Category: Chart of the Week

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.

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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.

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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.

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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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How Will Valuation Levels Normalize?

Active U.S. equity managers regularly point out that the stock market looks expensive, and as a result, they are having trouble finding good companies to buy. Our chart this week looks at the median P/E for the S&P 500 Index over the last decade compared to the current P/E (our E is based on trailing twelve months operating earnings). Not only does the broad index look expensive relative to history, but each of the sectors in the index also appears to be overpriced. But how overpriced? The green bars indicate the price correction needed to bring the index back in-line with the historic median P/E ratio. At current valuation levels it would take a full blown bear market (a price correction over 20%) before the market looks reasonably valued again.

However, there is another way for P/E multiples to normalize over time; an increase in earnings without a change in price. The orange bars show the earnings growth needed to bring the index back in-line with historic valuation ratios. While 27% earnings growth for the S&P may seem optimistic, investors should realize that after seven straight quarters of negative earnings growth from 4Q14 to 2Q16, overall index level earnings are growing again. Year-over-year earnings growth hit 21% in 4Q16 and analysts currently expect S&P 500 earnings to be up 22.6% in 2017.

Lastly, astute observers will notice our analysis excludes two S&P sectors. Real Estate is excluded for a lack of historical data, as it just became a stand-alone sector back in 2016. Energy is excluded because energy sector earnings are currently so low the P/E multiple is essentially meaningless. But investors are expecting energy earnings to bounce back in 2017, and play a key role in driving overall S&P 500 index earnings growth.

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The Easter Bunny’s Hopping All The Way To The Bank

The Easter Bunny has a lot to celebrate this holiday as cocoa and sugar prices continue to slump. Both commodities experienced a supply surplus in recent months, largely due to substantial rains during El Niño, which has substantially decreased prices. The Ivory Coast experienced a hearty rainy season and dry winds from Northern Africa were below their historical averages; both trends increased the country’s cocoa yield and led to a 20% reduction in cocoa prices over the past 6 months. Additionally, Brazil benefitted from a very healthy rain season which led to a record production of sugar crops and a global surplus of the commodity. Sugar prices have fallen 18% in the past 6 months.

Americans are anticipated to spend $2.6 billion on Easter candy this season and the Easter Bunny’s haul is a substantial portion of that total which should allow him to increase his margins. Given the uncertainty across the globe, coupled with high equity valuations and the prospect of rising interest rates, we recommend he invest in a diversified portfolio and rebalance as appropriate.

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