Get Indexology® Blog updates via email.

In This List

A Possible Brexit, a Weak Pound, and an Outperforming U.K. Gilt Bond Market

Divining Brexit

Rieger Report: Bond Market Malformation, Trouble Ahead?

Commodities Return Best 3-Months Since 2009

Home Prices Continue to Rise

A Possible Brexit, a Weak Pound, and an Outperforming U.K. Gilt Bond Market

Contributor Image
Heather Mcardle

Director, Fixed Income Indices

S&P Dow Jones Indices

Year-to-date, the U.K. gilt market has performed the best out of all of Europe’s safe-haven government bond markets.  The S&P U.K. Gilt Bond Index has returned 6.15% YTD, one of the highest in Europe.  Yields in U.K. gilts have tightened by 41 bps since the beginning of this year, with the S&P U.K. Gilt Bond Index yielding 1.36% as of June 1, 2016.  U.K. gilts are still seen as a safe haven despite concerns that the U.K. might elect to exit the European Union.  Concerns over a possible exit have put the pound near its seven-year lows versus the USD.  At the end of Q1 2016, GDP growth in the U.K. slowed to 0.4% from the 0.5% growth seen in the previous quarter, while annual growth was revised down to 2%.

Capture

U.K. polls offer no clear sign as to which direction the June 23, 2016 referendum will take.  Uncertainty often leads to a flight to safety, and the U.K. gilt market continues to be seen as a safe haven.  If a Brexit is voted for and uncertainty in the U.K. economy loom, U.K. gilts could benefit further (prices continue to rise and yields fall), as the Bank of England could keep rates low for longer.  Alternatively, if the British pound weakens significantly as a result of a Brexit, there could be a foreign capital flight out of the U.K.  This could cause a spike in inflation as import costs increase, thus encouraging bond yields to rise.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Divining Brexit

Contributor Image
Tim Edwards

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

The markets’ view of the pending British referendum on EU membership displays the hallmarks of a low probability, high impact event.  Correlations, and volatility expectations, are the key indicators.

When macroeconomic risk is dominant, as a select few narratives come to preoccupy investors, correlations increase.  For example, in August and September 2015, markets worldwide were roiled in concert: on the changing winds of a collapsing oil price, and a loud “pop” in Chinese equity prices, correlations achieved multi-year highs.

The chart below shows the average monthly correlation among the constituents of the S&P United Kingdom index:

Pic 11

Compared to recent levels, and to longer-term averages, UK equity correlations remain reassuringly low.  This tells us that Brexit risk is not currently a major driver of equity pricing. 

But British equities include a number of global standard-bearers with disperse operations such as BP, Unilever and HSBC.  Conversely, the pound sterling has far more direct sensitivity to specifically British trade opportunities, economic growth and sovereign credit.  We can also assess Brexit risk with the CBOE/CME FX Pound Sterling Volatility Index, a measure of the expected movement implied by options on the pound / U.S. dollar exchange rate.

The pound’s volatility gauge is warning of considerable trouble ahead.  The index currently stands at 21.7, having more than doubled in the last few weeks – to its highest level since February 2009.

Pic 12

Note that the current spike in the chart began just as the June 23rd referendum date moved within the 30-day range measured by the volatility index.  Currency volatility shows investors’ Brexit fears.

How can we reconcile these two indicators?  Is the market unconcerned with Brexit, as equity correlations indicate?  Or should we infer, as currency markets seem to be doing, an impending disruption on a level not experienced since the financial crisis?

Correlations tell us when events have come to dominate, implied volatility indicates the magnitude of misfortunes which may never happen.  The key is to appreciate that Brexit is a low probability, high impact event.  The low probability means that minor swings in polling have had little impact on the day-to-day fluctuations in the British equity markets.  Meanwhile, the high impact is shown by the greatly increased cost of insuring against the possible disruption that a vote for “leave” might entail.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Rieger Report: Bond Market Malformation, Trouble Ahead?

Contributor Image
J.R. Rieger

Former Head of Fixed Income Indices

S&P Dow Jones Indices

There is no doubt about it the bond markets are malformed due to quantitative easing (QE). The possibility of a Fed change of short term rates in June or July is on the minds of many. Are the investment grade municipal and corporate bond markets primed for a near term correction as a result? Only time will tell.

