Category: Chart of the Week

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

Asset Class Review: What Has Worked So Far in 2015?

This week’s chart shows broad asset class returns through July 31st of this year. Perhaps the most surprising performer has been international equity, which has outperformed even U.S. equities. Much of the outperformance is due to the strong U.S. dollar, which has increased international developed countries’ exports and the number of tourists.

This week’s chart shows broad asset class returns through July 31st of this year. Perhaps the most surprising performer has been international equity, which has outperformed even U.S. equities. Much of the outperformance is due to the strong U.S. dollar, which has increased international developed countries’ exports. The same factor has in turn contributed to the lower performance of U.S. equities. With so many of the S&P 500 companies’ revenues dependent on international growth (about 46%), the strong dollar has weighed heavily on EPS growth. In addition, the same factors many of our readers have heard before — the slowdown in the energy sector and the cold winter — have also played major roles.

The other darling this year, as widely predicted, has been Real Estate. Throughout the first half of the year, growth has in large part been due to income, lease turnover, and appreciation (most notably in the Southwest U.S.). The remainder of the year is likely to see less contribution from income and more contribution from appreciation.

Now let us turn to the poor performers. Bonds, both Global and U.S., continue their same old story: the specter of the Fed rate hike continues to loom, in addition to the Greek debt crisis and China’s now not-so-secret efforts to prop up growth. Emerging Markets have been the worst performers this year, thanks in large part to their dependence on commodities and the domino effect of China’s slowing growth which has translated into weakening currencies.

Where will the rest of the year take us? As the issues we have discussed will continue to weigh on asset classes, it will not be surprising if meandering to disappointing returns across asset classes continue for the rest of 2015.

1 Real Estate Returns through 6/30/15; Private Equity Returns through 3/31/15

Time to Buy U.S. Small-Cap Value Stocks?

Through the first seven months of 2015, growth stocks have far outpaced their value brethren in the U.S. equity market. While the theme has played out across all size sectors of the market, this trend has been most obvious for small-cap stocks.

Through the first seven months of 2015, growth stocks have far outpaced their value brethren in the U.S. equity market. While the theme has played out across all size sectors of the market, this trend has been most obvious for small-cap stocks. The Russell 2000 Growth index has returned 9.18% while the Russell 2000 Value index has dropped 2%. Given this disparity, it is worth examining whether now is an appropriate time to re-allocate to small-cap value stocks, since their recent struggles have driven prices lower. To help answer this question, we turn to a comparison of the current index price versus its 200-day average, a common valuation metric used to measure the relative value of a particular stock or index versus a longer-term average. As shown in the chart, the index dipped below its 200-day trading average in July and is now trading at a discount relative to its historic values.

From the broader perspective of portfolio construction, small-cap value stocks have historically offered upside potential and outperformance versus other style and size sectors in the U.S. equity market. In addition, since smaller companies’ operations tend to be more domestically focused, they could potentially provide a sanctuary from the rough geopolitical turmoil that is occurring in Europe and Asia. On a related note, the potential drag from a stronger U.S. Dollar would also be muted due to small-cap companies’ limited international exposure. Given the long-term benefits of small-cap value stocks along with the current valuation of the index, now may be an attractive opportunity to either rebalance or create exposure to the asset class.

How Will the High Level of M&A Activity Impact Investors?

For this week’s chart of the week we take a look at quarterly M&A deals, measured by volume. Typically, summer is a quiet period for M&A activity; however, we have seen the volume of deals for the month of July already surpass $475 billion dollars which would put it on pace to surpass the previous quarter high that was last seen in 2007, just before the start of the great recession.

For this week’s chart, we take a look at quarterly M&A deals, measured by volume. Typically, summer is a quiet period for M&A activity; however, we have seen the volume of deals for the month of July already surpass $475 billion dollars which would put it on pace to surpass the previous quarter high that was last seen in 2007, just before the start of the great recession. There are a variety of explanations for the increased M&A activity: pressure from activist investors, hostile takeovers, and companies with large cash positions beginning to deploy their savings as they better position themselves for future growth. Whether it is a close competitor or a company that compliments current operations, we have seen a great increase in deals over the previous two quarters.

One of the concerns with the elevated M&A activity is that companies are stretching for valuations when acquiring other firms, and given the elevated prices they are paying, it will be difficult to realize a profitable return on the size of their investments. Comparing deal counts to their respective volumes, we have seen less deals over the past two years, but higher dollar volumes than during the 2006–2007 boom years for M&A. The next two months bear watching to see if the furious M&A activity continues, or if the pace begins to abate. Of course, the real result of this activity will not be known for years, but the success – or lack thereof – of these mergers and acquisitions will no doubt manifest itself in capital market returns.

Some Perspective on the Size of Chinese Equity Market Losses

Over the last month, the Chinese equity market has been a cause of concern for investors and it is impossible to ignore its impact on recent market volatility.

