Category: Chart of the Week

Are MLP Valuations Too Rich?

This week’s Chart of the Week takes a look at Master Limited Partnerships (“MLPs”) and their current valuations based on their EBITDA Multiple (calculated by Enterprise Value divided by the 12-month EBITDA). Generally, a higher multiple implies a more expensive valuation. Relative to long-term averages and the S&P 500, MLPs appear expensive today. The elevated valuations, however, are pricing in higher expected rates of growth.

This week’s Chart of the Week takes a look at Master Limited Partnerships (“MLPs”) and their current valuations based on their EBITDA Multiple (calculated by Enterprise Value divided by the 12-month EBITDA). Generally, a higher multiple implies a more expensive valuation. Relative to long-term averages and the S&P 500, MLPs appear expensive today. The elevated valuations, however, are pricing in higher expected rates of growth. These higher growth expectations do not come as a surprise given the recent increase in domestic energy production and expected midstream infrastructure expenditures, which could approach $640 billion between now and 2035.1  Compared to the prior study done in 2011 ($261B), the 2014 estimates represent a 145% increase in infrastructure spending.

Paying a premium for MLPs relative to historical averages may not necessarily be a bad thing assuming that the estimated growth within the energy infrastructure sector comes to fruition. If, however, there is a catalyst in the market such as a rapid increase in interest rates, regulatory change, or an international crisis, MLPs may experience a correction.

1 Interstate Natural Gas Association of America

Favorable Relative Valuation for U.S. Large-Cap Stocks

This week’s Chart of the Week examines the historical valuation premium of U.S. small-cap stocks (as represented by the Russell 2000 index) relative to U.S. large-cap stocks (based on the Russell 1000 index). A line above 1.0 indicates a higher relative valuation for the Russell 2000 compared to the Russell 1000. As of June 30th, 2014, the small-cap index carried an 18.7% premium relative to the large-cap index

This week’s Chart of the Week examines the historical valuation premium of U.S. small-cap stocks (as represented by the Russell 2000 index) relative to U.S. large-cap stocks (based on the Russell 1000 index). A line above 1.0 indicates a higher relative valuation for the Russell 2000 compared to the Russell 1000. As of June 30th, 2014, the small-cap index carried an 18.7% premium relative to the large-cap index. Investors should typically expect small-caps to command a larger P/E multiple relative to large-caps given that small-cap stocks tend to have higher expected earnings growth rates assigned to them. Despite this, the chart above indicates that small-caps are currently at the upper end of their historical relative valuation premium. This suggests a more favorable entry point for large-cap stocks versus small-cap stocks.

With U.S. equity markets over 5-years into the current recovery and major indices trading near all time highs, small-cap stocks are facing a few headwinds. As the Fed winds down its asset purchasing program and as the market begins to anticipate a rise in interest rates, small-cap performance will be more linked to the health of the U.S. economy and face a greater sensitivity to a rise in interest rates versus large-caps. In addition, large-cap stocks derive a larger percentage of their revenues outside of the U.S. and would be poised to benefit to a greater extent over small-caps from higher expected growth rates outside of the U.S. With relative valuation levels between small-caps and large-caps currently at a high level, a better risk/reward trade-off exists for U.S. large-cap stocks.

Projecting the Increase in the Fed Funds Rate

On July 9, the Federal Reserve released the minutes from the June FOMC meeting which indicated that it is planning to continue the taper of its bond buying program at the current pace and expects to end the bond purchases entirely in October. With the Fed’s bond buying program (more formally known as quantitative easing) coming to an end, the next step for the Fed will likely be an increase in the fed funds rate.

On July 9, the Federal Reserve released the minutes from the June FOMC meeting which indicated that it is planning to continue the taper of its bond buying program at the current pace and expects to end the bond purchases entirely in October. With the Fed’s bond buying program (more formally known as quantitative easing) coming to an end, the next step for the Fed will likely be an increase in the fed funds rate. In order to illustrate the market’s expectations for the timing of the increase in the fed funds rate, this week’s Chart of the Week shows the implied fed funds rate derived from the fed funds futures market. As the chart indicates, the market currently expects the fed funds rate to remain within the current target level of 0.00–0.25% (0–25 basis points) throughout 2014 and expects the first rate hike to occur at the June 2015 meeting. From there, the market is currently pricing in a series of gradual hikes in the second half of 2015 and throughout 2016 and 2017.

