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Low Inflation isn’t Unusual

Momentum's Minsky Moment?

Integrating Carbon Risk With the Quality Factor

Maintaining Risk Reduction While Reducing Interest Rate Risk

Capital Market Performance During the Four Years of Narendra Modi’s Government

Low Inflation isn’t Unusual

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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Fed watchers and bond holders worry that inflation could spike, tempting the Fed to boost rates much farther than the current half percentage point the market expects in the rest of 2018.  With the Federal Open Market Committee, the central bank’s policy makers, meeting today and tomorrow these concerns are front and center.  This morning’s report from the Bureau of Labor Statistics showed the CPI up 0.2% in May and 2.8% over the last 12 months. Excluding the volatile factors of food and energy, the 12 month figure was 2.2%.  These figures are a bit higher than recent numbers: since the start of 2016, the average inflation rate was 1.8%.

Over the last 70 years inflation was as low as -3.0% during the 1948-49 recession and as high as 14.6% in 1980 during the second oil crisis.  High inflation is caused by oil price surges or wars. Inflation usually falls when the economy slows, but it takes a deep recession like the last one in 2007-9 to send it into negative numbers.  The chart shows the history of inflation since 1949, the shaded sections are recessions. There were four times when inflation topped 7.5%.  The first in 1948-9 was a spending surge at the end of World War II followed shortly by the Korean War. The two peaks in the 1970s were the 1973 and 1979 oil crises. Most notable though is the general trend – over seven decades the inflation rate remains essentially between zero and five percent. The average over the entire period, including spikes, is 3.5%.

Recently some analysts suggested that the internet and the rising share of on-line retail sales compared to traditional shopping is keeping inflation down. Research cited in the New York Times shows that price increases for goods sold on-line are generally lower than price increases for the same goods sold off-line.[i]  The impact of on-line sales are likely to increase. The share of retail sales on-line is now about 10%; at this rate it will be double that in 2024.

Today’s inflation rate is lower than the long term average.  Barring a war or another oil embargo and crisis, the figure should stay close to current levels.

[i] Austan Goolsbee and Peter Klenow, “Internet Rising, Prices Falling: Measuring Inflation in a World of E-Commerce,” working paper 2018-35, University of Chicago

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

Momentum's Minsky Moment?

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Tim Edwards

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

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U.S. equity funds following momentum (or relative strength) strategies have generally performed well recently, and their performance has been rewarded with inflows.  This is important because momentum, uniquely among investment styles, is self-reinforcing – until it isn’t.

Typically, as factors become more popular, their excess returns are likely to diminish.  For example: the more value investors dominate the market, the harder it becomes to find cheap stocks.  But momentum is different: momentum-based strategies, by their nature, focus on the market’s recent winners.  Flows into those strategies may further inflate those winning stocks, which can attract (or convert) still more trend followers, and so on in an inflationary cycle.

However, a “Minsky Moment” may await: eventually, bubbles pop.  The tipping points are hard to predict; it could be that valuations become so extended that they deter other investors, or it may even be a relatively minor event – such as a disappointing earnings report from one of the market’s current darlings.  Momentum-driven bubbles are inherently unstable.  At the first hint of a change in the trend, the most sensitive momentum investors will sell, amplifying the downtown and thereby reinforcing the strength of the “sell” signal to other momentum investors.  The more trend followers there are, the more dramatic the reversal.  The popularity of momentum accelerates both its performance and its sensitivity to a change in regime.  Hence, therefore, identifying when momentum appears to be both gaining in popularity – and performing particularly well – can determine whether a cautious or even contrarian approach is more prudent.

But what of the present?  2017 was a banner year for momentum – as represented by the S&P 500 Momentum Index.  The first six months of 2018 have seen this outperformance accelerate.  Exhibit 1 provides historical context by plotting the historical relative outperformance of momentum, controlled for the S&P 500’s concurrent stock-level dispersion.

Exhibit 1: Momentum’s Dispersion-Adjusted Relative Performance Reaches a 12-Year High.

The historical relative performance of momentum is clearly cyclical: when the series becomes elevated, it subsequently falls.  These declines represent periods of underperformance for investors tracking the momentum index.  The relatively high current reading suggests, at a minimum, that caution may be in order.  Nevertheless, it remains a hard task to predict exactly when the trend might reverse.  Indeed, as was the case in the late 1990s, we may yet see further relative outperformance.  But the longer this outperformance continues, the more unstable it may become.  And as Vanguard’s John Bogle put in his 10 rules for investing “reversion to the mean is a virtual certainty.”

