Category: Chart of the Week

Is It Time to Buy MLPs?

MLPs recorded their second worst year of performance in 2015 (-32.6%), reaching levels not seen since the financial crisis when the Alerian MLP Index fell 36.8% in 2008. Performance in 2015 can be attributed to the following factors…

MLPs recorded their second worst year of performance in 2015 (-32.6%), reaching levels not seen since the financial crisis when the Alerian MLP Index fell 36.8% in 2008. Performance in 2015 can be attributed to the following factors:

  • Increased supply from U.S. shale producers and OPEC members (especially Saudi Arabia) and concerns about weak demand from China led to a sharp drop in oil prices.
  • As energy prices dropped concerns emerged about U.S. oil and natural gas production volumes and the potential impact on MLPs.
  • As MLP prices began to fall, closed-end MLP funds — which use leverage — were forced to sell into a declining market to maintain their leverage ratios.
  • Investors began to worry that lower equity prices and higher costs of debt would force MLPs to cut their distributions in order to conserve cash for future growth funding.

As a result, many wonder if now is an attractive time to purchase MLPs, given the significant price decline in 2015. This week’s chart compares one of the most commonly used metrics to value MLPs, the enterprise value to earnings before interest, tax, depreciation, and amortization (“EV/EBITDA”) relative to the S&P 500. A ratio above (below) the average represents a premium (discount) on MLPs (based on the Alerian MLP Index) compared to the S&P 500. In light of the recent sell-off in the MLP sector, MLPs are now attractively priced with EV/EBITDA multiples trading more than one standard deviation below their long-term average (since June 2006). However, given the uncertainty around future Fed rate hikes combined with persistently low oil prices and negative sentiment across the energy sector, MLPs may experience further volatility in the short term before the market returns to equilibrium. Over the longer term, we expect midstream MLPs to benefit as commodity prices stabilize and volume growth resumes.

Is the U.S. on the Brink of a Recession?

The combination of rising high yield spreads and falling equity markets has led many investors to question if the U.S. is headed for a recession. This week’s chart examines the probability of a recession using the yield curve as a leading indicator of future economic activity.

The combination of rising high yield spreads and falling equity markets has led many investors to question if the U.S. is headed for a recession. This week’s chart examines the probability of a recession using the yield curve as a leading indicator of future economic activity. The Federal Reserve Bank of New York publishes a model that calculates the probability based on the difference (spread) between the 10-year and 3-month Treasury yields. As the spread narrows, the probability of a recession increases. Conversely, as the spread widens, the probability decreases. As the chart shows, this model has historically been a good predictor of future recessions. Based on January’s data there is only a 4.6% chance of a recession twelve months from now. Like all models, there are no guarantees that the predictive power will continue into the future, but this provides investors another tool to formulate future expectations.

Will China’s Changing Workforce Slow its Growth?

Lost among all the chatter about China and its effects on oil prices, global economies, and capital markets is the evolution of its workforce, which can at least partially explain some of the “hard landing” scenarios discussed for the country. More specifically, the slowing growth in China’s working age population is not expected to reverse, and this trend could have a meaningful impact on future growth prospects, both domestically and abroad.

Lost among all the chatter about China and its effects on oil prices, global economies, and capital markets is the evolution of its workforce, which can at least partially explain some of the “hard landing” scenarios discussed for the country. More specifically, the slowing growth in China’s working age population is not expected to reverse, and this trend could have a meaningful impact on future growth prospects, both domestically and abroad. If its workforce is aging and growing at a rate slower than past generations, future economic growth may be muted.

Shown here in the red line is China’s working age population, using the left-hand axis, as it grew from about 800 million in 1990 to about 1 billion today, and its projected decline projected to about 750 million in 2050. We similarly plotted Japan’s working age population, using the right-hand axis, but 20 years earlier, in the blue line. Japan showed a similar trajectory of working age population growth, from about 70 million in 1970 to a peak of about 85 million in 1995, and is projected to drop to 70 million in 2030. In other words, China’s working age population growth and decline pattern are almost identical to that of Japan’s, but only one generation behind.

