Indexology^® Blog

As the second quarter’s end nears, commodities are on pace to post their best quarter in seven years. The S&P GSCI Total Return is up 14.6% quarter-to-date (as of close on June 29, 2016,) the most since its quarterly gain of 19.2% in the second quarter of 2009.  So far in q2 2016, 12 of 24 commodities have returned over 10% with energy gaining 22.2% QTD.  The best performers for the quarter are sugar and natural gas up 34.3% and 28.3%, respectively.  Natural gas, brent crude and gasoil are on track to record their 8th best quarter in history.

Despite, a record hot second quarter, commodties may continue on their streak into the summer given the 3rd quarter is historically the best one for the asset class. On average since 1970, the S&P GSCI TR has gained 4.3% in Q3 that is more than the average historical returns of 2.8%, 3.0% and -0.7% in Q1, Q2 and Q4, respectively.

For seven commodities, the 3rd quarter has historically been the best quarter but the 3rd quarter has been the worst for six commodities.  Also, the 3rd quarter has been the best for both energy and precious metals with respect to their own histories. Based on the table below, commodities including cocoa, crude oil, gold, heating oil, wheat and lead may heat up this summer while aluminum, corn, cotton, natural gas, nickel and soybeans may cool off (though it is interesting to note that even in the worst quarter for soybeans, they still gained 3 basis points on average.)

However, for relatively hot plays in the space, unleaded gasoline (q1 is historically its best quarter gaining 9.2% on average,) lead, heating oil, crude oil, wheat, gold and silver have outperformed the index in past 3rd quarters. SImilarly to the table above, the same commodities that have had the worst performance relative to themselves also have had the worst performance compared with other commodties. For a sector play, energy may be the best outperformer based on its summertime history.

Important fundamentals to watch are U.S. inventories and supply for oil, driving demand for unleaded gasoline, El Nino impacts for agriculture and natural gas, seasonal grilling demand, unexpected supply shocks that may bring inflation, dollar moves and Brexit.

The latest weekend survey by the Daily Mail predicted the outcome of the June 23, 2016, U.K. vote in the “stay” column 45%-42%, as European markets either ralied or rebound on the news—depending on their timing and view of the situation.  The vote, which has been talked about for a while, came to the front burner last week, as the possibility of a “go” vote emerged, and markets reacted to the potential of significant European disruption in financing, trade, and labor.  The European impact will be significant, regardless of the vote, given the split among the voters and politicians and the mostly one-sided “stay” among business leaders.  Market volatility and an increase in trading is expected—again, regardless of the outcome—with the action taking effect globally.

A vote to stay will not end the debate, but could disrupt markets less, as the status quo permits business to continue.  In the longer term, since the issues would not stop with a “stay” vote, the ability of companies to commit to business plans (be it capital expenditures, hiring, M&A, or financial) could be impaired.

A vote to go could bring years of uncertainty, as the process to decouple would start, along with expected higher market (and political) volatility.  The best analogy at this point appears to be that a “go” vote would be similar to getting a divorce with no prenuptial agreement.  Issues of separation, use, and ownership of assets, rights, and labor would each need to be worked out by the overseeing agencies (and politicians).  The uncertainty in the short term could cause a disruption in business operations, as trade and travel would have to be negotiated.

From this side of the pond, the impact on U.S. stocks might be considerably less, but a knee-jerk reaction could be expected, with a prolonged one for a “go” vote.  Overall, S&P 500^® companies derive 45% of their sales from abroad, with approximately 8% of all sales from Europe.  U.K. sales have been on the uptick this year and account for approximately 25% of the European sales (2% of all S&P 500 sales).  Reporting on foreign sales in the U.S. is poor to say the least, with only one-half of the companies giving detailed information.  Even among those that report, a country breakdown is typically not given.  That said, Exhibits 1 and 2 show some of the issues that are more exposed to U.K. sales, along with those with exposure in Europe.

Similar to the Venn diagram in which the overlapping section of circles is the focus, the S&P U.S. High Quality Preferred Stock Index is designed to measure preferred securities that are constituents of both the fixed-rate and investment-grade preferred stock indices.

Exhibit 1: S&P U.S. Preferred Stock Indices Hierarchy

The weight of cumulative preferred stocks is set at 75%, while the weight of the non-cumulative category is set at 25%, subject to issuer limit.  Within each category, securities are equally weighted.  To reduce concentration risk, the maximum weight of each issuer is capped at 22.5% at each quarterly rebalancing.