It should be noted that while the fed funds futures market has historically been fairly accurate at predicting near term movements in the fed funds rate (i.e., six months and in), it has a fairly poor track record of predicting longer-term movements (i.e., greater than six months out) especially during periods of transition in Fed policy. Nonetheless, it is important to be aware of what the fed funds futures market’s current expectations are, as changes in these expectations have the potential to significantly impact the broad markets.

The Fed Is Adding Repos to Its Toolbox

A repurchase agreement (“repo”) is a transaction in which a dealer sells securities to an investor and agrees to repurchase the securities at a future date. Typically, the dealer sells the securities at a discount to the repurchase price.  The repo market is relevant because it is a critical mechanism for the U.S. financial system to facilitate short-term lending between major financial institutions, money market vehicles, and the Federal Reserve.

A repurchase agreement (“repo”) is a transaction in which a dealer sells securities to an investor and agrees to repurchase the securities at a future date. Typically, the dealer sells the securities at a discount to the repurchase price. Effectively, the arrangement is akin to a collateralized loan with the difference between the sales price and repurchase price equating to an interest payment and the securities serving as collateral in the event of default (i.e., failure to repurchase).

The repo market is relevant because it is a critical mechanism for the U.S. financial system to facilitate short-term lending between major financial institutions, money market vehicles, and the Federal Reserve. The credit crisis in 2008 was preceded by heightened leverage in the repo market. When the fragile state of banking institutions’ balance sheets became apparent, money market funds and private lenders collectively barred access to capital for borrowers perceived to be weak. Due to a general lack of transparency as well as market fear, access to capital from the repo market dried up and sealed the fate of the likes of Lehman Brothers and Bear, Stearns & Co. who depended on it as a source of borrowing. Since then, the Federal Reserve has been aware of the need for reforms to reduce reliance on private banks and money market funds for liquidity in the repo market during times of stress.

This week’s chart shows evidence of the Fed’s intervention in the U.S. repo market to manage liquidity in lending markets and promote the stability of the financial system. In 2008, the Fed acted as a lender of cash, increasing its position in repurchase agreements, attempting to supply much needed capital to the banking system. More recently, the Fed has done the opposite. On September 23, 2013, the Fed began testing its reverse repurchase agreement program. As part of the new program, the Fed has been increasing its position in reverse repurchase agreements which means it absorbs cash from private institutions, thus acting as a borrower. While some believe this is simply a measure of monetary tightening, a more compelling argument is that the Fed is maintaining its role as a provider of liquidity despite taking the other side of the trade. In the face of high demand for U.S. Treasury securities as collateral for private institutions and money market funds, the Fed is using reverse repos to increase the availability of those securities in the market by drawing them from its own balance sheet. Meanwhile, the New York Fed is monitoring the weighted average maturity of banks’ borrowings in the repo market to identify vulnerable institutions with an overreliance on borrowing. Though the program has not yet been permanently instituted, it seems probable that the Fed hopes to use this new tool to stabilize bond markets ad infinitum.

A Stock Picker’s Market?

So far, 2014 has seen a number of things fall: unemployment, interest rates, the pace of QE3, and correlations among U.S. equities. It is conventional wisdom that in times of crisis, correlations move to one and all equities fall in unison. Since 2008 when the correlations between sectors in the S&P 500 did indeed approach one, active equity managers have bemoaned the lack of dispersion that is commonly present in the U.S. equity market.

So far, 2014 has seen a number of things fall: unemployment, interest rates, the pace of QE3, and correlations among U.S. equities. It is conventional wisdom that in times of crisis, correlations move to one and all equities fall in unison. Since 2008 when the correlations between sectors in the S&P 500 did indeed approach one, active equity managers have bemoaned the lack of dispersion that is commonly present in the U.S. equity market. When dispersion is low and correlations are high, it is difficult for active managers to outperform a benchmark. During periods of high correlation, the market reacts to macro-type factors, punishing or rewarding all equities at once with little regard to stock specific fundamentals.

In 2014 however, correlations have once again begun to exhibit a downward trend, allowing active managers more opportunities to separate themselves from a benchmark. As measured by rolling 21-trading day windows, average correlations between the 10 sectors of the S&P 500 and the index itself reached a low of 63% in May, a level not seen since late 2010. If the trend of lower correlations continues throughout the year, expect greater dispersion between individual equities to be closely followed by greater dispersion between active managers and their benchmarks.