With Japan’s working age population currently less than its peak in 1995, economic growth has slowed as the non-working age population increasingly lives off of the economic growth generated by the working age population. Japan has had to resort to fiscal stimulus, monetary easing, and structural reforms (Japanese Prime Minister Shinzo Abe’s “Three Arrows” Abenomics policies) to battle this slowdown. If the current trajectory of its workforce continues, China may also have to implement similar measures in the decades to come. While continued technological and production efficiencies as well as a delay in the retirement age may help mitigate this slowdown, it is a dynamic that bears watching in the coming years.

The Implications of a Stronger Dollar on Emerging Market Investments

In 2015, the emerging market equity index declined 14.9%. While there are a variety of explanations for this, one can not underestimate the impact of a stronger dollar. In fact, currency losses were responsible for more than 60% of the decline for U.S.-based investors.

In 2015, the emerging market equity index declined 14.9%. While there are a variety of explanations for this, one can not underestimate the impact of a stronger dollar. In fact, currency losses were responsible for more than 60% of the decline for U.S.-based investors. This week’s chart of the week examines the mechanics of how a stronger dollar can drive losses for emerging market investments.

Typically when U.S. interest rates rise, the dollar strengthens relative to foreign currencies. Investors oftentimes onshore investments during rising rate periods, and as a result, the country as a whole “exports” less dollars. The commodity price declines — especially oil — have been a major contributor to the rise in the U.S. dollar as the U.S. exports fewer dollars per unit. In our chart, we use the quantity of oil imported multiplied by its price as a proxy for the amount of dollars exported each month. During 2014, the United States imported an average of $26 billion a month in oil. During the first ten months of 2015, the U.S. imported an average of $14 billion a month, clearly a large drop and in conjunction with dollar strengthening and emerging market equity declines.

So why do emerging market investments fall? Emerging market economies often depend on dollar-denominated revenues to service debts as well as manage interest rates and exchange rates. If emerging market countries are receiving less dollars from the U.S., they face increased pressures from higher borrowing costs and lower dollar-denominated revenues. In addition, with less revenue, it is more difficult to promote internal growth via exchange rates or interest rate policies. Unfortunately, as U.S. interest rates are poised to rise further in 2016, emerging markets are likely to experience heightened volatility as a result.

Is the Labor Market Approaching Full Employment?

On January 8th, the U.S. Bureau of Labor Statistics released the unemployment rate for December 2015 and additionally on January 12th released the Job Opening and Labor Turnover (JOLT) report for November 2015. This week’s chart focuses on these two reports and the strength of the U.S. labor market as we enter 2016.

On January 8th, the U.S. Bureau of Labor Statistics released the unemployment rate for December 2015 and additionally on January 12th released the Job Opening and Labor Turnover (JOLT) report for November 2015. This week’s chart focuses on these two reports and the strength of the U.S. labor market as we enter 2016. As the chart shows, unemployment has changed little over the past six months, ending at 5.0% for December. Furthermore, the amount of open jobs has also held steady over the same period, ending at approximately 5.4M openings as of November 2015.

The high number of open jobs could very well signal that the currently available workforce is unable to satisfy the requirements of these jobs and the economy is reaching (or already at) full employment. If the labor market is truly at full employment, we would expect to see several new dynamics emerge. First, upward pressure on wages could emerge as employers will have to offer more to potential workers for them to change jobs. Wage growth has been one of the slowest factors in the economic recovery, increasing only 1.55% during the first eleven months of 2015. Another outcome is that the jobs available require specific skills or education, thus meaning those unemployed could pursue such qualifications to obtain one of these open jobs. As job seekers choose to pursue additional training or education, they would likely drop out of the labor force, therefore further depressing the participation rate and potentially decreasing the unemployment rate through the “denominator effect.” A final outcome is that as the New Year starts and firms obtain fresh budgets, they will continue to hire, hence adding additional jobs to the labor market. While these outcomes described are not all-inclusive they do provide some insight into the current outlook for the labor market, and help explain why the Federal Reserve had sufficient confidence in the labor market to initiate the rate hike in December.

Why is Portfolio Diversification Important?

This week’s Chart of the Week shows what is commonly referred to as a “Periodic Table of Investment Returns”. It is a table showing historic calendar year returns for various asset classes ranked in order of performance from best to worst. One of the key takeaways from this table is that 2015 was a particularly challenging year for investment returns.

