Indexology^® Blog

Treasuries closed the week returning 1.02% as measured by the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index.  Last week’s return was the strongest weekly return since the flight to safety trade driven by Ukraine / Russia news from the week of March 14^th, which remains the largest weekly gain for the year.

This week started with a hop in Retail Sales, as reported numbers were stronger than expected and are at levels that have not been seen since September, 2012.  Treasuries sold off moving the 10-year yield to a 2.64%, up from its Friday close of 2.62%.  Tomorrow’s March CPI number (0.1% expected) along with Housing Starts (975K expected), Jobless (315k expected) and the end of the week Philadelphia Fed Outlook, all have the potential to move the indices.

Away from domestic economic measures, $18 billion of the 5-year TIPS will be auctioned by the Treasury on the 17^th.  The week has the potential to be quiet heading into the Easter Holiday, though global politics and the evolving Ukraine situation can affect the directions of markets at any time.

This week’s new issuance in investment grade debt continues at a healthy pace, the majority of new paper focuses around 3 and 5-year maturities, but there were some longer maturity deals such as $500 million Gerdau 7.25% 30-years.  The S&P U.S. Issued Investment Grade Corporate Bond Index returned 0.8% for the week and is just under about 1% (0.98%) for the month.  Year-to-date investment grade corporates are returning 3.90%.

The S&P U.S. Issued High Yield Corporate Bond Index is returning 0.23% for the month while year-to-date peaking at a 3.34% before dropping slightly to close the week at 3.2% YTD.  A number of ratings changes occurred through-out the week as rating agencies evaluate credit valuations.  One such familiar issuer was Alcoa who rating was cut from BBB- to BB+ by Fitch on the 11^th.  These bonds are already in the S&P U.S. Issued High Yield Corporate Bond Index because of their Moody’s rating of Ba1 and account for less than 1% of the index’s market value.

The pace of loan issuance slowed up a little this past week as issuers dealt with existing calendar deals that have been in the works.  The digestion of recent aggressively structured and priced deals has the S&P/LSTA U.S. Leveraged Loan 100 Index giving up ground for the week returning -0.10%.  Month-to-date this index is down -0.3% and the yearly return has hovered just at or under 1% since the middle of March.

Source: S&P Dow Jones Indices, Data as of 4/11/2014, Leveraged Loan data as of 4/13/2014.

What are Preferreds?
Preferred shares are hybrid equity securities, with characteristics that lie between the traditional fixed income and equity asset classes.  Like common shares, preferred shares represent ownership in a company and are listed as equity on the balance sheet; the ownership isn’t entirely the same though.  Preferreds have preferential rights to dividend payments before common shares, which is thanks to their seniority in the capital structure.  On the other hand, common shares come with the right to vote on corporate matters, a feature that preferreds lack.

Several characteristics that preferreds share with bonds are that they are issued at a fixed par value and dividend payments are a fixed percentage rate of par. Independent credit rating agencies, such as DBRS and S&P Ratings Services, rate preferred securities using the same guidelines as bonds.  Preferreds offer less security to investors than bonds, as they sit lower in the capital structure and issuers have more flexibility in cancelling or postponing a dividend payment if it is running into liquidity issues.

A main benefit of preferreds is that they pay sizable dividends, with most paying a fixed amount on a quarterly basis.  In fact, when looking at the asset class yields of bonds, preferreds and common equity, one can see that preferreds offer the highest yields.

Preferred Market Overview
With interest rates continuing to remain at historic lows, investors have been looking for investments that offer higher yields than common stocks and bonds.  Since preferreds meet this condition and have shown relatively low price volatility, the asset class has been a benefactor of investor demand.  The preferred market in Canada grew to an estimated CAD 61.5 billion at the end of the year in 2013, doubling in size since year-end 2008.  The exhibit below shows the growth of the Canadian preferred market over the past five years.

March marked the fifth anniversary from the Bear market low. Dividends have not only recovered from their bottom, but are setting new records. Yields are less, but relative to other instruments they remain competitive, and have a much lower tax rate. Two observations that became apparent are the risk-reward trade off and the yields. For the S&P indices, the large-cap market has more issues which pay a dividend and more issues which increase year-after-year. On a risk-reward note, the S&P 500 offers a higher yield, with a richer history of increases. However, that security of income comes at the cost of capital appreciation, with the S&P Small and Mid caps having returned more in stock price (and total return).

Data is for U.S. Domestic Common Stock, not just the S&P 500
U.S. domestic common issues set a first quarter record for dividend increases, as the ‘shareholder’ return theme continued. Increases have been made easier by record earnings and record cash holdings. Additionally, many issues (especially large-caps) have heard the knocking at the boardroom door – from activists. I expect strong dividend growth to continue in 2014, as ‘shareholder return’ continues to be the battle cry from boardrooms, and those knocking at the boardroom door. I expect the actual cash payments for 2014 to post a double-digit increase over the record setting 2013 level. Yields remain competitive, with qualified dividends have a tax advantage.

For U.S. domestic common stock in Q1 2014:
U.S. domestic common issues set a first quarter record for dividend increases, as the ‘shareholder’ return theme continued.

