Barclays revises up its inflation forecast, to 1.9% by next winter, while Lou Stanaslovich comments that TIPs will only perform well if inflation rises; S&P reports on global mutual funds holding at least 10% in cash; commodities continue to be volatile; Janney Scott Montgomery sees opportunities in the U.S., the Eurozone and Japan.
Louis P. Stanaslovich, Legend Financial Advisors, Risk Controlled Investing
Treasury Inflation Protected Securities (TIPS) have become a very popular investment vehicle over the last decade.
One obvious reason is they are designed to keep up with the Consumer Price Index(CPI). The return is actually divided into two components. The first part pays a variable spread or yield. For example, let’s suppose the yield is 1.5% over the CPI. An investor would receive the 1.5% plus the monthly change in the non-seasonally adjusted CPI.
This occurs in the form of a daily accrual to principal. Each coupon payment is then based upon the bond’s indexed principal amount, resulting in coupon payments that will be fully indexed for inflation as it accrues over time. The second part of the return is a fixed coupon payment that is accrued daily and paid semi-annually.
Historically speaking, TIPS were first issued by the U.S. Government in January, 1997. Although a few other countries issued their version of TIPS for a few years prior to the U.S. doing so, they did not really become a popular investment vehicle until U.S. issuance began. Today Great Britain, France, Sweden, Canada, New Zealand, Australia and a few other countries are now active issuers of real return bonds. The popularity of these bonds continues to grow.
Hence, it seems as if everyone’s recommending TIPS because many economic observers believe we’ll see higher inflation in future years due to the fact that most countries around the world have debased their currencies by borrowing massive amounts of debt to spur fiscal stimulus in their respective countries. Stay tuned for interest rate increases due to the fact that the U.S. Government needs unprecedented amounts of money (probably between $1.5 and $2.0 trillion annually over the next two to three years) and investors, especially foreign ones, will begin demanding higher interest rates.
Are TIPS a sound investment in the midst of this kind of monetary policy? The answer isn’t clear. TIPS theoretically perform well during periods of rising inflation, but not necessarily during periods of rising inflation expectations when either the Federal Reserve Bank (Fed) raises rates without a clear-cut increase in CPI numbers or when interest rates rise rapidly as they are now.
One factor disfavoring the usage of TIPS is the fear of entering a deflationary period. Listed below is a yield curve chart for TIPS across various maturities:
2-Year TIP Yield 1.409%
5-Year TIP Yield .426%
10-Year TIP Yield 1.000%
20-Year TIP Yield 1.778%
30-Year TIP Yield 1.951%
These spreads are vastly different than the 4.0%-plus spreads offered when government TIPS were first introduced in 1997. However, they are competitive by today’s standards.
Another factor working against TIPS as an investment is the understated rate of inflation (CPI). The understatement is generally thought to be 0.7% to 1.0%.
In short, if inflation rears its ugly head, TIPS will be an excellent investment. If inflation isn’t a factor, TIPS may end up resembling other government bonds from a total return standpoint if inflation does not rise. If instead deflation occurs over the next few years, Treasury securities with fixed coupons will offer significantly better returns.
Peter Newland, Barclay’s Capital, Market Strategy Americas
Last week, we revised up our forecasts for core CPI inflation. We now expect it to rise to 1.6% y/y in Q4 2011 and 1.9% in Q4 2012 (previously 1.4% and 1.7%). Our revisions come at a time when policymakers are beginning to pay a bit more attention to the inflation outlook. For example, the March FOMC statement noted that “recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation”. However, importantly, the Committee judged that these effects would prove to be “transitory”. Implicit in this statement is the belief that second-round effects from food and energy prices to the prices of other goods and services will be minimal.
Three factors likely underpin the Committee’s view: 1) the degree of spare capacity in the economy remains large, putting downward pressure on wages and restricting firms’ pricing power; 2) partly as a result of this, labor costs remain weak, even while non-labor costs (such as energy and other raw material inputs) have risen rapidly; 3) inflation expectations remain low and stable. Our own view is that the degree of spare capacity in the economy is not that large. Taken alongside an improving labor market and a return to more trend-like productivity growth, the economic backdrop is gradually turning more inflationary.
