Category: Chart of the Week

Drop in Shadow Inventory of U.S. Housing

In this week’s chart we examine the improving housing market and its outlook in terms of pricing stability as it relates to the number of homes in shadow inventory. To be brief, shadow inventory (courtesy of CoreLogic) represents the number of properties that are seriously delinquent, in foreclosure, and/or held by mortgage servicers that are expected to come to market in the future.

In this week’s chart, we examine the improving housing market and its outlook in terms of pricing stability as it relates to the number of homes in shadow inventory. To be brief, shadow inventory (courtesy of CoreLogic) represents the number of properties that are seriously delinquent, in foreclosure, and/or held by mortgage servicers that are expected to come to market in the future. During the recession, experts feared a second major dip in home prices would result from banks unloading the historically high number of distressed homes on their balance sheets.

Since 2009, the number of houses that comprise the shadow inventory has declined from roughly 3M to around 1.7M, thus approaching pre-recession levels. Homes prices, illustrated by the Case-Shiller Index, have continued to rebound from their 2011 lows. This represents a significant improvement in the housing market and as the shadow inventory continues to decrease the chances of a secondary dip in home prices becomes less likely.

Lower Debt Costs in Eurozone

This week’s chart examines the improving financial conditions in the Eurozone’s peripheral countries. Italy, Spain, and Portugal have recently seen their borrowing costs reach significant lows as investors’ confidence strengthens.

This week’s chart examines the improving financial conditions in the Eurozone’s peripheral countries. Italy, Spain, and Portugal have recently seen their borrowing costs reach significant lows as investors’ confidence strengthens. Italian and Spanish 10-Year bond yields fell to 3.1% in late April, the lowest since 1999 for Italy and 2005 for Spain. After its first regular debt auction since a 2011 bailout, Portugal saw its yields drop to 3.7% marking a new post-2009 low.

More than two years removed from the European debt crisis, investor sentiment has improved as economic growth (though small) has returned to the region with participation from the peripherals. The Eurozone’s purchasing managers composite index (PMI) has been in expansion territory for nine consecutive months and hit a post-crisis high of 54 in April. While the Eurozone certainly remains in a fragile state with only a tepid level of growth, investors are encouraged by the improving conditions as well as the commitment of additional support from the European Central Bank if needed.

Growth of Liquid Alternatives

This week’s chart looks at the recent fund flows and the trailing twelve month (“TTM”) percentage growth rate of liquid alternatives as of March 31, 2014. Over the past decade, private investment managers, traditionally associated with less liquid investments such as hedge funds, private equity, and real estate, have expanded their investment focus towards the creation of liquid alternative products that comply with the 1940 Investment Company Act in order to meet the demands of the rapidly growing defined contribution market.

This week’s chart looks at the recent fund flows and the trailing twelve-month (“TTM”) percentage growth rate of liquid alternatives as of March 31, 2014. Over the past decade, private investment managers, traditionally associated with less liquid investments such as hedge funds, private equity, and real estate, have expanded their investment focus towards the creation of liquid alternative products that comply with the 1940 Investment Company Act in order to meet the demands of the rapidly growing defined contribution market.

Within the open-ended mutual fund universe, liquid alternatives have once again topped all other asset classes with the highest organic growth rate over the TTM period, up 39.5% as of March 31, 2014. Although this growth rate is impressive, liquid alternative assets only represent 1.3% ($149B) of the U.S. mutual fund universe, which has over $11 trillion in assets.

As the trend toward liquid alternatives continues to grow, investors should consider the potential implications and effectiveness of the newly designed strategies. ’40 Act funds must comply with restrictions not required by traditional hedge funds such as leverage limits, short-selling, and liquidity. In addition, the standard 1.5% and 20% hedge fund fee structure has to be adjusted within the ’40 Act universe; currently, the average management fee for liquid alternative funds is around 1.5%. Since the significant rise in the formation of liquid alternative products has taken off within the past few years, investors should be cautious before diving into the space as the next decade will be a testing ground for these strategies as to whether or not they deliver on their performance expectations, in terms of both return and diversification.

Real Earnings Trend Upward

This week’s chart illustrates the year over year real average hourly earnings for all employees-inflation and seasonally adjusted.  Most important in the graph is the recent trend since mid-2012: hourly earnings have been increasing at a rate greater than inflation.  The primary reasons contributing to this are an improving labor force and falling inflation.

This week’s chart illustrates the year over year real average hourly earnings for all employees-inflation and seasonally adjusted.  Most important in the graph is the recent trend since mid-2012: hourly earnings have been increasing at a rate greater than inflation.  The primary reasons contributing to this are an improving labor force and falling inflation.  The U.S. has recovered the bulk of the jobs lost during the recession, and as the unemployment rate continues to decline and we work through some of the slack in labor markets, employers will have to pay higher wages to attract and retain workers.  Assuming the Federal Reserve can adequately control inflation in the future, the trend of improving real hourly earnings should continue.  As earnings continue to increase, GDP should benefit as approximately 68% of GDP is driven by consumer spending.

