Category: Chart of the Week

EM Growth Leads to Outperformance

After a tough 2015, emerging market (EM) equities have rebounded nicely, returning 16% through the first three quarters of the year. The asset class has benefitted from a change in the macro environment, including the stabilization and strength in commodities and currencies. Not surprisingly, GDP growth – particularly against developed countries – has started to accelerate and is expected to continue on its upward arc (shown by the blue line in the graph above).

After a tough 2015, emerging market (EM) equities have rebounded nicely, returning 16% through the first three quarters of the year. The asset class has benefitted from a change in the macro environment, including the stabilization and strength in commodities and currencies. Not surprisingly, GDP growth — particularly against developed countries — has started to accelerate and is expected to continue on its upward arc (shown by the blue line in the graph above).

The investment case for EM has always centered on growth and diversification. Investors look to capitalize on favorable demographics, urbanization trends, and expansion of the middle class across EM countries. EM equity’s performance versus developed markets (DM) follows closely with the difference in GDP growth between EM and DM. From 2000 to 2009 the differential grew from 1.7% to 6.3%, and outperformance followed. Since 2009 this gap has narrowed significantly, falling to 1.9% in 2015. DM largely outperformed during this time period. Looking forward, however, the IMF estimates the growth differential to widen beginning this year. This has furthered strengthened investor sentiment on the asset class and could be the start of a strong run for emerging market equities.

Is the Recent Spike in LIBOR a Cause for Concern?

This week’s chart of the week looks at the recent spike in the London Inter Bank Offered Rate (LIBOR), which is the rate at which banks charge one another for short term loans. As the chart illustrates, over the past year the 3-month LIBOR rate has increased from 0.32% to 0.88% (an increase of 0.56%), which is the highest rate for 3-month LIBOR since the spring of 2009. While other measures of short term interest rates – such as the Fed Funds Rate (increasing from 0.25% to 0.50%) and 3-month T-Bills (increasing from 0.01% to 0.33%) – have also risen over the past year, the magnitude of the LIBOR increase is significantly larger and warrants further examination.

This week’s chart of the week looks at the recent spike in the London Inter Bank Offered Rate (LIBOR), which is the rate at which banks charge one another for short-term loans. As the chart illustrates, over the past year the 3-month LIBOR rate has increased from 0.32% to 0.88% (an increase of 0.56%), which is the highest rate for 3-month LIBOR since the spring of 2009. While other measures of short term interest rates — such as the Fed Funds Rate (increasing from 0.25% to 0.50%) and 3-month T-Bills (increasing from 0.01% to 0.33%) — have also risen over the past year, the magnitude of the LIBOR increase is significantly larger and warrants further examination.

Over the past few months, both the Fed Funds Rate and T-Bills have remained flat, while LIBOR has continued to increase steadily (increasing from 0.65% on June 30th to 0.88% on September 18th). During this time period, the spread between LIBOR and T-Bills (known as the TED spread) has increased from 0.39% to 0.55%. In fact, the current spread of 0.55% is higher than the 0.42% average TED spread since the year 2000. This is concerning because historically, an increase in the TED spread has indicated stress in the financial markets. The TED spread spiked in mid-2007 when signs of the financial crisis first started to appear, and spiked again in 2008 as the crisis unfolded. Now that the TED spread is increasing again, there is some concern that this may be an early sign of another financial crisis starting to unfold.

In order to put the recent rise in LIBOR (and the corresponding rise in the TED spread) in context, it is important to look at what has driven these rates higher. Unlike the 2007/2008 financial crisis, the recent increase in LIBOR is not a result of distress in the credit markets. In fact, between June 30th and September 18th, high yield credit spreads (a reliable measure of the health of the credit markets) decreased by 1.4%. And unlike the 2007/2008 financial crisis, the recent increase in the TED spread has been relatively small. While the current 0.55% TED spread is slightly greater than the long-term average, it is well below the 4.63% peak we saw during the fourth quarter of 2008. The recent increase in LIBOR appears to be driven primarily by the money market reforms that went into effect on October 14th that require most money market funds to invest exclusively in U.S. government securities. As a result of this new regulation, more than $1 trillion has moved out of “prime” money market funds, which were allowed to invest in short-term corporate bonds and certificates of deposit tied to LIBOR rates, and into “government only” money market funds. It is unclear whether the increase in LIBOR rates and TED spreads are a temporary phenomenon driven by a supply/demand imbalance or if this is a permanent structural change. Either way, this is something that should be monitored closely in the coming months.

The Difficulty of Timing the Stock Market

Since markets hit their 2016 troughs back in February, they have continued to rally and hit new all time highs over the course of this year. With the upcoming election, talks and discussions surrounding a market bubble and looming recession, investors have begun to ask themselves if now is the right time to start lowering their equity market allocations to better position and protect themselves.