As of June 17, 2016, the S&P U.S. High Quality Preferred Stock Index had returned 1.40% YTD, while the broader .  The high-quality index includes investment-grade constituents only, whereas 44% of the broader preferred index includes speculative-grade stocks and another 14% is not rated.  Similar to corporate bonds, preferred stocks are sensitive to changes in interest rates, however, also similar to equity, preferred stocks exhibit more volatility than most fixed income asset classes.

Along with portfolio diversification, preferred stocks can enhance overall yield.  Current yields, as of June 17, 2016, are almost three times higher than those of equities.

Exhibit 2: Multi-Asset Yield Comparison

According to Graham Day, the Senior Vice President at Elkhorn, “investment grade and cumulative preferreds have historically provided lower drawdowns compared with the broader preferred market.”[1]

Exhibit 3: Historic Drawdown Table

[1]   Bill Conboy, May 24, 2016, “Elkhorn Launches the First High Quality Preferred ETF (BATS: EPRF).”

The S&P Canada Aggregate Bond Index offers an investable way to participate in a broad index that is designed to measure the performance of the Canadian market.  The index is made up of the following fixed income product groups (see Exhibit 1).

Exhibit 1: S&P Canada Aggregate Bond Index and its Subindices

The S&P Canada Aggregate Bond Index has returned 1.11% for the month and 3.16% YTD as of June 13, 2016.  This benchmark index is a market-cap-weighted aggregation of the individual components, of which sovereign bonds (federal bonds) have returned 2.47%, provincial & Municipal bonds have returned 3.68%, investment-grade corporate bonds have returned 3.04%, and collateralized bonds have returned 1.25%, as of June 13, 2016.  The heavier-weighted sector of the overall index are provincials & municipals (47%) and sovereigns (29%).

Exhibit 2: Sector Weights

Source: S&P Dow Jones Indices LLC.  Data as of June 13, 2016.  Chart is provided for illustrative purposes.

Diving deeper into the makeup of the index, the 47% weight held by provincials & municipals consists of issuers such as the ones displayed in Exhibit 3.

Exhibit 3: Issuers Within the S&P Canada Provincial & Municipal Bond Index

The S&P Canada Investment Grade Corporate Bond Index contains 607 bonds and has a yield-to-worst of 2.2%.  It is an investment-grade index, with 40% of its bonds residing in the ‘BBB’ rated category from a conservative ratings approach that takes the lowest of Standard & Poor’s Ratings Services, Moody’s, and Fitch.  As a reflection of the Canadian market, the financials sector holds 63% weight in the index.

The collateralized sector of the market accounts for a small percentage of the index, less than 1%.  The S&P Canada Collateralized Bond Index contains 15 bonds with a market value of CAD 10 billion that meet the qualifications.

As of June 10, 2016, there is USD 10.6 trillion in negative yielding assets throughout the world—that’s more than 15% of global GDP. The increase in assets with sub-zero yields is evident when looking at the S&P Global Developed Sovereign Bond Index. On a market value basis, sovereign bonds with negative yields now account for 51% of the index (up from 27% at year-end 2015).

There are a number of global factors that contribute to negative bond yields, however it’s worth clarifying that there is a difference between negative yields and negative rates. Central banks set policy rates to control economic growth, and economies require low levels of inflation to grow.  Central banks attempt to ensure adequate inflation while protecting against high inflationary conditions and avoiding deflationary conditions.  As such, the Bank of Japan first cut its benchmark interest rate below zero to -0.1% in January 2016.  The rate cut was an attempt to counteract the effect of falling oil prices and to help achieve its target inflation goal of 2%.  In November, central banks in Europe imposed negative rates on commercial banks in an effort to encourage banks to lend and prompt businesses and savers to spend and invest.  Furthermore, Sweden’s policy rate is currently -0.5%, and Switzerland cut its rate to -0.75%.

Alternatively, many yields on sovereign debt have turned negative due to a concern over a lack of economic growth. Yields have turned negative in Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Sweden, and Switzerland.  Since the financial crisis, sub-zero yields have occurred sporadically, however they have typically appeared during times of market stress and predominantly in short-dated, highly liquid assets.  It seems that this is no longer the case, as negative yields have now spread to intermediate maturities throughout European and Japanese sovereign bonds.  The current yield on a 20-year Swiss government bond is -0.08%.

The negative yield environment is reflective of a principal preservation mentality, in which market participants are more concerned with “return of capital” than “return on capital.” However, it’s worth noting that current yields assume that bonds will be held to maturity; some market participants may believe they will be able to sell the bonds for more than they paid (i.e., yields will fall even more).