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Double Dose of the Fed

Could Price Momentum Predict Australian Sector Returns?

Where to Find Yields in Japan?

Tobacco Settlement Bonds: the next cloud on the horizon for municipal bonds?

Russia, Where's The Wheat?

Double Dose of 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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Next week will be a double dose of Fed speculation and debate. First, on Wednesday at 2 PM the Fed will release the minutes from the last FOMC meeting on July 29th-30th.  Then on Thursday evening, Friday and Saturday the Kansas City Fed will hold its annual economic policy symposium in Jackson Hole Wyoming.   The symposium usually attracts a who’s-who of international monetary policy and central banking.  While the topic for this year, “Re-Evaluating Labor Market Dynamics” has been announced, the agenda and the speakers won’t be revealed until the evening of August 21st. However, Janet Yellen is certain to be someplace on the program; Stanley Fischer, Vice-chair of the Fed, might also speak along with some academics and foreign central bankers.

Labor market dynamics – will the unemployment rate keep falling, what is the right number for full employment and what will make wages rise enough to spark inflation anxiety – are one of three key Fed issues expected to dominate both next week and the rest of this year. The other two are when will interest rates rise and how will the Fed manage to control them.  After all the symposium’s economic theory and econometrics fade away two questions will remain: Will the improving labor market spark inflation? Will rising interest rates reverse recent labor gains?  If we believe recent statements by Janet Yellen, she sees little worry about the first question for 2014 or 2015, but has some concern about the second question which is wrapped up with how the Fed will raise interest rates.

Even though labor markets are the focus of the Kansas City Fed meetings, both interest rates and operating procedures will be discussed – during the breaks if not in the formal sessions.  Not everyone is as sanguine as the Fed chairwoman that unemployment can continue to fall and wages can rise without an immediate inflation penalty.  There is a more hawkish segment to both the FOMC and the meetings that will argue for an earlier effort to raise interest rates. Despite this, there is little evidence that the Fed will move before sometime in 2015, probably in the second or third quarters.  The truth is that no one knows — or can know – because it depends on how the economy unfolds going forward.

The last puzzle is what the Fed should do to raise interest rates.  Back before the financial crisis and QE 1-2-3 the Fed could adjust interest rates by adding or draining bank reserves from the nation’s banking system.  That worked than because the bank reserves were near the margin where a small drain would push the Fed funds rate up and a modest addition would send it down.  No longer.  Following quantitative easing, the banking system is awash in reserves and there is no way the Fed can drain enough to make a difference.  There are other approaches available: adjusting the interest rate the Fed pays to banks on excess reserves held at the Fed is one, auctioning reverse repurchase agreements is another.  These will work, but with little experience the central bank could overshoot the target or miss completely.   Like the Fed, the market has little experience with these new operating procedures.  When the Fed does raise interest rates, will the market know how to respond or will it over react and send rates either surging or collapsing.  The answer to that question may be the topic for the 2015 Kansas City Fed conference.

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

Could Price Momentum Predict Australian Sector Returns?

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Priscilla Luk

Managing Director, Global Research & Design, APAC

S&P Dow Jones Indices

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Sector allocation is one of the main pillars of equity portfolio management, and its use as a strategy to optimize investment allocations through sector rotation is increasingly abundant. In Australia, the equity market is diversified in sectors, and some of them can be traded through exchange-traded funds, making it possible to implement a rotation strategy.

Based on the S&P/ASX 200, financials is the biggest sector in the Australian equity market by index weight (46%), consisting of 41 stocks traded with a combined value of more than AUD 1.4 billion daily. Information technology (I.T.) is the smallest sector, weighting merely 0.7% and containing three stocks traded with a daily combined value of AUD 26 million.