Record number of increases (increases, extras, initiations, resumptions), as 1,078 issues increase, surpassing the record of 1,069 set in 1979 (records start in 1955) 102 issues decrease (decrease, suspend), verses 139 in Q1,’13

Q1,’14 indicated dividend rate increases $17.8 billion, a 22.9% rise over the Q1,’13 $14.5 billion gain 12 month March 2014 increases $60.0 billion verses 2013’s $56.7 billion

The percentage of dividend paying issues (U.S. domestic common, ASE, NYSE, NASD) decreased to 47.0% from Q4,’13’s 47.7% (Q3,’13’s 47.4%, Q2,’13’s 47.3%, but up from Q1,’13’s 46.1%)
The number of payers went up, but the number of trading issues went up much more 84.2% of the S&P 500 (421 issues) pay a cash dividend, the most since Sep,’98 (was 473 when I started in May,’77), and all of the DJIA30 issues pay

Yields slightly increased, as the market’s growth slowed (but there was price appreciation) Weighted dividend yield at the end of Q1,’14 was 2.48%, compared to 2.44% for Q4,’13, and Q1,’13 was 2.61%

Dividend yields remain relatively attractive compared to other instruments such as corporate bonds, treasuries, and bank CDs, especially considering the lower (permanent) tax rate advantage.

Payout rates (dividends as a percentage of As Reported GAAP earnings) remain low, as companies payout record amounts, but payout less as a percentage of what they are making -> cash sets another record

U.S. common stocks set a Q1 record (from 1955) for increases, beating out 1979 (fyi: 10-year is 2.68%, was 10.33% in ’79 and then went up to 15.8%; 500 yield is 1.9% and was 5.2%)

We have heard for many years now about the Chinese super-cycle that supported commodity prices since 1999 and we have also heard many debates about whether it has ended.  So if it has ended what now? How huge is the impact on commodity prices?

That all depends on the level of inventories that result from the combination of supply and demand. Theoretically if there were no inventories or supply, it wouldn’t matter how much Chinese demand fell. They could demand all they wanted but there would be no price impacts if there were no supply or inventories.  Realistically this is not the case but there are shortages in various commodities, so the slowdown in Chinese demand growth matters more for some commodities than others.

Another point to remember is that Chinese demand does not slow equally in all areas. Construction, automobile demand and food demand all require different natural resources, so it is understandable that copper, palladium, gasoline and soybeans may not move together. China has also been known to stockpile resources at various times, which may influence the available inventories like in cotton last year.

First let’s take a look at the slowdown in GDP growth from China.  In 2013 the growth was 7.7%, roughly the same as in 2012, which is also close to 1998-99 levels and almost half as much as in 2007 when it was 14.2%. There is no correlation (0.04) between the total returns of the S&P GSCI and Chinese GDP growth, while there is only slightly positive correlation of the commodities to the GDP growth of the US at 0.23 and UK at 0.30.

Further, let’s take a look at the supply and demand situations a few of the mainstay commodities. According to IEA’s March Oil Market Report, although the OPEC and Non-OPEC supply has increased roughly 2 mb/d yoy, it is against a backdrop of staggering inventory draws from a cold snap in the US. From this, the oil stock deficit to the seasonal average is at 154 mb, its widest in more than a decade.

Now let’s evaluate the demand side of oil, and again, what does a slowdown in Chinese demand mean? It depends on the commodity, even within the oil complex. For example gasoil has had the slowest growth yoy in 2013 of -1.6% and 2.5% (projected by the IEA) in 2014 since the demand for transporting coal has dropped. This translated into 54 kb/d coming off demand in 2013 but 83 kb/d coming back on in 2014 (projected by the IEA). However, gasoline demand has been relatively strong with a 6.5% growth in 2013 and 6.2% (projected by the IEA) in 2014 adding up to 129 kb/d in each year of 2013 and 2014 fueled by car sales.

Chinese demand also is relative to the rest of the world. They still have the highest demand growth in the world for oil and even if it is slowing, they are still consuming an additional 344 kb/d in 2014 (projected by the IEA) after a 278 kb/d incremental increase in 2013. The 344 kb/d is less than half of the consumption of the top 10 consumers in the world that the IEA projects will consume 834 kb/d more in 2014. It is actually the slowdown in the US which should be highlighted, where the demand growth is slowing the most, dropping to just 0.5% growth adding just 96 kb/d only behind Japan and Korea in 2014 (according to the IEA).  The world should also watch demand coming from India, Russia, Brazil and Saudi Arabia, which taken together are more powerful than China on the demand front with an IEA projection of an additional 364 kb/d in 2014.

This is all interesting but oil is not the only commodity where the possible Chinese super-cycle bust doesn’t really matter. There are mixed impacts on copper, and as I have pointed out before, copper is not the best indicator of economic health. Currently inventories are at relatively low levels despite weaker Chinese demand.

Despite this inventory drop, the S&P GSCI Copper has fallen 9.05% this year.  Undoubtedly, some of this loss is due to slower Chinese demand; however, more factors are at play. Copper is used as collateral for high risk loans where cash might not be available and the credit default caused a big scare. The bigger question surrounding copper’s future is probably around whether producers can deliver the supply they plan this year and whether Indonesia relaxes its export bans on copper concentrates.

This is evidence of the impacts of low inventories we have been seeing recently.  Commodities this time around, in the new cycle, might not be primarily driven by the super-cycle of Chinese demand growth and may be more impacted by the supply side.

For further evidence, let’s examine the agriculture and livestock. Take a look at the chart below of hog and pig supply. A slowdown in Chinese demand is just not powerful enough to kill the virus driving the rally, where the S&P GSCI Lean Hogs is up 42.4% YTD.

The S&P GSCI Agriculture has also spiked this year, up 15.1% YTD. This has been mainly due to weather that shocked the supply, again outpacing the demand drop from China due to the ban on GMO corn. It’s interesting that in the recent USDA report on World Agricultural Supply and Demand Estimates the focus is much more on China as a supplier than a consumer. Despite this, Agweb pointed out that China is still the third largest importer of US corn and the USDA projects imports to triple from 236 million bushels in 2014/5 to 836 million bushels by 2023. Some say a similar pattern in soybeans could follow.  That seems like super demand growth even with the end of a super-cycle.