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Currency Wars: Pandering to Debase

A Strange Century

Too Much Indexing?

Cracking Contango: Brent-Gas Hits 6-Year Seasonal Low

Observations on January Release of S&P Claims Based Indices (Allowed Charge Trends): Part 3

Currency Wars: Pandering to Debase

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Tim Edwards

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

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So far this year, we have seen a ravenous interest from U.S. investors in currency-hedged equity exposure.  Currency risks have increased; currency volatility is on the up:

FX pic 1

The reasons behind these trends can be understood in part via the nature of human psychology and power, and the reality of politics.

Consider yourself, for a brief moment, the ruler of a mid-ranking economy; the proud nation of Atlantis.  As in many parts of the world, your ministers, media and constituents are lamenting a series of profligate governments.  Mounting government and consumer debts are handicapping your hopes of Keynesian stimulus.  Meanwhile, international economic agencies besmirch your national pride: your labour force is “uncompetitive”; they and your social policies are at chiefly fault for your stuttering, moribund economy.

The choices are difficult.  You might impose drastic cuts in government services and raise taxes to “balance the books”, no doubt at the risk of further constraining the economy.  Or you could heed those plaintive calls from the IMF and drastically reform the marketplace for labour and businesses, reforming the tax code along the way for good measure.

Both options may engender significant opposition from vested interests to whom you are grateful for your position in power.  More certainly, such measures will cause abundant and vocal distress in the population.

I’m a politician – give me an easier option!

But what if you could simply debase your currency?  If the rest of the world is prepared to pay one U.S. Dollar for what is currently worth three of your Atlantan Mickles, how much more competitive would you be if you could sell the same thing for $0.50?  The answer seems obvious.  Lower your interest rates! Print money! Your currency will soon be worth nothing!

Having a less valuable currency might dent national pride, but there’s plenty to compensate.  Bond investors will benefit from falling yields; equity investors will celebrate your stimulus.  And remember those large debts? They are suddenly cheaper (in USD terms) to repay and your low-low interest rates mean that everyone’s debt just got easier to service.  Everyone’s a winner in Atlantis!

Sounds brilliant.  Are there any risks?

As anyone who has paid but the briefest attention to the critics of such programmes will know, the risk to such financial magic is the devastating consequences of too-high inflation.  Imports will immediately become more expensive, as will commodity prices in local terms.  Simply put, your citizens will have to pay more for what they buy.

And for politicians, this is a uniquely acute risk: there are few historic errors of government more stimulating to revolutionary sentiment than hyper-inflation, particularly in the absence of a rapidly growing economy.  One way of testing the extent to which your economy might be impacted by currency movements is to use the current account balance – a national measure which subtracts the value of imports from exports and accounts for other relevant financial flows (if you own property in the Bahamas and earn a rent on it, it is not an “export” but the income is nonetheless included in the current account balance).  Here are the current account balances for a few major economies:

FX 2 and a bit pic

So, can I debase my currency then?

Even if you are in command of economy with a positive current account balance, such as the countries on the right hand side of the table, only under certain conditions can one consider a strategy of currency debasement.  Inflation remains a risk and it would be incredibly helpful, for example, to have a collapse in energy and food prices before you start.

FX pic 2

Race to debase 

Well, you can see the temptation. Unfortunately, you may not be the only one to have thought of this:

FX Pic 3

So everybody’s doing it?

Therein lies the problem. We can’t all debase our currencies; it doesn’t work if everybody does it. But not quite everybody is.  The U.S. looks to be moving towards a rate increase in the next stage of its cycle, and it is no coincidence that the U.S. dollar strengthened more than any other major currency in 2014.  And that is why there is a renewed interest among U.S. investors in currency hedging their international exposures.  The stimulus and easing packages announced by central banks and governments across the world recently may well prove to deliver the anticipated benefit to local stock markets and economies.  But if a central component to their success is a depreciating currency, it makes sense to hedge it out.  In the meantime, versions of the conundrum facing Atlantis are being played out across the globe; not everyone can be a winner.

