Indexology^® Blog

In just over two years, China has developed a policy framework for green finance that aims to shift capital from “brown” fossil fuel industries to “green” low-carbon technologies. We have also seen impressive growth in Chinese green bond issuance that has taken the world by surprise. On joining-up green finance policy and practice, China is increasingly “the one to watch.”

However, scaling up green finance still faces challenges. According to Dr. Ma Jun, chief economist at the People’s Bank of China and director of China’s Green Finance Committee, the biggest problem is effectively internalizing environmental externalities, reversing underinvestment in green projects and overinvestment in brown projects.[1]

To address this issue, Trucost collaborated with the Industrial and Commercial Bank of China (ICBC) and the Green Finance Committee to assess and quantify the environmental externalities of major sectors in China. We recently published a tool for banks and other market participants to assess the potential internalized costs and environmental risks of their investments, using the aluminum sector as a case study.[2] The research identifies key risk factors, including environmental taxation, abatement costs and water scarcity, and quantifies their future cost internalization pathways.

The results showed that primary aluminum and alumina operations in China were most exposed to high costs driven by environmental risk factors. Environmental taxation was the largest cost, accounting for as much as 20% and 13% of the average price of alumina and aluminum ingot, respectively, in the high-stress scenario. Plant operators might find it more economical to opt for early installation of abatement to reduce long-term costs. As a result, they could benefit from emissions trading by selling permits.

ICBC stress-tested their credit in the aluminum sector against the implementation of an environmental tax in 2018. The bank applied the low-stress scenario, assuming that the tax would be implemented at the lower end of the proposed rate and remain constant across provinces over time. As a result, only a small number of corporate credit ratings would be downgraded.

ICBC also found that high-rated companies in its portfolio would be more resilient to the costs of the environmental tax. The probability of default among these companies is minimal, as they are often leading enterprises with strong performance.

Understanding how environmental externalities could be internalized by stress testing loanbooks and portfolios could help financial institutions better manage risks associated with the environmental impacts of their investments. If done at scale, it could channel much needed capital to greener assets, while limiting the flow to high-impact sectors.

It would also demonstrate a strong and constructive response to the Financial Stability Board’s Task Force on Climate-related Financial Disclosures,[3] whose draft recommendations due to be launched at the G20 conference in July 2017 call on organizations to conduct scenario analyses of the risks and opportunities that they face as a result of climate change.

[1] http://unepinquiry.org/publication/establishing-chinas-green-financial-system/

[2] https://www.trucost.com/publication/internalization-of-environmental-costs-for-investment-stress-testing/

[3] https://www.fsb-tcfd.org/publications/recommendations-report/

The proverb “do not put all your eggs in one basket” is what diversification achieves when it comes to investment.  A portfolio can be diversified by investing in multiple asset classes, such as stocks, bonds, real estate, commodities, etc.  A diversified portfolio helps improve the risk/return profile of the investments.

In capital markets, diversification refers to both the security level and sector level.  Security-level diversification refers to having different securities in a portfolio so that no single security makes up too large a percentage of the portfolio.  Sector-level diversification goes a step further, meaning that the portfolio should be distributed among multiple economic sectors and not be restricted to one or few sectors.  Since different securities and sectors may underperform or outperform during different periods, it is often best to avoid concentration of investment into similar stocks or sectors.  Instead, a portfolio may benefit from a focus on different sectors, with the aim of including the best securities from each sector.  A diversified portfolio is likely to not only minimize risk but also ensure lower volatility in the portfolio.

The S&P BSE SENSEX is a highly diversified index and its 30 constituents provide exposure to 10 major sectors: utilities, telecommunication services, information technology, industrials, healthcare, fast-moving consumer goods (FMCG), finance, energy, consumer discretionary, and basic materials.

It is difficult to track all sectors and securities on an active basis; one option to consider is investing in index linked Exchange Traded Funds (ETFs).  This can result in investments that not only have a diversified portfolio, but also a cost-effective one, as the cost of index linked ETFs tends to be comparatively lower.  Exhibit 1 depicts the sector composition of the S&P BSE SENSEX as of March 31, 2017.

Exhibit 1: S&P BSE SENSEX Sector Composition 

Source: S&P Dow Jones Indices LLC.  Data as of March 31, 2017.  Chart is provided for illustrative purposes.

Source: S&P Dow Jones Indices LLC.  Data from March 31, 2012 to March 31, 2017.  Table is provided for illustrative purposes.

Exhibit 2 shows the weight of each of the 10 sectors in the S&P BSE SENSEX from March 2012 to March 2017.

Exhibit 3: Pictorial Chart of S&P BSE SENSEX Yearly Sector Representation

Source: S&P Dow Jones Indices LLC.  Data from March 31, 2012, to March 31, 2017.  Chart is provided for illustrative purposes.

Exhibit 3 is a pictorial representation of Exhibit 2.  This exhibit shows how the 10 sectors of S&P BSE SENSEX have changed from March 2012 to March 2017.  From Exhibit 2, we can see that the finance and information technology sectors have consistently had higher weights.  From Exhibit 3, we can also see that the weight of the basic materials sector has decreased substantially since 2012.

To summarize, we can state that an equity portfolio may benefit from diversification across securities and sectors.

