Indexology^® Blog

Investing, for some can be a pretty cumbersome task. Surprisingly, many professionals may also confess to being lazy in the “investing” department. Very often investment houses enthuse the dormant investors with a rendition of a very popular slogan, “You are working hard for money, but is your money working hard for you?” It’s the same old story that we hear over and over with excuses founded on busy schedules, daily routines of hectic work and simply put, no time. Many of us are comfortable just knowing that our monthly paycheck sits safely, resting in a bank savings account. Currently, the average savings accounts interest rate(s) are between 4% and 6% but are we really earning that interest? The Inflation Rate (Consumer Price Index) in India has been close to reaching double-digits since 2009. If we were to actually understand the ultimate net return on our savings, we would realize that it’s actually negative!

In India, there are two popular avenues of investment, bank deposits and gold. The annual bank fixed deposit rates for the past year have ranged between of 8% and 10%. Realizing that inflation is in fact eroding the returns does give cause to look for viable investment options. As per the latest World Gold Council report, India, for the first time lost its tag of the world’s largest gold consumer to China, who was reported to have 1,065.8 tons in 2013. The Indian government in order to reduce the large current account deficit, introduced a number of measures last year.  These measures are intended to curb the demand for gold, which is one of the country’s biggest imports.  However, it seems that this was only an initial check as the demand for gold is expected to be back on the rise this year. While a few see gold as an investment, many consumers merely hoard this commodity, thereby widening the deficit even further. As shared by my colleague, Jodie in an earlier post on Indexology, in 2013 gold lost 28.3%, the most in a single year since 1981, when gold lost 32.8%. Following this event, a recovery period for gold started, which lasted 25 years. If history it set to repeat itself as we have all come to believe it does in some form or fashion, there may be a long recovery period for gold to follow. However, much of this depends on the fundamentals of investing for today and the availability of investment options today which are supposed to make investing effortless and simple. Olympic Metals: Going For The GOLD?!

It doesn’t take a weatherman to point out the crazy weather we have experienced in the recent past. There are more severe droughts, storms, freezes and heat that many blame on climate change. The National Climate Assessment, that will drive Barack Obama’s environmental agenda, notes that average temperature in the US has increased by about 1.5F (0.8C) since 1895, with more than 80% of that rise since 1980. The last decade was the hottest on record in the US.

What impact does this spike in temperature have on agriculture and the price of food we consume?

It depends on a number of factors and the answer may be different than you think. Production, a factor some think is an obvious driver, is often not closely related to price, which can be observed somewhat through the relationship of roll yield and price returns. Although in 1973, when a large percentage shortfall from expected production occurred, there was a large price spike, sometimes the impact has been far less severe. Other shortfalls happened in 1983, 1988, 1993 and in 2012 but the prices barely moved. The chart shows that a significant production shortfall is neither necessary nor sufficient to cause a price spike.

Looking at seasonal data that is broken by quarter from 1970-2014, the S&P GSCI Agriculture returns are generally stable with a decrease in returns during the summer quarters (Q3) mainly from the huge spike in the mid 70’s.

However, more than 80% of the temperature rise has occurred since 1980, and with that has come some prices increases, even with the financial crisis and huge demand drop of 2008-9. When we cut the shortfall of the 70’s out, the picture changes with an increase of roughly 16 basis points per summer quarter (Q3), which could be due to the climate change.

What is more interesting is the rise in premiums when premiums were commanded. Notice Q1 of 2014 is the best performing first quarter in the history of the index.  Seasonally in Q3, when the dog days of summer occur, is when the prices spike most.  Q3 of 2010 was the best performing summer in history, up 33.4%, besides in 1973 when prices spiked 44.0%. Return premiums are rising through time, except in the second quarter, and on average have been 6.0% (Q1), 8.6% (Q2), 10.0% (Q3) and 9.2% (Q4) with average quarterly rises of 0.16% (Q1), -0.39% (Q2), 0.30% (Q3) and 0.17% (Q4) .

