Interest Rates Archives — Page 24 of 25

Favorable Relative Valuation for U.S. Large-Cap Stocks

This week’s Chart of the Week examines the historical valuation premium of U.S. small-cap stocks (as represented by the Russell 2000 index) relative to U.S. large-cap stocks (based on the Russell 1000 index). A line above 1.0 indicates a higher relative valuation for the Russell 2000 compared to the Russell 1000. As of June 30th, 2014, the small-cap index carried an 18.7% premium relative to the large-cap index. Investors should typically expect small-caps to command a larger P/E multiple relative to large-caps given that small-cap stocks tend to have higher expected earnings growth rates assigned to them. Despite this, the chart above indicates that small-caps are currently at the upper end of their historical relative valuation premium. This suggests a more favorable entry point for large-cap stocks versus small-cap stocks.

With U.S. equity markets over 5-years into the current recovery and major indices trading near all time highs, small-cap stocks are facing a few headwinds. As the Fed winds down its asset purchasing program and as the market begins to anticipate a rise in interest rates, small-cap performance will be more linked to the health of the U.S. economy and face a greater sensitivity to a rise in interest rates versus large-caps. In addition, large-cap stocks derive a larger percentage of their revenues outside of the U.S. and would be poised to benefit to a greater extent over small-caps from higher expected growth rates outside of the U.S. With relative valuation levels between small-caps and large-caps currently at a high level, a better risk/reward trade-off exists for U.S. large-cap stocks.

Projecting the Increase in the Fed Funds Rate

On July 9, the Federal Reserve released the minutes from the June FOMC meeting which indicated that it is planning to continue the taper of its bond buying program at the current pace and expects to end the bond purchases entirely in October. With the Fed’s bond buying program (more formally known as quantitative easing) coming to an end, the next step for the Fed will likely be an increase in the fed funds rate. In order to illustrate the market’s expectations for the timing of the increase in the fed funds rate, this week’s Chart of the Week shows the implied fed funds rate derived from the fed funds futures market. As the chart indicates, the market currently expects the fed funds rate to remain within the current target level of 0.00–0.25% (0–25 basis points) throughout 2014 and expects the first rate hike to occur at the June 2015 meeting. From there, the market is currently pricing in a series of gradual hikes in the second half of 2015 and throughout 2016 and 2017.

It should be noted that while the fed funds futures market has historically been fairly accurate at predicting near term movements in the fed funds rate (i.e., six months and in), it has a fairly poor track record of predicting longer-term movements (i.e., greater than six months out) especially during periods of transition in Fed policy. Nonetheless, it is important to be aware of what the fed funds futures market’s current expectations are, as changes in these expectations have the potential to significantly impact the broad markets.

Taylor Rule Provides Clues to Future Short-Term Rates

Developed by Stanford economist John Taylor in 1992, the Taylor Rule is a mathematical model designed to estimate the level of short-term interest rates consistent with the Federal Reserve’s mandate to promote price stability and full employment. In making its prediction, the model measures current inflation and unemployment data against a set of ideal targets.

Prior to the great recession, the output of the Taylor Rule proved to be fairly accurate in predicting short-term interest rates. As the financial crisis deepened, however, the Taylor Rule began to suggest that a negative level of short-term rates would be necessary in order to restore economic growth. Bound by zero as the floor for interest rates, the Fed was unable to lower short-term rates to meet the level prescribed by the Taylor Rule. With further interest rate decreases no longer an option, the Fed turned to quantitative easing as a means to further loosen monetary policy. Five years later, with the U.S. economy on more stable ground, the level of short-term rates prescribed by the Taylor Rule has once again turned positive. Not surprisingly, the Fed has begun to slow the pace of quantitative easing with the program scheduled to come to an end altogether later this year. As investors eye Fed clues for the future path of short-term rates, consider the Taylor Rule as a useful guide.

Emerging Market Debt

This paper explores EMD as an asset class, focusing on the benefits and risks. Further, EMD characteristics and their impact on portfolio dynamics are discussed. Recommendations as well as guidance toward making an allocation to the asset class are included.

Due to risks, uncertainty, and overall lack of credit quality, institutional investors have not historically included emerging market debt (“EMD”) in their portfolios. However, the investment landscaped has changed over the past few years. Driven by low interest rates and deteriorating fundamentals in the United States and other developed countries, investors’ interest in EMD has skyrocketed in recent years.

This paper explores EMD as an asset class, focusing on the benefits and risks. Further, EMD characteristics and their impact on portfolio dynamics are discussed. Recommendations, as well as guidance toward making an allocation to the asset class, are included.