Despite the fact that the Australian equity market is dominated by the financials and materials sectors, historically, neither of these has persistently outperformed other sectors. Based on annual sector returns in the past 24 years from 1990 to 2013, we observed that sector leaders and laggards rotated every year and no single sector could consistently outperform the rest for extended periods of time. Utilities had the highest annualized return in the entire period, but its annual performance ranked within the top three only in 11 years—less than half of the time over the observed interval. Since sectors can fall in and out of favor, a sector rotation strategy that attempts to identify future sector leaders and laggards could be beneficial.

Our study on sector price momentum strategy shows that sectors with stronger price momentum in recent months tend to outperform in coming months. On the other hand, sectors with weaker price momentum in recent months are more likely to lag behind the market in the next months. A simple, long-only price momentum strategy to invest quarterly in the top three sectors based on a 12-month price change generated an annualized excess return of 4.6% when compared to the benchmark, from December 1990 to June 2014.

Historical Performance and Annual Return of 12-Month Strong and Weak Price Momentum Portfolios

Historical Performance and Annual Return of 12-Month Strong and Weak Price Momentum Portfolios

Source: S&P Dow Jones Indices LLC. Data from December 1990 to June 2014. Data are based on the S&P/ASX 200 universe (between March 31, 2000, and June 30, 2014) and the S&P Australia BMI universe (prior to March 31, 2000). Sectors in portfolios are equal-weighted and stocks within each sector are market cap weighted. Performance is based on total return in AUD. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results.

Like any typical price momentum strategy, sector price momentum strategy can also result in high portfolio turnover. Without optimization for lower turnover, the 12-month price momentum portfolio in our study recorded 129% annualized turnover. By assuming a one-way replication cost of 50 bps, the annualized return of the 12-month price momentum strategy would decrease by 1.29% to 3.3%. This non-optimized simple strategy remained profitable after replication costs.

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

Where to Find Yields in Japan?

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Michele Leung

Director, Fixed Income Indices

S&P Dow Jones Indices

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As tracked by the S&P Japan Bond Index, a broad base benchmark that measures the performance of the government and corporate local currency bonds in Japan, the total outstanding par amount have reached over 1,070 trillion Yen this August. Not surprisingly, over 92% of them are government debts, which expanded 3.7 times since the index first valued on January 30, 1998.

As shown in exhibit 1, the total return of the S&P Japan Government Bond Index and the S&P Japan Corporate Bond Index both advanced 1.34% and 1.23% year-to-date (YTD), as of August 8, 2014. It is interesting to note that while the yield-to-maturity of the S&P Japan Corporate Bond Index has tightened by 21bps to 0.399%, the spread of the two sector indices have contracted significantly from 15bps last December to currently 3bps, see Exhibit 2.

It is inevitably getting more difficult to source for the yields. Particularly, following the Abenomics and the unprecedented purchases of government debts by Bank of Japan, the yields have been kept low to support growth. Even the consumer prices have shown signs of improvement in the recent months, the bond yields continue to edge lower.

Contrarily, as part of the S&P Global Developed Sovereign Inflation-Linked Bond Index that measures the performance of the inflation-linked securities market,  the S&P Japan Sovereign Inflation-Linked Bond Index rose 3.84% YTD, see Exhibit 3, and its yield-to-maturity has also shifted from negative territory to 0.648% in the same period, which is a level last seen in early 2012.

Exhibit 1: The Total Return of S&P Japan Corporate Bond Index and the S&P Japan Government Bond Index

Source: S&P Dow Jones Indices.  Data as of August 8, 2014.  Charts are provided for illustrative purposes.   Past performance is no guarantee of future results.  This chart may reflect hypothetical historical performance.  Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.
Source: S&P Dow Jones Indices. Data as of August 8, 2014. Charts are provided for illustrative purposes. Past performance is no guarantee of future results. This chart may reflect hypothetical historical performance. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

Exhibit 2: The Yield-to-Maturity of S&P Japan Corporate Bond Index and the S&P Japan Government Bond Index

Source: S&P Dow Jones Indices.  Data as of August 8, 2014.  Charts are provided for illustrative purposes.   Past performance is no guarantee of future results.  This chart may reflect hypothetical historical performance.  Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.
Source: S&P Dow Jones Indices. Data as of August 8, 2014. Charts are provided for illustrative purposes. Past performance is no guarantee of future results. This chart may reflect hypothetical historical performance. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

