Category: Chart of the Week

Continued QE and the Fed’s Balance Sheet

Since 2008, the Federal Reserve has embarked upon an unprecedented effort to stabilize and support the national economy in the aftermath of the 2008 financial crisis. At first, the effort was more of an emergency response, aimed at stemming the worst economic calamity since the Great Depression. However, as the threat of a systematic meltdown subsided, the Fed’s focus shifted to ongoing support aimed at restoring economic health

Since 2008, the Federal Reserve has embarked upon an unprecedented effort to stabilize and support the national economy in the aftermath of the 2008 Financial Crisis. At first, the effort was more of an emergency response, aimed at stemming the worst economic calamity since the Great Depression. However, as the threat of a systematic meltdown subsided, the Fed’s focus shifted to ongoing support aimed at restoring economic health. Now, five years after the Global Financial Crisis, the recuperation continues. While the economy has been pulled from recession and is proceeding on the path to recovery, unemployment remains stubbornly high and overall growth is lackluster.

As a result, the Fed announced Wednesday that the third round of quantitative easing will continue as planned until economic data reflects a more robust recovery. The Fed will remain accommodative and continue to purchase $85 billion of Treasury and mortgage-backed securities on the open market per month. As the asset purchases continue indefinitely, the size of the Fed’s balance sheet, which has changed size and composition drastically since the crisis, will continue to expand. Going forward, we expect Wednesday’s announcement to support the ongoing bull market in the equity markets, but at the expense of bond yields, which will likely stay low until the Fed truly begins to taper its asset purchases.

Agg’s Stake in Treasuries Continues to Grow

This week’s chart shows the growth of Treasuries in the BarCap Agg index. As of June 30, 2013, U.S. Treasuries made up 37% of the Agg’s holdings, which is higher than it has been in previous years. In 2007, the Agg’s Treasury position was roughly 22% and in 2010, it moved up to 33%.

This week’s chart shows the growth of Treasuries in the BarCap Agg index. As of June 30, 2013, U.S. Treasuries made up 37% of the Agg’s holdings, which is higher than it has been in previous years. In 2007, the Agg’s Treasury position was roughly 22% and in 2010, it moved up to 33%.

Treasuries have been a growing piece of the Agg recently because the Agg is an issuance-based index. This means that areas of the market with more issuance will gain bigger positions in the index. The U.S. Treasury has been issuing more and more debt over the last few years to cover government shortfalls. As issuance has grown over time, Treasuries have taken up a larger piece of the index than previous years. Indeed, the Agg’s Treasury stake stayed in the mid-20 percent range for most of the 2000s until 2008, when the Fed’s quantitative easing (“QE”) program began. After that, the Treasury stake surged to the mid-30 percent range.

Investors should prepare for an even larger Treasury position in the Agg going forward. The Congressional Budget Office projects Treasury issuance to grow by an additional 68% over the next 10 years. With the taper of the Fed’s QE program looming and an expected rise in interest rates, an Agg that is even heavier in Treasuries is poised to struggle. Given this phenomena, investors should examine their fixed income portfolios and consider looking outside of core bonds for additional diversification and income sources.

The Current Yield Environment

The S&P 500 returned -3.1% excluding dividends for the month of August. As the bull market seems to be losing steam, institutional investors will likely see lower returns from equity markets. Further compounding future portfolio returns is that bond prices are likely to be hampered by the threat of rising interest rates.

The S&P 500 returned -3.1% excluding dividends for the month of August. As the bull market seems to be losing steam, institutional investors will likely see lower returns from equity markets. Further compounding future portfolio returns is that bond prices are likely to be hampered by the threat of rising interest rates. Looking forward, a larger portion of investors’ returns may rely on receiving income in the form of interest and dividends rather than price appreciation.