Then can rising prices be attributed to hotter summers?

There are still more factors at play such as inventories that incorporate supply, demand and storage.  Remember when inventories are critically low, like they were in the 70’s and may be now, prices are much more sensitive to shocks like weather.  According to Agricultural Market Information System (AMIS), “The discussion of the commodity market model shows that stocks moderate the price-increasing effects of negative shocks to available supply. Price spikes occur after stocks have been depleted. These observations have two implications: a. Price spikes tend to come after price has already increased to a threshold price region, consistent with low aggregate supply. b. Price spikes generally come only after stocks have been depleted to a low “critical” region.”

Also, the amount of risk investors are willing to take to supply the insurance to the producers may be lower depending on the time frame, such as after the financial crisis. When this happens, producers have less incentive to produce and store, causing volatility to spike as described by Lutz Killian.  See the chart below for spikes in volatility that correlate to production shortfalls.

Still all of these factors taken together, do not necessarily mean you will be spending more at the grocery store, especially if the commercial consumer like a cereal maker uses a substitute. According to Hicks’ theory of congenital weakness, it is easier for consumers to choose alternatives so they are less vulnerable to price increases than producers are to price drops. This means you may be eating wheat rather than corn, or soybean oil rather than palm oil, so that the price you pay at the grocery store is not higher. 

Population growth and wealth are also key factors in driving the prices of agriculture. In major consuming countries such as China and India, parts of the population consume both wheat and rice, and, as rice consumers become wealthier, they tend to substitute some wheat products for rice. (The countries are also stockpiling the grains, taking more supply off the market, possibly driving prices even higher.)

Whether the substitution is from the commercial consumer or by choice from the retail consumer, sometimes unfortunately substitution is not possible such as in 1975. The poor corn harvest in the United States occurred when global wheat and rice supplies were also low, so the usual substitutes could not fill the global yield gap in corn.

Various prices are reported by consumers in different regions, especially those far from developed futures exchanges. Also, sometimes consumer prices reflect other factors like taxes or trade bans. So, it is possible index levels recorded in the agriculture sector do not accurately represent the marginal value to global consumers.  However, global prices as measured by indices are often by far the best available measures of the state of the world’s agriculture markets.

That said, the the prices you see at the grocery store may very well be increasing from global warming. Though you don’t need to be poorer by shopping for food and may offset this inflation with a basket of commodities.

Yields on the 10-year Treasury continued lower last week as measured by the S&P/BGCantor Current 10 Year U.S. Treasury Index.  Friday’s 2.59% is one basis point off from this year’s low of 2.58% of February 3^rd.  The index recorded a 2.59% in spite of the fact that the April U.S. Unemployment rate reached a low of 6.3%, a level not seen since 2008.  The Ukraine crisis and the Fed’s near zero interest rate policy continued to keep yields low.  Wednesday’s conclusion of the FOMC meeting resulted in continued stimulus reduction and stating growth in economic activity has picked up recently after being effected by the harsh winter conditions.

Domestic economic news will be quieter than weeks past as the calendar is light.  Today’s Markit U.S. Services PMI was slightly higher at 55 (54.5 expected).  Treasuries sold off on the news after having been higher from news of weakness in China’s manufacturing sector.  March’s Trade Balance is scheduled for tomorrow while MBA Mortgage Applications (-5.9% prior) is due on Wednesday.  Initial Jobless Claims (325k expected) and March’s Wholesale Inventories (0.5% expected) will close out the week.

So far 2014 is off to a good start for investment grade corporates.  The S&P U.S. Issued Investment Grade Corporate Bond Index has not had a down month yet and has returned 0.45% for May.  Year-to-date this index has returned 4.54%, 80 basis points more than high yield.  All industry sectors except for catalog retail are contributing positively to the index with the top performing sectors being electric utilities, diversified banks and integrated telecommunications.

