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US Economy Finished 2013 Healthier than Ever

Index Investing Did NOT Spike Price; BRENT FELL

Emerging Markets, the Dollar and the Fed

Voting with Their Feet

Getting Grim For Gold Miners?

US Economy Finished 2013 Healthier than Ever

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Bluford Putnam

Managing Director and Chief Economist

CME Group

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The US economy finished 2013 healthier than it has been since the depths of the financial recession in 2008 and 2009.  There were a number of milestones in 2013; many have not been fully appreciated.

First, the US energy production boom has probably adding some 0.5% annually to US real GDP.  US crude oil production and natural gas production are already some 40% higher than 2005-2006 levels.  But what really has given the economy a big assist is the less expensive energy prices compared to global competitors leading to an industrial renaissance as well as the huge build-out of infrastructure to move the new gas and oil to market.  In economics, it is often the case that indirect effects swamp the direct observations, and that is certainly happening with the energy boom.

Second, the hugely positive monetary policy event that occurred at the end 2013 was the change in the Fed’s signaling about the economy.  Even though the US economy has been growing at a steady, if not exciting, pace of +2% real GDP since Q3/2009, the Fed has been telling the world that the economy was so fragile it needed life support and emergency measures.  Our perspective is that this negative message caused much more damage to confidence than any jobs that might have been created by quantitative easing.  The Fed’s negative messaging encouraged corporations to sit on their cash and to be much hesitant to invest and expand than otherwise, while quantitative easing did nothing to help the state and local governments get their finances in order – the sector where the job losses have been concentrated since 2009, which leads us to our next point about the milestones passed in 2013.

Third, fiscal drag diminished markedly in 2013.  Most market analysts do not even realize that about 850,000 government jobs were lost between mid-2009 and mid-2013, mostly from states and local authorities.  This was a huge drag on the economy and was the main reason job growth was not stronger and the unemployment rate lower.   This sector finally stabilized in mid-2013.  And then there is the US federal budget deficit, which was vastly expanded to combat the financial crisis.  The federal budget deficit peaked in FY2009 at $1.4 trillion (approaching 10% of GDP).  For FY2013, the deficit had been cut in half, on the back 8% growth in tax revenues and virtually no growth in expenses.  Progress on reducing the federal budget deficit has been coming much faster than many had thought possible.

Fourth, the biggest hurdle of the past few post-crisis years has been resolved.  Recoveries from financial disasters generally are longer and more difficult than a recovery from a cyclical economic correction, because financial disasters expose fundamental weaknesses in the over-extended balance sheets of nearly every sector of an economy.  The process of deleveraging and rebalancing has taken nearly four years, and now that the process is largely complete, the US economy finished 2013 in the best health it has been since 2003-2006, before the financial crisis.

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only.  The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions.  This report and the information herein should not be considered investment advice or the results of actual market experience.

S&P Dow Jones Indices is an independent third party provider of investable indices.  We do not sponsor, endorse, sell or promote any investment fund or other vehicle that is offered by third parties. The views and opinions of any third party contributor are his/her own and may not necessarily represent the views or opinions of S&P Dow Jones Indices or any of its affiliates.

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

Index Investing Did NOT Spike Price; BRENT FELL

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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Maybe the verdict is still undecided for some, but it is hard to look at the evidence and still be questioning the idea that index investing drives underlying commodity prices.   Now that the commodity index rebalance is over and the shift between WTI and Brent is behind, we can examine the impact.  As I mentioned in a prior blog post, Not ALL Weights are EQUAL: Why Brent isn’t Heavier than WTI, there has been a dramatic move out of WTI and into Brent since 2011.  Below is the table:

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

If one follows the logic that prices increase based on index investing, then one would have witnessed falling WTI prices and rising Brent prices.  However, that is not what happened. 

Source: S&P Dow Jones Indices. Data from Jan 2011 to Jan 2014. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance.
Source: S&P Dow Jones Indices. Data from Jan 2011 to Jan 2014. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance.

Notice 3 out of 4 years when the index weights were increasing in Brent, the return over the rebalance period was negative.  Also notice that in 2 of 4 years when the index weights were decreasing in WTI, the return over the rebalance period was positive.

Supply and demand should be unaffected by commodity futures investing since there is no physical delivery from commodity futures investing.  Along with the simple example over the rebalance, there are fundamental stories that demonstrate a disconnect between money flow and price. For example, Brent recently fell pressured by incremental increases in Libyan oil supply and expectations that Iranian crude will return to market.