Since markets hit their 2016 troughs back in February, they have continued to rally and hit new all-time highs over the course of this year. With the upcoming election, talks and discussions surrounding a market bubble and looming recession, investors have begun to ask themselves if now is the right time to start lowering their equity market allocations to better position and protect themselves.

Of course, reducing equity exposure in anticipation of a market downturn requires close to perfect timing on the front end — reducing equity exposure — and on the back end — renewing equity exposure. The cost of getting this timing wrong can be dramatic, especially if some of the days on the sidelines end up being some of the strongest days of market returns on record — which is especially true on the days coming out of a correction. Our chart above illustrates the dramatic shortfall which can emerge if investors are out of the market on notably high returning days in the market. Clearly, despite the inherent volatility of the stock market, it is better to be fully invested in the market than trying to time the market in anticipation of market corrections and subsequent recoveries.

Note: Returns calculated using daily price returns of the S&P 500 Index over the past 50 years, for the period ending September 30, 2016.

Core vs. Intermediate Government/Credit: Which to Choose?

Our Chart of the Week examines the relative performance of Core and Intermediate Government/Credit fixed income strategies in rising and falling rate environments. The chart shows Core’s annual total return since the 1970s as represented in the blue using the Barclays U.S. Aggregate index. Annual total return of the Barclays Intermediate Government/Credit index is shown in orange. We also include inflation in green, using the CPI’s annual change, and the 10-year Treasury yield in gray. As one can see, Core beat Intermediate Government/Credit and inflation when rates dropped during the 30-year bull run for bonds from the 1980s to today. This is because Core features higher yields and longer duration, the latter of which boosts bond prices when rates drop. But Core lags Intermediate Government/Credit and inflation if rates rise significantly, as we experienced during the 1970s oil crisis. This was again because of Core’s longer duration. In other words, Core’s longer-dated bonds took much longer to be recycled out as rates rose and newer, higher-yielding bonds came to market; as a result, returns lagged.

Our Chart of the Week examines the relative performance of Core and Intermediate Government/Credit fixed income strategies in rising and falling rate environments. The chart shows Core’s annual total return since the 1970s as represented in the blue using the Barclays U.S. Aggregate index. Annual total return of the Barclays Intermediate Government/Credit index is shown in orange. We also include inflation in green, using the CPI’s annual change, and the 10-year Treasury yield in gray. As one can see, Core beat Intermediate Government/Credit and inflation when rates dropped during the 30-year bull run for bonds from the 1980s to today. This is because Core features higher yields and longer duration, the latter of which boosts bond prices when rates drop. But Core lags Intermediate Government/Credit and inflation if rates rise significantly, as we experienced during the 1970s oil crisis. This was again because of Core’s longer duration. In other words, Core’s longer-dated bonds took much longer to be recycled out as rates rose and newer, higher-yielding bonds came to market; as a result, returns lagged.

Going forward, no one knows whether rates will go up or down. We performed projections based on the likely scenario that the Fed hikes 25bp per year for the next three years. We assume a flattening curve and the 10-year Treasury rises 10bp per year. In this scenario, we estimate that Core will beat Intermediate Government/Credit because of its higher yield despite its longer duration. If the economy gets worse, we assume there are no hikes and the 10-year Treasury yield goes to zero in three years. For this case, we estimate that Core will beat Intermediate Government/Credit handily because of both its duration and yield pickup. What it takes for Intermediate Government/Credit to beat Core is extremely strong economic growth or a dramatic inflationary environment where prices of goods skyrocket, during which we assume 0.5% or more of annual increases in the 10-year Treasury yield. Here, Core’s longer duration hurts it more than its higher yield. These estimates do not account for technical market selloffs or buying binges, but show what a perfectly rational market is expected to do.

As a practical takeaway, if investors are deciding between Core vs. Intermediate Government/Credit, this shows that Core is more resilient in the more likely scenarios. On the other hand, if an investor has chosen Intermediate Government/Credit for its lower duration, its performance will be relatively similar to that of Core in all scenarios. Ultimately, both strategies will provide liquidity, diversification, and safety in the event of market stress; relative performance across interest rate environments will not be significant, though core offers a bit higher upside under the most likely interest rate scenario over the next few years.

Manufacturing Industry Looking for Qualified Workers

While this year’s political election has featured much discussion about jobs going overseas, a larger impact on manufacturing employment has come from technology advances. Over the years, manufacturing companies have replaced jobs with computerized equipment to reduce production costs. However, the considerably more complex equipment demands workers with new skill sets to operate these machines. So while such technological advances helped the manufacturing industry reduce the number of required workers yet increase production, many factories are finding it difficult to find employees with the necessary skills to operate and maintain the advanced machinery. This week’s chart takes a look at the number of manufacturing jobs that are going unfilled even with improving employment rates and the steady addition of jobs.