The S&P U.S. Issued High Yield Corporate Bond Index has returned 0.08% so far for May after having returned only 0.67% for the month of April.  To date, the best performing month has been the 1.92% in February.  Year-to-date high yield has returned 3.74%.

The tone in the market improved over the past week as the S&P/LSTA U.S. Leveraged Loan 100 Index has returned 0.19% month-to-date and 1.33% year-to-date.  Last week the long-anticipated bankruptcy filing of Energy Future Holdings (formerly known as TXU) occurred.  The S&P/LSTA U.S. Leveraged Loan 100 Index holds two loans which accounted for a 0.03% weight within the index.  The loans will remain in the index though not contribute to its yield measures.

The S&P U.S. Preferred Stock Index [TR] so far has returned 0.21% for May and year-to-date has returned 9.15%.  Like investment grade corporates, this index has not had a losing month this year.  January and February were well above 2% while March and April both returned 1.8%.  Longer duration issues in positively performing names such as Royal Bank of Scotland, American Homes and General Electric have increased the returns of this index.

Source: S&P Dow Jones Indices, Data as of 5/2/2014, Leveraged Loan data as of 5/4/2014.

In the weekend Wall Street Journal (May 3, 2014) there is an informative article entitled “The Risks of Floating Rate Funds”.  The article does a great job of delving into the risks of these types of structures and is quite timely as the low rate environment continues. The investor appetite for floating rate assets while facing the prospect of future rising interest rates is a fascinating topic. The goal of this blog is to add some information in to the discussion.

The volatility of the senior loan asset class is an important topic.  There certainly was a volatile time period during 2008 and 2009 for the financial markets.  The S&P/LSTA U.S. Leveraged Loan 100 Index tracking the senior loan market saw a dramatic decline in value in 2008 of just under 28%.  It may be valuable to also consider the environment and compare that drop in value to other asset classes during that time period: the S&P 500 Index was down over 46%, the S&P GSCI was down over 67% and high yield corporate bonds were down over 30%. During the twelve month period of ending April 2014 the senior loan market experienced a maximum decline of 0.9% while the other markets have experienced larger negative swings.

Source: S&P Dow Jones LLC. Data as of March 31, 2014.

Echoing an important point raised in the Wall Street Journal article is the aspect of interest rate ‘floors’. During this low rate environment the interest rate paid out by many senior loans has been held to minimums or ‘floors’.  The interest rate of these floating rate loans are tied to benchmark rates, typically LIBOR, that have dropped significantly.  As of year end 2013, approximately 80% of the loans in the S&P/LSTA U.S. Leveraged Loan 100 Index have some type of interest rate floor.  For the interest rate on those loans to rise the benchmark rate, LIBOR, needs to rise to a point where the rate (LIBOR plus spread) breaks through that minimum rate or the ‘floor’ of these loans.  The key aspect of this is when the rate does rise enough to be above the interest rate ‘floor’ the lenders get the benefit of a rising rate. Meanwhile, the loans with floors are earning above market yields due to the ‘floor’.

There are many other aspects of risk and reward related to the senior loan and high yield corporate bond markets that can be discussed in additional posts.

Data as of May 1, 2014

2013 was a not a fun year for municipal bond investors with bond prices and returns being pushed down by events in Detroit and Puerto Rico. 2014 is a different story, demand has shifted back to municipals as the S&P Municipal Bond Index has recorded a 4.91% total return, year to date. Yields of municipal bonds have come down at a faster clip than their counterparts in the U.S. Corporate bond markets. Since year end, investment grade municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index has seen its yield drop to 2.24% (down 87bps) while the S&P U.S. Issued Investment Grade Corporate Bond Index yield ended at 2.82% (down 28bps). High yield municipal bonds, Puerto Rico and Tobacco Settlement bonds while volatile this year have shown strength as investors continue to seek incremental yield over low rate alternatives.