Exhibit 3: The Total Return of S&P Japan Sovereign Inflation-Linked Bond Index 

Source: S&P Dow Jones Indices.  Data as of August 8, 2014. Charts are provided for illustrative purposes.  Past performance is no guarantee of future results.  This chart may reflect hypothetical historical performance.  Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.
Source: S&P Dow Jones Indices. Data as of August 8, 2014. Charts are provided for illustrative purposes. Past performance is no guarantee of future results. This chart may reflect hypothetical historical performance. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

 

 

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

Tobacco Settlement Bonds: the next cloud on the horizon for municipal bonds?

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J.R. Rieger

Head of Fixed Income Indices

S&P Dow Jones Indices

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As the young gas station attendant says at the end of the movie Terminator “there is a storm coming”.  While Detroit and Puerto Rico’s financial struggles continue to rattle the municipal bond market, the over $87billion state issued tobacco settlement bond market is another potential dark cloud worthy of watching.

A recent article in the Huffington Post ‘How Wall Street Tobacco Deals Left States With Billions of Toxic Debt‘ initiates an important discussion on the future of the future of this large sector of bonds.The S&P Municipal Bond Tobacco Index has returned over10.6% year to date as it leads all other municipal bond sectors in performance.  These impressive short term gains mask the risk associated with these bonds.  Two of the largest risks are that the average credit quality of bonds in this sector is well below investment grade and the heavy issuance of zero coupon bonds creates a sector that has one of the longest durations in the municipal bond market.

Why worry now? The hazardous combination of credit and interest rate risk.  Repayment of these bonds is heavily dependent upon sales of tobacco products in the U.S. at a time when U.S. tobacco consumption is declining.  The long duration of bonds in this sector make it highly vulnerable to when interest rates begin to rise – the prices of these bonds will fall more quickly and by a larger amount when interest rates begin to rise.TobaccoReturns August 2014

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

Russia, Where's The Wheat?

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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Wheat lost more than 8% in July from the near perfect weather that brought the agriculture sector down to its lowest in four years.  Now, in the first week of August the DJCI All Wheat Total Return is already up 5.4% MTD through Aug 7, despite a 1.2% loss for the day.

Source: S&P Dow Jones Indices. Data from Jul 1, 2014 to Aug 7, 2014. Past performance is not an indication of future results.
Source: S&P Dow Jones Indices. Data from Jul 1, 2014 to Aug 7, 2014. Past performance is not an indication of future results.

However, Russia’s food trade ban has implications that may push wheat prices up or down, depending on location. The simple economics dictate the Russian ban on food imports could raise inventories in exporting countries, which may depress local prices. On the other hand, if there is a ban on its food exports, there may be price increases in importing countries.

http://atlas.media.mit.edu/profile/hs/1001/
http://atlas.media.mit.edu/profile/hs/1001/
http://atlas.media.mit.edu/profile/hs/1001/
http://atlas.media.mit.edu/profile/hs/1001/

What is an important detail is that Russia, the 4th largest wheat exporter, is a big producer of competitively priced wheat that is not experiencing the same quality problems emerging in the US, Ukraine, and in the European Union from the harvest -time rains, boosting kernel sprouting that has reduced milling appeal. This means that the ban on exports may generally elevate wheat prices since the high quality, abundant, cheap wheat is being hoarded. Although the rationale is different, the impacts are similar as for cotton from China’s stockpile, and for nickel from the Indonesian ban on exports.

According to the UN FAO, cereal prices dropped 5.5% to a four-year low, “a reaction to excellent production prospects in many major producing countries and to the anticipation of abundant exportable supplies in the 2014-15 marketing season”, the agency said.

If this is the case, in order to keep prices down – all else equal – the U.S., Australia, Canada and France will need to see a strong crop to compensate for the loss of Russia’s export market.

 

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