High Yield Primary Market Indicative of Credit Cycle

Recent events have raised investors’ concerns about how much runway we have left for a risk-on fixed income portfolio. This week’s chart explores high yield bond issuance ratings and use of proceeds as indicators of where we are in the credit cycle.

Recent events have raised investors’ concerns about how much runway we have left for a risk-on fixed income portfolio. First, the ECB made an unprecedented move towards negative deposit rates for banks to deposit funds with the central bank, thereby incentivizing more lending with the aim of further stimulating Europe’s economy and containing the risk of deflation. Second, while the Fed maintains its dovish stance, swaps indicate that the market anticipates Yellen to raise rates by July 2015. Third, the TXU bankruptcy’s $20 billion in defaulted loans increased the bank loan default rate to 4.64%, but it is expected to drop back to the 1% to 2% average next quarter. Lastly, as of May 2014, 2nd lien bank loans were 4.58% of all bank loans outstanding, which for the first time since the housing bubble is above the long-term average (since January 2004) of 4.51%.

This week’s chart explores high yield bond issuance ratings and use of proceeds as indicators of where we are in the credit cycle.

The lowest quality bonds, CCC-rated, reached a peak of 32.9% as a percentage of all high yield issues in 2007, just before the housing bubble burst. For the first quarter of 2014, this figure was only 15.2%, roughly at 2004 levels. This segment of the capital-raising pipeline is very telling because it shows whether there is an atypical amount of the most speculative rated companies accessing capital to meet the demand of investors reaching for yield, which was the case in 2007. Based on the current data, this trend does not appear to be resurfacing.

Another key insight can be gleaned from how the proceeds of newly issued high yield bonds are used. More specifically, the greater the amount of proceeds used for LBOs (as opposed to less risky actions such as refinancing debt or repurchasing equity), the more heated the market. LBOs as a percentage of new high yield issues reached a peak of 33.7% in 2007, just before the housing bubble burst. However, the same data point was only 2.6% for the first quarter of 2014, which equates to 2003 levels.

Collectively, these two metrics peaked before spreads blew out during the 2008 credit crisis and deserve careful observation as the credit rally continues. Fortunately, based on current levels, they indicate that we have perhaps another few years to go before another major market correction.

Commodities Start Positively in 2014

This week’s Chart of the Week examines how the commodities markets have fared since the start of the year. After three years of negative returns driven by relative unattractiveness to equities and fixed income, coupled with declining inflation, commodities began 2014 on a strong foot.

This week’s Chart of the Week examines how the commodities markets have fared since the start of the year. After three years of negative returns driven by relative unattractiveness to equities and fixed income, coupled with declining inflation, commodities began 2014 on a strong foot.

Commodities, as measured by the Dow Jones UBS Total Return Commodity Index, enjoyed four months of consecutive gains and, despite May’s pullback, have advanced by 6.4% so far this year. The strongest growth came from the livestock complex, as the DJ UBS Livestock sub-index benefited from improving supply fundamentals and climbed 12.2% in the first five months of the year. Agriculture has also been strong this year with a gain of 11.9%.

Industrial metals have been the weakest area in 2014. The DJ UBS Industrial Metals sub-index increased by only a modest 0.9% through the end of May. China’s economy, no doubt, has had a negative impact on base metals — concerns over slowing growth in the Chinese economy have weighed on the industrial metals complex. Precious metals have fared slightly better this year with a gain of 1.6%.

Although commodities in aggregate remain below their 2010 levels, their upward momentum thus far provides a positive outlook for investors with commodities exposure.

Playing Politics Helps Emerging Market Investors

After a very disappointing year in 2013 emerging market equities got off to a rough start in 2014, underperforming U.S. stocks by 2.2% during the first quarter. However, emerging markets stocks have recently started to show signs of life, up over 5% since the end of March and outperforming U.S. markets. So why the outperformance?

After a very disappointing year in 2013, emerging market equities got off to a rough start in 2014, underperforming U.S. stocks by 2.2% during the first quarter. However, emerging markets stocks have recently started to show signs of life, up over 5% since the end of March and outperforming U.S. markets. This may come as a surprise to some as the economic data out of China has remained weak and there have been only modest improvements in the current account balances of the “fragile five” (Indonesia, India, Turkey, South Africa, and Brazil). So why the outperformance?

