- Charts can feed curiosity about markets and inspire investors to dig deeper to ferret out potential investment opportunities that exist around the world.
- They might surprise you, provoke a question, or confirm your intuitions. They tell stories about various regions and markets. And they each have investment implications.
- In this month’s commentary, read about five fabulous charts that will hopefully make you wonder, “Why is that, and what does it mean?”.
For many sports fans, the "Fab Five" refers to the immensely talented 1991 University of Michigan men's basketball team's starting lineup. In this month's commentary, I'm using the Fab Five to mean five fabulous charts that will hopefully make you wonder, "Why is that, and what does it mean?" I look at charts practically all day long. They feed my curiosity about markets, and they inspire me to dig deeper to ferret out potential investment opportunities that exist around the world. Here-in no particular order-are five charts that I currently find interesting and that might surprise you, provoke a question, or confirm your intuitions. They tell stories about various regions and markets, and they each have investment implications.
Deflation Is Dead in Japan
Investors remain skeptical about Japan, especially in light of negative second-quarter GDP (Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period); however, signals indicate that recovery is underway. Second-quarter growth was heavily distorted by the value-added tax which boosted first-quarter activity and subtracted from second-quarter activity. Figure 1 shows that inflation in Japan has been steadily rising since 2009. The new value-added tax is a factor, but price increases are sticking and the economy is not stumbling. The Bank of Japan is aggressively expanding its balance sheet, which now represents a larger percentage of GDP than the balance sheets of any other developed economy. I believe improving growth and a worker shortage will put pressure on wages, further underpinning inflation and incenting businesses and consumers to make purchases sooner and shift their portfolios to riskier assets. The market has not yet embraced these developments; Japanese equities currently trade at about 14 times 12-month forward earnings, well below their historical median of 26 times earnings.
Investment implication: I favor Japanese equities within a global portfolio.
Source: Haver Analytics
The Japan Consumer Price Index (CPI) is a measure of the average price which consumers spend on a market-based "basket" of goods and services.
Aging U.S. Population Means Slower Growth and Lower Interest Rates
In 15 years, 20% of the U.S. population will be older than age 65 (Figure 2), a situation that implies a sharp decrease in the percentage of the working-age population. Because economic growth is a byproduct of three components-size of the workforce, labor utilization (hours worked), and productivity-we estimate that the decline in potential workers will detract about 0.75% from annualized growth. Absent a surge in productivity, slower economic growth means that interest rates are likely to be lower in the future than they have been historically. Improving growth is likely to lift interest rates; however, peak rates could be lower than in the past.
Investment implication: Don't abandon fixed income. Rate rises are likely to be slow and gradual, and high-quality bonds can play an important diversifying role in an equity market sell-off.
High Sovereign Yields in Brazil
Emerging markets (EM) are likely to continue to be vulnerable to geopolitical risk. However, I see distinct opportunities in individual countries, particularly Brazil. Brazilian sovereign bonds have a steep yield curve, with 10-year yields at 11.75% (Figure 3). In addition, the economy has suffered from weak growth and sticky inflation, and markets are pricing in continued interest-rate hikes. I think weak growth will cause the Brazilian central bank to stop raising rates which should benefit 10-year local bonds. The Brazilian real, which has been hit hard since the beginning of the year, also offers upside, especially if a new market-friendly government is elected in October.
Investment implication: Despite geopolitical uncertainty, EM debt offers opportunities in individual countries and currencies. In particular, Brazil local debt is attractive in 10-year maturities.
Middle, Not Final, Innings of the Credit Cycle
Almost six years into the U.S. recovery, it's fair to ask when the credit cycle will end, especially given that most investors have considerably more credit exposure today than at the start of the recovery. Figure 4 measures the credit cycle in terms of peak-to-trough credit spreads in BBB-rated credit. I think this credit cycle still has legs for several reasons. First, the deep, unprecedented financial shock in 2008 means this recovery will take longer to gain traction. Second, corporate fundamentals remain strong, with high cash balances and healthy interest coverage. Third, valuations in investment-grade credit are not at rich levels. True, a larger liquidity premium is embedded in credit spreads-due in part to the reduced market-making role of broker-dealers-so spreads are unlikely to tighten as much as they have in the past. But with the Federal Reserve (Fed) likely to normalize rates gradually, the turn in the cycle is likely to be years, not months, away.
Investment implication: Maintain exposure to higher-quality credit, as credit fundamentals remain healthy and the Fed remains accommodative.
Bank Loans Are More Attractive Than High Yield
Media coverage about deteriorating quality, covenant-lite deals, and pricey valuations among the high yield and bank loan markets has been prevalent, so let's set the record straight. Figure 5 illustrates that even with the recent sell-off in high yield, bank loans are more attractively priced than high yield. At the 61st percentile, bank loan spreads have been priced cheaper than current spreads only 39% of the time, whereas high yield spreads are currently in the 27th percentile, meaning they have been cheaper 73% of the time.
Other favorable aspects of bank loans are their floating index rate-which rises when interest rates rise-and their higher status in the capital structure, meaning they have a higher recovery rate in the event of default. Finally, the demand technicals for bank loans are favorable, as collateralized-loan obligations (CLOs) are an important support for these securities, buying more than half of bank loan net new issues in the second quarter. On the other hand, liquidity is worse in bank loans than high yield and other higher-quality fixed-income assets, so investors should consider bank loans a long-term investment, to avoid selling at depressed prices. In fact, one year ago, when markets were jolted by the "taper tantrum," (when risk assets broadly declined following the Fed's announcement it would scale back its monthly bond-purchase program), investors who bought cheaper paper following the liquidity-induced sell-off were rewarded with attractive returns. Finally, investors may want to keep in mind that bank loans may not respond initially to interest-rate rises because the London Interbank Offered Rate (LIBOR) floors on which bank loans are based are typically set at higher interest rates than current-market rates.
Investment implication: Bank loans, which have lagged high yield's performance, now look comparatively more attractive.
Recap of Investment Implications
- I favor Japanese equities within a global portfolio.
- Don't abandon fixed income. Rate rises are likely to be slow and gradual, and high-quality bonds can play an important diversifying role in an equity market sell-off.
- Despite geopolitical uncertainty, EM debt offers opportunities in individual countries and currencies. In particular, Brazil local debt is attractive in 10-year maturities.
- Maintain exposure to higher-quality credit, as credit fundamentals remain healthy and the Fed remains accommodative.
- Bank loans, which have lagged high yield's performance, now look comparatively more attractive.
A Word About Risk: All investments are subject to risks, including possible loss of principal. Fixed-income investments are subject to interest-rate risk (the risk that the value of an investment decreases when interest rates rise) and credit risk (the risk that the issuing company of a security is unable to pay interest and principal when due) and call risk (the risk that an investment may be redeemed early). Investments in high-yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Unlike stocks and bonds, U.S. Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. Investments in foreign securities may be riskier than investments in U.S. securities. Potential risks include the risks of illiquidity, increased price volatility, less government regulation, less extensive and less frequent accounting and other reporting requirements, unfavorable changes in currency exchange rates, and economic and political disruptions. These risks are generally greater for investments in emerging markets. Sovereign debt investments are subject to credit risk and the risk of default.
The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice or as the views of Hartford Funds. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management.
All information and representations herein are as of 8/14, unless otherwise noted.