Category: Chart of the Week

Attractive Level for Bank Loan Discount Margin

This week we look at the historic three year discount margin for bank loans. Bank loans provide a source of financing for public and private corporations as well as private equity firms. They are a floating rate debt obligation generally linked to LIBOR and typically callable with few or no penalties.

This week we look at the historic three year discount margin for bank loans. Bank loans provide a source of financing for public and private corporations as well as private equity firms. They are a floating rate debt obligation generally linked to LIBOR and typically callable with few or no penalties. In comparison to investment grade bonds, bank loans have higher credit and liquidity risk, but lower interest rate risk. In a low rate environment, floating coupons can be attractive to investors.

In 2008 and 2009 liquidity issues caused bank loan prices to drop drastically. This can be seen in the chart, as the price drop drove the three year discount margin to all time highs. Since then, liquidity has improved and the discount margin has come down. In 2012 we saw the discount margin fall from 656 bp to 555 bp. Even with the pronounced decline from 2009, discount margins are still above the long term median of 387 bp. This spread appears to be an enticing option for investors looking to decrease interest rate risk. The discount margin also compares favorably with high yield bonds, and based on early data, institutional investors have begun to swap high yield investments for bank loans.

Is Forward P/E Ratio a Good Predictor for Market Returns?

Today’s Chart of the Week looks at the historic level of the S&P 500 Index relative to the forward estimated price-to-earnings (“P/E”) ratio of the S&P 500 from January 1, 2006 to January 15, 2013. The purpose of this chart is to see whether or not the forward looking P/E ratio can predict performance of the index.

Today’s Chart of the Week looks at the historic level of the S&P 500 Index relative to the forward estimated price-to-earnings (“P/E”) ratio of the S&P 500 from January 1, 2006 to January 15, 2013. The purpose of this chart is to see whether or not the forward looking P/E ratio can predict performance of the index. The P/E ratio compares the value of the share price to estimated earnings per share over the subsequent year. A higher P/E suggests that the market may be approaching a downturn, while a lower P/E may represent a buying opportunity and potential for market gains. Over the last seven years, the forward P/E ratio has averaged 12.5 (depicted in green).

The correlation between forward P/E ratio and the following one year return has been negative, which is to be expected: as suggested above, lower P/E ratios are typically followed by a rising market, while higher P/E ratios have predicted negative returns. Looking at the chart, we see that this basic intuition is supported: low P/E ratios are followed by rising markets. However, the correlation has not been especially strong, with a value of -.39 for the seven years studied in this analysis. More importantly, the correlation has not been stable over this time period, thus making the reliance on forward P/E ratios to predict market performance relatively useless. Certainly, outliers of this ratio – such as its extreme low value on March 9, 2009 (the date that the market bottomed following the financial crisis) – have been useful indicators of extreme market conditions, but they have not proven to be a consistent market predictor.

Therefore, inference of 2013 stock market performance based upon the most recent figure of 11.9 (below the long term average of 12.5) is not meaningful. As much as we would like to extract a precise prediction for the following year’s stock market performance, the relationship between the two variables is not strong enough to predict future performance.

Projected Trends in Employment

This week’s Chart of the Week shows projected trends for non-agriculture employment in the U.S. by major industry sectors over the 2010-2020 timeframe. Every two years, the Bureau of Labor Statistics (BLS) estimates labor force trends over a 10-year period.

This week’s Chart of the Week shows projected trends for non-agriculture employment in the U.S. by major industry sectors over the 2010-2020 timeframe. Every two years, the Bureau of Labor Statistics (BLS) estimates labor force trends over a 10-year period. BLS employment estimates are based on projected changes in both population growth and labor force participation rates within U.S. demographic groups.

Notable employment changes during this time include health care and social assistance (5.6 Mil), professional and business services (3.8 Mil), and construction (1.8 Mil). Nearly half of the projected job growth during 2010-2020 is expected to come from health care / social assistance and professional and business services. Despite strong projected growth in the construction industry, employment is not expected to reach pre-recession levels. Federal government employment is expected to lose approximately 370K jobs with nearly half of those reductions coming from the Postal Service.