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

A Strange Century

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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Credit Suisse recently published their Global Investment Year Book for 2015 covering investment performance from 1900 to 2014 for 23 countries.  The results so far in the 21st century are surprising: in 19 of the 23 markets bonds and fixed income outperformed stocks from 2000 to 2014.  The four equity markets that beat fixed income were Denmark, New Zealand, Norway and South Africa. In the 20th century stocks beat bonds in every market. (Data on China do not cover the entire century so it 22 of 22 for 20th century stocks.)

The results aren’t driven by bear markets in stocks. Although five markets show negative returns so far in this epoch, there were some reasonably strong equity markets which still lagged fixed income including Australia, Canada and Sweden. The explanation is both the currently low interest rates and the misfortunes of equities.  Ten year treasury yields peaked in the fall of 1981 and been bumping downward ever since.  The bull market in bonds covers the last fifth of the 20th century and all of the 21st we have seen so far.   The equity story is very different – once bond yields began sliding in 1981, equities began a 20 year bull market that carried them through to the turn of the century. Then fortunes turned and we have seen two deep bear markets where the S&P 500 lost about 50% since 2000.  With interest rates down to zero and even negative in a few European markets, one must believe that the bull market in bonds is close to ending.  Providing equities advance, the odds favor stocks out-performing bonds during much of the new century.

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

Too Much Indexing?

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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Active management is difficult; most of its practitioners underperform passive indices most of the time; and 2014 was a particularly tough year.  Not surprisingly, active managers are not touting last year’s performance.  Instead, the pitch for active management increasingly cites its putative social benefits — arguing, e.g. that “Markets are efficient only because active managers buy underpriced assets and sell overpriced ones.”  Too much indexing, the argument goes, will produce inefficient capital markets and insufficient price discovery, as “not enough” investors trade in response to perceived misvaluation, and “too many” investors simply accept whatever price the market gives them.

At the limit, this is a logical argument; one academic observer compares misvaluation to street crime and active managers to police officers on the beat.  More police, less crime; more active managers, less misvaluation.  But:

  • A completely passive investor buys the market portfolio and then, for all practical purposes, never trades again.  In a world with some active investors and some completely passive investors, 100% of the trading is done by active investors motivated by perceived misvaluations.  With lower trading volume, there may be wider fluctuations around fair value than there are now, but there’s no reason to suppose that fair value won’t continue to be the central tendency of prices.
  • If the fluctuations away from fair value become “too wide,” the process is self-correcting.  Wider departures from fair value mean bigger opportunities for the surviving active managers; bigger opportunities mean higher alpha for the successful; higher alpha means that assets flow back to active management.  Just remember that, weighted by assets, no more than 50% of the active managers can be successful — otherwise said, that while bigger opportunities mean higher alpha for the winners, they also imply lower alpha for the losers.
  • Passive assets can rise dramatically without significantly diminishing the share of trading done by active investors.
Source: S&P Dow Jones Indices.  Assumes that passive turnover is 10% annually and active turnover 100% annually.
Source: S&P Dow Jones Indices. Assumes that passive turnover is 10% annually and active turnover 100% annually.

The reason that passive assets can rise so dramatically is that active turnover is much higher than passive turnover.  In the chart above, we assume that the average active fund turns over 100% annually versus only 10% for the average passive fund (a very generous estimate on the passive side).  On those assumptions, if half of the market’s assets are indexed, active managers will still do 91% of the trading.  Indeed, if 90% of the assets are indexed, active managers will do 53% of the trading.

It is trading, not asset ownership per se, that sets prices and putatively corrects misvaluations.  If active trading makes for an efficient market, indexing has a long way to go before market efficiency is impaired.

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

Cracking Contango: Brent-Gas Hits 6-Year Seasonal Low

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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The Brent crude oil and unleaded gasoline price difference, or “crack spread“, is a widely followed relationship to measure the value extracted along the chain of producing oil to refining it that can serve as a proxy for profit margins.  The EIA (Energy Information Agency) reported global gasoline supply and demand patterns have been evolving with demand greater than supply in Asia, Latin America, and the Middle East. In the U.S., the production of gasoline has been outpacing the demand, resulting in increasing exports of U.S. gasoline into the global market. Despite the relative cheapness of U.S. gasoline to the international markets from the fundamentals, the transportability has allowed benchmarks to measure the global seasonality.

gasoline exports

In indexing, the difference in roll yields can be measured to theoretically reflect the relationship between excess and shortage in the oil and gas markets since it is the storage markets that drive the shape of the curves.  There is a historically wide roll spread between unleaded gasoline and brent crude oil, seasonally in each February, where the excess inventory of unleaded gasoline markedly exceeds the excess inventory of brent. What is interesting so far this February is that the spread is the narrowest in six years.