 

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

Integrating Carbon Risk With the Quality Factor

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Bill Hao

Director, Global Research & Design

S&P Dow Jones Indices

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In a prior blog, we demonstrated that a sector-relative, carbon-efficient portfolio was superior to a sector-unconstrained one when forming low-carbon portfolios. In this blog, we explore the integration of carbon risk in quality factor portfolios. High-quality companies seek to generate higher profitability and enjoy more stable growth than “average” companies. Equally important, high-quality companies seek to adopt a conservative, yet effective, capital structure that allows them to grow. Finally, high-quality companies tend to exercise prudence in the administration of company affairs.[1]

We capture the quality investment style by equally weighting three factors: financial leverage ratio, return on equity (ROE), and balance sheet accruals ratio.

Correlation of Carbon Intensity and Quality Factors

We first analyzed the firm-level correlation between carbon intensity and each of the three quality factors in our test universe for each rebalance period (every three months), then we took the average of the cross-sectional correlations and calculated the t-statistics (see Exhibit 1).[2]

We can see that companies that are more carbon-efficient (or have lower carbon intensity) tended to have lower financial leverage ratios while displaying higher ROE, both of which were statistically significant at a 95% confidence level. In sum, carbon-efficient firms tended to be high-quality companies. Such findings are not surprising, as high-quality companies have more prudent capital structure, higher profitability, and higher earnings quality than their competitors. As a result, high-quality companies may have the financial strength to meet the market obligations that come with moving toward a low-carbon economy.

Integrating Carbon Risk With Quality Portfolios

One way to incorporate carbon risk with the quality factor is to construct an integrated quality-carbon composite score. The quality style score is defined as the equal-weighted combination of the three quality factors, while the quality-carbon composite score is defined as the equal-weighted combination of the quality style score and the carbon-efficiency score. Quintile portfolios were constructed based on the integrated quality-carbon composite score.

We compared the hypothetical quality-carbon-integrated portfolios (quality + carbon efficiency and sector-relative (SR) quality + carbon efficiency) to the unconstrained carbon-efficient portfolio, the quality portfolio, and the underlying benchmark (see Exhibit 2).

The quality + carbon efficiency portfolio had slightly lower risk-adjusted returns (0.78) than the quality portfolio (0.80). However, the carbon intensity of the quality + carbon efficiency portfolio was reduced to 19% of the underlying universe. The sector-relative quality + carbon efficiency portfolio also outperformed the benchmark on a risk-adjusted basis, albeit with a lower Sharpe ratio than its quality and quality + carbon efficiency counterparts.

Integrated Quality-Carbon Portfolios Maintained Target Factor Exposure

In this section, we examine the quality style exposure of integrated quality-carbon portfolios. We compared the weighted average style z-score of the integrated portfolios to the pure factor portfolio, as well as the broad benchmark (see Exhibit 3).

We can see that combining carbon efficiency with quality portfolios had little impact on quality style exposure, as measured by the weighted average z-score and t-statistics (the critical value of 95% confidence level is 1.99) from two sample t-tests.

The results from Exhibits 1, 2, and 3 showed that carbon-efficient firms tend to be high-quality companies. Moreover, integrated quality-carbon-efficient portfolios tend to have improved risk-adjusted returns and tend to be more carbon efficient over the underlying benchmark, while maintaining similar factor exposure level in comparison with pure quality factor portfolios. In the next blog, we will explore sector composition, risk exposure, and risk composition of quality-carbon-efficient portfolios.

[1]   D. Ung, P. Luk, and X. Kang. “Quality: A Distinct Equity Factor?” 2014. S&P Dow Jones Indices LLC.

[2]   B. Hao, A. Soe, and K. Tang. “Carbon Risk Integration in Factor Portfolios.” 2018. S&P Dow Jones Indices LLC.

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

Maintaining Risk Reduction While Reducing Interest Rate Risk

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Phillip Brzenk

Senior Director, Strategy Indices

S&P Dow Jones Indices

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Previously, we highlighted that the S&P 500® Low Volatility Rate Response Index fared better than the S&P 500 Low Volatility Index when interest rates increased. The objective of low volatility portfolios is to deliver lower portfolio volatility than the broad market benchmark, leading to higher risk-adjusted returns over a long-term investment horizon.

In this blog, we demonstrate that minimizing the interest rate exposure does not have to come at the expense of portfolio volatility reduction. We first look at a multi-horizon risk/return chart for the two indices compared with the S&P 500, going back to 1991 (see Exhibit 1).

Over the longer time horizons, the low volatility and rate response indices outperformed the S&P 500, with lower volatility. In fact, the rate response index performed better than both the low volatility index and the S&P 500 for all measured periods. The rate response index was slightly more volatile than the low volatility index—nevertheless, it had a cumulative risk reduction of 19.3% relative to the S&P 500 (the low volatility index had a risk reduction of 23%). Exhibit 2 shows the annualized risk reduction of the two strategies compared with the S&P 500 for the different periods.

Exhibit 2 shows that both the rate response and low volatility indices had lower volatility than the S&P 500 across different lookback periods. In recent years, stocks have been in one of the longest-running bull markets with low volatility, leading to somewhat moderate volatility reduction for the two indices. However, for the time horizons that cover at least one full market cycle (bull and bear markets), the risk reduction of the two indices versus the S&P 500 was more evident.