The latest release, from February 2012, reflects key demographic changes taking place in the U.S. over the next 10 years. A slower rate of growth within the U.S. population, the continued aging of the baby-boom generation, and decreases in labor force participation rates are expected. These changes will have an effect on both the rate of growth within the U.S. economy as well as which industries will be the driving force of that growth.

Labor Force Participation Rate

Last week, The Federal Reserve agreed to continue purchasing mortgage backed securities, expanding its holdings of Treasury securities and keeping short-term interest rates near zero until the unemployment rate is below 6.5% and inflation remains under 2.5%.

Last week, the Federal Reserve agreed to continue purchasing mortgage backed securities, expanding its holdings of Treasury securities and keeping short-term interest rates near zero until the unemployment rate is below 6.5% and inflation remains under 2.5%.

The unemployment rate has declined from 8.5% at the end of 2011 to 7.7% as of November 2012. On average, the economy has added approximately 150,000 jobs per month in 2012. While 150,000 jobs is a positive figure, it has not been the only driver in reducing the unemployment rate. A drop in the labor participation rate has been the other factor in the declining unemployment rate.

The chart above illustrates the labor force participation rate from January 1948-November 2012. Note that the rate grew precipitously from the 1960’s through the late 1990’s based upon the secular trend of women entering the workforce. Cyclical changes such as recessions have traditionally led to declines as unemployed workers temporarily leave the workforce.

In December 2007, the participation rate was 66%; today it is 63.6%. Now that the Federal Reserve has tied its economic policies to specific unemployment figures, it is difficult to determine if the labor force participation rate declines are cyclical or secular changes. Are the declines due to the baby boomer generation retiring or the younger population staying in school longer? Conversely, are the declines due to a disproportionate amount of discouraged workers who have given up on the job search?

According to the Bureau of Labor Statistics, there are 12 million unemployed and 2.5 million marginally employed. Depending on if and when the marginally employed begin searching for jobs, there may be an uptick in unemployment if job growth cannot accommodate their reentrance and population growth. Given these facts, it may be difficult for the Federal Reserve to achieve its goal of 6.5% unemployment by 2015 without an uptick in the economy.

Buyer Beware?

Our Chart of the Week looks at analyst expectations for 2013 S&P 500 operating earnings. This is a “bottoms-up” estimate which means it is based on earnings expectations for each of the 500 underlying companies in the S&P 500 index.

Our Chart of the Week looks at analyst expectations for 2013 S&P 500 operating earnings. This is a “bottoms-up” estimate which means it is based on earnings expectations for each of the 500 underlying companies in the S&P 500 index.

The S&P 500 index closed last night at 1427.84 and the consensus estimate for 2012 S&P 500 operating earnings is $103.92. This means the current market P/E (price/earnings) multiple is 13.7. Assuming that the current estimate of $114.81 for 2013 is accurate, and assuming no change in the market multiple, this implies a 2013 year-end value for the S&P of 1576 and a total return for equity investors of 12.8% (10.5% price appreciation plus a 2.3% dividend yield).

While this sounds attractive, the prediction above relies heavily on analysts’ 2013 earnings estimates for S&P 500 companies. But as the chart shows, analysts have consistently lowered their expectations for 2013 earnings over the course of the year. After peaking at $119.02 on May 1st earnings expectations have dropped 3.5% and have been falling steadily. Should this trend continue, it not only implies a lower year end value for the S&P 500, but earnings growth expectations are also falling. For investors, these patterns may result in lower than expected equity market returns in 2013.

Real vs. Potential GDP

Among the many factors the Congressional Budget Office (“CBO”) must estimate in budget projections provided to Congress, GDP is often the most important, as it provides a foundation for most other forecasts. While near term GDP growth can often be estimated with some accuracy based on current trends, longer term forecasts rely upon potential GDP.

Among the many factors the Congressional Budget Office (“CBO”) must estimate in budget projections provided to Congress, GDP is often the most important, as it provides a foundation for most other forecasts. While near term GDP growth can often be estimated with some accuracy based on current trends, longer term forecasts rely upon potential GDP. Utilizing the economic factors of labor input and physical capital, potential GDP is a measure of the maximum sustainable output of the national economy. It is the level that national output should be when the economy is at full employment and full resource utilization.

Going back to the 1950’s, real GDP has often plotted very near the CBO’s potential GDP forecast, often correcting any deviation quickly. Since the sharp economic downturn experienced in 2008, however, real GDP has remained below potential GDP, creating a sizeable output gap. In order to close that output gap, the national economy must grow at a faster rate than it has since 2008.