While this year’s political election has featured much discussion about jobs going overseas, a larger impact on manufacturing employment has come from technology advances. Over the years, manufacturing companies have replaced jobs with computerized equipment to reduce production costs. However, the considerably more complex equipment demands workers with new skill sets to operate these machines. So while such technological advances helped the manufacturing industry reduce the number of required workers yet increase production, many factories are finding it difficult to find employees with the necessary skills to operate and maintain the advanced machinery. This week’s chart takes a look at the number of manufacturing jobs that are going unfilled even with improving employment rates and the steady addition of jobs.

The chart above compares the number of people hired for manufacturing jobs versus the number of job openings. Any ratio above 1 indicates that more people are hired in a month than the number of jobs available in the market; this is explained by elevated hiring levels as well as turnover in the industry. Critically, a ratio above 1 also suggests minimal mismatch between worker qualifications and desired skill sets for the open manufacturing jobs. This ratio peaked in late 2009, as companies were aggressively hiring as they emerged from the trough of the recession. Since then, the ratio has steadily decreased and now sits below 1, therefore suggesting a growth in the divide between qualified workers and the required skill sets to fill these new open manufacturing jobs. Broadly speaking, this mismatch poses problems for the economy as these unfilled positions slow production and weigh on growth. While there are no easy solutions, further training and education for potential workers will help fill these roles vital for production output and stronger economic growth.

Growth in Direct Lending

This week’s chart shows the significant growth in direct lending over the last decade, as indicated by the number of funds and amount of capital raised.

Direct lending is defined as a loan made by a private entity to a small – medium size company which generally carries a floating interest rate. The loans have a 3 to 5 year term and are in most cases held to maturity. For some perspective, this space was largely dominated by commercial banks and proprietary trading desks at investment banks leading up to the global financial crisis of 2008 when private lenders had little market share. The landscape has changed since then as banks now face significant regulatory pressure as a result of the Basel III and Dodd-Frank bills, which call for higher risk-based capital charges for non-rated loans and an increase of 25% or more in Tier 1 capital ratios by 2018, making the practice of direct lending an increasingly inefficient use of bank balance sheet capital.

This week’s chart shows the significant growth in direct lending over the last decade, as indicated by the number of funds and amount of capital raised.

Direct lending is defined as a loan made by a private entity to a small–medium size company which generally carries a floating interest rate. The loans have a 3- to 5-year term and are in most cases held to maturity. For some perspective, this space was largely dominated by commercial banks and proprietary trading desks at investment banks leading up to the global financial crisis of 2008 when private lenders had little market share. The landscape has changed since then as banks now face significant regulatory pressure as a result of the Basel III and Dodd-Frank bills, which call for higher risk-based capital charges for non-rated loans and an increase of 25% or more in Tier 1 capital ratios by 2018, making the practice of direct lending an increasingly inefficient use of bank balance sheet capital.

As a result, banks today are virtually inactive in this area and direct lending by private investment managers has emerged as a natural structural replacement. On the demand side, the current low global interest rate environment is fueling increased appetite for this strategy as investors continue to search for yield and diversification in their portfolios.

China Commits to Financing a Green(er) Economy

Earlier this month China and the United States jointly pledged to ratify the Paris climate change agreement, a monumental step for the world’s two largest polluting economies. Executing a dramatic reduction in greenhouse gas (GHG) emissions will require creative financing, and China is looking towards green bonds to support their commitment.

Earlier this month China and the United States jointly pledged to ratify the Paris climate change agreement, a monumental step for the world’s two largest polluting economies. Executing a dramatic reduction in greenhouse gas (GHG) emissions will require creative financing, and China is looking towards green bonds to support their commitment.

Green bonds are financial instruments that raise capital for specific projects with targeted environmental benefits. Apple made headlines in February of this year by issuing the largest green bond from a U.S. corporation. The tech giant sold $1.5 billion in green bonds earmarked for clean energy projects, green buildings, and resource conservation efforts.

Despite the large issuance from Apple, China has surpassed the United States as the largest issuer of green bonds. The country seeks to attract global investors to help finance the Chinese economy’s transition away from polluting industries and towards advanced technology and services.

China approved more than $17.4 billion of sales of green bonds so far this year — over 40% of the market — after issuing its first green bond less than two years ago. However, some of the domestic green bonds being issued do not meet international standards and require additional scrutiny by prospective investors.

For example, some of the Chinese green bonds are tagged to fund clean coal projects. While clean coal might represent environmental progress in pollution-afflicted China, internationally these bonds conflict with the majority of environmentally-friendly investment mandates, as well as the Green Bond Principles, which serve as the gold standard in green bonds.

China is currently responsible for over 20% of GHG emissions, closely trailed by the United States at just under 18%. As both countries seek financial support for their climate change commitments, investors must be wary of products that aren’t as green as they seem.