Note:  Real earnings during the 2008-2009 appear inflated, but this is really the result of the CPI declining precipitously during this time.

Active Share: An Increasingly Relevant Measure

The popularity of passive or indexed investment strategies is as high as ever due to low costs, strong recent performance, and compelling research by the likes of Eugene Fama indicating active management is a losing endeavor in aggregate. Nevertheless, as more assets move to passive strategies from active, skillful active management becomes more attractive assuming market pricing is not perfectly efficient

The popularity of passive or indexed investment strategies is as high as ever due to low costs, strong recent performance, and compelling research by the likes of Eugene Fama indicating active management is a losing endeavor in aggregate. Nevertheless, as more assets move to passive strategies from active, skillful active management becomes more attractive assuming market pricing is not perfectly efficient.

While the average active manager underperforms the market after fees, there are both successful and unsuccessful managers within the herd. The above table includes a sample of the results from a research study titled “Active Share and Mutual Fund Performance” by former Yale and NYU professor Antti Petajisto. The results of the study indicate that a specific subset of active mutual fund managers, specifically those with high Active Share, have exhibited persistent relative outperformance on a net-of-fees basis.

Active Share is a measure of how different a portfolio’s positions are from those of the passive index. The results of Petajisto’s study suggest that, on average, managers with high Active Share (i.e., Concentrated or Stock Picker type) outperform active managers with low to moderate Active Share. In fact, managers with both high Active Share and lower portfolio turnover actually outperformed the passive index net-of-fees by an average of 1.26% per annum with only slightly higher than average tracking error. A reasonable interpretation is that managers can be successful if they take active positions in strong companies and maintain conviction over time in those investments, avoiding excessive turnover. Meanwhile, managers with the lowest Active Share, termed Closet Indexers, persistently underperformed despite having the lowest fees and greatest diversification. This is unsurprising because these managers act mostly like the index but still charge fees reflective of active management. It is notable that large-cap stock strategies are more commonly closet indexers than small-cap strategies, and funds with too many assets under management have operational inability to take high active share.

In summary, there is a place in many portfolios for both active and passive management. The data does not indicate that all managers with high Active Share will outperform. Nevertheless, evaluating a manager’s Active Share in combination with other qualitative and quantitative factors can be very useful. Through due diligence, an independent investment consultant can help investors distinguish active managers who are more likely to exhibit talent and conviction. More importantly, if investors in so-called closet index funds were to move 60% of their money to a high Active Share manager and 40% of their money to a passive strategy, they could achieve the same level of Active Share while decreasing fees and increasing expected alpha. Take caution though: only patient investors who are comfortable with short-term tracking error can expect to realize the benefits of Active Share strategies, a virtue not exhibited by all.

Time to Bail on Bank Loans?

With record net inflows, compressed spreads, rising levels of corporate debt and a dramatic increase in covenant-light loans, bank loan investors have become concerned about their investments. While there are many ways to assess future prospects for the asset class, one key indicator to examine is the amount of 2nd lien bank loans compared to the total bank loan market.

With record net inflows, compressed spreads, rising levels of corporate debt, and a dramatic increase in covenant-light loans, bank loan investors have become concerned about their investments. While there are many ways to assess future prospects for the asset class, one key indicator to examine is the amount of 2nd lien bank loans compared to the total bank loan market. 2nd lien loans outstanding as a percentage of the market is a useful gauge because it shows the level of risk investors are willing to take just to hold senior secured debt that is subordinate to 1st lien holders in the event of a bankruptcy and/or liquidation. A primary concern about the amount of 2nd lien loans is that as the market heats up and investors reach more and more for yield or, as in the case of 2007, become enamored with the illusion of safety and superior yield offered by subordinated paper, companies will issue more and more 2nd lien loans to meet that demand, as was seen throughout 2006 and 2007.

The good news is that we are not yet in such an environment. As shown in the chart above, 2nd lien bank loans outstanding as a percentage of all bank loans outstanding is currently at 3.9%, well below the peak of 6.8% reached in 2007. While it has risen from its recent trough of 2.7% in March 2013, it is still below the 10-year average of 4.5%. Although yields on bank loans have compressed over the last several years, the asset class still remains one of the most compelling fixed income investments available to institutional investors, especially relative to the much lower yields found in other sectors. Going forward, it is critical to keep a pulse on inflows, leverage, cov-lite issuance, and 2nd lien loans as a means to monitor the health of the bank loan market. However, at the present time, investors should remain in bank loans and maintain their allocations until 2nd lien loans outstanding as a portion of the whole rise well above their long-term average.

Taylor Rule Provides Clues to Future Short-Term Rates

Developed by Stanford economist John Taylor in 1992, the Taylor Rule is a mathematical model designed to estimate the level of short-term interest rates consistent with the Federal Reserve’s mandate to promote price stability and full employment. In making its prediction, the model measures current inflation and unemployment data against a set of ideal targets.

