hard and local currencies.  These overweight positions have rewarded investors over the past year as Brazil led the overall emerging markets debt (EMD) space in spread tightening, helping drive double-digit returns for the asset class.  This was primarily due to renewed optimism after the impeachment of former Brazilian President Dilma Rousseff.

However, the possibility of two presidential impeachments in Brazil within a year has arisen over the last few weeks as news circulated that the Chairman of the world’s largest meat company has taped conversations of new Brazilian President Michel Temer discussing bribes related to Operation Car Wash.  Operation Car Wash involves officials at Petrobras, Brazil’s main semi-public petroleum company, allegedly taking bribes for awarding contracts to construction companies at inflated prices.  Temer denies any wrongdoing.

At least temporarily, this latest controversy threatened to derail the positive momentum from Brazilian bonds.  As shown in this week’s chart, spreads spiked during the news broadcast of Temer’s allegations, but have retreated back to the previous tights of earlier this year as the market is apparently confident that Brazil’s economy can sustain another impeachment or that impeachment is unlikely.  Of course, all EMD asset managers will continue to assess and adjust their positioning based on their interpretations of fundamentals, value and technicals.  In spite of this recent news from Brazil, we recommend maintaining EMD holdings for the time being.

Print PDF

What’s Realistic for GDP?

Though GDP growth varies greatly throughout an economic cycle, the last several decades have seen it slowly decline. One of the many promises made by Trump and other presidential candidates during the election was to restore GDP to its higher levels once again. But even with beneficial policy changes, is it possible to achieve 3%-4% year-over-year growth?

GDP growth essentially comes from two areas: an increase in the number of workers or an improvement in output per worker. Output per worker, or productivity, generally comes from businesses investing in technology and equipment to improve efficiency.  In this week’s chart, we’ve estimated this by taking the difference between growth in GDP and total workers. As the chart shows, productivity gained very little the last several years as most of GDP’s growth came from an improvement in the employment situation. The exception to this came during the financial crisis when employers tried to cut costs and become leaner. It seems after this there has been little room for businesses to become more efficient.

What makes this concerning is that the growth seen in employment is not sustainable. With the unemployment rate at about 4.5%, we are either at or nearing full employment, meaning that any growth in workers has to come from people joining the worker force. However, the opposite is expected over the next 10 years as baby bombers continue to retire. This suggests that productivity will have to improve just to maintain the current growth rate of the economy. While things like tax reform and infrastructure spending should boost growth, it seems unlikely that GDP will return to more historic levels any time soon.

Print PDF