While we mostly focus on economic data and the business cycle to inform our understanding of financial markets, it is important to remember that politics can play a role as well, particularly in emerging markets. This week’s chart looks at the impact of two recent political events on financial markets.

First, the blue line on this chart shows the cumulative price performance, on a quarter-to-date (“QTD”) basis, for the Sensex Index, the main stock market index in India. As the chart shows, improved equity market performance has coincided with the recent Indian election in which Narendra Modi and the BJP party recently won a sweeping victory. Mr. Modi has an impressive record of reform and growth from his days as the Chief Minister of Gujarat and has been elected with a mandate to improve economic growth by cutting red tape and loosening restrictive labor markets.

Second, Gazprom (the largest energy company in Russia) shares have rallied recently ahead of Putin’s much anticipated visit to Beijing. This visit culminated on May 23rd with the announcement that Russia had signed a $400 billion, 30-year pact to supply China with natural gas. Gazprom is the largest natural gas producer in Russia and is likely to be the largest direct beneficiary of the agreement.

India represents 7.08% of the MSCI Emerging Markets index and Gazprom represents 1.27% of the MSCI Emerging Markets index and is the sixth-largest holding in the index. As a result, these recent political developments have had a meaningful effect on the performance of emerging market investors’ portfolios and serve as a reminder that political — as well as economic — developments can drive equity market returns.

Tackling Unemployment: Significant Job Growth Still Needed

This week’s Chart of the Week takes a closer look at the current employment situation compared to pre-recession numbers. Recently, the U.S. hit a new high water mark for the number of private sector employees, though the total amount of workers employed is still behind by approximately 900k jobs when compared to its previous high set in November 2007. Considering that over 8.5 million jobs were lost during the recession, with total employment falling at one point to about 138 million, the economy has come a long way.

This week’s Chart of the Week takes a closer look at the current employment situation compared to pre-recession numbers. Recently, the U.S. hit a new high water mark for the number of private sector employees, though the total amount of workers employed is still behind by approximately 900k jobs when compared to its previous high set in November 2007. Considering that over 8.5 million jobs were lost during the recession, with total employment falling at one point to about 138 million, the economy has come a long way.

However, there are two additional factors that should be taken into account when discussing the improvement in employment. The first is population growth. To achieve the same unemployment rate as November 2007 (4.9%), total employment would need to increase by about 2.5 million to 148.1 million. The second, and much larger factor, is the difference in participation rate, which measures the labor force as a percentage of the total population over 16. Prior to the recession, the participation rate was 66%, and it has been steadily declining since then to 62.8%. To look at it another way, the civilian population has grown by almost 14.5 million people but the labor force has only grown by about 1.5 million. All else being equal, if the participation rate today was 66% unemployment would be at 10.8%. At this level, nearly 10 million jobs would need to be added to reach the pre-recession unemployment rate.

There is much debate whether or not this participation rate is the new norm. The decrease has mainly been attributed to students staying in school longer. If this trend reverses as job prospects improve and tuition costs grow, the participation rate, and in turn the unemployment rate, could increase substantially. On the other hand, as more baby boomers leave the workforce to retire, there will be continued downward pressure on the participation rate. Depending on how these factors are viewed, the condition of employment and the economy can vary greatly.

Growing Debt in China

This week’s chart of the week examines the difference in private non-financial sector debt levels as a percentage of GDP for the United States and China. Private non-financial sector includes non-financial corporations (both private-owned and public owned), households and non-profit institutions serving households. Rising debt levels are a concern to any economy, as higher debt as a percentage of GDP is a potential drag on growth.

This week’s chart of the week examines the difference in private non-financial sector debt levels as a percentage of GDP for the United States and China. Private non-financial sector includes non-financial corporations (both private-owned and public-owned), households, and non-profit institutions serving households. Rising debt levels are a concern to any economy, as higher debt as a percentage of GDP is a potential drag on growth.

In the chart above, the most striking development is that China’s debt (as a percentage of GDP) is now higher than the U.S. There are a variety of reasons for this, including deleveraging in the U.S. in the wake of the Great Recession, as well as easy credit coupled with massive infrastructure spending in China. Collectively, these trends have driven the relative debt in China higher than the U.S., which is especially worrisome for future growth prospects in China, and by extension, investments in the country. It is not surprising that investor sentiment has cooled regarding China as of late, and investors will closely watch the growing debt level in the coming years.