With that in mind, we focus this week’s chart on asset class yields. Although the 10-year Treasury yield rose sharply in the 2nd quarter, this rise did not represent a parallel shift of the yield curve: yields on the shorter end of the curve remain low. Consequently, traditional bond portfolios with lower duration are still faced with the challenge of low yields, and the yields-to-maturity of the U.S. and Global Aggregate Bond Indexes remain compressed at 2.48% and 2.14%, respectively. Looking purely at yield, we see that senior secured loans (as measured by the CSFB Leveraged Loan Index), real estate (NCREIF Property Index), emerging markets debt, and high yield bonds are all yielding more than double the core bond market. Additionally, senior secured loans and real estate, in particular, offer lower interest rate risk. As such, these asset classes continue to offer compelling diversification benefits as components of an institutional portfolio.

The Wage Gap Between the U.S. and China Continues to Narrow

This week’s Chart of the Week examines the differences in average wages in the United States and China. As China has experienced substantial economic growth, it has also seen its average yearly wage for employed people in urban units rise from ¥9,333 in 2000 to ¥41,799 in 2011.

This week’s Chart of the Week examines the difference in average wages in the United States and China. As China has experienced substantial economic growth, it has also seen its average yearly wage for employed people in urban units rise from ¥9,333 in 2000 to ¥41,799 in 2011 (most recently available data). When converted and normalized into 2011 U.S. dollars, this is an increase from $1,472 to $6,468, which constitutes a 14.6% compounded annual growth rate in real dollars. On the other hand the U.S., like most other developed countries, has experienced stagnant real wage growth, fluctuating between $41K and $44K over the past decade.

A significant difference between the two wage levels remains with the average wage in the U.S. almost seven times higher than the average Chinese wage. However, many of the largest sectors of the Chinese economy are far more labor intensive and better represented by the U.S. minimum wage. The current minimum wage in the U.S. is $7.25/hr or $14,500 annually. Assuming there is no change in the U.S. real minimum wage, the Chinese average wage is on pace to surpass this in 2017.

While China has often been a cheap source of labor for businesses, wage increases could hurt the competitiveness of firms located in China. If Chinese wage growth continues on the current trend companies may decide that it is no longer optimal to produce in China. The effect this would have is twofold. As businesses leave China, the growth in the Chinese economy could slow. Secondly, this could lead to more jobs returning to the U.S., lowering unemployment and increasing wages.

Consumer Driven Economy

This week’s Chart of the Week examines the importance of personal consumer expenditures (PCE) on the U.S. economy. From 1970 to 1st quarter 2013, PCE has grown from 60% to 69% of GDP as the health of the economy has become more dependent on consumers.

This week’s Chart of the Week examines the importance of personal consumer expenditures (PCE) on the U.S. economy. From 1970 to 1st quarter 2013, PCE has grown from 60% to 69% of GDP as the health of the economy has become more dependent on consumers. While many factors can account for the PCE figure, one of the more telling data points is the personal savings rate: if consumers are spending more, they must naturally be saving less. Not surprisingly, the personal savings rate has declined from 12.3% in 1970, indicating a trend of consumers saving less and spending more. Savings rates hit all time lows leading up to the recent recession as consumers spent outside of their means in an overheated economy. In reaction to the economic downturn, consumers became conservative and increased their savings, applying further negative pressure to an already troubled economy. Currently the savings rate has trended back down, a sign that fear has subsided and investors are spending more. This coupled with favorable trends in housing and consumer confidence are positive indicators for future economic growth.

Retail Sales Signal Stronger Economic Growth

Given that consumption constitutes roughly 67% of U.S. GDP, it is not surprising that the trends of retail sales are closely watched to reveal emerging growth or contraction in the economy. In an effort to uncover evidence of economic expansion in the U.S., our chart of the week examines the monthly change of retail sales over the last six years, with a focus on the last few months of 2013.

