Topic Tags: Commodities

The Easter Bunny’s Hopping All The Way To The Bank

The Easter Bunny has a lot to celebrate this holiday as cocoa and sugar prices continue to slump. Both commodities experienced a supply surplus in recent months, largely due to substantial rains during El Niño, which has substantially decreased prices. The Ivory Coast experienced a hearty rainy season and dry winds from Northern Africa were below their historical averages; both trends increased the country’s cocoa yield and led to a 20% reduction in cocoa prices over the past 6 months. Additionally, Brazil benefitted from a very healthy rain season which led to a record production of sugar crops and a global surplus of the commodity. Sugar prices have fallen 18% in the past 6 months.

Americans are anticipated to spend $2.6 billion on Easter candy this season and the Easter Bunny’s haul is a substantial portion of that total which should allow him to increase his margins. Given the uncertainty across the globe, coupled with high equity valuations and the prospect of rising interest rates, we recommend he invest in a diversified portfolio and rebalance as appropriate.

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Should Investors Allocate to EMD in 2017?

Recent events have strengthened the case for Emerging Markets Debt (EMD). Our chart of the week shows how yields for local and hard currency strategies are above their historical averages and are an attractive opportunity as we begin 2017.

Recent events have strengthened the case for Emerging Markets Debt (EMD). Our chart of the week shows how yields for local and hard currency strategies are above their historical averages and are an attractive opportunity as we begin 2017.

The European Central Bank extended stimulus by nine months, albeit at €60 billion per month instead of the original €80 billion per month. Trump’s trade policy proposal is largely isolated to China, and his immigration policy may have a positive effect on Mexico given that its consumer pool and labor force may grow as a result. Lastly, the price of oil is on the rise with the recent OPEC deal, which is a positive for EM oil exporters. All of these facts support an allocation to EMD.

If Trump’s infrastructure policy is enacted we would expect commodity prices to rise, which would be a tailwind for EM commodity exporters. If Trump’s trade policy is adopted, it should be a headwind for EM manufacturers. But overall, EMD fundamentals are attractive. Current accounts of EM countries are stronger and leverage is still low relative to developed market countries. Spreads are at wide levels and yields are high, which provide a cushion for any downside. In total, EMD offers diversification, yield, and upside potential and should contribute to positive returns for investors in 2017.

What Does The Future Hold For Oil?

While the above curves are simple in appearance, they can hold great predictive power for investors. Futures curves are just as they sound: future price speculation on a given day. The red line represents the futures pricing of WTI Crude Oil as of November 28th, just a few days before OPEC members decided to cut output in the hopes of combating oversupply and ultimately raising oil prices. Purchasing futures on oil for delivery in July of 2017 would give the futures owner the right to sell oil at a price of about $50/barrel. This investment strategy is often employed by speculators, hedge funds, and producers. Producers are able to hedge their exposure to oil and buy futures as a pseudo insurance policy as it locks in the price at which they can sell oil at some point in the future.

While the above curves are simple in appearance, they can hold great predictive power for investors. Futures curves are just as they sound: future price speculation on a given day. The red line represents the futures pricing of WTI Crude Oil as of November 28th, just a few days before OPEC members decided to cut output in the hopes of combating oversupply and ultimately raising oil prices. Purchasing futures on oil for delivery in July of 2017 would give the futures owner the right to sell oil at a price of about $50/barrel. This investment strategy is often employed by speculators, hedge funds, and producers. Producers are able to hedge their exposure to oil and buy futures as a pseudo insurance policy as it locks in the price at which they can sell oil at some point in the future.

The blue curve is shifted dramatically upwards because it represents the futures pricing of oil on December 5th, just days after the OPEC meeting. After OPEC members agreed to rein in production, prices rose dramatically: 13% in just 2 days. While this near-term shift upwards makes sense, the inverted portion of the curve tells an additional story. The inversion referenced in the chart suggests a strong producer hedging presence in the market; oil producers wanting to buy futures on oil outnumbered speculators that would take the other end of this bet. To compensate for this disparity, producers will accept a slightly lower price for the security of locking in a sales price now. The enthusiasm with which producers were locking in their future sales price may imply that producers do not believe oil prices will increase a significant amount within the near future. In other words, perhaps they are not incredibly optimistic about the outcome of this OPEC deal.

The deal’s success does face some challenges. Recently, a few African OPEC member countries have actually increased their output as they are not held to the OPEC cut obligations due to extenuating domestic circumstances, meaning other member countries will need to compensate via further reductions. More generally, many did not believe the group could reach an agreement, so that a deal was even reached is an optimistic sign for oil. While the reliability of the member countries is questioned by some, ultimately we will see if the group has been successfully cutting production in the coming months as output data is released. If the cuts are made then we may continue to see the price of oil rise in 2017.