Together with the analysis provided in the first blog, we have seen that the rate response index has been able to perform better than the low volatility index in periods of rising interest rates, while also retaining the volatility reduction characteristics of a low volatility strategy. In a future post, we will further examine the relative exposure of interest rate changes between the rate response and low volatility indices.

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

Capital Market Performance During the Four Years of Narendra Modi’s Government

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Ved Malla

Associate Director, Client Coverage

S&P Dow Jones Indices

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On May 16, 2014, Lok Sabha election results were announced, and Narendra Modi’s Bharatiya Janata Party got a clear mandate to form the government. Narendra Modi was sworn in as the 14th Prime Minister of India on May 26, 2014, and his government recently passed the four-year mark of being in power. This government has one more year before India has its next general election, so both the government and the opposition parties are now in election mode.

Over the past four years, the government has made several landmark policy decisions and initiatives that have had a major impact on the Indian economy. Some of the major policy and regulatory changes that have been initiated/implemented by the government are as follows.

  1. Goods and Services Tax (GST)
  2. Demonetization
  3. Arbitration and Conciliation (Amendment) Act
  4. Real Estate (Regulation and Development) Act
  5. Insolvency and Bankruptcy Code

Even after disruptive reforms like the demonetization and GST, economic growth is back on track. The government also eased foreign investment norms in important sectors like construction, retail, and aviation, which is expected to have a positive impact on these key sectors. Inflation during these four years has been moderate due to easing commodity prices, a good agricultural harvest, and the Reserve Bank of India’s monetary policies targeting inflation. However, the rupee has weakened since this government came into power.

When this government came into power, crude oil prices were over USD 100 per barrel; however, these prices have fallen substantially, which worked in the government’s favor and gave Narendra Modi room to roll out various reforms. However, oil prices have climbed over the past few months, and this will pose a challenge for the government, especially as elections are less than one year away.

Capital markets in India have been on a bull run since this government came into power. The S&P BSE SENSEX total return value moved from 32,735.68 on May 31, 2014, to 50,572.53 on May 31, 2018; that is a four-year absolute return of 54.49%. The S&P BSE AllCap, a broad benchmark index with over 900 constituents, had a four-year absolute return of 69.79%. Among the size indices, the four-year absolute return of the S&P BSE MidCap was the highest, at 98.31%, followed by the S&P BSE SmallCap, at 98.25%, while the S&P BSE LargeCap was at 56.85%. Exhibit 1 depicts the total returns of the S&P BSE SENSEX, S&P BSE AllCap, S&P BSE LargeCap, S&P BSE MidCap, and S&P BSE SmallCap for the four-year period ending on May 31, 2018.

Exhibit 1: Total Return of the S&P BSE SENSEX and S&P BSE Size Indices 

Exhibit 2 provides the four-year absolute returns of the S&P BSE AllCap series. We can see that among the sub-sector indices in the S&P BSE AllCap, the S&P BSE Consumer Discretionary Goods & Services and the S&P BSE Finance posted the best four-year absolute returns of 113.95% and 93.60%, respectively, while the S&P BSE Telecom had the worst return of -6.06%.

Exhibit 2: Four-Year Absolute Returns of the S&P BSE AllCap Series
INDEX INDEX VALUE ON MAY 31, 2014 INDEX VALUE ON MAY 31, 2018 3-YEAR ABSOLUTE RETURN (%)
S&P BSE AllCap 2,964.50 5,033.34 69.79
S&P BSE LargeCap 3,169.73 4,971.62 56.85
S&P BSE MidCap 9,486.29 18,811.84 98.31
S&P BSE SmallCap 10,151.26 20,125.14 98.25
S&P BSE Consumer Discretionary Goods & Services 2,221.81 4,753.64 113.95
S&P BSE Finance 3,685.57 7,135.23 93.60
S&P BSE Fast Moving Consumer Goods 8,059.50 14,144.68 75.50
S&P BSE Information Technology 9,615.65 16,593.38 72.57
S&P BSE Basic Materials 2,244.72 3,835.42 70.86
S&P BSE Energy 3,247.41 5,062.84 55.90
S&P BSE Industrials 2,898.42 4,003.18 38.12
S&P BSE Healthcare 11,138.54 14,339.33 28.74
S&P BSE Utilities 1,971.70 2,522.48 27.93
S&P BSE Telecom 1,364.29 1,281.66 -6.06

Source: S&P Dow Jones Indices LLC. Data from May 31, 2014, to May 31, 2018. Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance. The S&P BSE AllCap, S&P BSE LargeCap, S&P BSE Consumer Discretionary Goods & Services, S&P BSE Finance, S&P BSE Basic Materials, S&P BSE Energy, S&P BSE Industrials, S&P BSE Utilities, and S&P BSE Telecom were launched on April 15, 2015.

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