Indexology^® Blog

On Wednesday morning the US Bureau of Economic Analysis reported disappointing numbers for first quarter GDP with real growth a scant 0.1% at annual rates – essentially zero.  The same day the Fed reported on its two day policy meeting stating that the economy continues to improve and, as a result, the reductions in quantitative easing will continue.  Commentators are wondering if the Fed somehow didn’t see the GDP numbers or is suddenly not worried about low inflation and the weak labor market.

Rest assured that the Fed does read the GDP numbers, probably more closely than most people do. The headline GDP was nasty but there are some explanations. Exports fell sharply indicating weak economies abroad.  Cold weather was also a factor, probably contributing to the decline in inventories.   Consumer spending grew by about 2%, certainly not a big gain but almost ok. Moreover, consumer spending grew less in January than February and less in February than March.  Monthly patterns within the quarter can have a surprising impact on quarterly GDP.  To calculate consumer spending first quarter growth, one divides the first quarter dollar value of consumer spending by the figure for the fourth quarter of last year.  The quarterly number is average of the the three monthly numbers. If the first quarter consumer spending consisted of no growth in January or February followed by a jump in March the average would be lower than if the growth was front loaded in January followed by two flat months. The first quarter consumer spending was tilted towards much more growth in March so the averaging understated the strength.  The really bad GDP news was the poor results in housing and business investment, both are a real concern. So, digging into GDP, things were a bit better than they appeared, though not wonderful.

There are other reasons for the Fed to continue the process of ending quantitative easing.  QE, even at reduced levels, is boosting asset prices of bonds, stocks and houses. Were the Fed to halt the QE wind-down we would be back to talking about bubbles.  Second, aside from bubbles, the Fed would like to move back to a more normal monetary policy regime where it can reassert its control of interest rates. We have a long way to go and the first step is to do away with QE.

Finally, in April, commodities got hot enough to turn around even the base metals (also known as the industrial metals,) up 1.8% for the month. Although this comeback is not driven by the main supply shocks we are experiencing in energy and agriculture, it is fundamental in nature.  China’s State Reserves Bureau (SRB) is now buying copper in a big way for the first time since 2009.  Also, Indonesia‘s ban on exports of nickel ore has driven it to be the best YTD performer in the S&P GSCI, up 31.6%, only behind coffee, which has gained 81.0%.

While nickel has been up all year, its performance was exceptional in April with a gain of 15.2%, the biggest in the S&P GSCI for the month. All of the other commodities in the base metals sector were also positive with the exception of copper, which has at least stopped bleeding with 0.0% return in April.  It seems the copper buying has overtaken the fears of slowing Chinese demand growth and credit weakness, and again, is not very highly related to Chinese GDP growth.

What is most interesting about the current performance and term structure of base metals is that the performance turned positive this month and term structure is becoming less in contango. The roll yield, a measure of term structure, is now costing only 90 basis points for the year thus far. This is the lowest since 2007 when the last streak of backwardation ended in the sector.  In fact, going back as far as 1978, there were only two periods when the base metals were in backwardation, 1987-90 and 2004-07.

In these periods the average annual premium was 17.9%  with an average return annually of 49.7%. The majority of times for the S&P GSCI Industrial Metals are in contango with an average cost of 5.2%. However, when there is backwardation, it is potent as you can see especially in the 80’s when the sector was up 560.5%, more than three times the still attractive 164.0% just before the crisis.  In these times, the S&P GSCI Total Return was up 182.6% and 65.9%, respectively.

Now may be the turning point for the base metals given the flattening term structure driven by supply shocks and demand pickup. If this is the case, it may just be another fuel in the fire for commodities this year.

Source: S&P Dow Jones Indices and Bloomberg. Data from Jan 1978 to April 2014. 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.

Gold, traditionally, has been perceived as a safe haven that investors flock to during periods of uncertainty and high inflation. The question we are interested in examining is whether or not the safe-haven argument holds true for protecting against homes’ falling prices.

Home prices are generally considered a leading economic indicator since a drop in housing prices implies excess demand and houses being overvalued. Price declines can reduce homeowner’s wealth and employment opportunities in the construction sector as well as government resources through the reduction in property taxes collected.

Gold and home prices, with regard to this post are represented by the S&P Case-Shriller 10-City Home Price Index and the S&P GSCI^® Gold.

The chart below depicts the index levels – rebased on January 1987- of the gold and home price indices. It can be seen that during the housing trough in 2011, gold peaked. In fact, during that time period, physical gold reached a record high of $1,921 per ounce.