Another simple argument is as follows: trading, production and open interest stats are similar for crude oil and natural gas where futures trading volume is several times larger than production or consumption.  Sometimes oil prices are up while natural gas is down, so how can futures trading be driving price of oil up while gas, with same trading stats, is down? (Nat gas may be down from fracking technology increasing supply.  A supporting comment is at http://www.econbrowser.com/archives/2012/04/a_ban_on_oil_sp.html with a follow up at http://www.econbrowser.com/)

There is a helpful summary of research studies on the topic of futures trading versus spot prices, which states that currently, there is no clear evidence of futures trading driving spot prices. An article on Vox by Lutz Kilian was based on his paper, “The Role of Speculation in Oil Markets: What Have We Learned So Far?” He co-authored the paper with Bassam Fattouh and Lavan Mahadeva. The article neatly summarized the results of a number of studies on the topic and concluded that the literature has shown that the presence of index funds has, if anything, been associated with reduced price volatility. (This is since long-only investors provide insurance to producers, hence reducing price volatility from the supply side) They found that the existing evidence is not supportive of an important role of speculation in driving the spot price of oil after 2003. Instead, there is strong evidence that the co-movement between spot and futures prices reflects common economic fundamentals, rather than the financialization of the oil futures markets.

Another research piece on the link between commodity futures investing and spot price can be found at http://docs.edhec-risk.com/ERI-Days-Asia-2012/documents/Long-Short_Commodity_Investing.pdf.  The 2009 Staff Report by the U.S. Senate Permanent Subcommittee on Investigation argues that commodity index traders were disruptive forces, driving prices away from fundamentals. If established, this would support calls for an increase in transparency, position limits and margins to curb excessive speculation, and it is hoped – volatility. Since then, the claim that the financialization of commodity markets is responsible for the observed volatility in commodity prices has been the subject of an intense academic debate – the overwhelming conclusion of which has been that it is not possible to empirically link investments in commodity futures and commodity futures prices. (See for Irwin and Sanders (2011) for a recent review of the evidence at Irwin, S., and D., Sanders, 2011, Index funds, financialization, and commodity futures markets, Applied Economic Perspectives and Policy, 1-31.)

The Edhec paper also studies whether the observed financialization of commodity futures markets (as evidenced by the increase in the long, as well as short, positions of speculators over time) has led to change in the conditional volatility of commodity markets or to changes in their conditional correlations with traditional assets. Their results find no support for the hypothesis that speculators have destabilised commodity prices by increasing volatility or co-movements between commodity prices and those of traditional assets. Interestingly, this conclusion holds irrespective of whether speculators are labelled as “non-commercial” in the CFTC Commitment of Traders report or “professional money managers” (i.e., CTAs, CPOs and hedge funds) in the CFTC Disaggregated Commitment of Traders report. Thus their analysis does not call for a change in the regulation relating to the participation of professional money managers in commodity futures markets.

One last simple example, beyond oil, that commodity futures investing is not driving prices is from the summer of 2012.  According to Barclays Capital, commodity index flows were negative approximately $5-6 billion in 2012, but S&P GSCI Grains was up between 30-50%. Why? There was a major drought that destroyed the crop yield. The yield was worst for soybeans from the crop rotation out of the soil, which had the highest return not only from the low supply but from the relatively inelastic demand due to lack of substitutes for soy products.

 

 

 

 

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

Emerging Markets, the Dollar and the Fed

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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The talk that QE 1-2-3 may end sparked predictions that the U.S. dollar’s FX value will rise in 2014 and that this will, in turn, hurt emerging markets.  There are risks in emerging markets, as there are in all markets, but the risks stemming from the expected end of QE 1-2-3 seem to be overblown.  While here at home the Fed’s primary concerns are employment and inflation – these are embodied in the laws that created the Fed – the central bank recognizes that financial damage abroad echoes loudly back to the US economy.  The winding down of QE 1-2-3 will raise interest rates somewhat and will be accompanied by improvements in the US economy.  While both these factors are likely to strengthen the dollar, stronger US domestic demand will be a plus for emerging markets.

However, the real action resulting from a stronger dollar is likely to be in the emerging markets, not in the Fed’s board room. The strengthening dollar, along with higher interest rates, will put downward pressure on emerging market currencies. Further borrowing by emerging markets countries, especially in dollars, will become more expensive. The stronger dollar will lower dollar denominated returns to investing in emerging market equities and may also dissuade some investors.

