Category: Chart of the Week

High Yield: Don’t Throw the Babies Out With the Bathwater

This week’s Chart of the Week takes a look at the sell-off over the last month in risk credit as a direct result of global concern over China’s continued slowdown. Our chart shows the high yield bond spreads for each industry since the beginning of the year.

This week’s Chart of the Week takes a look at the sell-off over the last month in risk credit as a direct result of global concern over China’s continued slowdown.  Our chart shows the high yield bond spreads for each industry since the beginning of the year.

Not surprisingly, spreads for energy high yield issuers, shown in the purple, and spreads for metals/minerals high yield issuers, shown in the pink, have widened dramatically. In other words, their prices have depreciated significantly, as there is an inverse relationship between bond prices and their spreads.  This widening of energy and metals/minerals high yield bond spreads was due to the financial markets’ recognition of reduced Chinese demand for energy and metals/minerals.

However, all other sectors from chemicals, shown in the red, to utilities, shown in the orange, have seen their high yield spreads widen out as well. In our opinion, this is akin to throwing “the babies out with the bathwater.” In other words, the widening of spreads in all other industries except for energy and metals/minerals appears to be unjustifiably so.  The last two weeks have seen spread tightening across all industries as news of general stabilization has come out of China and Europe.  However, spreads for all other industries except for energy and metals/minerals remain elevated compared to where they were in the spring, suggesting some good value and opportunities in high yield within these industries.

How Have Capital Market Valuations Evolved Over the Last Year?

This week’s chart shows that current valuations across equity and fixed income markets are lower today compared to where they stood at the end of September last year. The big takeaway here is that equities broadly appear to still be cheaper than bonds.

This week’s chart shows that current valuations across equity and fixed income markets are lower today compared to where they stood at the end of September last year. The big takeaway here is that equities broadly appear to still be cheaper than bonds.

Japanese Government Bonds and German Bunds are some of the most expensive debt instruments currently available to investors. As it relates to the former, the Bank of Japan’s unprecedented stimulus has helped push Japanese Government Bond yields to record lows, and earlier this year, yields on securities with maturities up to five years turned negative for the first time. Looking ahead, the Fed’s willingness to delay an increase in U.S. interest rates should support demand for riskier assets and as a result, fixed income valuations may normalize over time. Compared to last year, the most precipitous drop in valuations has taken place in U.S. High Yield, U.S. Credit and U.S. dollar-denominated Emerging Markets Debt.

As it relates to equities, with the exception of the U.S., South Africa, and Mexico, valuations around other parts of the globe are on the lower end of their historical averages.  Finally, valuations in Canadian, Spanish, and Taiwanese equity markets have come down the most over the past year as these markets have sold off over the near term.

Note: Percentile ranks show valuations of assets versus their historical ranges. Example: If an asset is in the 75th percentile, this means it trades at a valuation equal to or greater than 75% of its history. Valuation percentiles are based on an aggregation of standard valuation measures versus their long-term history.

Has the Fed “Missed the Boat”?

The wait for the Federal Reserve to raise interest rates seems to be endless. Unemployment has fallen below the Fed’s desired level and inflation- when adjusted for the drop in oil prices – is just under target.  At the beginning of this year, many predicted September would be the right time for it to finally happen.

The wait for the Federal Reserve to raise interest rates seems to be endless. Unemployment has fallen below the Fed’s desired level and inflation — when adjusted for the drop in oil prices — is just under target. At the beginning of this year, many predicted September would be the right time for it to finally happen. Even with bad news coming out of China and other parts of the world hurting domestic financial markets, until the actual meeting, economists were still split on whether there would be a rate increase. But, clearly, there wasn’t.

Data suggests that a rate hike by the Fed in September would have been poor timing. Initial rate increases generally occur during periods of strong earnings growth. But for the past year, earnings have been relatively flat, and with global economies struggling this trend doesn’t seem likely to change. Additionally, after a rate increase valuations tend to fall. With the trailing 12-month P/E ratio for the S&P 500 dropping from 18.6x to just under 17x in the last two months stock prices have already undergone a sizeable correction. Any Fed action at this point in time would likely only lead to further losses.

CAPEX Cuts Continue in the Energy Industry

As oil prices oscillate around $40, market participants continue to wonder how long these low prices will persist. The decline in oil prices, due in part to strong supply growth and lower-than-expected demand growth, has caused headaches for many in the energy industry.

As oil prices oscillate around $40, market participants continue to wonder how long these low prices will persist. The decline in oil prices, due in part to strong supply growth and lower-than-expected demand growth, has caused headaches for many in the energy industry. Energy companies have made cuts to their CAPEX (capital expenditure) levels and canceled future expansions to reduce spending and maintain low costs. This week’s chart examines the Baker Hughes United States Crude Oil Rotary Rig Counts. Rotary rig counts are often included as an input when analyzing future oil prices — the logic is that a decline in rig counts foreshadows a reduction in supply, and a rise in rig counts precipitates an increase in supply.