The chart below illustrates the year–over-year returns of the S&P Case-Shiller 10-City Home Price Index and the S&P GSCI Gold. Not taking into account the period between 2001 and 2006, yearly returns moved in opposite directions. During the 2001-2006 period, interest rates were historically low and reached a record 1% in 2001. In short, low interest rates make housing more affordable, driving up demand and prices. Low interest rates also make gold investments more attractive, which again drives prices up. In addition during that time period demand for physical gold from China was strong due to its strengthening economy.

Out of the 27 year period covered in the analysis for this post, home prices had 10 annual year-to-date declines. Within the same time frame gold prices recorded seven year-to-date increases. See table below.

Will your floors be paved with Gold?

Source: S&P Dow Jones Indices and Bloomberg. Data from Jan 1987 to December 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.

The possibility of interest rates remaining low means investors will continue to search for yield while also looking to diversify market exposures.  Below we offer a snapshot of two corporate bond landscapes: the U.S. corporate bond market and the Chinese corporate bond market, which has expanded rapidly in recent years.

Size
Tracked by the S&P U.S. Issued Investment Grade Corporate Bond Index and the S&P U.S. Issued High Yield Corporate Bond Index, the total size of the U.S. corporate bond market is around USD 4.8 trillion, which is approximately four times that of the Chinese corporate bond market. Within the Chinese corporate bond market, the offshore market, denoted by the S&P/DB ORBIT Credit Index, is relatively small compared with the onshore market, represented by the S&P China Corporate Bond Index.

Duration and Yield
Both onshore and offshore Chinese corporates demonstrated shorter durations and higher yields when compared with U.S. corporates. See Exhibit 1 for the comparison.

• The S&P U.S. Issued Investment Grade Corporate Bond Index has the longest modified duration and lowest yield-to-maturity when compared with other indices, which reflects the underlying bonds’ quality premium, as well as the difference in the risk-free rates.
• The S&P China Corporate Bond Index measures the performance of onshore corporate bonds and is composed of locally rated investment-grade, high-yield and unrated bonds. The index generally outperforms the S&P U.S. Issued High Yield Corporate Bond Index in terms of both yield-to-maturity and modified duration. Exhibit 2 lists the top five index constituents, which are all financial entities.
• Given its short duration and mostly investment-grade-rated composition, the S&P/DB ORBIT Credit Index provides a compelling yield of 4.52%.

Investors are taught to diversify their portfolio by investing in several different asset classes with different risks and exposures.  In today’s low rate environment, the investment grade corporate bond market in the US and abroad offers a way to pick up additional yield and diversification, while maintaining a relatively low level of risk.  I weighed the performance scenarios of combining both U.S. and International Corporates in today’s economic environment. I compared two corporate bond indices: The S&P International Corporate Bond Index and the S&P US Issued Investment Grade Corporate Bond Index to determine what performance risks both face in their respective markets.  See below a comparison using at 1 year of Yield to Worst (YTW) history.

At first look, we see that the ytw for the US index is 2.85%, while the International index is 2.33%. An investor might choose the US corporate asset class on the lone basis that it is yielding 52bps higher. But to weigh future performance scenarios, while there are many different variables to consider, we will only focus on interest rates and f/x risk, and how those two factors affect bond prices.

The S&P US Issued Investment Grade Corporate Bond Index is comprised of US corporations issuing investment grade bonds in US dollars.  Rates in the US are currently at 0-.25%, all-time lows.  With the tapering of the government stimulus program and positive economic data like the shrinking of the unemployment rate, interest rates in the US are expected to go up.  A rise in interest rates will cause existing bond prices to go down.  This means the 52bp pick up in yield that one gets today would result in a lower total return later, as bond prices would decrease in a rising interest rate environment.

The S&P International Corporate Bond Index is comprised of non-U.S. investment grade corporate issuers and is calculated in US dollars.   Since this index comprises of bonds from the G10 currencies, with the euro having the largest weight, we will focus on Europe.   Europe has low rates of .25% currently. Inflation is very low at .5% and faces deflation risk. The European economy while growing, is growing at a very slow pace, currently .2% and unemployment rates are high. There seems to be no need to raise rates any time soon. If rates don’t go up in Europe then bond prices should remain relatively steady and will hedge any price depreciation in the US.  F/X rates will change the USD value for coupon and redemption payments. If rates in the US go up, the USD will strengthen.  The international fund would be worth less when converted to USD, even though their prices may stay relatively the same, as per the above scenario. Though, there is the possibility that the US economy isn’t growing fast enough for a significant rise in interest rates any time soon. If that’s the case, the USD would not necessarily go up and could weaken, causing the f/x risk in foreign markets to lessen, and possibly raise the value of those bonds in USD.   The USD could also weaken if it loses its safe haven premium.

In today’s market environment it is important to diversify and weigh risks accordingly.