Category: Chart of the Week

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.

How Will the Stock Market React to June’s Decline?

After 7 months of consecutive gains, the S&P 500 Index (“SPX”) dropped by 1.3% in June. While a down month in the market was inevitable, one of the primary worries for investors as we enter the second half of the year is how the stock market will react to June’s losses. In an effort to answer this question, this week’s chart examines market reactions after previous “winning streaks” were broken.

After 7 months of consecutive gains, the S&P 500 Index (“SPX”) dropped by 1.3% in June. While a down month in the market was inevitable, one of the primary worries for investors as we enter the second half of the year is how the stock market will react to June’s losses. In an effort to answer this question, this week’s chart examines market reactions after previous “winning streaks” were broken. For purposes of the analysis, we define “winning streaks” as positive streaks of six months or more for the SPX. From 1954 to 2012 there have been 18 such winning streaks that were broken. Because we are focused on the second half of 2013, we chart the subsequent 6 month returns of the SPX.

Of the 18 data points in the analysis, there were 16 winners (89%) with a median percentage change of 8.87%. In other words, almost 9 out of 10 times, the end of a winning streak has been followed by positive returns in the U.S. stock market. Although historical data may not be indicative of future performance, investors might take comfort from the S&P 500’s past responses to snapped win streaks.

Health Care Borrowing Costs

This week’s chart compares non-profit health care organizations’ (“HCOs”) cost of debt versus their size. The table illustrates the financial characteristics of 630 HCOs divided into quartiles based on borrowing costs measured by option-adjusted spread (“OAS”). The HCOs examined show a wide dispersion of borrowing costs.

This week’s chart compares non-profit health care organizations’ (“HCOs”) cost of debt versus their size. The chart illustrates the financial characteristics of 630 HCOs divided into quartiles based on borrowing costs measured by option-adjusted spread1 (“OAS”). The HCOs examined show a wide dispersion of borrowing costs. Top quartile HCOs have an average OAS of 0.76%, while bottom quartile HCOs have an average OAS of 3.69%.

Looking at the data, there is a clear positive correlation between an HCO’s size, as defined by revenue and assets, and its OAS. Higher revenue and more assets appear to equate to lower borrowing costs. In addition to revenue and assets, average days cash-on-hand is a financial metric commonly used to assess HCOs financial health. The table illustrates that a higher days cash-on-hand metric typically, but not always, translates into lower borrowing costs.

It appears that while days cash-on-hand is an important determinant of an HCO’s financial health, an HCO’s size, as defined by revenue and assets, is the primary determinant of borrowing costs. If size continues to be the main determinant of HCOs borrowing costs, we would expect to see smaller HCOs continue to merge with larger peers.

1The option adjusted spread is the spread over U.S. Treasuries that would discount a bond’s future cash flows back to its current price.

Planning the End of Fed Stimulus: Can the Housing Recovery Continue Amid Tapering Talk?

Since the end of 2008, the Federal Reserve has held the Federal Funds Rate at approximately 0% in an attempt to stimulate bank lending and revive the collapsing U.S. housing market. The aggressively accommodative monetary policy has caused borrowing rates on traditional 30-year mortgages to steadily decrease from 5.94% in September of 2008 to 3.40% at the beginning of 2013.

Since the end of 2008, the Federal Reserve has held the Federal Funds Rate at approximately 0% in an attempt to stimulate bank lending and revive the collapsing U.S. housing market. The aggressively accommodative monetary policy has caused borrowing rates on traditional 30-year mortgages to steadily decrease from 5.94% in September of 2008 to 3.40% at the beginning of 2013. Following the commencement of this loose monetary policy and a period of bank deleveraging, the deterioration in the housing market began to subside by the close of 2009. Accordingly, the percentage of mortgages considered seriously delinquent (i.e. 90+ days past due or in foreclosure) has steadily declined since then. Additionally, the level of “Shadow Inventory” in the housing market which includes not only homes for sale but also estimates of those that may come to market has decreased by over one third during the same period.

