Category: Chart of the Week

Should Investors Allocate to EMD in 2017?

Recent events have strengthened the case for Emerging Markets Debt (EMD). Our chart of the week shows how yields for local and hard currency strategies are above their historical averages and are an attractive opportunity as we begin 2017.

Recent events have strengthened the case for Emerging Markets Debt (EMD). Our chart of the week shows how yields for local and hard currency strategies are above their historical averages and are an attractive opportunity as we begin 2017.

The European Central Bank extended stimulus by nine months, albeit at €60 billion per month instead of the original €80 billion per month. Trump’s trade policy proposal is largely isolated to China, and his immigration policy may have a positive effect on Mexico given that its consumer pool and labor force may grow as a result. Lastly, the price of oil is on the rise with the recent OPEC deal, which is a positive for EM oil exporters. All of these facts support an allocation to EMD.

If Trump’s infrastructure policy is enacted we would expect commodity prices to rise, which would be a tailwind for EM commodity exporters. If Trump’s trade policy is adopted, it should be a headwind for EM manufacturers. But overall, EMD fundamentals are attractive. Current accounts of EM countries are stronger and leverage is still low relative to developed market countries. Spreads are at wide levels and yields are high, which provide a cushion for any downside. In total, EMD offers diversification, yield, and upside potential and should contribute to positive returns for investors in 2017.

What Does the Buffett Indicator Tell Us About U.S. Equity Valuations?

As markets continue to reach new all-time highs many investors are wondering how much more runway is left for the current 8-year bull market. While different valuation metrics will tell different stories, it can be helpful to look at what Warren Buffett has dubbed the single best measure of long-term market valuations.

For this week’s chart of the week, we take a look at the “Buffett Indicator” which consists of the Wilshire 5000 index market cap divided by the quarterly nominal GDP of the U.S. economy. As of the third quarter, the reading stood at 121%, just below its two decade high and 45-year two standard deviation average. These readings would suggest that the market is overbought. However, there is no perfect market indicator, so while the Buffett Indicator can be used as a sign of caution to investors who are considering committing further funds to U.S. equities, it should not be relied upon as an exclusive predictor of future market returns. Although the Buffett Indicator suggests that valuation levels are high, positive earnings growth began to emerge in late 2016 and could provide further support for current valuations if companies can deliver on profit projections. These statistics will be watched closely as the year unfolds to gauge the future direction of the U.S. equity market.

Hedge Fund Assets Under Management Continue To March Higher

As the investment community continues to debate the role of hedge funds in the future, one thing is for certain, assets continue to flow into this much debated space. 

As the investment community continues to debate the role of hedge funds in the future, one thing is for certain, assets continue to flow into this much debated space.

The above chart goes back ten years to show the overall growth of assets in hedge funds. As it would be expected, 2008 saw overall assets under management decline following a difficult market environment. Since that timeframe assets have steadily increased year over year, despite high fees and at times disappointing performance. 2016 was no different with a difficult first half as overall returns underperformed the broader market indices, assets still flowed into this space. Hedge funds will still be a sought after asset class for institutional investors as they provide diversification, bond-like volatility, and low correlation to traditional long-only assets. To remain competitive, hedge funds will have to cut management and performance fees to remain attractive to the largest capital allocators.

2016 Asset Allocation Winners and Losers

January is a time to reflect on the past year and assess what went right and what went wrong, and asset allocation is no different in this regard. Elevated valuations at the start of 2016 did not hold back U.S. equities as they climbed to record highs; small caps were the outright winner with a 21% return. These smaller cap companies received a post-election boost as they were expected to be less affected by the strengthening dollar and potential trade policies enacted by Trump, since they do not typically conduct much international business. The knock-on benefits of a potential lower corporate tax rate also helped propel small-cap equities higher after the election.

January is a time to reflect on the past year and assess what went right and what went wrong, and asset allocation is no different in this regard. Elevated valuations at the start of 2016 did not hold back U.S. equities as they climbed to record highs; small-caps were the outright winner with a 21% return. These smaller-cap companies received a post-election boost as they were expected to be less affected by the strengthening dollar and potential trade policies enacted by Trump, since they do not typically conduct much international business. The knock-on benefits of a potential lower corporate tax rate also helped propel small-cap equities higher after the election.