Since peaking in October 2014, rig counts have fallen by 60% to the lowest level in over five years. Rig counts saw 29 consecutive weeks of decline between December 2014 and June 2015. The rig counts appeared to consolidate and even ticked up after that 29-week period, with 54 rigs joining the count over a period of 8 positive weeks. This led many investors and market participants to project a continuation of downward pressure on oil prices due to the expected additional supply as a result of the added rigs. However, CAPEX cuts continue in the energy industry, as 42 rigs have come offline since the end of June (with the majority coming offline in September), almost completely reversing the effects of the increase seen in July and August. For investors and market participants, the data suggests that a bottom is forming in the rig counts and energy companies may be nearing the end of their CAPEX cuts. Whether or not this translates into an increase in oil prices remains to be seen.

China: Manufacturing vs. Services

This week’s chart examines Markit’s Purchase Manager Index (PMI) for the manufacturing and services sectors in China.  PMI serves as an indicator of economic health.  A reading above 50 represents expansion while a reading below 50 indicates contraction.

This week’s chart examines Markit’s Purchase Manager Index (PMI) for the manufacturing and services sectors in China. PMI serves as an indicator of economic health. A reading above 50 represents expansion while a reading below 50 indicates contraction. The manufacturing sector (blue line) continues to weaken with the September flash coming in at 47. Meanwhile, the services sector (red line), an increasingly important part of the economy, remains in expansion territory.

Given the economy’s current size and transition from export-driven to domestic consumption-focused, a slowdown in overall growth should be expected, with more growth ultimately coming from consumption (represented by the service sector) than export-related activity (measured by manufacturing). Analysts have often cited 5–6% as a reasonable range for medium-term growth, a far cry from a crash landing. The IMF recently cited China’s progress in domestic rebalancing, with consumption contributing slightly more growth than gross fixed capital.1 Therefore, the traditional data points focused on manufacturing and infrastructure do not provide a complete picture of the current Chinese economy. Instead, the growth in services PMI reflects how the Chinese economy is becoming more dependent on domestic consumption than exports to other countries.

 

1 IMF Country Report No. 15/234, August 2015

Is the Canary in the Coal Mine of the Global Economy Sounding an Alarm?

This week’s chart of the week looks at the recent drop in South Korean exports, which fell by 14.7% in the 12 months ending August 31. South Korean exports have historically been a reliable and early indicator of the state of global trade, so much so that they have earned the nickname, the “canary in the coal mine” of the global economy.

This week’s chart of the week looks at the recent drop in South Korean exports, which fell by 14.7% in the 12 months ending August 31. South Korean exports have historically been a reliable and early indicator of the state of global trade, so much so that they have earned the nickname, the “canary in the coal mine” of the global economy. This is largely due to the fact that South Korean exports are a diversified mix of raw materials (such as oil, iron, and steel), intermediate goods (such as semiconductors and machine parts), and finished goods (such as cars, ships, and consumer electronics), as well as the fact that South Korea exports goods to both developed and emerging markets.

The fact that exports dropped by 14.7% in August (the largest drop since August 2009) is notable, especially considering that the consensus forecast was for a decrease of 5.9%. Even more concerning, this was the eighth consecutive month in which exports contracted. Since 1970, every prolonged drop in South Korean exports (defined as at least six consecutive monthly declines) has coincided with a material slowdown in the global economy. This was witnessed during the oil crisis of the mid-1970s, the Asian financial crisis of the late-1990s, the bursting of the tech bubble in the early-2000s, as well as the financial crisis of 2008.

While it is too soon to tell if the canary in the coal mine is accurately predicting trouble on the horizon, this prolonged drop in exports is clearly concerning.  However, there are a few factors that could be causing this signal to be a false alarm this time around. For one, exports to China (currently representing about 25% of all South Korean exports) are a greater share of exports than they have been historically, so the slowdown in China is having a larger impact on exports than in the past. In addition, the steep plunge in commodity prices over the past year has had a major impact on South Korea’s exports of oil products, petrochemicals, as well as iron and steel. These three export sectors, which represent 6.4%, 7.3%, and 6.1% of all South Korean exports respectively, have seen the largest declines of any major sector, declining 40.3%, 25.7%, and 17.4% respectively.

The Apple Effect?

On Wednesday, September 9th Apple announced the details on its latest iteration of its flagship product – the iPhone. The iPhone 6S and 6SPlus will be the ninth major iPhone announcement since the iPhone 1 was first unveiled to the world on June 29th 2007 (excluding new storage space and color variations of the same model).