Should our view prove accurate, core inflation could pick up faster over the forecast horizon than policymakers currently expect. However, without a sustained rise in inflation expectations we doubt the Fed’s stance on inflation will shift significantly in the near term.
Dormant inflation pressures could soon awaken…
Two factors underlie pricing decisions: costs (mainly labor costs, but with energy, raw materials and other input costs also playing a role) and the mark-up of prices over costs.
During the recession and early stages of the recovery firms faced a perfectly disinflationary environment, with labor costs depressed by weak wage growth on the one hand (in turn reflecting a large degree of spare capacity in the labor market) and strong productivity growth on the other (as employment and hours declined more sharply than output). At the same time, pricing power was limited by weak demand.
These disinflationary forces have eased considerably, in our view. Although several FOMC members assume that labor market slack (ie, a high unemployment rate relative to the NAIRU) will continue to subdue wages, we believe that the NAIRU has risen.) This suggests that wage growth could find a trough sooner than policymakers expect. In addition, if growth in employment and hours picks up, as we are forecasting, productivity growth will slow further, having risen rapidly in 2010. Wage growth in excess of productivity growth signifies rising unit labor costs.
Meanwhile, the recovery in demand has likely made it easier for firms to pass on rising costs. A proxy based on prices and total unit costs in the nonfinancial corporate sector supports this view. Taken together, a pick-up in unit labor costs (alongside the recent surge in some non-labor costs) and firms’ greater ability to mark up prices in response would suggest that some modest inflationary pressures could soon build.
…but inflation expectations remain key for the Fed
Policymakers will be tracking these dynamics closely. Evidence of a stabilization in wage growth, in particular, could be interpreted as a sign that the degree of slack is smaller than they currently judge, and that inflation could pick up a bit faster as a result. However, given the low starting level of core inflation the Fed is likely to point to stable long-term inflation expectations as reassurance that price pressures will remain well contained and that policy can continue to focus on nurturing the recovery. Although market and survey measures of inflation expectations have risen recently, both are close to pre-crisis levels. It would likely take a substantial move higher to shift the Fed’s current stance.
James Corridore, S&P Equity Analyst
With the catastrophe in Japan still unfolding, and with the global economic implications still unknown and rapidly changing, investors are understandably worried about global equity investing. In addition, the fighting in Libya and chaos in several other Middle Eastern countries, along with the still evolving financial difficulties in several European nations, add to the risk of international investing at this time. However, S&P Equity Research still believes that global diversification should remain a key part of many investors' diversification strategies.
So, keeping in mind that investors remain interested in international equity exposure but are understandably concerned about global shocks in Japan, the Middle East and Europe, it seems sensible that having some cash on the sidelines would be a prudent philosophy for global funds at the present time. We see two reasons why this makes sense. First, not being fully invested at a time when global events are still unfolding strikes us as prudent, since we still don't know how bad economic shocks related to unfolding international events will turn out to be. Second, we remain convinced that the current crises, like those of the past, will eventually end, and the skies will ultimately clear. Having ample cash to put to work when global conditions stabilize could provide an edge to those mutual funds that have the wherewithal to invest when that time comes.
With that thesis in mind, we decided to screen for global equity funds still open to new investors that have at least 10% of their holdings in cash, and that are ranked at least four stars by S&P Mutual Fund Reports. Using the screening tool available on S&P's MarketScope Advisor website, here are a few of the names that qualified.
ENCPX is ranked four stars by S&P Mutual Fund Reports, and is a global equity fund in the multi-cap growth space. Among positive characteristics highlighted by S&P Mutual Fund Reports, the fund has a below average net expense ratio of 1.45%, vs. the 1.64% peer group average, and has 1- and 3-year performance in the top quartile of peers. In 2010, the fund's total return of 60.0% was best among its peers and compared to a peer average return of 16.5%. As of November 30, 2010, it had 17.9% of its total assets in cash. The fund's largest sector weightings were in materials and energy.
ING Global Value Choice Fund; C (NAWCX)
NAWCX is a global equity fund in the multi-cap value space that is ranked four stars by S&P Mutual Fund Reports. The fund's 1- and 3-year performance were in the second quartile among peers, and its total return in 2010 of 21.8% compared favorably to a peer average return of 15.4%. Among its top 10 holdings were several names recommended by S&P equity analysts, including Barrick Gold (ABX 50 ****), Newmont Mining (NEM 51 ****) and Chesapeake Energy (CHK 34 ****). The fund has 11.9% of its total assets in cash, and 26% of its assets exposed to Asia developed markets and 13% in Europe developed markets.