Look Out For Falling Angels

Over the past year, many bonds from energy and metal/minerals issuers which previously held investment grade ratings were reduced to junk bond status, commonly known as fallen angels. These include Freeport-McMoRan, the largest copper producer in the world and Chesapeake Energy, the second-largest gas producer in the U.S. This week’s chart examines this unprecedented phenomenon. Fallen angels now account for a mind-boggling 42% of the energy and metal/minerals constituents in the Credit Suisse High Yield Index. With this influx of fallen angels, energy and metal/minerals now make up about 21% of the high yield index, up from 15% in February.

Over the past year, many bonds from energy and metal/minerals issuers which previously held investment grade ratings were reduced to junk bond status, commonly known as fallen angels. These include Freeport-McMoRan, the largest copper producer in the world and Chesapeake Energy, the second-largest gas producer in the U.S. This week’s chart examines this unprecedented phenomenon. Fallen angels now account for a mind-boggling 42% of the energy and metal/minerals constituents in the Credit Suisse High Yield Index. With this influx of fallen angels, energy and metal/minerals now make up about 21% of the high yield index, up from 15% in February.

Many investment grade strategies, as well as their institutional investors, have been forced to sell these fallen angels because of investment policy guidelines, temporarily depressing prices and thus presenting cheaper than normal buying opportunities. Furthermore, the shift of bonds from investment grade to high yield has created a unique challenge for the team dynamics of investment managers. Investment grade research analysts are losing issuers to cover since many of them have been downgraded while high yield research analysts are now responsible for covering more issuers. Some investment managers are even transferring investment grade analysts to high yield positions because they are already familiar with the bonds that have become fallen angels.

Marquette recommends that investors maintain their high yield bond allocations. Because of these temporarily depressed prices and the change in name coverage within investment management teams, inefficiencies and opportunities have been created in this cross-over section of the bond market. However, there are risks. We should continue to see an increase in the default rate for high yield energy and metals/minerals issuers. Given lower commodity prices across the globe, while costs have been reduced for pumping oil or mining for metals, the energy and metal/minerals industries have yet to make any significant improvements. Many companies are still filing for bankruptcy, even though oil prices are beginning to slightly rebound. Ultimately, the current opportunities should outweigh these risks, but volatility in the high yield market will likely remain elevated for the foreseeable future.

A Bifurcation in High Yield Defaults

The price of oil recently rose over $50 per barrel following a dip near $30 only a few months ago. Despite this price recovery, many high yield energy issuers are still finding it difficult to make their debt payments, and default activity surged in May.

The price of oil recently rose over $50 per barrel following a dip near $30 only a few months ago. Despite this price recovery, many high yield energy issuers are still finding it difficult to make their debt payments, and default activity surged in May. These defaults are defined as missed coupon payments, missed principal payments, bankruptcy filings, or distressed exchanges. Notable May defaults include Linn Energy, SandRidge Energy, Midstates Petroleum, Breitburn Energy Partners, and Penn Virginia.

The default rate of the overall high yield index is now 5.2%, as shown by the blue line in this week’s chart. The default rate has recently risen due to more defaults in the high yield energy and metals/mining sectors. Defaults of issuers in that space now stand at 17.8%, as shown in the red line. Meanwhile, excluding energy and metals/mining, the default rate is at pre- and post-crisis lows, at 1.7% as shown in the green line. This bifurcation means that while the energy and metals/mining sectors have suffered from low oil and metals prices, the rest of the economy — healthcare, technology, financials, etc. — have performed as well as ever, at least in terms of how defaults can reflect performance.

The 5.2% overall high yield default rate and the 17.8% high yield energy and metals/mining issuer default rate confirm our previous paper about expected defaults for the year. Based on March-end spreads as a measure of the market’s expectation of defaults, the market was implying a default rate of 4.77%. The range we provided was 4% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 10%, to 6.2% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 30%, to 8.4% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 50%. With the steady rise in the price of oil, we would be surprised to see the high yield energy and metals/mining issuer default rate reach as high as 50%, which should eliminate the worst case scenario for high yield investors. Of course, capital markets are dynamic and can change unpredictably, so we will continue to monitor this trend.

What Should We Expect From an Oil Rebound?

Over the past 18 months oil has been a significant drag on global financial markets. While oil producing countries have obviously been hit the hardest, the rest of the world has also struggled. But recently there’s been a mild resurgence in oil, with the WTI index now near $50 per barrel.

Over the past 18 months, oil has been a significant drag on global financial markets. While oil producing countries have obviously been hit the hardest, the rest of the world has also struggled. But recently there’s been a mild resurgence in oil, with the WTI index now near $50 per barrel. This is still nowhere near its previous levels of over $100, but it is a significant increase from the low of about $26 seen earlier this year. This Chart of the Week examines what this means for different parts of the world by looking at the daily correlations between oil and MSCI countries’ indices over the past 18 months.

Not surprisingly, emerging markets, along with Canada, have the highest correlations due to their heavy dependence on oil exports. They’ve also had the worst performance over the past few years but stand to gain the most from rising oil prices. Developed markets though also have high correlations and even in the U.S. and Japan, which have the least significant correlations, oil is still a major factor. These correlations won’t necessarily hold up going forward, but the trend suggests that if oil continues its slow recovery financial markets will benefit across the board. While other issues may affect this recovery, such as a “Brexit” or Japan’s deflationary pressures, overall rising oil prices should be a boost to the global economy.