Given that consumption constitutes roughly 67% of U.S. GDP, it is not surprising that the trends of retail sales are closely watched to reveal emerging growth or contraction in the economy. In an effort to uncover evidence of economic expansion in the U.S., our chart of the week examines the monthly change of retail sales over the last six years, with a focus on the last few months of 2013. In particular, the past four consecutive months of gains in retail sales provide some additional optimism about GDP growth for the second half of the year. While July fell short of expectations growth was still positive (a 0.2% gain in retail sales), though not as strong as June’s increase of 0.6%. The United States Commerce Department stated that business surpluses were unchanged in June while sales sprouted, which implies that companies will need to restock their inventory in the coming months. In turn, economic growth should follow. Overall, this contributes to the growing confidence about the U.S. economy: gains in employment, growing home and equity prices, rising household wealth and more accessible consumer credit are translating into better growth in retail sales and the broader economy.

Stronger Economic Growth Ahead?

Recently we have witnessed the much publicized rise in long term interest rates. Meanwhile, short term rates have remained near record lows as evidenced by 3 month Treasury bill yields near zero. The above chart compares the spread between the yield on 10 year Treasury bonds and 3 month Treasury bills with real GDP growth.

Recently we have witnessed the much publicized rise in long term interest rates. Meanwhile, short term rates have remained near record lows as evidenced by 3-month Treasury bill yields near zero. The above chart compares the spread between the yield on 10-year Treasury bonds and 3-month Treasury bills with real GDP growth. The chart shows a significant widening of the spread in recent months. Historically, a rising spread between the 10-year and 3-month Treasury bonds has been a predictor of strengthening future economic growth, while a declining or inverted spread often foreshadows slowing economic growth or recession. The ability of changes in the yield curve to be a leading indicator of future economic growth is demonstrated by the sharp drop and inverting of the spread prior to the 2008 recession.

The spread between the 10-year and 3-month Treasury bonds has risen by almost 100 basis points over the past few months. This dramatic steepening of the yield curve is a positive sign for stronger future economic growth, which could provide a catalyst for continued stock market gains.

Can Consumer Confidence Continue to Boost the Stock Market?

This week’s Chart of the Week compares consumer confidence (based on the University of Michigan Index of Consumer Sentiment) to the performance of the S&P 500 over the past five years. As the chart illustrates, there has been a very strong correlation between consumer confidence and the performance of the S&P 500 over the past five years, as evidenced by a correlation coefficient of 0.72 over that time period.

This week’s Chart of the Week compares consumer confidence (based on the University of Michigan Index of Consumer Sentiment) to the performance of the S&P 500 over the past five years. As the chart illustrates, there has been a very strong correlation between consumer confidence and the performance of the S&P 500 over the past five years, as evidenced by a correlation coefficient of 0.72 over that time period.

In July, the University of Michigan Index of Consumer Sentiment came in at a level of 85.1, which was the highest level of the index since July of 2007. Given the recent combination of improving labor market conditions, a rebound in housing prices, and all time highs in the U.S. equity markets, it is not surprising that consumer confidence is on the rise. This recent rise in consumer confidence has been accompanied by a simultaneous increase of money flowing into equity mutual funds, which have seen inflows of more than $92 billion year to date in 2013, following five consecutive years of out flows from equity mutual funds (from 2008-2012 when a total of $535 billion flowed out of equity mutual funds)1. The flows into equity funds, along with relatively strong economic data as of late, have resulted in the S&P 500 reaching all time highs during the month of July.

It should be noted, though, that there are some potential risks to consumer confidence over the near term. The July consumer confidence survey indicated that a continuation of the recent rise in interest rates has the potential to be a drag on confidence. The renewed battle over the U.S. budget, which is set to expire at the end of September – including talks of a government shutdown and possible default due to a battle over lifting the debt ceiling – is eerily similar to what occurred in the summer of 2011. During the budget negotiations in summer of 2011, consumer confidence dropped from 74.3 to 55.7, and the S&P 500 from May to September dropped 17.9%. To be sure, there were factors other than the budget battle that contributed to the steep drops in consumer confidence and the equity markets (notably, the Euro crisis was in full swing during this time period).

