Category: Chart of the Week

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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Will 2017 Bring a Surge of IPOs?

Snapchat (SNAP) — which went public in early March — was the first venture-backed technology company to do so in 2017. The firm sold 200 million shares to raise approximately $3.4 billion, making it the largest tech IPO after Alibaba Group in 2014. As private companies like Uber, Airbnb, and Pinterest continue to use private markets to raise capital, how much longer can they wait before turning to the public markets?

This week’s chart shows total global IPOs going back to 2008. Compared to 2015, 2016 saw 32% fewer global companies entering public markets. As accelerated growth continues among private companies, many market participants expect lower corporate taxes and fewer regulations. These potential changes would likely lead to more IPOs in 2017. According to Renaissance Capital, U.S. IPOs were off to a solid start in the first quarter with 25 companies going public and raising $10 billion. If in fact IPOs do pick up globally in 2017, it will become a much stronger year for venture and private equity investment firms. These firms will be able to monetize investments following the IPOs, creating a financial windfall for investors. A broad market sell-off in 2017 could be the only thing standing in the way of a record setting year for IPOs.

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ESG Update: Continued Growth in Supply and Demand

This week’s Chart of the Week is an excerpt from our recently released white paper, Bracing for Impact: How to Prepare for the Next Generation of Defined Contribution Plans.

Both the demand for and supply of ESG investment opportunities have surged over the past several years. This week’s chart depicts the rise in institutional ESG assets. The value of sustainable, responsible and impact investing assets in the United States rose by an unprecedented 116% between 2012 and 2016 according to the Forum of Sustainable and Responsible Investment.

From the demand side, signatories to the Principles for Responsible Investment, a set of investment principles that enable incorporation of ESG considerations into investment practices, grew in combined assets from less than $6 trillion in 2006 to nearly $60 trillion by the end of April 2015. In response, the supply of ESG strategies in the market continues to increase as well, with investment firms offering ESG products in both the traditional and alternative asset classes.

Regulatory changes, new research, and shifting investor demographics have fostered increased interest in ESG investing, and plan sponsors should be prepared to adapt their investment options to accommodate the changing landscape.

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What Will Drive Real Estate Returns in the Coming Years?

Core real estate investments have flourished since the financial crisis. The NCREIF Property Index (NPI), since returning six consecutive double-digit annual returns through 2015, delivered an 8% total return in 2016. Despite lower projected absolute returns compared to what we have experienced over the last six years, real estate remains an attractive investment relative to other asset classes.

This week’s chart illustrates the historical 1-year trailing total returns of the NCREIF Property Index (NPI) going back to 1979 broken down by the three main components of total return: dividend yield, cap rate shift (also known as cap rate compression / expansion), and net operating income (NOI) growth. As seen in the chart, the slowdown in total returns since last peaking in the third quarter of 2015 has been dominated by the cap rate shift effect as cap rates level off at their current historically low levels. NOI growth, on the other hand, has been relatively stable since the slowdown and will be a critical component of future real estate returns going forward as overall fundamentals for the asset class remain strong. Despite lower projected absolute returns, real estate is still an attractive investment relative to other asset classes and should deliver positive returns to investors again in 2017.

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