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In This List

The Turning Point

Rising Rates and Inflation: Implications for Equities

Why Cutting OPEC Supply From Highest to Higher Still Hurts

Why MSCI and S&P Dow Jones Indices Began Working Together in One Important Way

The Green-Eyed [Bond] Monster

The Turning Point

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David Blitzer

Former Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

Thirty-five years ago on September 30, 1981 the 10 Year treasury yield peaked at 15.85%.  With a few bumps it has slid downward ever since – until now. The events of the last few weeks moved interest rates higher and added about 25 bp to the ten year treasury.  Even allowing for some near-term volatility it is increasingly likely that the low yield of 1.36% set on July 8, 2016 is the low.

The chart shows the pattern of yields going back 46 years for the Fed funds rate, T-bills, the ten year Treasury note and long maturity treasury bonds. The long maturity combines the yields on the 20 and 30 year treasuries because the government shifted the maturities of issues over time.

Why It Looks Like Up from Here:

Economic growth increases the demand for credit and puts upward pressure on interest rates. The US economy is growing. Third quarter GDP was 3.2%, the strongest figure in two years.  Major GDP components except for government were significant contributors to growth.  Other economic statistics also point to growth: with an unemployment rate of 5% the economy is close to full employment, housing sales and starts are gathering strength and consumer confidence points to further spending gains.  These trends point to a rise in inflation and interest rates.

The economy will get a boost from the new administration’s widely discussed trillion dollar infrastructure program.  Since current taxes do not cover current spending, the infrastructure program will be funded with debt.  Any tax cuts will add to government borrowing and put further upward pressure on interest rates.

One immediate factor raising interest rates is oil. Follow the announcement yesterday of an agreement within OPEC to lower product, both oil prices and bond yields have jumped. Oil prices drive inflation and bond yields. However, the last few years proved that oil prices are volatile and unpredictable –the OPEC agreement could vanish and send oil back down to the 30s.

Higher inflation would mean higher interest rates. Despite the sense that inflation is almost zero, the numbers say otherwise and could go higher still. The CPI core rate – excluding the volatile food and energy sectors is about 2.2% for 2016 compared to 1.5% in 2013-14.  The headline CPI has been held down by low oil prices; as this reverses due to the OPEC supply reduction agreement, headline inflation will climb above the core rate.

The last reason to expect higher inflation may be the first: The Fed. The central bank’s policy makers – the FOMC – will meet on December 14th.  The committee is expected to raise the fed funds target by 25 bp. Moreover, if the economy continues to grow and government policy stays on track, there will be more Fed actions and higher yields in 2017.

A return to the double digit yields seen in the 1980s is not likely.  Those were caused by high inflation, global oil embargos and wide-spread expectations that neither inflation nor interest rates would ever fall. It took two recessions, a 10.7% unemployment rate and a lot of economic pain to bring interest rates down and give us a 35 year bond rally.

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

Rising Rates and Inflation: Implications for Equities

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Hamish Preston

Director, U.S. Equity Indices

S&P Dow Jones Indices

Even a cursory glance at financial markets indicates that market participants are expecting some form of interest rate increase in the near future—there has been a sell-off in the 10-Year U.S. Treasury Bond market, and certain sectors that are expected to benefit from such a rate increase have gained.  For instance, the S&P 500 Financials increased over 13% for the month as of Nov. 30, 2016, compared with a total return of 1.8% for the preceding 10-month period.

Despite evidence to the contrary, conventional wisdom still dictates that rising rates are bad for equities.  From January to October 2016, there was a high correlation (0.75) between the S&P 500® and the S&P U.S. Treasury Bond 5-10 Year Index.  What was good (or bad) for the U.S. Treasury market tended to have the same directional impact on the U.S. equity market.  However, this relationship broke down in November 2016—the S&P U.S. Treasury Bond 5-10 Year Index lost over 3% as of Nov. 30, 2016, while the S&P 500 closed at record highs on multiple occasions.  Why might this be?