This week’s Chart of the Week shows what is commonly referred to as a “Periodic Table of Investment Returns.” It is a table showing historic calendar year returns for various asset classes ranked in order of performance from best to worst. One of the key takeaways from this table is that 2015 was a particularly challenging year for investment returns. With the exception of real estate, there were no major asset classes that posted double-digit gains in 2015, and except for emerging market equities, there were no major asset classes that posted double-digit losses for the year. In an environment where most asset classes posted low single-digit returns for the year (either positive or negative), it was extremely difficult for diversified portfolios to achieve their target rates of return in 2015.

The other key takeaway from this table is the importance of diversification within a portfolio. As seen in the table, there has been very little consistency in the best and worst performing asset class from year to year. In fact, since 2007 just about every asset class that was the best performing asset class for a year was also the worst performing asset class for a year during this time frame. Just because an asset class performs well in one year it will not necessarily perform well the next, and just because an asset class performs poorly in one year it will not necessarily perform poorly again the next. This illustrates the importance of adhering to strategic asset allocation targets and rebalancing portfolios back to targets over time.

1Represents YTD return as of 9/30/15.  4Q 2015 returns are not yet available.
2Represents YTD return as of 11/30/15.  December 2015 returns are not yet available.

Asset Class Benchmark
Large Cap Russell 1000
Mid Cap Russell Mid Cap
Small Cap Russell 2000
Core Fixed Barclays US Agg Bond
High Yield Barclays US Corporate High Yield
Bank Loans Credit Suisse Leveraged Loan
Developed Lg Cap MSCI EAFE
Developed Sm Cap MSCI EAFE Small Cap
Emerging Markets MSCI EM
Real Estate NFI
Hedge Funds HFRI FOF: Diversified Index
Private Equity Cambridge All PE

What Happened to High Yield?

The recent sell-off in the U.S. High Yield market has caused concern among investors and many worry that the situation will worsen before improving; this is especially concerning because of its effects on portfolio values before calendar year-end. The Credit Suisse High Yield Index returned -1.08% on Friday December 11th and recorded another down day when the markets reopened on Monday with a return of -1.39%.

The recent sell-off in the U.S. high yield market has caused concern among investors and many worry that the situation will worsen before improving; this is especially concerning because of its effects on portfolio values before calendar year-end. The Credit Suisse High Yield Index returned -1.08% on Friday, December 11th and recorded another down day when the markets reopened on Monday with a return of -1.39%. Through December 14th, high yield has dropped 4.15% for the month and 6.11% for the year. As of December 14th, the yield for the index is 9.42% and the spread is 774bp.

The declines reflect liquidity concerns in the high yield market after the closure of a junk-bond mutual fund. Many investors took advantage of low bond prices after the financial crisis, betting that the U.S. economy would recover. While that thesis proved to be a profitable one, there has been a gradual change in sentiment, with significant outflows in high yield mutual funds over the last three years, including $10.5 billion this year. So what is driving this liquidity concern and subsequent sell-off?

Many would argue that the prolonged period of low oil and other commodity prices are the primary drivers of the sell-off, and are expected to drive default rates higher for the energy portion of the high yield index. As shown in the chart above, energy and metals/minerals constitute roughly 18% of the index. With commodity prices struggling and OPEC not willing to slow production in oil, the fear is that the underlying prices will continue to fall. A further fall in prices — particularly in the energy and metals/minerals industries — will lead to greater revenue losses and a higher likelihood of defaults. Although default rates for the other sectors of the index are expected to remain close to their long-term averages, high yield funds with a significant overweight to the energy and metals/minerals sectors may suffer above average losses over the coming year.

Is It Finally Going to Happen Next Week?

In testimony before the House Financial Services Committee on November 4, Federal Reserve Chairwoman Janet Yellen remarked that a rate hike was still a “live possibility” in December, should economic data remain supportive.

In testimony before the House Financial Services Committee on November 4, Federal Reserve Chairwoman Janet Yellen remarked that a rate hike was still a “live possibility” in December, should economic data remain supportive. Prior to that comment, the market was unsure of any policy change at the Fed’s December meeting, with the Fed Fund’s Futures market implying a  50% probability of a rake hike. After Yellen’s comments, the probability of a hike in December jumped to nearly 70%, and currently sits at 80%, thanks to strong payroll reports over the last two months and further hawkish comments from FOMC members.