BlackRock Natural Resources Trust; C (MCGRX)
MCGRX is a global equity fund that is mostly invested in the North American natural resources sector, with 58% of its assets in the U.S. and 17.6% in Canada. It also has 6% if its assets in Europe and 3% in Asia. As of the most recent report, it had 10% of its assets in cash. Among its top 10 holdings are several names recommended by S&P Equity analysts, including EOG Resources (EOG, 110 ****), Apache Corp. (APA 123 *****), Chevron (CVX 105 *****), Exxon Mobil (XOM 83 *****) and National Oilwell Varco (NOV 79 ****).
Sudakshina Unnikrishnan and Kerri Maddock, Barclays Capital
Commodity sector views
Oil prices remain firm, with Brent trading upward of $115/bbl and WTI above $105/bbl. Developments in the past week continue to repeat key themes in the oil market: exceedingly strong demand and tenuous supply. Early in the week, the first indications of OECD and Chinese oil demand showed no signs of easing. The latest JODI data places OECD demand growth at 1m b/d for January with growth in each region: North America, Europe and Asia Pacific. In addition, for February, Chinese oil demand was reported up 10% y/y and at the second highest monthly level ever. Against this backdrop, geopolitical concerns are meddling with supply, namely in Libya in the form of reduced production, and in Bahrain, where the bigger threat is its effect on Saudi Arabia, the world’s swing producer. This list could expand further into the region and with US-Saudi relations strained recently, the Kingdom’s motivation to calm markets by raising production may be reduced. We have recently raised our price forecasts to reflect 2010’s demand shock (that we expect to continue into 2011), a recalibration lower of global spare capacity, shut-in Libyan production, and the likelihood of other geopolitical pressures to continue for a protracted period of time. We raised 2011 to $106 for WTI and $112 for Brent. Our forecasts remain unchanged for 2012 at $105 for WTI and Brent and for 2015 at $137 for WTI and $135 for Brent. We introduce a 2020 forecast: $185 for WTI and $184 for Brent.
US natural gas
Natural gas prices have gained impressively over the past week, embracing a larger-thanexpected weekly withdrawal from storage and a colder outlook for the end of March. Despite recent bullishness in sentiment, we think that once short-term temperatures recede, robust injections will reveal a weak supply-demand balance.
The main contracts for coal delivered into Europe, the API-2, had a quieter week as last week’s nuclear crisis left the market to stabilise at higher levels at about 130 $/t. The market continues to reflect a weak Pacific-basin in which the market is still smarting from an inability to deliver cargo into Japan and diverted cargoes finding homes in other countries in the region, although China’s activity still appears muted due to a healthy domestic supply and good stock levels. In Europe, utilities are looking for coal cargoes and this is helping keep prices supported.
After the strong gains of last week, driven by the German closure of 7 GW of nuclear plant, the market stabilised before reminding participants of exactly how long it is and dropping value down to 16.50 €/t, a w/w loss of 4%.The market does remain well supplied and with the abruptness of last week’s ramp, some heavy industrial selling and profit taking at these higher levels was always going to be a downside risk. Where prices go from here will still be driven by the underlying fundamental driver of utility hedging, and we still expect this to appear in Q2 when the utilities historically hedge considerable volumes. If anything has changed, the nuclear closure does drive an expectation of even higher levels of hedging to come out of Germany.
The base metals continue to reel from Middle Eastern political uprisings and the largest earthquake ever to hit Japan. This has certainly increased uncertainty and volatility in prices, but our economists believe that these events have not yet stopped the economic recovery.
However, until there is more clarity on how developments will play out metals prices are likely to remain volatile. Rising oil prices and policymaker response to increased inflationary pressures are the main risks to global growth and metals demand, nevertheless, unless events turn out worse than expected we remain positive on the outlook for this year.
