Category: Chart of the Week

Changing Composition of the Barcap Agg?

As many commentators have pointed out, over the past two years the BarCap Aggregate has seen a large increase in its benchmark allocation to treasuries. Since December 2008, treasuries as a percentage of the Agg have grown from 21% to 33%. This highlights a drawback of any bond benchmark based on issuance.

As many commentators have pointed out, over the past two years the BarCap Aggregate has seen a large increase in its benchmark allocation to treasuries. Since December 2008, treasuries as a percentage of the Agg have grown from 21% to 33% (see first image above – click on thumbnail for larger version). This highlights a drawback of any bond benchmark based on issuance. Issuance based benchmarks by their nature drive allocations not based on expected risk and return, but based on the funding needs of underlying issuers. One of the primary drivers of the increase in treasuries as a percentage of the Agg has been the large federal deficits caused by the 2008 recession necessitating higher treasury issuance. Historical and projected deficits are shown in the second image above (click thumbnail for larger version).

The federal deficit picture shows why the Treasury component of the Agg may stabilize, albeit at a higher level. While the Federal budget remains challenged and the political environment uncertain, through GDP growth alone the Federal deficit will decrease from its peak.

A more important concern for investors is how the change in the composition of the Agg affects the risk and return profile of their fixed income portfolios. If treasuries increased in market weighting in the Agg, clearly other sectors decreased in weighting. The change in sector weighting in the Agg for major sectors is shown below:

 

Treasury

Credit

MBS

Agency

Securitized
Chg. In Mkt

11.02%

1.16%

-6.49%

-2.59%

-3.10%

Source: Barcap; changes since December 2008

As treasuries have increased as a percentage of the Agg, MBS, agency bonds, and securitized products (ABS and CMBS) have decreased. This is due to a combination of decreases in issuance, especially for securitized products, and Fed purchases (MBS). Notably, the percentage weight to corporate bonds has remained constant on relatively strong issuance, and the weight to credit as a whole has actually increased.

Over the past 10 years, treasuries have been highly correlated with agencies (0.96) and MBS (0.85), and had a lower correlation with credit (0.62). Returns and standard deviations for the past ten years are shown below:

Return

Stdev
Treasury

5.54%

5.09%
Agency

5.36%

3.68%
MBS

5.81%

2.81%
Credit

6.48%

5.85%
If these relative trends continue, and the sector allocation of the Agg continues to have a higher percentage of treasuries passive investors in the Agg will likely not see much difference in expected future returns. However, passive investors will likely see an increase in future volatility, as the standard deviation of treasuries has been much higher than the standard deviation for agencies and MBS. Investors in active core fixed managers are unlikely to experience changes in expectations due to the changing composition of the Agg, as active managers are often perpetually underweight treasuries.

Quantitative Easing and the U.S. Stock Market

In an attempt to stimulate economic growth, the Federal Reserve (the “Fed”) has used multiple monetary policy tools in the past few years: reducing short-term interest rates to virtually zero, introducing numerous facilities to stabilize specific areas of the market, and implementing quantitative easing (“QE”) programs.

In an attempt to stimulate economic growth, the Federal Reserve (the “Fed”) has used multiple monetary policy tools in the past few years: reducing short-term interest rates to virtually zero, introducing numerous facilities to stabilize specific areas of the market, and implementing quantitative easing (“QE”) programs. Announced in late 2008, the first round of quantitative easing (“QE1”) involved the purchase of $100 billion of government sponsored entity obligations and $500 billion of mortgage backed securities. After its effectiveness was reconsidered, QE1 was expanded in March 2009 with the Fed purchasing $1.25 trillion in mortgage backed securities and up to $300 billion of longer term Treasury securities. This massive increase in the Fed’s balance sheet is evident in the chart above, which depicts the securities held outright by the Fed – along with movement of the S&P 500 Index – since 2007. The equity markets rallied more than 50% from the inception of QE1 to its completion; however, once QE1 purchases stopped and the market experienced several troubling issues including riots in Greece and the “Flash Crash” of May 6, 2010, the equity markets experienced a sharp pullback.

In late August 2010, Fed Chairman Ben Bernanke hinted at a second round of quantitative easing (“QE2”) during a speech in Jackson Hole, Wyoming. After the official announcement of an additional $600 billion in longer term Treasury purchases, Chairman Bernanke wrote about QE2 in an op-ed piece for the Washington Post. He noted that QE programs have “eased financial conditions in the past and, so far, look to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action”. He continued, “Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion”. Since the Jackson Hole speech in August 2010, the equity markets rallied nearly 30% through the end of April, 2011.