Despite this guesswork, Yellen and other members of the FOMC have stressed that the timing of the first rate hike in over nine years is less important that the pace of successive increases. While the futures market hasn’t been an overly reliable predictor of the future path of the Fed Funds rate, it is worth noting that the market appears to accept the Fed’s pledge to enact future increases in a slow and steady manner. Assuming a 0.25% increase on December 16 as a near certainty, the futures market doesn’t imply any meaningful probability of the next increase until the March 2016 meeting, with the most likely landing spot of the Fed Funds rate to be between 0.75% and 1.00% at the end of 2016. While a Fed Funds rate of 1.00% would be a notable shift from the Fed’s post-crisis zero interest rate policy, it would still be seen as highly accommodative in a historical context, and supportive of future economic growth.

How Soon Should We Expect the Next Recession?

What has become known as the Great Recession officially came to an end in June 2009. Since then, GDP has expanded to new real highs, we are approaching full employment, and the U.S. dollar is the strongest it has been in the past decade. Though various issues remain within the economy, overall things seem to be going well.

What has become known as the Great Recession officially came to an end in June 2009. Since then, GDP has expanded to new real highs, we are approaching full employment, and the U.S. dollar is the strongest it has been in the past decade. Though various issues remain within the economy, overall things seem to be going well.

The question on many people’s minds is how long can this last? Currently, we are 78 months out from the trough of the recession. Of the recessions since WWII, on average the period from the end of one recession to the start of the next lasts 58 months, suggesting we may be due. However, the last three recovery/expansion phases lasted longer than this and during the 1990s this period lasted 120 months leading up to the Tech Bubble.

Additionally, recessions do not occur simply with the passage of time; generally, there has to be a catalyst for the drop. Potential current areas of concern include slower wage growth, lower productivity, and the Fed tightening monetary policy.  However, the worst shocks to the economy are often unexpected; very few people predicted the housing crash. At this point though, there don’t seem to be any major red flags. The IMF’s most recent World Economic Outlook predicted only a 16% chance of the U.S. entering a recession through the first half of 2016. Also, with the last recession the worst since the Great Depression, it is plausible that the next crisis could be delayed as a result of people exhibiting more caution as it relates to spending and speculation. Ultimately, it is impossible to accurately predict when a recession will occur, so while the U.S. could enter a recession at anytime, we may still have several more years of expansion ahead of us.

How Much Longer Will Growth Outperform Value?

This week’s Chart of the Week examines the relative performance of growth versus value. The above chart shows the price level of the Russell 3000 Growth index relative to the Russell 3000 Value index. Growth is outperforming value when the line is in an uptrend and value is outperforming growth when the line is trending downward.

This week’s Chart of the Week examines the relative performance of growth versus value. The above chart shows the price level of the Russell 3000 Growth index relative to the Russell 3000 Value index. Growth is outperforming value when the line is in an uptrend and value is outperforming growth when the line is trending downward.

Investors may have noticed the recent outperformance of growth versus value year-to-date across small-, mid-, and large-cap. When viewed over a longer time horizon though, growth has outperformed value for almost ten years. The outperformance of growth prior to the tech bubble was much greater in magnitude; however, the current multi-year period of growth outperformance is the longest since the early 1980s.

One explanation for the current leadership of growth over value may simply be how these indices are constructed. Value indices feature a much larger allocation to the Financial and Energy sectors (representing approximately 43% of the Russell 3000 Value index as of 9/30/2015). When examining performance since the October 2007 market peak, Financials and Energy have lagged other sectors, posting cumulative returns of -20.8% and +3.1%, respectively. Areas such as Technology, Health Care, and Consumer Discretionary are among the best performing sectors since the October 2007 market peak and carry higher weightings within growth indices.

Over the long term, there will be periods when value is in favor and periods when growth is in favor. The duration of the current growth cycle calls into question how much longer growth’s outperformance will persist. Ultimately, it is extremely difficult to predict when the relative performance will shift, and yet another reminder that it is imperative to be diversified across the various size and style boxes of the U.S. equity market.