Indexology^® Blog

In anticipation of S&P Dow Jones Indices’ ETF Masterclass for Canadian Advisors on June 23, 2016: A Bright Future for Financial Advisory, it helps to revisit some of the company’s involvement in the country.  Our firm has always been committed to Canada, with an office on King Street West, and the company has always shown an eagerness to serve the country’s investment community.  Through the partnership with the Toronto Stock Exchange, the S&P/TSX Composite Index has been the headline index for the Canadian equity market since 1977.  In addition to equity performance measurement and design of strategic investing approaches, S&P DJI has provided Canadian market participants with products for other areas of investment.  The S&P/TSX Preferred Share Index launched on June 12, 2007 and is designed to measure the performance of Canadian preferred stock.

Recently, a Canadian fixed income family of indices was introduced, expanding S&P DJI’s product offerings.  The index series seeks track the entirety of Canada’s fixed income market by providing performance measurement tools that range from Treasury bills, benchmark sovereigns (through core fixed income products) to Canadian high-yield and real-return bonds.

The S&P Canada All Bond Index is a broad, market value weighted index that is designed to measure both high-yield and investment-grade bonds.  The index has been broken down into respective subindices (the S&P Canada Aggregate Bond Index and S&P Canada High Yield Corporate Bond Index) that match the different money management styles between the high-yield and investment-grade categories.  Within each of these indices, the segments of fixed income have been broken down further into subindices that measure the characteristics and performance of each respective fixed income product group.

Notably, the March 30, 2016 launch of an ETF product by Toronto Dominion Asset Management has added to the ability of investors to track the performance of the S&P Canada Aggregate Bond Index.

In upcoming blog posts, we’ll analyze more of the sovereign, provincial and municipal (quasi-government), corporate, and collateralized subindices in regard to total return performance, index characteristics, and issuer composition.

Exhibit 1: S&P Dow Jones Canadian Indices

If you would like to hear more on our Canadian fixed income indices, attend our upcoming event in Toronto on June 23, 2016.

Year-to-date, the U.K. gilt market has performed the best out of all of Europe’s safe-haven government bond markets.  The S&P U.K. Gilt Bond Index has returned 6.15% YTD, one of the highest in Europe.  Yields in U.K. gilts have tightened by 41 bps since the beginning of this year, with the S&P U.K. Gilt Bond Index yielding 1.36% as of June 1, 2016.  U.K. gilts are still seen as a safe haven despite concerns that the U.K. might elect to exit the European Union.  Concerns over a possible exit have put the pound near its seven-year lows versus the USD.  At the end of Q1 2016, GDP growth in the U.K. slowed to 0.4% from the 0.5% growth seen in the previous quarter, while annual growth was revised down to 2%.

U.K. polls offer no clear sign as to which direction the June 23, 2016 referendum will take.  Uncertainty often leads to a flight to safety, and the U.K. gilt market continues to be seen as a safe haven.  If a Brexit is voted for and uncertainty in the U.K. economy loom, U.K. gilts could benefit further (prices continue to rise and yields fall), as the Bank of England could keep rates low for longer.  Alternatively, if the British pound weakens significantly as a result of a Brexit, there could be a foreign capital flight out of the U.K.  This could cause a spike in inflation as import costs increase, thus encouraging bond yields to rise.

The markets’ view of the pending British referendum on EU membership displays the hallmarks of a low probability, high impact event.  Correlations, and volatility expectations, are the key indicators.

When macroeconomic risk is dominant, as a select few narratives come to preoccupy investors, correlations increase.  For example, in August and September 2015, markets worldwide were roiled in concert: on the changing winds of a collapsing oil price, and a loud “pop” in Chinese equity prices, correlations achieved multi-year highs.

The chart below shows the average monthly correlation among the constituents of the S&P United Kingdom index:

Compared to recent levels, and to longer-term averages, UK equity correlations remain reassuringly low.  This tells us that Brexit risk is not currently a major driver of equity pricing. 

But British equities include a number of global standard-bearers with disperse operations such as BP, Unilever and HSBC.  Conversely, the pound sterling has far more direct sensitivity to specifically British trade opportunities, economic growth and sovereign credit.  We can also assess Brexit risk with the CBOE/CME FX Pound Sterling Volatility Index, a measure of the expected movement implied by options on the pound / U.S. dollar exchange rate.