Despite increased uncertainty and headwinds metals prices have held up well with lead and aluminium setting multi-year highs. Aluminium is taking support from rising energy prices and expectations that future energy costs could be pushed further higher as nuclear power’s role in the global energy mix is in question. In our view, the risk-reward of being long aluminium, particularly far-dated aluminium, has become increasingly attractive given its relatively limited loss profile. Although copper has underperformed recently, we advocate being long and see dips as buying opportunities, given the expected big improvement in fundamentals we forecast over the coming months. Nickel also looks attractive, having suffered selling pressure in spite of a positive fundamental picture and supply disruptions.
Gold and silver prices set all-time and 31-year highs as market uncertainty and rising geopolitical tensions fuelled investor appetite. The events in Japan are most likely to affect the PGMs in terms of potential negative demand, given auto-catalyst consumption losses following the closure of auto production facilities. However, Japan is also a large consumer of platinum jewellery, as well as physical and speculative investment in platinum, which are likely affected negatively in the short term. Should ETP flows turn negative, price moves could be exacerbated to the downside, but the market balance is still set to tighten longer term. Gold has continued to find good support upon price dips from physical demand in Asia, and bar premiums in Tokyo have hit three-year highs. The broad market uncertainty is set to support investor interest with gold ETP flows turning positive this month. Silver prices continue to take gold’s cue but are likely to remain volatile given their weak fundamentals.
Agricultural commodities have moved up over the past week, recouping some of the price declines that came due to risk aversion, choppy external markets, geopolitical concerns and the earthquake in Japan. We continue to reiterate our positive view on the grains complex.
Next week’s USDA Prospective Plantings report will give a good indication of the intention of US farmers in terms of acreage allocation between the main row crops. Dry weather in the US Southern Plains continues to provide support to wheat prices, while there are also concerns starting to surface that the US may face a delayed spring planting season – this may imply fewer corn acres being harvested than expected and may also hold implications for yields. With US corn stocks at very thin levels and demand from both the feed and fuel sectors increasing, the need for a robust corn crop from the US has assumed pivotal importance. Latest weekly US export sales data show strength in exports for corn, wheat, soybeans and cotton. Meanwhile, with crude oil prices at current levels, ethanol margins remain positive and weekly EIA data have shown another rise in US ethanol production, at 913Kbpd. After easing for much of this week, especially with India’s decision to allow the export of 500Kt sugar, ICE sugar prices edged up on excess rainfall in Brazil and its implications for sugar production and exports.
Mark Luschini, Janney Montgomery Scott
The financial markets are always processing the range of unknowns that loom from large to small. At times when there are few obvious conditions under which the market could be shocked, the tails of the proverbial bell curve are thin. In other words, most of what could go wrong is in plain sight, leaving little room for a surprise. The events over the last several weeks, however, served to widen those tails as the outcomes relating to the unrest in Libya, and the Fukushima nuclear facility in Japan, are far less certain. Uncertainty fattens the tail risk, as the consequence of something bad happening has high stakes. Market participants pricing in the unknown were on full display…as stocks dropped precipitously across all global equity indices. Circumstances in Japan seemed to stop worsening and tensions in the Middle East didn’t produce a spike in oil prices. After having declined 431 points in the first three trading sessions, the Dow Jones Industrial Average caught a bid and rallied to close Friday with a loss of a relatively paltry 186 points on the week, or down 1.5%, to 11,859. Government bond prices, on the other hand, strengthened as investors sought the safety of U.S. funds which drove yields to levels not seen in quite some time. The 10-year Treasury bond yield reached 3.14% at one point (from a peak of 3.77% in February).
There is no denying that a nasty exogenous event could inflict damage on the economy. At the moment, though, none of the potential threats have inflicted anything strong enough to derail the global business cycle. A report on regional manufacturers from the Philadelphia Federal Reserve Bank showed an increase in activity to a level not seen since January 1984. This data has had a historically high correlation with the GDP in the U.S. as whole, and as a consequence is encouraging. Within the survey, a separate index of expected business conditions over the next six months improved to its highest level since 1992. This, as well as many other items, point importantly to a level of momentum in the economy that should allow it to move past these events. Hence, we expect the cyclical bull market in stocks to pass this corrective phase and advance to higher levels. Investors should remain focused on U.S. large cap stocks, but also key in to other international markets that have been rendered attractive through this recent sell-off in global equities. These areas include the Euro zone and Japan.
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