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President-elect Donald Trump’s victory in the Nov. 8, 2016 election caused a reflation theme to emerge; the incoming administration’s proposed infrastructure spending and tax reductions resulted in expectations of increased inflation and an upward shift in the anticipated path of nominal interest rates.  This has been bad news for U.S. Treasury bond prices; the predefined stream of nominal coupon payments is being divided by a higher discount rate.  In that case, why haven’t equities been affected in the same way?  After all, the Gordon Growth Model tells us that equity prices should fall as the nominal discount rate increases, ceteris paribus.

The answer can be found in the concept of inflation pass-through, broadly defined as a company’s ability to pass on inflation to its customers.  The explanation is simple—because companies are able to change their dividends over time, inflation affects the nominal discount rate and the expected growth rate of dividends.  Companies that are able to pass on inflation to customers could increase their expected growth rates by more than the rise in the nominal discount rate.  This dynamic is even more relevant to the S&P 500, as its constituents are blue-chip companies with strong brand reputations.  Therefore, they may be able to increase prices in line with inflation, without the drop in earnings that may be experienced by other companies.

As a result, we might expect to see the S&P 500 increase (decrease) when the relative return of the S&P US Treasury TIPS 5-10 Year Index to the S&P U.S. Treasury Bond 5-10 Year Index improves (worsens) and for the reverse to be true for Treasury bonds.  This is exactly what has happened since the start of 2016. If this trend continues, market participants may want to remember the impact of inflation pass-through before agreeing with the conventional wisdom regarding interest rates and equity valuations.

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

Why Cutting OPEC Supply From Highest to Higher Still Hurts

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Jodie Gunzberg

Former Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

After OPEC agreed to an oil output cut in Algiers on Sep. 29, they increased supply by 230 kb/d to a record 33.83 mb/d in October according to the International Energy Agency (IEA).  Supply from Iraq reached the highest level ever and Iran pushed flows to a pre-sanctions rate of 3.72 mb/d. Now OPEC supply has increased by 1.3 mb/d from last year while output has risen for five consecutive months.

It is difficult to see how implementing the cuts will work with the resistance from Iraq and Iran. Even if the OPEC coordination worked, the resulting cuts may be ineffective because there are currently more powerful forces on oil price.  Two possible factors that are more critical to oil price formation, but ones that are even harder to control are the Chinese demand and U.S. production.

The Chinese have been strategic about buying and selling commodities so may buy more oil as the prices drop if OPEC does not cut supply.  China also has the power to heat the competition on the supply side by shopping around.  Conversely if OPEC does cut and oil prices increase, China may use their own reserves – or even worse – might export into the open market, essentially keeping the oil range-bound, which could reach between $25 – $85 dollars before reaching unprecedented levels according to index return history.

The U.S. production is also a key driver that is possibly more important for oil prices than OPEC’s decision. OPEC has the ability to be the swing producer given its large market share, spare capacity, low production costs and capability of acting alone or in a cartel; however, U.S. inventories need to be low for it to matter.  

Source: Bloomberg, IEA.
Source: Till, Hilary. Does OPEC Spare Capacity Matter? Modern Trader Magazine. May 16, 2016. Data Sources are Bloomberg and IEA.

The U.S. companies act independently and have already cut back production so further output reduction may be limited at today’s price levels.  This is reflected in the magnitude reduction of the large negative roll return seen in the second quarter of this year. The competition between U.S. producers is apparent versus the stability of the state run OPEC in the volatility of the roll return between WTI and Brent where WTI has bigger excesses and shortages than Brent.

Source: S&P Dow Jones Indices
Source: S&P Dow Jones Indices

The U.S. producers may move quickly to fill the gap if OPEC cuts. The low oil price forced consolidation to improve efficiencies bringing down the cost of production. The race has changed from a race for land to a race for efficiency. The increase in efficiency should bring the oil production back faster than in 1998 or 2009 – it is said to be roughly 9 months.