Developed by Stanford economist John Taylor in 1992, the Taylor Rule is a mathematical model designed to estimate the level of short-term interest rates consistent with the Federal Reserve’s mandate to promote price stability and full employment. In making its prediction, the model measures current inflation and unemployment data against a set of ideal targets. Currently, the model utilizes the Fed’s stated inflation target of 2% and an unemployment rate of 5.6% as the ideals for a healthy economic environment.

Prior to the great recession, the output of the Taylor Rule proved to be fairly accurate in predicting short-term interest rates. As the financial crisis deepened, however, the Taylor Rule began to suggest that a negative level of short-term rates would be necessary in order to restore economic growth. Bound by zero as the floor for interest rates, the Fed was unable to lower short-term rates to meet the level prescribed by the Taylor Rule. With further interest rate decreases no longer an option, the Fed turned to quantitative easing as a means to further loosen monetary policy. Five years later, with the U.S. economy on more stable ground, the level of short-term rates prescribed by the Taylor Rule has once again turned positive. Not surprisingly, the Fed has begun to slow the pace of quantitative easing with the program scheduled to come to an end altogether later this year. As investors eye Fed clues for the future path of short-term rates, consider the Taylor Rule as a useful guide.

Good News for “Abenomics” and Japanese Wage Growth

In an attempt to revive the long struggling Japanese economy, Prime Minister Shinzo Abe implemented his “Abenomics” strategy which included an unprecedented open-ended asset purchase program. The monetary easing policy was implemented with the goal of spurring domestic spending and increasing exports via a devalued currency.

In an attempt to revive the long struggling Japanese economy, Prime Minister Shinzo Abe implemented his “Abenomics” strategy which included an unprecedented open-ended asset purchase program. The monetary easing policy was implemented with the goal of spurring domestic spending and increasing exports via a devalued currency. Equity investors reacted positively to the plan and the MSCI Japan Index returned 27.4% in 2013. With both corporate profits and business confidence rising, the initial results of “Abenomics” appear promising.

To keep things on course, Japanese companies will need to boost workers’ wages, a phenomenon that has rarely occurred for earners. This week’s chart shows the year-over-year change in wage earnings has been largely negative over the last 24 months. However in recent weeks during the annual wage negotiations (known as “shunto,” which translates to “spring offensive”) between unions and employers, several large companies, including Toyota, Honda, and Toshiba announced significant wage increases for the first time since 2008. Now economists will observe whether medium and small size companies follow suit. A rise in wages will help continue the initial positive momentum created by the monetary easing policies of “Abenomics” and could mean Japanese equities still have some upside left.

Economic Surprise Index Turns Negative

In this week’s chart we take a look at the CITI Economic Surprise Index. As a matter of background, the CITI Economic Surprise Index is a composition of various economic indicators that are released; anything above 0 indicates that economic reports are beating expectations and anything below 0 is underperforming estimates.

In this week’s chart, we take a look at the CITI Economic Surprise Index. As a matter of background, the CITI Economic Surprise Index is a composition of various economic indicators that are released; anything above 0 indicates that economic reports are beating expectations and anything below 0 is underperforming estimates. Since its peak in mid-January, the index has been on a steady decline and just reached its lowest point since June of last year.

The start of 2014 saw several key economic indicators fall short of expectations including retail sales, new jobs, manufacturing, and the consumer confidence index; such trends help explain the decline. On the bright side, many experts have blamed the historically dreadful weather conditions as key contributors to such pull-backs in economic activity, and expect a rebound once spring arrives. Indeed, the market appears to agree: after a negative January (-3.5%), the S&P 500 returned 4.6% in February, shrugging off much of the poor economic data. Given the optimistic outlook shared by most economists for 2014, it is expected that the Economic Surprise Index will swing back to positive territory as winter gives way to spring.

Expect Fed Funds Rate to Remain Unchanged at 6.5% Unemployment

With the unemployment rate (6.6%) approaching the Fed’s forward guidance target of 6.5%, this week’s chart examines two additional labor market indicators: the number of people working part time for economic reasons and the number of individuals who have been unemployed for longer than six months.

With the unemployment rate (6.6%) approaching the Fed’s forward guidance target of 6.5%, this week’s chart examines two additional labor market indicators: the number of people working part-time for economic reasons and the number of individuals who have been unemployed for longer than six months. In her February report to Congress, the new Fed Chairperson, Janet Yellen, identified these two data points as important gauges for evaluating the health of the U.S. job market.

While we have seen steady improvement in the headline unemployment number (down from a high of 10.0%), much of the “recovery” has been due to a decreasing labor participation rate, and overall the labor market remains relatively weak. Many individuals have resorted to working part-time due to poor labor demand and this segment constitutes 5.3% of currently “employed” workers. While below the high (7.0%) it is still above the long-term average of 4.4%. In addition, a large percentage of the unemployed (35.6%) have been so for more than six months. This is above the long-term average of 25.5% yet below the peak of 45%.

With the risk of inflation remaining relatively low, the market expects the central bank to refrain from increasing the fed funds rate at least through the first half of 2014 in an attempt to strengthen the economy and labor market even if the unemployment rate drops below 6.5%.