Other factors will offset some of the pressures from the rising greenback. For companies based in emerging markets, when the local currency falls exports priced in the local currency become more competitive while exports priced in dollars (many natural resources) generate larger local currency revenues. On the debt and fixed income side, many emerging market central banks remember the Asian currency crisis of the late 1990s, hold large foreign reserves and can withstand pressures for devaluations and the rising costs of dollar0denominated debts.  The appearance of local bond markets in some developing nations means less borrow in dollars or euros and more debts in their local currency.

For investors looking beyond the US all this is a reminder to do one’s homework.  The factors mentioned here – interest rates, the dollar, and the extent of local currency borrowing or local bond markets, and whether exports are priced in dollars or something else – all matter. And they all vary from market to market; in some emerging markets a stronger dollar might be a reason to invest.

Lastly, as usual there is no guarantee that an end to QE 1-2-3 will lead to a higher dollar.  The chart of the Fed’s Broad Trade Weighted Index of the dollar leaves the next move far from clear.Not Yet a Dollar Revival

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

Voting with Their Feet

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Tim Edwards

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

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Despite superb returns for the equity markets across the developed world, 2013 was a tough year for active managers.  While the average hedge fund recorded fairly solid gains over the year, such performance paled in comparison to the rampant equity markets.  It was also a year that saw historic lows for the potential returns available from the expert selection of securities.  By some measures, it was the toughest year for stock pickers in decades: rarely in history did the average stock deviate so little from its peers, or from the market1.  The average dispersion between S&P 500® stocks over the twelve months of the year was just below 5%, which is the lowest value across the 23-year data set we’ve collected:

Average S&P 500 monthly dispersion

Source: S&P Dow Jones Indices, as of January 2014.

In such circumstances, the relative value of active management in the equity markets is constrained.  Simply put, accurate bets deliver less alpha. We recently predicted that assets in broad-based index trackers (ETFs in particular) would grow or have already grown larger than the entire hedge fund industry.  December’s numbers are now in for both industries2, and it seems that investors have been voting with their feet in favour of our prediction.  With the current lack of opportunities facing active managers, who can blame them?

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1. Of course, there were plenty of individual equities that recorded stellar or catastrophic performances. The point is that on average such instances were less commonplace – and less dramatic – than has historically been the case.

2. ETFs assets grew around 2% in December (according to Blackrock)

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

Getting Grim For Gold Miners?

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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If you are worried that gold prices are falling, the prognosis could be much worse for gold miner stocks. Although many investors believe the performance of gold miners is just like the performance of gold, this is not quite the case.  If investors look at correlations alone to determine they are getting their gold exposure through gold miner stocks, they are missing a big part of the picture.

The historical correlation of monthly returns between the S&P GSCI Gold (gold) and the S&P Global BMI Gold (gold miner stocks) from Jan 1995-Dec 2013 was 0.78, though it has ranged from 0.68 to 0.90 when looking at 3-year rolling periods and it is at its highest now.

GoldGoldMinerCorrel

So when analyzing the relationship between gold and gold miner stocks, from that perspective, it looks strong – but is potentially deceptive. 

There are influences on gold miner stocks that are less related to gold.  Generally the management of the companies aims to maximize shareholder value where decisions may be in or out of line with the gold price.  For example, decisions on dividends, debt/equity ratios, hedging out the price of gold or switching the metal they are actually mining may drive the stock price.  Sometimes even stocks that are classified as gold miners may have a greater percentage of revenue coming from other metals.

During the aforementioned period (Jan 1995-Dec 2013,) the S&P GSCI Gold returned 212.8% versus a loss for the S&P Global BMI Gold of 36.1%.

Gold Gold Miner CumRet

Why is this? The losses of the gold miners are so much bigger in the negative years for gold and not as positive in the positive years for gold. On average when gold lost in a year, it lost 12.1%, while gold miner stocks lost 27.7%.  When gold gained in a year, on average it returned 14.4% but gold miner stocks were only up 12.8%.

Gold Gold Miner Returns

Also, the annualized volatility of the gold miner stocks is 37.1%, double that of gold at 16.7%.

Gold Gold Miner Volatility

Although there have been years with positive gold returns and negative gold miner stock returns, there has never been a negative year for gold with a positive gold miner stock return. So, a falling gold price could be a bad sign for the gold miners.

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