Over the last month, the Chinese equity market has been a cause of concern for investors and it is impossible to ignore its impact on recent market volatility. In an effort to provide some perspective on the size of recent market losses in relation to Chinese consumers, this week’s chart of the week compares the size of the market cap loss to household assets represented by household deposits, 2014 GDP, household financial balance sheets, and household total balance sheets. As shown above, the Chinese equity market cap loss only represented 12% of household financial balance sheet assets which include stocks, bonds, and cash. Additionally, the market cap loss only represented 5% of total household assets which notably include personal real estate. Although the recent loss in the Chinese equity market was not insignificant, at this point in time the overall effect on the Chinese economy is bearable and should not be considered catastrophic.

Putting Greece in its Place

There has been much talk about a potential “Grexit”, as some believe it is inevitable and may be the best solution in the long run. Nonetheless, Greece is receiving its third bailout in five years to prevent such a thing.

There has been much talk about a potential “Grexit,” as some believe it is inevitable and may be the best solution in the long run. Nonetheless, Greece is receiving its third bailout in five years to prevent such a thing. The new bailout plan comes with some tough austerity measures in which Greece will have to make cuts to pensions and increase taxes in order to receive €86B ($96B) in new loans.

The fear of contagion has been cited as a reason for yet another Greek bailout. If Greece were to leave the Eurozone, a dangerous precedent may be set and other countries with high debt levels (such as Spain, Italy, and Portugal) may decide to follow. Even if these countries do stay, they may have difficulty finding investors to purchase their bonds. On the other hand, by continuing to bail out Greece, these countries may be less willing to make reforms and come to expect their own bailouts if their debt gets out of hand.

However, this week’s chart puts the Greece situation into perspective, particularly for U.S. investors. For all the attention Greece receives, it has a smaller economy than the state of Wisconsin and is less than half the size of Illinois. Even among the Eurozone, Greece contributes a mere 1.9% to the area’s GDP. Though there is the possibility of a domino effect, it seems unlikely that the events in Greece will have a large effect on the global economy.

The Impact of Interest Rates on Real Estate Returns

As the U.S. faces a potential interest rate hike this fall, it is worthwhile to review the impact of interest rates on the real estate sector. This week’s chart looks at the historical performance of the NFI ODCE Index versus the 10-Year Treasury.

As the U.S. faces a potential interest rate hike this fall, it is worthwhile to review the impact of interest rates on the real estate sector. This week’s chart looks at the historical performance of the NFI ODCE Index versus the 10-Year Treasury. The correlation between the two variables is positive but weak, owing in part to a time lag between the change in interest rates and when the change impacts property values.

A moderate interest rate hike after the Financial Crisis may be viewed as the Fed’s vote of confidence that we are seeing economic recovery. Factors that drive interest rates up — such as inflationary pressures from economic growth — cause real estate fundamentals to improve and potentially offset the negative impacts of rising rates. Additionally, we expect to see income rise as property managers pass on higher interest rates to tenants by increasing rents, thus providing a partial hedge against rising rates. While we are still in the initial expansion stage, economic growth and rising interest rates should prove accretive for real estate investments.

Downside Protection for U.S. Equity Managers

This week, we take a look at down market captures (DMC) relative to top, middle and bottom tier managers for U.S. large-cap equities. Down market captures illustrate how active managers perform during periods of negative benchmark performance. In this case, we are comparing the last 12 years of rolling 1-year down market captures for U.S. large-cap core managers who feature the S&P 500 index as their primary benchmark.

This week, we take a look at down market captures (DMC) relative to top, middle, and bottom tier managers for U.S. large-cap equities. Down market captures illustrate how active managers perform during periods of negative benchmark performance. In this case, we are comparing the last 12 years of rolling 1-year down market captures for U.S. large-cap core managers who feature the S&P 500 index as their primary benchmark.

Theoretically, passive management is less beneficial than active management in down markets as passive management will capture 100% of the index returns during the negative periods. In examining the median manager down market captures (red line in chart), we see that the majority of the time active managers are able to outperform the benchmark in times of market declines (a reading below 100 indicates that the manager lost less than the benchmark).1  This is more evident when looking at the DMCs of managers in the 25th percentile. These managers are consistently outperforming the benchmark during the down market, and losing less capital for their investors. Managers in the 75th percentile consistently have DMCs greater than 100%, meaning they captured more than the negative performance of the benchmark, thus failing to protect in a downside market.

Given the overall efficiency of the U.S. large-cap equity asset class, many investors have moved away from active management over the last five years. And while this trend is not likely to reverse itself anytime soon, those who have identified above median managers may face less downside risk in the event of a market correction.

1It should be noted that outperforming the benchmark in times of market drops does NOT equate to positive returns; the manager just loses less than the benchmark.