Collectively, these forces have driven a significant recovery in the housing market. However, the recovery may soon face some considerable headwinds as mortgage rates have recently reversed their downward trend. This reversal was partly a result of the release of the Federal Open Market Committee minutes on June 19th in which the Fed indicated the mere possibility of scaling back its stimulus program later this year. While the Fed’s policy remains unchanged and the Federal Funds Rate is expected to remain low through 2015, the perception that federal stimulus cannot continue has had a tangible impact. One week after the release of Fed minutes, the average borrowing rate on a 30-year fixed mortgage has increased from below 4.0% to around 4.6%, one of the more rapid rises in U.S. history. According to the Mortgage Bankers Association Weekly Mortgage Applications Survey, applications fell 3.0% on a seasonally-adjusted basis in the week ending June 21st and 3.3% in the week prior.

It remains to be seen if the housing market, which has been aided by decreasing borrowing rates to this point, can continue along its current trajectory of recovery with rising borrowing costs for homebuyers. A stalling housing recovery would have negative implications across the broad economy and slow nascent growth.

Tough Times for TIPS

This week’s Chart of the Week illustrates the significant increase in yields on the 10 Year Treasury Inflation Protected Security (TIPS) over the past several weeks. From May 1, 2013 to June 19, 2013, the yield on 10 Year TIPS increased from -0.67% to +0.26% (an increase of 0.93%).

This week’s Chart of the Week illustrates the significant increase in yields on the 10 Year Treasury Inflation Protected Security (TIPS) over the past several weeks. From May 1, 2013 to June 19, 2013, the yield on 10 Year TIPS increased from -0.67% to +0.26% (an increase of 0.93%). Over that time frame, investors holding 10 Year TIPS contracts suffered losses of approximately 8.0% (there is an inverse relationship between prices and yields, so as yields increase, prices fall). This huge selloff in TIPS has largely been driven by the increase in yields on the 10 Year Nominal Treasury, which saw yields jump by 0.72% over the same time period (representing a loss of 4.9%). Much of the increase in the 10 Year Nominal Treasury yield has been attributed to expectations that the Federal Reserve Bank, which is currently purchasing $85 billion worth of Treasuries and Mortgage Backed Securities every month as part of its various quantitative easing programs, is going to start winding down its asset purchases in the near future. This was confirmed on June 19, when Federal Reserve Chairman Ben Bernanke announced that if economic data continues to come in line with the Fed’s current expectations, the Fed will begin to scale back the level of asset purchases later this year, and could end the asset purchases entirely by mid-year 2014.

However, the jump in nominal Treasury yields does not fully explain the recent increase in TIPS yields. The yields on TIPS are driven by two primary forces, nominal Treasury yields, and inflationary expectations. Thus, the increase in TIPS yields that is not explained by the increase in nominal Treasury yields is primarily attributable to falling inflationary expectations. This should not be surprising given that one of the primary goals of the Fed’s quantitative easing programs was to prevent deflation from occurring in the U.S. economy (i.e. increasing inflation). The simultaneous combination of higher nominal Treasury yields and falling inflationary expectations are the perfect storm that led to the significant losses in TIPS over the past several weeks.

Fiscal Health Improvements for the U.S.

This week’s chart looks at the CBO’s updated fiscal projections for the U.S. federal government published on May 14th (the red line on this chart is the updated deficit/GDP estimate). These projections are an update from the last set of projections made in February (gray line) and include the full effect of the tax increases implemented on January 1, 2013 and the budget cuts mandated by sequestration, which began on March 1st.

This week’s chart looks at the CBO’s updated fiscal projections for the U.S. federal government published on May 14th (the red line on this chart is the updated deficit/GDP estimate). These projections are an update from the last set of projections made in February (gray line) and include the full effect of the tax increases implemented on January 1, 2013 and the budget cuts mandated by sequestration, which began on March 1st. These updated projections show a $642 billion drop in the expected federal budget deficit in 2013, and over a $6 trillion reduction in the expected deficit over the next decade. The bars on this chart show the projected improvement in the deficit (higher revenue or lower expenditures) compared to the previous projections. Interestingly, a large part of the improvement in 2013 is driven by payments to the U.S. Treasury from Fannie Mae and Freddie Mac, which have recently returned to profitability after being taken over by the federal government during the credit crisis. While the deficit-to-GDP ratio is now expected to shrink substantially over the next few years, the CBO projections still show the U.S. federal government running a structural deficit of 3%-4% of GDP indefinitely. This is because the recent improvement in the deficit has been driven by a cyclical recovery in the U.S. economy and fiscal austerity, but the long term problem of entitlements remains unsolved. These updated projections are clearly good news for the economy and the market in the near term, but until the long term structural deficits are addressed, investors are unlikely to view the U.S. as back to full fiscal health.