It is important for investors to pay attention to these potential risks that are on the horizon. Considering the tight correlation between consumer confidence and equity market returns in recent years, any event that has the potential to erode consumer confidence could result in losses in the equity market as well.

1 According to the Investment Company Institute

Small-Caps Lead the Way

The chart above illustrates the year to date outperformance of small-cap stocks (Russell 2000) versus large-cap stocks (Russell 1000). Year to date, small-cap and large-cap stocks have returned 24.8% and 20.3%, respectively.  

The chart above illustrates the year to date outperformance of small-cap stocks (Russell 2000) versus large-cap stocks (Russell 1000). Year to date, small-cap and large-cap stocks have returned 24.8% and 20.3%, respectively. While both indices have largely been positive throughout the year, small-caps have outperformed substantially since June 24th as the stock market has come to grips with a higher interest rate environment, as an increase in Treasury yields has diminished the appeal of large-cap dividend paying stocks. Investors may be willing to take on additional risk and rotate into small-caps, in search of returns via capital appreciation rather than income growth. Additionally, with the prolonged difficulties in international markets, investors may also find small-caps attractive since a smaller portion of their sales are derived from overseas. As a percentage of total revenue, the Russell 1000 derives approximately 34% of their sales overseas, while the Russell 2000 only around 18%. Finally, as corporations sit on large piles of cash, debt is relatively cheap and organic growth remains difficult, we may see continued activity in the mergers and acquisitions markets that should benefit small-cap stocks. These factors may help explain the recent outperformance.

The Effect of “Abenomics” on Equity Returns

Following his election in December 2012, Japanese Prime Minister Shinzo Abe introduced a suite of measures designed to revive the long struggling Japanese economy. Dubbed “Abenomics”, these revamped economic policies sought to revive the economy using three primary “arrows”: monetary easing, fiscal stimulus, and structural reform.  As part of this strategy, the Bank of Japan has embarked on an unprecedented open-ended asset purchasing program that will nearly double the country’s monetary base in two years.

Following his election in December 2012, Japanese Prime Minister Shinzo Abe introduced a suite of measures designed to revive the long struggling Japanese economy. Dubbed “Abenomics”, these revamped economic policies sought to revive the economy using three primary “arrows”: monetary easing, fiscal stimulus, and structural reform. As part of this strategy, the Bank of Japan has embarked on an unprecedented open-ended asset purchasing program that will nearly double the country’s monetary base in two years. The move, which seeks to expand the monetary base from ¥135 trillion to ¥270 trillion by the end of 2014, is seen as a massive gamble to lift inflation expectations and boost growth.

The broad results of these policy changes are shown in the chart above. As the monetary base (blue line) has rapidly expanded in 2013, the Japanese stock market has taken off (red line), albeit with a pull-back in the spring. Not unlike the U.S., easy monetary policy has translated into a positive wealth effect for investors holding Japanese stocks.

For U.S. dollar-based investors, the rally has also had an impact on year-to-date returns. Despite a strong sell-off later in the second quarter and headwinds due to the weakening Yen, the broad based MSCI Japan Index is up over 23% year-to-date as of July 12, 2013. With Japan constituting over 20% of the MSCI EAFE index and nearly 15% of the MSCI ACWI ex U.S. index, Abenomics has played an important role in both index fund and active manager returns year-to-date. Many active global and non-U.S. equity managers held a substantial underweight to the country, which has been a drag on returns in 2013. With the U.S. dollar strengthening, particularly against the Yen, active managers’ position on currency hedging has also played a large role in relative returns over the last year. As investment managers continue to evaluate the effects of Abenomics on companies in Japan and the surrounding region, it is clear that Japan’s fiscal and monetary policies will continue to have a large impact on non-U.S. equity performance.