Look Out For Falling Angels

Over the past year, many bonds from energy and metal/minerals issuers which previously held investment grade ratings were reduced to junk bond status, commonly known as fallen angels. These include Freeport-McMoRan, the largest copper producer in the world and Chesapeake Energy, the second-largest gas producer in the U.S. This week’s chart examines this unprecedented phenomenon. Fallen angels now account for a mind-boggling 42% of the energy and metal/minerals constituents in the Credit Suisse High Yield Index. With this influx of fallen angels, energy and metal/minerals now make up about 21% of the high yield index, up from 15% in February.

Over the past year, many bonds from energy and metal/minerals issuers which previously held investment grade ratings were reduced to junk bond status, commonly known as fallen angels. These include Freeport-McMoRan, the largest copper producer in the world and Chesapeake Energy, the second-largest gas producer in the U.S. This week’s chart examines this unprecedented phenomenon. Fallen angels now account for a mind-boggling 42% of the energy and metal/minerals constituents in the Credit Suisse High Yield Index. With this influx of fallen angels, energy and metal/minerals now make up about 21% of the high yield index, up from 15% in February.

Many investment grade strategies, as well as their institutional investors, have been forced to sell these fallen angels because of investment policy guidelines, temporarily depressing prices and thus presenting cheaper than normal buying opportunities. Furthermore, the shift of bonds from investment grade to high yield has created a unique challenge for the team dynamics of investment managers. Investment grade research analysts are losing issuers to cover since many of them have been downgraded while high yield research analysts are now responsible for covering more issuers. Some investment managers are even transferring investment grade analysts to high yield positions because they are already familiar with the bonds that have become fallen angels.

Marquette recommends that investors maintain their high yield bond allocations. Because of these temporarily depressed prices and the change in name coverage within investment management teams, inefficiencies and opportunities have been created in this cross-over section of the bond market. However, there are risks. We should continue to see an increase in the default rate for high yield energy and metals/minerals issuers. Given lower commodity prices across the globe, while costs have been reduced for pumping oil or mining for metals, the energy and metal/minerals industries have yet to make any significant improvements. Many companies are still filing for bankruptcy, even though oil prices are beginning to slightly rebound. Ultimately, the current opportunities should outweigh these risks, but volatility in the high yield market will likely remain elevated for the foreseeable future.

Low Productivity and Its Impact on Global Growth

Productivity is the change in output per hour worked and serves as a key indicator of real economic growth. Not surprisingly, it is one of the critical macroeconomic variables analyzed by the Fed when deciding whether or not to raise interest rates. Lower levels of productivity can result from economic policy and shocks, changing demographics, and slower gains from technological innovations.

Productivity is the change in output per hour worked and serves as a key indicator of real economic growth. Not surprisingly, it is one of the critical macroeconomic variables analyzed by the Fed when deciding whether or not to raise interest rates. Lower levels of productivity can result from economic policy and shocks, changing demographics, and slower gains from technological innovations.

This week’s chart shows the productivity changes of the three largest developed market currency blocks: the United States, Japan, and the Eurozone. The graph illustrates that all three are currently struggling to produce meaningful productivity gains. In the U.S., output per hour worked has now contracted for three consecutive quarters. Most of the U.S. contraction can be accounted for by lower energy prices, but the more important theme is the lower levels of productivity across the developed world and their likely contribution to stagnating global growth. If this trend continues, it will be serve as yet another headwind for stronger growth across the globe.

Is Higher Debt Among Companies Something to Worry About?

As the Federal Reserve maintains interest rates at all time lows, corporate balance sheets continue to benefit from this accommodative environment, as the low rate environment combined with a bull market has allowed corporations to add leverage to their balance sheets at an alarming rate. With borrowing costs so low, corporations have used this debt to finance stock buybacks, dividend growth, and M&A deals.

As the Federal Reserve maintains interest rates at all time lows, corporate balance sheets continue to benefit from this accommodative environment, as the low rate environment combined with a bull market has allowed corporations to add leverage to their balance sheets at an alarming rate. With borrowing costs so low, corporations have used this debt to finance stock buybacks, dividend growth, and M&A deals.

The growth of net debt among the S&P 500 constituents has hit levels not seen in the past 10 years, rising significantly against EBITDA levels. Thus, corporations’ operational cash flows are not expanding quickly enough to keep pace with their growing debt loads. This type of imbalance in past cycles has led companies to cut back on spending and hiring.

While consumers have deleveraged since the 2008 housing crisis, corporations have taken advantage of the low rates and subsequent cheap financing. If the Federal Reserve begins to raise rates or economic growth continues to slow, corporations could struggle to cover interest payments on their outstanding debt, which would likely translate to subpar returns for both equity and debt investors.