The various dotted lines on the graph contemplate constant forward growth rates in real GDP from the last recorded observation in the third quarter of 2012. Although it is unrealistic to assume the national economy will grow at a constant rate going forward, the analysis presents a hypothetical best/worst case scenario. If the national economy were to grow at a constant 5% annualized growth rate beginning in the fourth quarter of 2012, it would take the national economy until the third quarter of 2014 to realize its potential output. A 4% growth rate would reach potential GDP in the second quarter of 2015, and a 3% constant growth rate would reach potential GDP in the third quarter of 2020. If the national economy were to grow at a constant 2% rate – not far from the observed growth rates of the previous handful of quarters – the gap between real and potential output will continue to grow.

Dramatic Changes for Money Market Funds?

The challenges facing the money market industry continue to mount, with investors and asset managers growing more frustrated with recent trends. As the chart shows, while the decline has stabilized, the downward trend has yet to reverse itself.

The challenges facing the money market industry continue to mount, with investors and asset managers growing more frustrated with recent trends. Investors have now experienced several years of near zero returns out of money market funds. The low rate environment has also forced nearly all money market funds to waive part or all of their fees to ensure a positive or flat yield for investors. Revisions to SEC Rule 2a-7 have created money market funds with shorter maturities, higher credit quality and improved liquidity, all of which have added to lower potential returns for money market funds. In addition, the crisis surrounding Lehman Brothers in 2008 which led to the Reserve Primary Fund “breaking the buck” caused large outflows from money market funds into deposit accounts. Not surprisingly, assets in money market funds have dropped dramatically since 2008. As the chart shows, while the decline has stabilized, the downward trend has yet to reverse itself.

Proposed reforms to money market funds seem to further cloud the issue. The Financial Stability Oversight Committee (“FOSC”) recently outlined three possible reform options, while the Financial Stability Board (“FSB”) proposed similar measures. The FOSC proposals are as follows:

  • Require money market funds to have a floating net asset value.
  • Allow money market funds to continue using a stable net asset value, but require a NAV buffer of up to one percent of assets, and “minimum balance at risk” be made available for redemption on a delayed basis.
  • Allow money market funds to continue using a stable net asset value, but require a risk-based NAV buffer of 3 percent, combined with other measures including diversification requirements, increased minimum liquidity levels, and more robust disclosures.

The FSB is endorsing a recommendation that would convert stable NAV funds to floating NAV funds where possible. The money market industry has come out against these proposals, arguing that such moves would undermine the money market product and drive cash to less regulated financial instruments as investment managers come out with new, more profitable cash management strategies.

Investors rely on money market funds for principal protection, and converting to a floating NAV would have a large effect on the cash management industry. Investors would be left to choose between the safety of the underlying assets of a floating NAV money market fund, versus the creditworthiness of a banking institution, were they to allocate assets to a bank in a deposit account above the FDIC limit. If such regulations were made, the market would likely respond as it has done in the past by creating a product that allows investors to invest in a single product that reduces the administrative complexity of allocating assets to multiple bank deposit accounts to ensure FDIC protection.

Business Investment and GDP

Business investment spending (formally known as non-residential private fixed investment) measures spending by private businesses and nonprofit institutions on fixed assets in the U.S. economy. Business investment spending serves as an indicator of the willingness of private businesses and nonprofit institutions to expand their production capacity, and thus, movements in business investment spending serve as a barometer of confidence in, and support for, future economic growth.

This week’s Chart of the Week compares the rate of change in business investment spending to GDP growth. Business investment spending (formally known as non-residential private fixed investment) measures spending by private businesses and nonprofit institutions on fixed assets in the U.S. economy. According to the Bureau of Economic Analysis, fixed assets consist of structures, equipment, and software that are used in the production of goods and services. Business investment spending includes the creation of new productive assets, the improvement of existing assets, and the replacement of worn out or obsolete assets. Business investment spending serves as an indicator of the willingness of private businesses and nonprofit institutions to expand their production capacity. Thus, movements in business investment spending serve as a barometer of confidence in, and support for, future economic growth.