However, there are factors that would argue against such a proposition:

  • A rise in rates is most likely ‘baked in’ to each of these markets.
  • The technical imbalance that overhangs both of these markets is supply vs. demand:
    • While investment grade corporate bonds were issued in record numbers, that issuance has slowed, demand however has not. That demand is driven by the need for low risk but incremental yield over risk free yields. Please see yield spread chart below of the bonds of the companies in the S&P 500 (the S&P 500 Bond Index is approximately 92% investment grade) vs. the 10 year U.S. Treasury Bond Index.
    • Municipal bond issuance has seen periods of increased issuance as well as relative ‘dry spells’. The net effect is new issue supply remains below historical norms. Demand for quality tax-exempt bonds remains firm yet still historically cheap relative to U.S. Treasury bond yields.
  • While setting record highs, the equity markets have also seen periods of high volatility. The lower volatility seen in the investment grade corporate and municipal bond markets may continue to be seen as a value proposition for risk averse or ‘risk off’ investor mind sets. The volatility and risk adjusted returns for the S&P 500, S&P 500 Bond Index and the S&P Municipal Bond Index for 3, 5 and 10 year periods ending May 2016 can be seen in the table below.

For a discussion on the U.S. Treasury bond market there is a good read in the recent article “I wouldn’t buy a bond with your money” by Jared Dillian at Mauldin Economics which is focused on the U.S. Treasury bond market, particularly the 10 year bond.

Chart 1: Select indices and their yields (Yield to worst):

Source: S&P Dow Jones Indices, LLC. Data as of June 2, 2016. Chart is provided for illustrative purposes. It is not possible to invest directly in an index. Past performance is no guarantee of future results.
Source: S&P Dow Jones Indices, LLC. Data as of June 2, 2016. Chart is provided for illustrative purposes. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

Table 1: Risk and Risk Adjusted Returns of Select Indices as of May 31, 2016:

Source: S&P Dow Jones Indices, LLC. Data as of May 31, 2016. Table is provided for illustrative purposes. It is not possible to invest directly in an index. Past performance is no guarantee of future results. Risk is defined as standard deviation calculated based on total returns using monthly values.
Source: S&P Dow Jones Indices, LLC. Data as of May 31, 2016. Table is provided for illustrative purposes. It is not possible to invest directly in an index. Past performance is no guarantee of future results. Risk is defined as standard deviation calculated based on total returns using monthly values.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Commodities Return Best 3-Months Since 2009

Contributor Image
Jodie Gunzberg

Former Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

Commodities are starting summer hot and early. Ending May, the Dow Jones Commodity Index (DJCI) was flat, but the S&P GSCI gained a total return of 2.2%, making it the third consecutive positive month for the index. This is the first time commodities have gained three months in a row since the period ending in Apr. 2014, and this is the biggest three month gain, 18.1%, for commodities since the period ending in July 2009 when they returned 20.9%.

Although the industrial metals sector lost 7.1%, posting its worst month in a year, and the precious metals sector lost 6.3% in its first negative month of 2016, the energy sector, currently comprising near 70% of the index, gained 4.6% in May, for a three month return of 30.4%. It’s the biggest three month gain for energy since the period ending in Jun. 2008 when it gained 37.5%. Also, livestock and agriculture gained 3.2% and 1.3%, respectively in May. However, what is interesting is the roll return (measuring backwardation in the sector) turned positive in agriculture for the first time since May 2015 and has improved in energy from -5.6% in Feb. to just -1.5% in May. There has not been an increase in roll yield this quickly in energy in seven years, since May 2009.

Year-to-date, the total return of the S&P GSCI is positive 9.8%, and has gained 26.2% off its bottom in Feb. Commodities are now outperforming stocks for the first year since 2007.

Source: S&P Dow Jones Indices.
Source: S&P Dow Jones Indices.

If this outperformance holds through the year’s end, it will break the longest number of consecutive years that stocks outperformed commodities. Following the last time equities outperformed commodities for near as long in 1980-86, seven consecutive years, commodities returned almost 300% through 1990 when the trend reversed. (The bottom index level of the S&P GSCI Total Return on April 16, 1986 was 716.51. The index returned 299.8% to reach a high level of 2864.40 on Oct 9, 1990.) 

 

 

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Home Prices Continue to Rise

Contributor Image
David Blitzer

Former Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

Charts from the latest S&P/Case-Shiller Home Price Indices released this morning.  Full data available here.

Nationally home prices continue at a about a 5% annual rate.  Price gains vary across the 20 cities covered with the Pacific Northwest region showing the largest gains.

The posts on this blog are opinions, not advice. Please read our Disclaimers.