The unintended consequences of OPEC’s policy (in summer of 2014) of flooding the market with oil to lower prices and gain market share are starting to show.  It seems they failed to realize increasing the price by cutting back supply wouldn’t work with high U.S. inventories.  The spare capacity of OPEC does not matter for oil price when U.S. inventories are high.

Chinese demand in addition to U.S. production (including Trump’s export policy,) is probably more critical to oil price formation so is likely keeping oil range-bound, even if the possible range is wide.  According to index history, oil could reach between $25 – $85 dollars before setting record moves.   As OPEC cuts and if U.S. inventories decline to low levels, oil prices may increase, so China may use their own reserves or shop around rather than purchase oil at a higher price, capping the high end of the price range.  Worst case scenario, China might start exporting their reserves into the open market, as they have with other commodities, pushing prices back down. If the U.S. continues with high production and inventories, China may buy more oil as the prices drop, putting a floor on the price.

One may think in this case a directional view is highly uncertain so going long or short oil is a risky bet.  That might be true, but unfortunately, the typical spread and volatility trades available when oil  is range-bound may be scarce now.  The correlation between Brent and (WTI) Crude is now nearly perfect, well above its average, and volatility is only about 2/3 of its historical average with Brent at 22.4% and WTI at 23.2% versus averages of 31.3% and 33.9%, respectively.

The term structures are also tight.  Historically on average, Crude’s contango is 3.5 times bigger than Brent’s, but now, their term structures are similar with a difference of just 11 basis points, only 1/4 of the average historical absolute difference.

Here’s a closeup of the past year in the graph above:

The result is the curve positions are difficult to monetize.  Historically, the dynamic rolling strategy that picks the optimal contract on the curve (as measured by highest implied roll yield) every month adds about 40 basis points monthly to Brent and almost double that to (WTI) Crude.  Now, the dynamic roll is underperforming and the difference in spread between the Brent and (WTI) Crude optimal contracts are only 10 basis points, as compared to an average near 40 basis points.

In this period of market rebalancing, it seems opportunities are hard to find but the good news possibly is there seems to be more stability from the lower volatility, higher correlation and tight term structures.  If it is underpinned by the fundamentals of a recovering oil market, there could be more upside than downside.  This combination of possible upside with low volatility may be attractive for the 2x leveraged versions of oil.

There are generally two types of dividend strategies:

1. Dividend growers: Those targeting stocks that consistently grow their dividends over time
2. High dividend yielders: Those focusing on stocks that pay a high dividend yield

Not all dividend strategies are created equal
These dividend strategies are constructed differently and may be used to accomplish different objectives. For example, investors seeking a greater-than-average income may choose high dividend yield strategies. But these strategies tend to have significant weightings in sectors that are highly sensitive to interest rate movements, thus introducing interest rate risk into the equity allocation.

On the other hand, strategies focused on stocks that have grown their dividends consistently (but don’t always have the highest yields) may provide an all-weather dividend solution—one that has the potential to perform well regardless of the direction of rates.

Comparing dividend growers and high dividend yielders in different rate environments
Let’s examine two popular dividend indexes as an example: S&P 500^® Dividend Aristocrats^® Index (dividend growers) vs. Dow Jones U.S. Select Dividend^TM Index (high dividend yielders).

For illustrative purposes only. Source: Bloomberg, 5/2/05–3/31/17. Results show average performance of dividend strategies based on monthly interest rate changes. S&P 500 Dividend Aristocrats measures the performance of S&P 500 companies that have increased dividends every year for the last 25 consecutive years. Dow Jones U.S. Select Dividend Index represents the United States’ leading stocks by dividend yield; this index is shown here because it is tracked by the largest high dividend yield ETF by assets. Past performance is not a guarantee of future results. There is no guarantee dividends will be paid. Companies may reduce or eliminate dividends at any time, and those that do will be dropped from the indexes at reconstitution.

The takeaway
As investors consider dividend strategies, it’s important to note the difference between high dividend yield strategies and dividend growth strategies. While the former may provide the higher income many investors crave, they tend to be sensitive to interest rate movements. The latter, on the other hand, offer all-weather potential, having performed well in a variety of interest rate environments.

There have been a myriad of articles with headlines and content about rising rates, the coming evisceration and other zombie apocalypse events in the bond markets.   There can be no doubt that yields for fixed income asset classes are low and there is also no doubt that rates will eventually be higher.  How, when and what that will look like is a total unknown.  Meanwhile, the bond yield world is flat.  Bond yields have been flat in 2017 and have lots of reasons why they could remain in a range for the near term. A Rieger Report on December 30, 2016 outlined a number of those factors, many of which still exist today.

Graph 1) Yields of select asset class indices for the period of January 2 through May 23, 2017:

What could hold yields down for longer?

• Uncertainty and the risk-off trade: including Trump, Russia, Syria, China, Brazil, energy, Terrorism/ISIS, Brexit, EU, Inflation/lack of inflation to name a few
• Low/zero/negative yield environment in Europe and Japan (search for yield)
• Strong U.S. Dollar
• New issue supply of investment grade municipal bonds  off the pace set in 2016
• New issue supply of investment grade U.S. corporate bonds is also off pace for the last three month period vs same period as last year

The value proposition for bonds also remains: predictable income, lower volatility than equities and commodities and continue to be diversifying asset classes.

Eventually rates will rise, the shape of the curve will change and prices will fall and yields will become attractive.  Until then the yield world is flat.