Complete transcripts of the Fed’s policy meetings and conference calls are published with a five year lag. Last week the central bank released the transcripts from 2008, probably one of the more interesting years to “hear” word for word what the members of the FOMC were saying.  The release was almost to the day the five year anniversary of the signing of the American Recovery and Reinvestment Act – better known as Obama’s stimulus — on February 17^th 2009.  These two events are generating discussion of both monetary and fiscal policy over the last few years along with a lot of Monday morning quarter-backing.

If journalism is instant history, then journalism with a five year lag is certainly not history written with sufficient time to digest events and gain perspective.  Recent comments about both the Fed and the fiscal stimulus reflect current policy debates more than anything else. The comments also demonstrate that most of us have forgotten how dark the economy and the markets looked as Lehman collapsed and Congress rejected the first attempt to pass legislation to address the crisis. While acknowledging that we don’t yet understand everything that happened to the economy or why, it is still possible to draw a few conclusions with some possible pointers should such things happen again.

On the fiscal policy side, leaving aside the claims that fiscal policy doesn’t work, that it would have worked if it had been larger or that it did work because without we would have had a second Great Depression, a little bit of data:  The US stock market bottomed out and turned up on March 9^th 2009, about three weeks after the stimulus bill became law. US real (inflation adjusted) GDP quarter to quarter at annual rates were -8.3% in 2008:4, -5.4% in 2009:1, -0.4 in 2009:2 and +1.3% in 2009:3.  Job losses bottomed in the first quarter of 2009 and were positive by the end of the year.  In the numbers, the fiscal stimulus worked.  There was a very deep recession but no second Great Depression.  It is too early to give fiscal policy and the stimulus law a final grade, but it certainly passed and made a large positive contribution.

The Fed transcripts run about 1500 pages including meetings, phone calls and supporting documents.  The number of commentators who have read through all the documents is probably very small (and does not include me).  From the selections reported and repeated in the media and among blogs, one hears of moments of great insight as well as surprise, shock and sometimes scant comprehension of what was happening.  A few things that were learned, and shouldn’t be forgotten, include: what absolutely can’t happen sometimes does, it is difficult to forget or eliminate yesterday’s fears (such as inflation) and just because something hasn’t been done before is not a reason to not do it.  In the end the Fed recognized the liquidity had vanished, that the solvency of many major institutions was being questioned and that no one would accept any risk. The central bank took steps to address these issues with the focus on liquidity and risk by pushing interest rates to zero and flooding the market with liquidity. The resulting rise in asset prices helped address some of the solvency problems. Inflation, five years later, is lower now than it was iat the beginning of 2008.  Through the comments echoed in the media both Chairpersons – Ben Bernanke and Janet Yellen – come across as having understood the problems as quickly as anyone while maintaining a sense of perspective and humor.

It is a familiar concept that commodities have provided inflation protection as discussed in a recent post about a discussion I had with Bluford Putnam, Managing Director and Chief Economist, of our partner, CME Group, to discuss why inflation is likely to appear this year.

I have also discussed how much inflation protection has been provided in a special video on commodities and inflation from our Index Matters Series with Bob Greer of PIMCO and Boris Shrayer (formerly) from Morgan Stanley.

Inflation and commodities generally move together as shown in the chart below:

Source: S&P Dow Jones Indices and ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
Data from Jan 2004 to Dec 2013.  Past performance is not an indication of future results.
This chart reflects hypothetical historical performance. Please note that any information
prior to the launch of the index is considered hypothetical historical performance (backtesting).
Backtested performance is not actual performance and there are a number of inherent limitations
associated with backtested performance, including the fact that backtested calculations are
generally prepared with the benefit of hindsight.

However, in light of the inflation announcement from Feb 20, 2014 that stated US inflation ticked up in January 2014, I have received some questions from investors around the world regarding whether the commodity indices protect them from local inflation.  The answer is that it depends but for most of the countries in the table below, the answer is yes.  As I have explained inflation beta in prior posts, the results can be interpreted as, “if there was a 1% change in CPI, then there was an x% change in the index”.

In the table below, the country CPI is compared to both a global flagship, the S&P GSCI, and an international flagship the S&P WCI.  Notice generally the inflation beta is higher from the international benchmark, the S&P WCI.  Also notice for some countries like South Africa and Mexico, there may not be the local inflation protection one might get from other countries. This is not completely surprising given that some countries have local price controls despite the global nature of commodities, discussed in this post including discussions with the CME Group, ICE and NYSE-LIFFE.

For any investor who has chosen lean hogs as the commodity to invest in 2014, s/he is as “happy as a pig in the index“. The S&P GSCI Lean Hogs are the 3rd best performing commodity in the index YTD, up 16.3%, before the roll.  Even after the roll, the lean hogs are the 5th best performing commodity in the S&P GSCI and the best performing commodity in its sector, livestock. Now the  S&P GSCI Lean Hogs is just 4.5% short of reaching its all-time index level high which occurred in March 2011.  