Given that business investment spending accounts for approximately 11% of total GDP in the U.S., it is not surprising that there is a fairly high correlation between business investment spending and GDP growth. As the chart illustrates, since 2000 the correlation between the quarterly change in business investment spending and the quarterly change in GDP is 0.7.

In 3Q 2012, business investment spending shrunk at an annualized rate of 1.3% compared to the previous quarter, while GDP grew at an annualized rate of 2.0% compared to the previous quarter. Business investment spending has historically been much more volatile than GDP growth, so it is important to note that a contraction in business investment spending in the third quarter does not automatically translate to a future contraction in GDP. In addition, external factors such as uncertainty surrounding the recent elections and the pending fiscal cliff in the U.S. may have caused businesses to temporarily delay investment spending. However, if this contraction in business investment spending continues over the next few quarters, it is likely indicative of a larger negative trend in the economy as a whole. In terms of impact on the financial markets, it is likely dilutive for the equity market, but accretive to Treasuries.

Investors Leave Emerging Markets Behind

This week’s Chart of the Week highlights the relative underperformance of emerging market stocks compared to other “risky” asset classes. Since January 1, 2010, U.S. small-cap stocks1 have returned a cumulative 35.8% and international small-cap stocks2 have returned a cumulative 18% through October 2012. However, quite surprisingly, emerging market stocks3 are only up 8.9% over the same time-period.

This week’s Chart of the Week highlights the relative underperformance of emerging market stocks compared to other “risky” asset classes. Since January 1, 2010, U.S. small-cap stocks1 have returned a cumulative 35.8% and international small-cap stocks2 have returned a cumulative 18% through October 2012. However, quite surprisingly, emerging market stocks3 are only up 8.9% over the same time-period.

Emerging market equities are still treated as a risk-on, risk-off investment. As the graph above illustrates, it appears that investors have returned to some of the riskier equity markets, but have left emerging markets behind. The underperformance of international small-cap and emerging market stocks compared to U.S. small-cap stocks is somewhat explained by investors’ continued concerns with Europe. However, when looking at one of the traditional valuation metrics, price-to-earnings (“P/E”) ratio, it appears that investors may be unfairly discounting emerging market stocks. As of 9/30/2012, U.S. small-cap, international small-cap, and emerging market stocks had P/E ratios of 33.7, 19.8, and 12.5, respectively.

Continued global economic and policy uncertainty suggests that this trend may persist. However, given their low P/E ratios, coupled with growth rates and fiscal health relative to developed countries, emerging market stocks should deliver long-term compelling returns, despite their recent struggles versus other risky equity indices.

1Represented by the Russell 2000 Index
2Represented by the S&P Developed ex. U.S. Small-Cap Index
3Represented by the MSCI Emerging Markets Index

Real Estate Market on the Rebound?

Recently, the decline in the U.S. housing market has shown some evidence of bottoming. The national average home price has crept up off of lows according to the Case-Shiller Home Price Index, and inventories of existing homes on the markets have shrank significantly since the outset of the credit crunch.

Recently, the decline in the U.S. housing market has shown some evidence of bottoming. The national average home price has crept up off of lows according to the Case-Shiller Home Price Index, and inventories of existing homes on the markets have shrunk significantly since the outset of the credit crunch. Given this new data and a Federal Reserve fiscal policy including QE3 designed to induce access to home financing, it begs the question, “Has access to home financing returned?”

The Federal Reserve conducts a quarterly survey of banks operating in the U.S. called the Senior Loan Officer Opinion Survey on Bank Lending Practices. As part of this survey, mortgage lenders report changes in demand for residential loans as well as whether standards for loan approval are becoming more or less stringent. To assess the health of the loan market, this week’s chart focuses on prime mortgage borrowing, since this category reflects loan seekers that should be considered creditworthy. In the chart, we see that banks are reporting a notable increase in demand for prime residential loans this year. Meanwhile, lending standards required by banks remain strict. The data appears to show that for Americans with control over their personal finances, the affordability of home ownership is starting to outweigh the risks. Meanwhile, banks remain cautious. The percentage of outstanding prime mortgages on their balance sheets remains elevated above the historical average. If these trends continue, investors can expect slow improvements in the residential real estate market, but given the persistent attention to high lending standards that was absent pre-crisis, these improvements should prove to be sustainable and accretive to long-term value.