Will the Emerging Market Equity Rally Continue?

For this week’s chart of the week we take a look at the year to date return stream of emerging market equities, as measured by the MSCI Emerging Markets (“EM”) Index, which has been on a wild ride as oil prices fluctuated over the first three months of the year.

For this week’s chart, we look at the year-to-date return stream of emerging market equities, as measured by the MSCI Emerging Markets (“EM”) Index, which has been on a wild ride as oil prices fluctuated over the first three months of the year.

After reaching their 2016 low in the middle of January, emerging markets embarked on a sharp rally in the second half of February that continued through March and early April. On February 10th, due to concerns about the impact of a further rate hike on both domestic and foreign economies, Federal Reserve Chair Janet Yellen signaled postponement on the March rate hikes. The postponed rate hike decision coupled with continued weakness of the dollar and stabilization of commodities led to the rally starting on February 12th.

Earlier this week, China released positive upbeat news, announcing its exports rose 11.5% compared to a year earlier and surpassing analyst expectations which led to a strong April start for emerging market equities. As volatile as this first quarter of 2016 was, we frequently remind clients of the importance of having a long-term approach to investing as we have seen the EM index swing from significantly negative in January to +6.7% year to date as of April 13th. Certainly, EM investments will demonstrate elevated volatility across market cycles, but it is critical to maintain a long-term focus on their performance as it relates to total portfolio returns.

Is Now the Time to Buy Emerging Market Equities?

March 2016

Over the last five years, emerging market (“EM”) equities have struggled to keep up with their developed market (“DM”) counterparts. Losses were extended into 2015, when this asset class lost 14.9%. Given the poor performance, it is not surprising that emerging market equities currently offer the most attractive valuations. The S&P 500 and MSCI EAFE trade at roughly 7–10% above their ten-year averages while the MSCI EM index trades 17% below. Given these valuations, when should investors expect a pick-up in performance?

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Has Oil Driven Down the U.S. Equity Market?

Given the recent drops in oil and U.S. equity prices, many have concluded that the significant decline in oil prices has driven down the stock market.  Indeed, from the onset of oil’s sharp dip, correlation between the two daily returns has greatly increased to about 45% on a 6-month rolling basis.

Given the recent drops in oil and U.S. equity prices, many have concluded that the significant decline in oil prices has driven down the stock market. Indeed, from the onset of oil’s sharp dip, correlation between the two daily returns has greatly increased to about 45% on a 6-month rolling basis. Our chart this week examines if the correlation between oil prices and the equity market has always been so significant.

Going back to 1984, we graph the correlation between oil prices and the U.S. equity market (represented by the S&P 500 index) against the price of oil. Over this longer time period, it is quite apparent that the correlation is fluid, changing significantly across different time periods. Over the entire time period, the correlation averages only 7.7%. Certainly, in times of oil price volatility, correlation tends to rise between oil prices and stock markets, but it is not consistent over time and thus not a reliable indicator of future stock market direction. Though correlation does not imply causality, oil’s apparent influence on investors’ nerves, and consequently the market, may be a temporary indicator of market sentiment.

Is It Time to Buy MLPs?

MLPs recorded their second worst year of performance in 2015 (-32.6%), reaching levels not seen since the financial crisis when the Alerian MLP Index fell 36.8% in 2008. Performance in 2015 can be attributed to the following factors…

MLPs recorded their second worst year of performance in 2015 (-32.6%), reaching levels not seen since the financial crisis when the Alerian MLP Index fell 36.8% in 2008. Performance in 2015 can be attributed to the following factors:

  • Increased supply from U.S. shale producers and OPEC members (especially Saudi Arabia) and concerns about weak demand from China led to a sharp drop in oil prices.
  • As energy prices dropped concerns emerged about U.S. oil and natural gas production volumes and the potential impact on MLPs.
  • As MLP prices began to fall, closed-end MLP funds — which use leverage — were forced to sell into a declining market to maintain their leverage ratios.
  • Investors began to worry that lower equity prices and higher costs of debt would force MLPs to cut their distributions in order to conserve cash for future growth funding.

As a result, many wonder if now is an attractive time to purchase MLPs, given the significant price decline in 2015. This week’s chart compares one of the most commonly used metrics to value MLPs, the enterprise value to earnings before interest, tax, depreciation, and amortization (“EV/EBITDA”) relative to the S&P 500. A ratio above (below) the average represents a premium (discount) on MLPs (based on the Alerian MLP Index) compared to the S&P 500. In light of the recent sell-off in the MLP sector, MLPs are now attractively priced with EV/EBITDA multiples trading more than one standard deviation below their long-term average (since June 2006). However, given the uncertainty around future Fed rate hikes combined with persistently low oil prices and negative sentiment across the energy sector, MLPs may experience further volatility in the short term before the market returns to equilibrium. Over the longer term, we expect midstream MLPs to benefit as commodity prices stabilize and volume growth resumes.