If OPEC fails to cut output, it will likely lengthen the rebalancing.  One interesting result in the S&P GSCI Brent Crude  is that it’s on the cusp of the longest consecutive monthly contango in history (as measured by the negative roll return of the index since 1999, and greater negative roll returns reflect higher excess inventory and storage costs.)

Also, after the 2008 period, the indices show WTI crude took about 6 years before the excess inventory turned into a shortage. We’re now only two years into the current glut, so the rebalance may take several more years.

  • November is the 29th month in a row in contango, only beaten by a longer streak of 32 months from May 2008 – Nov 2010.
  • This Nov. Brent is showing the 2nd highest contango of any Nov. in history with a -2.4% roll return, only second to Nov, in 2008 when the negative roll return was -2.7%. It is almost 10x the average negative roll return of -0.29% in Nov.
  • Brent’s current negative roll of -2.4% has doubled from Oct. and is the highest since Jan. 2016

WTI’s negative roll has also almost doubled from -0.9% in Oct. to -1.5% now, but is only a fraction of Feb’s levels when inventory started to pull back. This shows the relative flexibility in the US production at work.

Source: S&P Dow Jones Indices
Source: S&P Dow Jones Indices

Other macro factors that may be less direct though still influential include the dollar, interest rates and inflation:

  • If the dollar strengthens, oil is one of the most negatively impacted, losing on average about 1.7% for every 1% rise in the USD. If dollar falls it is much more powerful, boosting oil about 4.5% for every 1% drop in the USD.
  • Rising interest rates are potentially good for oil futures from the higher margin collateral and interest from storage that push futures price up.
  • Energy has a high inflation beta, meaning oil performs well with inflation. If inflation rises 1%, there is about 15% increase in the S&P GSCI (70% energy) and 11% Dow Jones Commodity Index (DJCI about 33% energy)
  • This works globally except in countries that regulate price (like Mexico and S. Africa). Oil is most sensitive to Eurozone inflation followed by US CPI and then Australia and Asia.

Last, if OPEC cuts and the price rises in the near-term, it is important to consider the impact of the seasonal demand versus true supply impact. Coming into the winter months, the cold weather generally helps support oil.  In the meantime, for the passive investor that might be long oil through this time of term structure volatility in the sea of excess oil, dynamic and enhanced rolling strategies are known to have added 2-3% in negative months for oil.

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

Why MSCI and S&P Dow Jones Indices Began Working Together in One Important Way

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Reid Steadman

Managing Director, Global Head of ESG & Innovation

S&P Dow Jones Indices

MSCI and S&P Dow Jones Indices respect each other, as good rivals should, but we often disagree. We see South Korea as a developed market and MSCI classifies it as emerging; we have 500 companies represented in our leading US index and MSCI has 295; we have our own free float methodology and they have theirs.

However, we agree in at least one respect: in our approach to classifying stocks by sectors and industries. In fact, in this area we are partners. In 1999, together we established a classification system – called the Global Industry Classification Standard (GICS®) – and now we meet regularly to maintain it. How did we get here?

Why We Agreed
It wasn’t a given that MSCI and S&P Dow Jones Indices would work together in this way. As I noted before, we don’t agree on many aspects of index construction. I spoke with Dr. David Blitzer, the head of the S&P 500 Index Committee, who was part of the team that developed GICS, to learn why two rivals decided to link arms. He gave three reasons.

First, the industry was converging to certain best practices. Index providers were watching each other closely. In the game of setting sector and industry classifications, it simply didn’t pay to be an outlier. Though it was difficult to win new business simply because of one’s industry classification system, an index provider could definitely frustrate and potentially lose investors with unconventional classifications.

Second, MSCI and S&P were able to avoid duplicating efforts by collaborating.