The pound’s volatility gauge is warning of considerable trouble ahead.  The index currently stands at 21.7, having more than doubled in the last few weeks – to its highest level since February 2009.

Note that the current spike in the chart began just as the June 23^rd referendum date moved within the 30-day range measured by the volatility index.  Currency volatility shows investors’ Brexit fears.

How can we reconcile these two indicators?  Is the market unconcerned with Brexit, as equity correlations indicate?  Or should we infer, as currency markets seem to be doing, an impending disruption on a level not experienced since the financial crisis?

Correlations tell us when events have come to dominate, implied volatility indicates the magnitude of misfortunes which may never happen.  The key is to appreciate that Brexit is a low probability, high impact event.  The low probability means that minor swings in polling have had little impact on the day-to-day fluctuations in the British equity markets.  Meanwhile, the high impact is shown by the greatly increased cost of insuring against the possible disruption that a vote for “leave” might entail.

There is no doubt about it the bond markets are malformed due to quantitative easing (QE). The possibility of a Fed change of short term rates in June or July is on the minds of many. Are the investment grade municipal and corporate bond markets primed for a near term correction as a result? Only time will tell.

However, there are factors that would argue against such a proposition:

• A rise in rates is most likely ‘baked in’ to each of these markets.
• The technical imbalance that overhangs both of these markets is supply vs. demand:
  • While investment grade corporate bonds were issued in record numbers, that issuance has slowed, demand however has not. That demand is driven by the need for low risk but incremental yield over risk free yields. Please see yield spread chart below of the bonds of the companies in the S&P 500 (the S&P 500 Bond Index is approximately 92% investment grade) vs. the 10 year U.S. Treasury Bond Index.
  • Municipal bond issuance has seen periods of increased issuance as well as relative ‘dry spells’. The net effect is new issue supply remains below historical norms. Demand for quality tax-exempt bonds remains firm yet still historically cheap relative to U.S. Treasury bond yields.
• While setting record highs, the equity markets have also seen periods of high volatility. The lower volatility seen in the investment grade corporate and municipal bond markets may continue to be seen as a value proposition for risk averse or ‘risk off’ investor mind sets. The volatility and risk adjusted returns for the S&P 500, S&P 500 Bond Index and the S&P Municipal Bond Index for 3, 5 and 10 year periods ending May 2016 can be seen in the table below.

For a discussion on the U.S. Treasury bond market there is a good read in the recent article “I wouldn’t buy a bond with your money” by Jared Dillian at Mauldin Economics which is focused on the U.S. Treasury bond market, particularly the 10 year bond.

Chart 1: Select indices and their yields (Yield to worst):

Table 1: Risk and Risk Adjusted Returns of Select Indices as of May 31, 2016:

Commodities are starting summer hot and early. Ending May, the Dow Jones Commodity Index (DJCI) was flat, but the S&P GSCI gained a total return of 2.2%, making it the third consecutive positive month for the index. This is the first time commodities have gained three months in a row since the period ending in Apr. 2014, and this is the biggest three month gain, 18.1%, for commodities since the period ending in July 2009 when they returned 20.9%.

Although the industrial metals sector lost 7.1%, posting its worst month in a year, and the precious metals sector lost 6.3% in its first negative month of 2016, the energy sector, currently comprising near 70% of the index, gained 4.6% in May, for a three month return of 30.4%. It’s the biggest three month gain for energy since the period ending in Jun. 2008 when it gained 37.5%. Also, livestock and agriculture gained 3.2% and 1.3%, respectively in May. However, what is interesting is the roll return (measuring backwardation in the sector) turned positive in agriculture for the first time since May 2015 and has improved in energy from -5.6% in Feb. to just -1.5% in May. There has not been an increase in roll yield this quickly in energy in seven years, since May 2009.

Year-to-date, the total return of the S&P GSCI is positive 9.8%, and has gained 26.2% off its bottom in Feb. Commodities are now outperforming stocks for the first year since 2007.

If this outperformance holds through the year’s end, it will break the longest number of consecutive years that stocks outperformed commodities. Following the last time equities outperformed commodities for near as long in 1980-86, seven consecutive years, commodities returned almost 300% through 1990 when the trend reversed. (The bottom index level of the S&P GSCI Total Return on April 16, 1986 was 716.51. The index returned 299.8% to reach a high level of 2864.40 on Oct 9, 1990.)