However, with the culmination of QE2 approaching at the end of June, a recent round of subpar economic news and a decline in the equity markets that erased nearly all of 2011’s year-to-date gains, eyes have turned backed to the Fed to see if additional policy measures will be implemented. During his speech on June 7th, Chairman Bernanke failed to hint of another round of QE as he did in his Jackson Hole speech. Following the speech, several major financial institutions, including Goldman Sachs, JP Morgan, and PIMCO, have stated that the Fed is unlikely to initiate another round of QE, which would leave the markets without ongoing support from the Fed for the second time in nearly three years.

IPO Return Analysis

Last week’s chart addressed the increase in IPOs during 2011. In addition to the number of companies coming to market, the returns of these companies post-offering can also serve as an important metric.

Last week’s chart addressed the increase in IPOs during 2011. In addition to the number of companies coming to market, the returns of these companies post-offering can also serve as an important metric. So far in 2011, stocks that have been public for less than one year, as measured by the Bloomberg IPO index, have returned a positive 4.1%, yet are lagging behind the broad Russell 3000 index which is up 6.7% for the year. While the returns of newly listed companies are often linked to the general direction of the market in which they trade, severe dislocations like the occurrence in 1999 are cause for concern. Although there is some concern about the rapid price increase witnessed for some of the IPOs in 2011, we are still far from the misplaced exuberance of 1999.

Is the IPO Market Back?

As LinkedIn’s highly successful IPO commanded lofty valuations and headlines across the financial press, commentators began drawing parallels to the hot IPO market that preceded the tech collapse at the end of the last decade. Although it has likely been ten years since a new company listing has generated so much buzz, the state of the equity IPO market in the U.S. has a long way to go before reaching the levels seen in the late 1990’s.

As LinkedIn’s highly successful IPO commanded lofty valuations and headlines across the financial press, commentators began drawing parallels to the hot IPO market that preceded the tech collapse at the end of the last decade. Although it has likely been ten years since a new company listing has generated so much buzz, the state of the equity IPO market in the U.S. has a long way to go before reaching the levels seen in the late 1990’s. Through the end of May 2011, 95 new deals came to market raising aggregate proceeds of nearly $30 billion. With a backlog of companies expected to go public in the second half of the year, 2011 is projected to surpass the improved totals recorded in 2010. The offering market has seen a revival since 2008 when only 58 companies went public, but is still a long way from the types of numbers seen in 1999 when 549 companies listed raising over $90 billion.

Foreclosure Trends

There has been much discussion in the media about the improving conditions of the U.S. housing market. As the graph through April 30, 2011 indicates, the rate of new foreclosures is decreasing, the rise in number of significantly delinquent loans has tapered off, and residential construction spending appears to have bottomed out.

There has been much discussion in the media about the improving conditions of the U.S. housing market. As the graph through April 30, 2011 indicates, the rate of new foreclosures is decreasing, the rise in number of significantly delinquent loans has tapered off, and residential construction spending appears to have bottomed out.

Unfortunately, the data does not indicate that all of the U.S. housing market problems are behind us. According to Lender Processing Services, foreclosure inventories on March 31, 2011 reached 8 times historical norms. Additionally, the average days payments were delinquent for properties in foreclosure was 549 compared to 251 in early 2008. As home prices continue to decrease, lenders appear to be showing an increased willingness to modify loans or ignore delinquency in their efforts to spread out the realization of their losses on the sale of foreclosed properties. While this is good news for some delinquent borrowers, it should serve as a reminder of the fragility of the U.S. economy amid the exuberance over strong corporate profits.

The Taylor Rule

The Taylor rule, proposed by John Taylor, is a formula for determining the target Fed Funds rate. In the Taylor Rule, the Fed Funds rate baseline is set to the target nominal rate (target real rate plus target inflation), and then adjusted based on economic conditions. The rule states that the Fed Funds rate should be raised when inflation is higher than target inflation (“Inflation Gap”), and lowered when economic output is lower than potential output (“Output Gap”).

The Taylor rule, proposed by John Taylor, is a formula for determining the target Fed Funds rate. In the Taylor Rule, the Fed Funds rate baseline is set to the target nominal rate (target real rate plus target inflation), and then adjusted based on economic conditions. The rule states that the Fed Funds rate should be raised when inflation is higher than target inflation (“Inflation Gap”), and lowered when economic output is lower than potential output (“Output Gap”). The equation for the Taylor rule is shown below:

Target Fed Funds = Inflation + Target Real Rate + a1(Inflation Gap) + a2(Output Gap)

Though the rule itself is relatively simple, there are many different interpretations of how to implement it. There are of course multiple measures of inflation, and multiple measures of the output gap. In the chart, we use the Core Personal Consumption Expenditures (PCE) deflator, one of the measures favored by the Fed, as our measure of inflation. To measure the output gap, we use the CBO real potential GDP series, a trend line estimate, less actual real GDP.