Internationally, slowing growth concerns were a determinant of performance. The “anti-establishment” sentiment seen in Europe was a major source of uncertainty. Emerging markets were the most appealing in terms of relative valuations, which helped them deliver double-digit returns after three consecutive negative years.

Lastly, fixed income was led by high yield bonds which rallied back from an end-of-year dip in 2015, with lower quality issues leading the way. Long duration bonds were also a top performer within fixed income, as were bank loans. After the Trump victory revived inflation expectations, TIPS became a topic of discussion. Realistically, as policies will take time to implement, inflation will manifest slowly and will be only one of a few indicators to monitor.

Of course, 2016 is behind us and investors are at this point more interested in what the markets will bring us in 2017. While predicting market winners and losers each year is a difficult exercise, it is safe to say that we will not see a repeat of 2016 asset class performance, and maintaining a diversified portfolio with disciplined rebalancing will help to mitigate risk no matter what happens across the global markets.

Are Active U.S. Equity Managers Poised for a Rebound Heading into 2017?

This week’s chart of the week highlights the recent change in correlation between the stocks that comprise the S&P 500 as measured by the CBOE S&P 500 Implied Correlation Index. On November 18, 2016 correlation among stocks fell to a post-recessionary low of 26.5 compared to an average reading of 59.8.

This week’s chart of the week highlights the recent change in correlation between the stocks that comprise the S&P 500 as measured by the CBOE S&P 500 Implied Correlation Index. On November 18, 2016 correlation among stocks fell to a post-recessionary low of 26.5 compared to an average reading of 59.8.1 A lower measure signals to investors that sectors and styles in the S&P 500 have started to move independently after years of volatility and tighter correlation. This environment should allow active managers to generate alpha, as stock selection plays a key role in outperformance. As this trend continues, managers can focus on bottom-up fundamentals (i.e., company valuations) and less on macro-economic events that could cause dispersion within the asset class. For active managers, dispersion is critical because it allows them more opportunity to select winners and losers and thus outperform the indices against which they are measured. For investors with large allocations to actively managed U.S. equity portfolios, this is good news heading into the New Year.

 

1The Implied Correlation Index measures correlation on a scale of -100 to 100, rather than the mathematical scale which is between -1 and 1.

What Does The Future Hold For Oil?

While the above curves are simple in appearance, they can hold great predictive power for investors. Futures curves are just as they sound: future price speculation on a given day. The red line represents the futures pricing of WTI Crude Oil as of November 28th, just a few days before OPEC members decided to cut output in the hopes of combating oversupply and ultimately raising oil prices. Purchasing futures on oil for delivery in July of 2017 would give the futures owner the right to sell oil at a price of about $50/barrel. This investment strategy is often employed by speculators, hedge funds, and producers. Producers are able to hedge their exposure to oil and buy futures as a pseudo insurance policy as it locks in the price at which they can sell oil at some point in the future.

While the above curves are simple in appearance, they can hold great predictive power for investors. Futures curves are just as they sound: future price speculation on a given day. The red line represents the futures pricing of WTI Crude Oil as of November 28th, just a few days before OPEC members decided to cut output in the hopes of combating oversupply and ultimately raising oil prices. Purchasing futures on oil for delivery in July of 2017 would give the futures owner the right to sell oil at a price of about $50/barrel. This investment strategy is often employed by speculators, hedge funds, and producers. Producers are able to hedge their exposure to oil and buy futures as a pseudo insurance policy as it locks in the price at which they can sell oil at some point in the future.

The blue curve is shifted dramatically upwards because it represents the futures pricing of oil on December 5th, just days after the OPEC meeting. After OPEC members agreed to rein in production, prices rose dramatically: 13% in just 2 days. While this near-term shift upwards makes sense, the inverted portion of the curve tells an additional story. The inversion referenced in the chart suggests a strong producer hedging presence in the market; oil producers wanting to buy futures on oil outnumbered speculators that would take the other end of this bet. To compensate for this disparity, producers will accept a slightly lower price for the security of locking in a sales price now. The enthusiasm with which producers were locking in their future sales price may imply that producers do not believe oil prices will increase a significant amount within the near future. In other words, perhaps they are not incredibly optimistic about the outcome of this OPEC deal.