On Wednesday, September 9th, Apple announced the details on the latest iteration of its flagship product – the iPhone. The iPhone 6S and 6SPlus were the ninth major iPhone announcements since the iPhone 1 was first unveiled to the world on June 29th, 2007 (excluding new storage space and color variations of the same model). The announcement events are widely covered by the media and fans of one of the most innovative companies of the 21st Century.

This week’s chart examines the change in Apple’s stock price from the announcement through the following six days and comparing that change to the return of the S&P 500 over the same time periods. On average, Apple has outperformed the index by 2.62% over the past eight announcement dates.

The importance of this announcement can be seen in the S&P 500 holdings, of which Apple is the largest contributor with a 3.71% weight. While it cannot be said with utmost certainty that Apple will outperform the market with its latest product announcement, it is safe to assume that these products will continue to be a major revenue source for the company, drive movements in the stock price, and therefore have a significant influence on the return of the index.

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

Historical analysis has shown that an inverted or flattening yield curve may be a warning sign of an upcoming recession. Since the 1950s, an inverted curve has preceded seven of the last eight recessions, with spreads near zero in 1960.

Historical analysis has shown that an inverted or flattening yield curve may be a warning sign of an upcoming recession. Since the 1950s, an inverted curve has preceded seven of the last eight recessions, with spreads near zero in 1960. An inverted yield curve occurs when short-term yields to maturity are higher than long-term yields to maturity (depicted where spreads fall below zero on the chart). This indicator has proven to be a reliable predictor of recessions and future economic activity.

Last week’s correction has led to investor concern that the market will continue to decline and evolve into a bear market, which is unlikely unless there is a recession and corresponding inversion of the yield curve. This week’s chart shows that the yield curve is currently positively sloped and has in fact steepened on a year-to-date basis, providing some confidence that recent market volatility is indicative of a correction rather than another recession.

It’s That Time of Year Again…

Between August 17th and 25th, the U.S. equity market – as represented by the S&P 500 Index – declined 11%. The pace and magnitude of the market drop came as a shock to many and left investors pondering how they should react to this swift downdraft. While some may be looking to underlying fundamentals or economic data for guidance, one could simply point to history as an indicator.

Between August 17th and 25th, the U.S. equity market — as represented by the S&P 500 Index — declined 11%. The pace and magnitude of the market drop came as a shock to many and left investors pondering how they should react to this swift downdraft. While some may be looking to underlying fundamentals or economic data for guidance, one could simply point to history as an indicator. This week’s chart looks at the maximum intra-year drawdown for the S&P 500 Index over the last 30 years.

While this recent decline is notable, it is not unusual for the market to experience a significant intra-year drawdown. Over the last 30 years, returns for the S&P 500 have only been negative five times. However, 15 of these 30 years have featured max intra-year drawdowns greater than 10%, with 10 of those years actually posting a gain for the year. In other words, the S&P 500 has shown resiliency over the long term, and the recent 12.4% drawdown for 2015 does not automatically translate to a negative year for U.S. equity investments. In fact, the last two days have seen an impressive rebound in the markets, and when markets closed on August 27th, the S&P 500 index was down only 2.1% for the year.

For more information on the recent market volatility as well as what to expect in the coming months, please read our U.S. equity market update which was released earlier this week.

Impact of Higher Interest Rates on High Yield Bonds

Under the Fed’s zero interest rate policy, high yield bonds have enjoyed a terrific run of performance. For the five year period ending June 30, 2014, the Barclays U.S. Corporate High Yield index produced an impressive annualized return of 14.0% per year. However, returns in this more speculative portion of the bond market have been disappointing since last summer, when the high yield spread over Treasuries reached a multi-decade low of 221 basis points.

Under the Fed’s zero interest rate policy, high yield bonds have enjoyed a terrific run of performance. For the five-year period ending June 30, 2014, the Barclays U.S. Corporate High Yield index produced an impressive annualized return of 14.0% per year. However, returns in this more speculative portion of the bond market have been disappointing since last summer, when the high yield spread over Treasuries reached a multi-decade low of 221 basis points. The index fell 0.4% in the twelve months ending June 30, 2015, and has continued to show weakness, falling another 1.9% through the middle of August.

This week’s chart examines the past relationship between high yield spreads and rate tightening cycles.1  Although there certainly isn’t a perfect correlation, tightening activity by the Fed has often caused high yield spreads to widen, significantly impacting total return potential. It is no secret that low and stable interest rates are good for speculative companies that are active in the debt markets. While a rake hike doesn’t spell impending doom for the entire high yield universe, some of the more speculative borrowers who have become accustomed to borrowing at ultra-low rates could be in trouble, particularly if the Fed embarks on a prolonged period of successive rate hikes. As we prepare for the first Fed rate hike — likely later this fall — it will be important to pay close attention to high yield exposure within investment portfolios as well as manager positioning within the high yield space.

1 Most recent rate tightening lines refer to the end of QE 1 and 2 and the start of the Fed’s tapering