The other two important components of the Taylor rule are the “weights” placed on the inflation gap and the output gap. These are the terms a1 and a2 in the formula. The larger the weighting, the more the prescribed Fed Funds rate moves in response to changes in inflation and output. In his original formulation, Taylor proposed weights of 0.5 for both inflation and output.

While the Fed does not explicitly follow the Taylor rule, it has proved to be a reasonable approximation of Fed policy. However, the Fed has indicated that it places more “weight” on the output gap than Taylor originally suggested. The graph shows the “original” Taylor rule, as well as an “alternate” Taylor rule with more weight placed on the output gap. In normal times these rules track fairly closely, however, when the output gap is large the alternate rule prescribes a much lower Fed Funds rate than the original rule. This formulation currently suggests a negative Fed Funds rate. Because the Fed Funds rate is up against a zero lower bound, this explains why the Fed engaged in unconventional monetary policy actions such as quantitative easing.

The graph projects out the target Fed Funds rate based on both formulations of the Taylor rule. Real GDP is projected using Bloomberg consensus estimates, and a constant 1.5% inflation rate based on the PCE deflator is assumed. This inflation rate is lower than the 2% target, but higher than the recent reading of 0.9%. Given these assumptions, the alternate rule does not imply an increased Fed Funds rate until 3Q 2012. This is roughly in line with the futures market, which suggests a greater than 50% chance of an increased Fed Funds rate in 2Q 2012.

Finally, this chart is not intended as a forecast, but merely as a template for understanding Fed policy. Any large surprise either to the upside or downside for GDP could impact Fed policy. The more important indicator to watch may be measures of core inflation. The Fed has stated that it favors measures of core inflation (inflation less food and energy), and has described the current commodities led uptick in CPI as “transient.” As long as measures of core inflation remain subdued there is little pressure on the Fed to raise rates until the output gap narrows. Economists should debate why the Fed makes its decisions; investors should only be concerned with how the Fed makes its decisions to determine likely outcomes.

Top Ten Holdings of Domestic and International Equity Indices

This chart illustrates the top ten holdings for the three indices that give investors broad exposure to the U.S. (S&P 500), Non-U.S. Developed Markets (MSCI EAFE) and Emerging Markets (MSCI Emerging Markets). The chart shows the market caps of each of the ten largest companies in the index and are listed from the largest weights (at the bottom) to the smallest weights (at the top).

This chart illustrates the top ten holdings for the three indices that give investors broad exposure to the U.S. (S&P 500), Non-U.S. Developed Markets (MSCI EAFE) and Emerging Markets (MSCI Emerging Markets). The chart shows the market caps of each of the ten largest companies in the index and are listed from the largest weights (at the bottom) to the smallest weights (at the top). Two things stand out. First, investors often believe that by investing in emerging markets they are gaining exposure to smaller companies but, as this chart shows, the largest emerging market firms are multi-national corporations very similar in size and scope to the largest firms in the U.S. Secondly, for both international funds, the relative weights of the companies in the index do not closely match the relative market capitalization of the companies in the index. This is because all of these indices are weighted based on “free float”, which excludes holdings by insiders or other strategic investors. Governments own a significant portion of many of the large multi-national firms in both the MSCI EAFE and MSCI Emerging Markets indices which slightly distorts the weights of these firms in the respective indices.

St. Louis Fed Financial Stress Index

The U.S. economy has strengthened substantially over the past several quarters, and at some point the Fed will have to begin removing excess liquidity and end the special programs it created to support the economy during the crisis. With the Federal Reserve’s second round of quantitative easing (QE2) set to expire in June, there has been much speculation about what will happen once QE2 comes to an end, and when the Fed will begin tightening monetary policy.

In response to the financial crisis and the accompanying recession that began in 2007, the Fed injected massive amounts of liquidity into the U.S. economy and undertook unprecedented actions to help alleviate the stress in the financial markets. The U.S. economy has strengthened substantially over the past several quarters, and at some point the Fed will have to begin removing excess liquidity and end the special programs it created to support the economy during the crisis. With the Federal Reserve’s second round of quantitative easing (QE2) set to expire in June, there has been much speculation about what will happen once QE2 comes to an end, and when the Fed will begin tightening monetary policy.