The deal’s success does face some challenges. Recently, a few African OPEC member countries have actually increased their output as they are not held to the OPEC cut obligations due to extenuating domestic circumstances, meaning other member countries will need to compensate via further reductions. More generally, many did not believe the group could reach an agreement, so that a deal was even reached is an optimistic sign for oil. While the reliability of the member countries is questioned by some, ultimately we will see if the group has been successfully cutting production in the coming months as output data is released. If the cuts are made then we may continue to see the price of oil rise in 2017.

Will Cyclical Outperformance Continue for U.S. Equities?

This week’s chart highlights recent changes in sector leadership across U.S. equities.

The first half of the year was marked by global growth concerns coupled with reduced expectations for further interest rate hikes in 2016. As this sentiment became priced into the market, a flight to perceived safety ensued which helped to fuel the strong performance of defensive sectors. Telecom, Utilities, Real Estate, and Consumer Staples were the main beneficiaries of this trend. Additionally, these sectors tend to offer attractive dividend yields. Strong interest from yield seeking investors, given the current low interest rate environment, helped propel performance and valuations to elevated levels within these sectors.

This week’s chart highlights recent changes in sector leadership across U.S. equities.

The first half of the year was marked by global growth concerns coupled with reduced expectations for further interest rate hikes in 2016. As this sentiment became priced into the market, a flight to perceived safety ensued which helped to fuel the strong performance of defensive sectors. Telecom, Utilities, Real Estate, and Consumer Staples were the main beneficiaries of this trend. Additionally, these sectors tend to offer attractive dividend yields. Strong interest from yield seeking investors, given the current low interest rate environment, helped propel performance and valuations to elevated levels within these sectors.

The third quarter saw signs of improved economic growth in the U.S. along with positive earnings growth for the S&P 500. The third quarter earnings growth followed five consecutive quarters of negative year-over-year growth. Cyclical sectors were the main beneficiary of these growth improvements, and this trend has continued post-election given the pro-growth rhetoric of a Trump administration and the subsequent expectation of higher interest rates in the future.

This performance leadership from cyclical sectors may continue — at least in the near-term — given the headwinds facing defensive sectors (valuations trading at premiums to the broad market and expectations for higher interest rates) as well as the tailwinds for cyclical sectors (valuation levels relative to defensive sectors and higher expected GDP growth).

Why Small-Caps “Trumped” Large-Caps Last Week

The election of Donald Trump last week caught the market by surprise and created a significant amount of volatility and dispersion across the U.S. equity market. One area of note was the huge outperformance of small caps (up 7.7% from November 8 – 11) vs. large caps (up 1.2% November 8 – 11). The Republicans made it a clean sweep Tuesday night, winning the White House and maintaining control of the House of Representatives and the Senate. While there is a lot of policy uncertainty as a result of this election, the market now believes there is a high likelihood of corporate tax reform being passed sometime in 2017. Donald Trump’s plan calls for a reduction of the corporate rate from the current level of 35% (one of the highest rates in the world) to just 15%. Paul Ryan previously put forward a plan for corporate tax reform that would lower the rate to 20%.

The election of Donald Trump last week caught the market by surprise and created a significant amount of volatility and dispersion across the U.S. equity market. One area of note was the huge outperformance of small-caps (up 7.7% from November 8–11) vs. large-caps (up 1.2% November 8–11). The Republicans made it a clean sweep Tuesday night, winning the White House and maintaining control of the House of Representatives and the Senate. While there is a lot of policy uncertainty as a result of this election, the market now believes there is a high likelihood of corporate tax reform being passed some time in 2017. Donald Trump’s plan calls for a reduction of the corporate rate from the current level of 35% (one of the highest rates in the world) to just 15%. Paul Ryan previously put forward a plan for corporate tax reform that would lower the rate to 20%.