Source: S&P Dow Jones Indices. Past performance is not an indication of future results.
Source: S&P Dow Jones Indices. Past performance is not an indication of future results.

According to the IEA (International Energy Agency), global refining capacity is expected to rise after falling to a six-year low and that global refinery margins will come under renewed pressure. They predict further consolidation in the refining industry, especially in Europe and developed Asia as product markets continue to expand and globalise.

While the excess inventory of brent crude oil is larger at this time than in last February, when brent showed a shortage with a positive roll yield, the excess inventory of unleaded gasoline shown by the roll yield of -3.3% is down half from last year and is seasonally very low. This is illustrated in the graph below:

Source: S&P Dow Jones Indices. Past performance is not an indication of future results.
Source: S&P Dow Jones Indices. Past performance is not an indication of future results.

The last time the roll spread was this narrow in February 2009, it marked the bottom of brent. The fundamentals are different this time, driven much more by supply than demand, but the resulting inventory is what might matter most.

Source: S&P Dow Jones Indices. Past performance is not an indication of future results.
Source: S&P Dow Jones Indices. Past performance is not an indication of future results.

 

 

 

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

Observations on January Release of S&P Claims Based Indices (Allowed Charge Trends): Part 3

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John Cookson

Principal, Consulting Actuary

Milliman

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The overall medical trend rates covering all services have continued to be modest in the S&P data through the 3rd quarter of 2014—increasing up to 3.5% on a 12-month moving average basis as of September[1].

But in 2014 the Individual trends reported by S&P are now over 45% based on 3-month moving average trends as of September.  These can reflect the impact of adverse selection, higher demographics and higher minimum (essential) benefits required under the ACA.  To one degree or another, the industry tried to anticipate these effects in the initial rating for 2014.  It remains to be seen if we see a similar effect on Small Group in 2015.  We would not expect the impact to be as dramatic on Small Group as it was for Individual in 2014, however the results remain uncertain at this time.  The Small Group ACA coverage requirement and electronic enrollment had been deferred until 2015 and insureds in this category were only allowed to enroll electronically staring in late 2014 so no experience due to Small Group ACA enrollment is yet apparent, but there could be an increase in these measured trends, although probably not as dramatic as the Individual trends.

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THE REPORT IS PROVIDED “AS-IS” AND, TO THE MAXIMUM EXTENT PERMITTED BY APPLICABLE LAW, MILLIMAN DISCLAIMS ALL GUARANTEES AND WARRANTIES, WHETHER EXPRESS, IMPLIED OR STATUTORY, REGARDING THE REPORT, INCLUDING ANY WARRANTY OF FITNESS FOR A PARTICULAR PURPOSE, TITLE, MERCHANTABILITY, AND NON-INFRINGEMENT.
[1] We track the LG/ASO trends as representative of underlying trends, since Individual and Small Group are impacted more significantly by the Affordable Care Act (ACA).  Keep in mind that actual trends experienced by plans are likely to be higher than as reported in S&P data.  Trends experienced by large employers on plans that have not changed in the previous year could be higher by as much as 2% or more on bronze level plans and higher by 1% or more on gold level plans due to the effects of deductible and copay leverage.  So risk takers need to take this into account.  In addition, the S&P Indices do not reflect the impact of benefit buy-downs by employers (i.e., higher deductibles, etc.), since the indices are based on full allowed charges.  As noted above, actual trends experienced by employers and insurers in the absence of benefit buy-downs can be expected to be higher than reported S&P trends due to plan design issues such as deductibles, copays, out-of-pocket maximums, etc.   Benefit buy-downs do not represent trend changes since they are benefit reductions in exchange for premium concessions, but they can have a dampening effect on utilization due to higher member copayments, and this can have a dampening effect on measured S&P trends compared to plans with no benefit changes, further pushing up experienced trends relative to those reported in the indices.

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