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Expect Fed Funds Rate to Remain Unchanged at 6.5% Unemployment

With the unemployment rate (6.6%) approaching the Fed’s forward guidance target of 6.5%, this week’s chart examines two additional labor market indicators: the number of people working part-time for economic reasons and the number of individuals who have been unemployed for longer than six months. In her February report to Congress, the new Fed Chairperson, Janet Yellen, identified these two data points as important gauges for evaluating the health of the U.S. job market.

While we have seen steady improvement in the headline unemployment number (down from a high of 10.0%), much of the “recovery” has been due to a decreasing labor participation rate, and overall the labor market remains relatively weak. Many individuals have resorted to working part-time due to poor labor demand and this segment constitutes 5.3% of currently “employed” workers. While below the high (7.0%) it is still above the long-term average of 4.4%. In addition, a large percentage of the unemployed (35.6%) have been so for more than six months. This is above the long-term average of 25.5% yet below the peak of 45%.

With the risk of inflation remaining relatively low, the market expects the central bank to refrain from increasing the fed funds rate at least through the first half of 2014 in an attempt to strengthen the economy and labor market even if the unemployment rate drops below 6.5%.

2014 Market Preview

January 2014

Similar to previous years, we present our annual market preview newsletter. Each year presents new challenges to our clients, and 2014 is no different: We are coming off a banner year for U.S. equities, low interest rates continue to stymie fixed income investors, and while developed market equities enjoyed a strong 2013, emerging market stocks sputtered. In the alternative space, real estate and hedge funds proved accretive to portfolio returns, while growing dry powder in the private equity space is starting to raise a few eyebrows.

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A Challenging Year for Core Bonds

This week’s chart depicts the challenging environment core fixed income investors faced in 2013. The ten-year Treasury rate jumped causing significant price depreciation while the coupons failed to cover the losses. The Barclays Agg index declined 2.0% in 2013, the first negative calendar year return since 1999. This performance was made up of a -4.6% price return and a 2.6% coupon return.

Facing the prospects of low income and prices losses, many investors transitioned away from traditional core bonds in favor of higher yields and/or lower interest rate risk. It should be noted that this allocation change generally accompanies an increase in credit risk as there is no free lunch. While the bull market in fixed income is likely over and return expectations have been lowered, traditional bonds still serve an important role as an anchor to diversified portfolios, providing a steady source of income and principal repayment to investors.

Fixed Income Repositioning

This week’s Chart of the Week examines the estimated net mutual fund flows that occurred within fixed income from January 2013 through November 2013. Notable fund flow trends during this time included investors diversifying away from more traditional bond categories such as intermediate-term, municipal, government, inflation-protected bonds, and money markets. With generally low yield levels across fixed income asset classes and the expectation of a rising interest rate environment, investors added to categories such as bank loans, nontraditional bonds (which include unconstrained and opportunistic categories), world bonds, and short-term bonds.

Favored bond categories in 2013 tended to carry less interest rate risk such as bank loans and shorter maturity securities. Tactical investments like nontraditional bond and world bond categories where the investment manager typically has more control over interest rate or credit exposures taken at any given time also drew investment dollars. Short and ultra-short bonds were favored as a substitute for money market funds in the current low yield environment.

As investors reposition their fixed income portfolios for an expected low growth and rising interest rate environment, strategies with low interest rate risk or an emphasis on tactical flexibility within their mandates will likely continue to see net positive fund flows.

Income Drives Core Bond Returns

This week’s chart shows the since inception growth of a dollar in core bonds, represented by the BarCap Agg index from January 1976 through August 2013. The total return components, price return and income return, are broken out separately to highlight just how significant the coupon payment is for the performance of this index over time.

This week’s chart shows the since inception growth of a dollar in core bonds, represented by the BarCap Agg index, from January 1976 through August 2013. The total return components — price return and income return — are broken out separately to highlight just how significant the coupon payment is for the performance of this index over time. Since inception, approximately 85% of total return is attributable to the income component.

Given our current low rate environment and the future headwinds of rising interest rates, performance going forward is anticipated to be lower than what was achieved during the last 30 years, which was largely a falling interest rate environment. However, it is important to note that the income component will always yield a positive return, unlike price appreciation which will vary depending on interest rates. Principal repayment and the income from coupons represent a steady and consistent source of return for investors. This feature continues to make core bonds a sensible asset class for most institutional investors who want to maintain liquidity and principal protection in their portfolios.

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