While a cut in corporate taxes is likely to benefit all companies, our chart of the week shows that small-cap companies pay a much higher effective rate (i.e., the rate they actually pay after deductions and credits) than their large-cap peers. This is primarily because large multi-national companies generate a significant portion of their earnings in lower tax countries, while small-cap companies tend to be domestically focused, and thus pay very close to the U.S. statutory rate.

If the corporate tax rate is cut to 20%, this will result in a much larger increase in earnings for small-cap companies compared to large-cap firms (shown by the green dots on the graph). Optimism that this increase in earnings from a tax cut will materialize at some point next year is one of the key factors that drove the outperformance of small-caps last week.

Mexican Peso Tumbles in Wake of Election Results

The chart of the week shows the performance of the Mexican Peso from November 8th through the 10th. The Peso served as a barometer of sorts throughout the U.S. Presidential campaign, as Donald Trump had pledged to renegotiate the North American Free Trade Agreement (NAFTA) and stop illegal immigration by building a wall along the U.S./Mexican border.

The chart of the week shows the performance of the Mexican Peso from November 8th through the 10th. The Peso served as a barometer of sorts throughout the U.S. presidential campaign, as Donald Trump had pledged to renegotiate the North American Free Trade Agreement (NAFTA) and stop illegal immigration by building a wall along the U.S./Mexican border. On Election Day, the Peso hit a high of $0.055 (1 Peso can buy 0.055 USD) at 7PM ET and quickly sold off as it became increasingly clear that Hilary Clinton was struggling to win key swing states. The Peso hit a low of $0.048 at 11pm ET as more polling data came through showing Donald Trump was leading and a Clinton victory would be harder to pull off. The Peso bounced slightly higher following a gracious acceptance speech from President-elect Trump but still remains near its lows as details about his NAFTA and wall plans have still not been announced. Trump’s policies regarding NAFTA and immigration will be critical to watch, as the volatility we saw with the Peso this week underscores how Mexican stocks could be materially impacted by changes to current policy. Such movement also reinforces the importance of diversification across countries when investing in global equities.

Public vs. Private Real Estate Investments: Risk and Return

The S&P Dow Jones Indices and MSCI Inc. announced the creation of a new real estate sector, formerly included in the financial sector, within the GICS system which became effective August 31, 2016. The new real estate sector marks the 11th GICS sector and the first time a new sector has been added to the GICS classification since its inception in 1999. The creation of a separate real estate sector recognizes the growth in both size and complexity of the asset class. Real estate, which began as two sub-sectors, has grown over time to now contain a total of 13 sub-sectors.

The S&P Dow Jones Indices and MSCI Inc. announced the creation of a new real estate sector, formerly included in the financial sector, within the GICS system which became effective August 31, 2016. The new real estate sector marks the 11th GICS sector and the first time a new sector has been added to the GICS classification since its inception in 1999. The creation of a separate real estate sector recognizes the growth in both size and complexity of the asset class. Real estate, which began as two sub-sectors, has grown over time to now contain a total of 13 sub-sectors.

These sub-sectors are an area of differentiation when it comes to public REITs vs. private real estate investments.1 Private real estate investments typically fall into one of four main sub-sectors: industrial, retail, office, and multifamily. REITs, on the other hand, often carry significant exposures to “alternative” real estate which includes sub-sectors such as self-storage, hotel, and healthcare. Additionally, the risk and return profiles of the same sub-sectors between public (REITs) and private real estate can vary significantly — particularly from a risk perspective, as measured by standard deviation. The chart above not only shows the annual returns of each REIT sector — note the dispersion of returns between sectors each year as well as the annual volatility of each sub-sector — but the level of standard deviation over the nine years of sub-sector returns in the table. Critically, the private real estate risk (industrial: 6.3%; retail: 5.1%; office: 6.8%; multifamily: 6.6%) is materially lower than the equivalent sub-sectors from REITs (respectively: 44%, 31%, 28%, and 26% (residential)). So while both public and private real estate investments may appear to invest in similar assets, their respective risk profiles can vary significantly.

___________________

1Private real estate is measured by the NCREIF Property Index (“NPI”), a composite of real estate investment performance from a very large pool of individual commercial real estate properties acquired in the private market for investment purposes only.