Third and most usefully, S&P Dow Jones Indices and MSCI and were able to set a standard that would make U.S. and international markets comparable. This was crucial, particularly in the year GICS launched.

The Euro and GICS
That GICS was established in 1999 wasn’t an accident. Investors were in great need of a standard that would allow them to compare markets across continents. Why? The investment world was both excited and worried about the introduction of the euro.

The euro was far from the only reason S&P Dow Jones Indices and MSCI created GICS, but it did highlight a need. Journals were filled with articles like this one, speculating about how the world would change because of this development. To see what industries in which countries would come out on top, securities had to be grouped in useful, comparable ways. It wasn’t enough to compare company groups within individual regions. They needed to be comparable across regions.

In 1999, S&P Dow Jones Indices – which was just “S&P” then – did not own a full set of international indices. To my knowledge, MSCI did not publish U.S. indices. And because both S&P and MSCI maintained their own industry classification systems, investors were forced to reconcile the differences between the two index families themselves.

When GICS was finally introduced in 1999, a portfolio manager told Dr. Blitzer that he was very happy – he could now go golfing on Thursdays! He had been liberated from the many hours he had spent each week mapping European companies according to the S&P classification system so he could compare the two regions. At last, investors could prepare for big events like the launch of the euro without first reclassifying companies one by one.

A Leading Standard
Both MSCI and S&P Dow Jones Indices now offer equity indices that cover every developed, emerging, and frontier market. If this were the case in 1999 – and if the euro hadn’t come along to put some stress on the investment world – we might not have a single standard across the two major index providers. But that standard is now set and life is easier for everyone because of the Global Industry Classification Standard.

 

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

The Green-Eyed [Bond] Monster

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Emily Ulrich

Former Senior Product Manager, ESG Indices

S&P Dow Jones Indices

Green bonds are bonds created to fund projects with positive outcomes that are directly related to the environment.

They include the following.

  • “Use of proceeds” bonds and revenue bonds, which are designated for green projects.
  • Green project bonds, the proceeds of which are earmarked for specific projects with positive environmental outcomes.
  • Green securitized bonds, which are designated for green projects (specific or otherwise).[1]

As depicted in Exhibit 1, green bond issuance has grown significantly in recent years.

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Additionally, as of the end of September 2016, green bond issuances already totaled USD 50 billion—illustrating that this rapid growth shows no signs of stopping.  This upward trajectory is likely due to a few key factors.

  • Green bonds are relatively simple and contain traditional debt—there are no specialized cash flows and no financial engineering.
  • Multiple coalitions began surrounding the green bond market in 2014, including the Green Bond Principles and three different green bond index launches (including that of S&P Dow Jones Indices). These movements helped spur the green bond market further into the spotlight and spread awareness to market participants.

Another prime example of the growth of this market is the increasing constituent count of the S&P Green Bond Index.

The S&P Green Bond Index includes any green-labeled bond, as flagged by Reuters and the Climate Bonds Initiative (CBI), which makes it a superb indicator of the green bond marketplace.

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As depicted in Exhibit 2, there were 31 bonds in the index in 2010.  As of September 2016, there were 1,320.

Even with this considerable expansion, the green bond marketplace is still flawed.  As with many areas of sustainable finance, it still lacks standardization.  The CBI has standards in place, but they are non-binding and typically viewed in the marketplace as guidelines rather than hard-line standards.

However, we expect the green bond market to continue to grow.  It’s a relatively easy way for market participants to tango with green finance—a prospect even more desirable after the COP 21 “two degree” investment initiative, the G20 Summit goals, and increasing regulations surrounding divestment.

As more and more market participants engage with green bonds, it’s reasonable to expect that regulation will come naturally, as a means to standardize a fast-growing market.  After all, the first “climate awareness” bond was only launched in 2007.

[1]   “Explaining Green Bonds,” Climate Bonds Initiative.  https://www.climatebonds.net/market/explaining-green-bonds

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