During periods of economic recovery, the Fed has traditionally used consumer and business spending as well as the level of upward pressure on prices and wages to determine when to begin tightening monetary policy. However, given that the recession the U.S. economy is currently recovering from was largely caused by a financial crisis, the Fed has the added challenge of determining what effect financial market stress will have on the current recovery. In response to this, the Federal Reserve Bank of St. Louis developed the St. Louis Fed Financial Stress Index as a way to measure the overall “stress” in the financial markets. The St. Louis Fed Financial Stress Index combines 18 financial market variables (see table below), each of which captures some aspect of financial stress, into a single index that is compiled on a weekly basis.

This week’s Chart of the Week shows the St. Louis Fed Financial Stress Index from December 31, 1993 through April 15, 2011 (the index was created in December 2009 and was populated with data going back to December 1993). Positive values in the index indicate that financial stress is above the long-term average and negative values indicate that financial stress is below the long-term average. On April 15, 2011 (the most recent date data is available), the St. Louis Fed Financial Stress Index was -0.14, indicating that financial stress is slightly below the long-term average. This is the lowest level the index has reached since October 2007 (i.e. financial market stress is the lowest it has been since October 2007), and the first time the index has posted a negative reading for three consecutive weeks since 2007.

Components of the St. Louis Fed Financial Stress Index:

Interest Rates:
• Effective federal funds rate
• 2-year Treasury
• 10-year Treasury
• 30-year Treasury
• Baa-rated corporate
• Merrill Lynch High-Yield Corporate Master II Index
• Merrill Lynch Asset-Backed Master BBB-rated

Yield Spreads:
• Yield curve: 10-year Treasury minus 3-month Treasury
• Corporate Baa-rated bond minus 10-year Treasury
• Merrill Lynch High-Yield Corporate Master II Index minus 10-year Treasury
• 3-month London Interbank Offering Rate–Overnight Index Swap (LIBOR-OIS) spread
• 3-month Treasury-Eurodollar (TED) spread
• 3-month commercial paper minus 3-month Treasury bill

Other Indicators:
• J.P. Morgan Emerging Markets Bond Index Plus
• Chicago Board Options Exchange Market Volatility Index (VIX)
• Merrill Lynch Bond Market Volatility Index (1-month)
• 10-year nominal Treasury yield minus 10-year Treasury Inflation Protected Security yield (breakeven inflation rate)
• Vanguard Financials Exchange-Traded Fund

Dispersion of Funding Ratios for Public Pension Plans

In aggregate, public pensions are approximately 75% funded (down from a high of 103% in 2000), but there is a great degree of dispersion of funding ratios on a state by state basis.

For all the bad press about the state of public pension plans, the chart above shows that not every state’s pension system is poorly funded. In aggregate, public pensions are approximately 75% funded (down from a high of 103% in 2000), but there is a great degree of dispersion of funding ratios on a state by state basis. Certainly, there are problem states, as shown by the bar on the left, with 11% (as a percentage of total public plan assets) funded at less than 60%. On the other hand, an almost equal percentage is fully funded, thus showing that not every state’s pension system is in need of massive contributions.

Existing Home Sales

While the U.S stock market enjoyed an upward trajectory over the past 18 months, the U.S. housing market continues to experience its ups and downs. Enacted in the beginning of 2009, the American Recovery and Reinvestment Act provided a tax credit to home buyers. At the time, U.S home sales were in a freefall, but this credit helped reignite the market.

While the U.S stock market enjoyed an upward trajectory over the past 18 months, the U.S. housing market continues to experience its ups and downs. Enacted in the beginning of 2009, the American Recovery and Reinvestment Act provided a tax credit to home buyers. At the time, U.S home sales were in a freefall, but this credit helped reignite the market. That was a short-lived phenomenon, however. Following the tax credit’s expiration in 2010, home sales dropped precipitously again. Average sales prices have also been on a steady decline since July 2010, and now stand at their lowest level since 2002. Interestingly, cash sales (33% of all existing home sales) reached a record level in February 2011, as homebuyers and investors take advantage of lower prices.

The real estate market continues to show stress in 2011. The most recent February report showed a sharp drop in existing U.S. home sales, which fell well below consensus expectations. The number of previously owned homes on the market rose 3.5% to 3.49 million. That represents nearly 9 months of supply based on the current rate of sales. Coupled with the “shadow” housing inventory of bank-owned and potentially foreclosed homes, that number increases to nearly 5.3 million homes, or over 13 months of supply.

Without the enticement of the housing tax credit and the increasing stock pile of foreclosures and existing homes on the market, the U.S residential real estate will continue to struggle for the foreseeable future.