Rising expectations that cash hog supplies will tighten soon and an increase in wholesale-pork prices have supported the lean hogs in the index. Packers were willing to pay higher prices to insure their immediate slaughter needs (known as convenience yield) were covered as they attempt to catch up production in the wake of weather-induced closures and delays (known as expectational variance or supply shocks). Summer hog contracts remain strong on the expectation Porcine Epidemic Diarrhea virus (PEDv), which is fatal to baby pigs, will cut the U.S. hog herd.

Average monthly returns between Jan-Feb of 2014 of 7.9% are the highest of any first two months since 1999. Further, the average monthly summer backwardation in 2013 of 4.2% was the highest since 2001 and has been increasing since 2010, when it was just 1.9%.  Also in history, only in 14 of 39 years have we seen  backwardation in February and we haven’t seen three years in a row with a backwardated February, like we see now, since 1978-80. 

In the summer months of June-Sept, during the years of backwardation in February, the average monthly total return of lean hogs was 117 basis points higher than in all the years taken together. If this pattern continues with tight supplies of lean hogs, there could be a hot roll this summer. Though one might be cautious given the history of abundance in March.

See in the charts below the data showing historical average returns, backwardation and contango.

Source: S&P Dow Jones Indices and/or its affiliates. Data from Jan 1973 to Feb 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.

The S&P/BGCantor Current 10 Year U.S. Treasury Bond Index closed last week up 0.12%.  January’s Housing Starts number of 880k fell well below the 950k expected number and the prior revised level of 1048k pushing Treasuries up for the week.  The question was how much of the number was due to harsh winter weather or whether a slower economy might be a factor.

The Treasury will be coming to market with supply of 2’s (both floating & fixed), 5’s and 7-year notes. The $109 billion in debt will be auctioned this week.

This week will bring more housing and economic information.  Already U.S. Treasuries are slightly down in price as the Chicago Fed National Activity Index reported a -0.39.  The expected number was -0.20 and the prior December number was a 0.16 which later was revised down to -0.03.  The Dallas Fed Manufacturing Outlook reflected the same sluggishness in the economy as February number was a 0.3 versus a prior 3.8.  Tomorrow’s House Price Index release along with the S&P/Case-Shiller Home Price Index should add insight on top of last week’s Housing Starts number.  Also due to be release this week, outside of housing indicators, will be Durable Goods, Initial Jobless Claims, GDP information and the University of Michigan Confidence Index.  Each and every one of the numbers has the potential to shed more transparency on the overall strength of the economic recovery.

Very little curve movement for this month has the S&P U.S. Issued Investment Grade Corporate Bond Index returning only 0.22% for the month.  The OAS (Option-Adjusted Spread) of the S&P U.S. Issued Investment Grade Corporate Bond Index is pretty much unchanged for February, while in January they were tighter by 8 basis points.  The BBB rating sub-index has tightened in both January and February as moving back down in credit to gain yield has picked up again.

The performance of high yield as measured by the S&P U.S. Issued High Yield Corporate Bond Index reflects the need for yield.  The index is returning 1.26% for the month and 2.03% year-to-date.  The loans in the S&P/LSTA U.S. Leveraged Loan 100 Index have not kept pace with the longer duration high yield index as loans returns 0.04% for the month and 0.65% year-to-date.  Though, a reversal in the direction of rates could change the story very quickly when comparing loans to high yield.

Source: S&P Down Jones Indices, Data as of 2/21/2014, Leverage Loan data as of 2/23/2014.

It is now a well-established trend that institutional investors are allocating to smart beta / risk premia strategies. In a recent survey of 300 institutional investors, 42% of the investors say they have committed a portion of their portfolios to smart beta, while a further 24% say they intend to do so in the future. Regionally speaking, Europe has led the way in the adoption of smart beta, as there are a much higher percentage of European institutional investors making allocation than that of North America and Asia Pacific.

Smart beta strategies typically capture some of the well-known systematic risk premia, such as small cap, value, low volatility, momentum and quality in equities, as well as curve, value, and momentum in commodities. Investors are increasingly using such strategies as building blocks of asset allocation, often with an objective to achieve certain investment outcomes, such as volatility reduction, diversification, and return enhancement.

Exhibit: Categorization of Smart Beta Equity Strategies

Source:  S&P Dow Jones Indices.

The development of smart beta strategies represents an opportunity for individual and institutional investors, as it expands the toolkits investors can use in their portfolio construction and asset allocation. As investors become increasingly aware of the potential benefits and risks of smart beta strategies, the adoption of smart beta may continue to gather pace over the coming years. In particular, investors may increasingly take a multi-factor and multi-asset-class approach to smart beta investing, where they aim to harvest risk premia across asset classes via efficient and low cost vehicles.

Join us at our complimentary seminars to hear our panel of industry thinkers discuss the trends, opportunities and challenges in incorporating smart beta and risk premia strategies in asset allocation. Register here: http://bit.ly/1jDrPqj