The current geopolitical risk in the Middle East puts even more into focus commodity price trends and their effect on equity markets. When commodity prices are trending higher, do commodity exporting markets do better and commodity importing do worse? And vice versa. When commodity prices are trending lower, do commodity exporting markets do worse and commodity importing markets do better. In other words, can the trend of export prices relative to import prices be useful in allocating the equity markets?
The Heckman Global Allocation Model² uses a smart beta (factor based) approach to allocating the global markets using a set of 13 valuation and macro-economic investment factors. The model can evaluate the efficiency of each factor for allocating markets on a standalone basis as well as a combination of factors. To test whether the trend of export vs import prices be useful in allocating the equity markets, we created a terms-of-trade index based on the imported or export composition for each market and the price of four different exported and imported items – fuel, metal/minerals, agriculture, and manufacturing. For each market, we compare today’s index vs where the index was 18 months ago. For example, if oil prices have gone up compared to where they were 18 months ago, large oil exporters such as Norway or Brazil would have positive terms-of-trade. Conversely, under these circumstances over the same time period, if a market is a large oil importer, such as Japan, its terms-of-trade would be negative. Conversely, when the price of oil has gone down compared to where it was 18 months ago, Norway’s terms-of-trade would become negative and Japan’s positive (as an oil importer). We tested whether overweighting markets with positive terms-of-trade and underweighting markets with negative terms-of-trade was a strategy that produced alpha over a benchmark.
Starting with benchmark country capitalization weights, we re-balanced the country allocation monthly by assigning overweights to markets with higher-than-average terms-of-trade and underweights to markets with lower-than-average terms-of-trade. Each country gets an overweight or underweight allocation relative to the benchmark that is roughly in proportion to the difference between its score and the cross-market average score (with restrictions on the maximum allocation possible to small markets to avoid unrealistically large exposures). The allocation coming the Heckman model is updated each month and performance returns (gross and net of estimated transactions costs) are calculated monthly. Returns are then measured relative to the relevant universe benchmark returns.
Results of Standalone Backtests
The annualized alphas for overweighting markets based on its terms-of-trade trend on a standalone basis using the Heckman Global Allocation model are shown in the following figures. The tests were done across the markets in the MSCI All-Country World Index (ACWI) which include both the developed and emerging markets, across the markets in the MSCI All-Country World Index (ACWI ex US) which include both the developed and emerging markets but excluding the U.S., across the markets in the MSCI World Index (all the developed markets), and across the markets in the MSCI Emerging Market Index (all the emerging markets). Figure 1 shows the hypothetical annualized alphas (gross and net of estimated transaction costs) from January 1990 through November 2023. Figure 2 shows the hypothetical annualized alphas (gross and net of estimated transaction costs) more recently from January 2014 through November 2023³.
What the charts show is the trend in export and import prices can be useful for allocating equity markets. Over the whole period starting in January 1990, it has been most useful for allocating the ACWI markets, the ACWI (excluding the U.S.) markets, and the Emerging Markets. In contrast, allocating markets based on export prices relative to import prices appears to have offered less alpha in allocating the developed markets. In particular, over the last 10 years, performance of the developed markets has been dominated by outperformance of the U.S. market and by tech - rather than by export vs import prices movements.
Figure 1
Figure 2
¹ For Institutional Investors Only
² The Heckman Global Allocation Model is a hypothetical model. Performance results were not actually achieved by any portfolio of the adviser.
³ January 1990 is when the Heckman Global Model started. The Model data goes back to January 1990, and 2014 was trying to represent as close to the recent 10 years
DISCLOSURE:
For Institutional Investors Only. This publication is provided by Heckman Global Advisors (“HGA”), which is not an independent entity but is a Division of DCM Advisors, LLC, a registered investment adviser. The views herein are solely those of HGA and may differ from those of other business units of DCM Advisors, LLC and are subject to change without notice. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors, LLC vehicle(s).
All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. Past performance is no guarantee of future results. All returns are illustrative based on the assumptions as outlined. There can be no assurance that the returns could have been achieved or avoid substantial losses. The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed.
Indices are presented herein for illustration purposes only as the Heckman Global Allocation model does not intend to track any index or benchmark. The MSCI All-Country World Index (ACWI) , which includes both the developed and emerging markets, is designed to represent performance of the full opportunity set of large- and mid-cap stocks across 23 developed and 24 emerging markets.
The MSCI All-Country World Index (ACWI ex US) which includes both the developed and emerging markets but excluding the U.S., captures large, mid and small cap representation across 22 of 23 Developed Markets (DM) countries (excluding the United States) and 24 Emerging Markets (EM) countries
The MSCI World Index (all the developed markets), is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI Emerging Market Index (all the emerging markets) is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
These materials are the exclusive property of DCM Advisors, LLC. Unless otherwise expressly permitted by DCM Advisors, LLC in writing, please do not distribute, reproduce or use these materials for any purpose other than internal business purposes solely in connection with the management of investment funds or investment products that are sponsored or advised by you. This publication is not considered a Research report under FINRA Rule 2241(a)(11) and related rules.
DCM-24-07
What is the relationship of market consensus earnings growth forecasts for a market (aggregated bottom-up from company data)¹ and future country returns?
To answer this question, for each of the MSCI Developed and Emerging markets, each month, we looked both at the consensus forecasted earnings growth for the current year (after all one does not know the actual earnings growth for the current year until early the following year) as well as the consensus forecasted earnings growth for the following year. We correlated both the earnings growth forecast for the current year and the earnings growth forecast for the following year with each market’s MSCI returns over 3 periods:
- Over the next 3 months
- Over the next 6 months
- Over the next 12 months
We cover 23 developed and 24 emerging markets as defined by MSCI. The study utilizes a database and returns covering a 30-plus year period from January 1990 through March 2023 for most developed markets and from August 1992 through March 2023 for many emerging markets. The charts below show the average correlation for developed, emerging, and all markets of forecasted earnings growth with market returns over 3 different periods of time.
These results suggest that at the market level there is little correlation in the near term (3,6, and 12 months out) with earnings growth forecasts and stock prices at the market level.
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¹ I/B/E/S, Heckman Global Advisors, Bloomberg
Disclosure: This publication is provided by Heckman Global Advisors (“HGA”), which is not an independent entity but is a Division of DCM Advisors, LLC, a registered investment adviser. The region and sector allocations recommended herein are solely those of HGA and may differ from those of other business units of DCM Advisors, LLC. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors, LLC vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM Advisors, LLC and are subject to change without notice. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. Copyright © 2023 DCM Advisors, LLC. All Rights Reserved. These materials are the exclusive property of DCM Advisors, LLC. Unless otherwise expressly permitted by DCM Advisors, LLC in writing, please do not distribute, reproduce or use these materials for any purpose other than internal business purposes solely in connection with the management of investment funds or investment products that are sponsored or advised by you. This publication is not considered a Research report under FINRA Rule 2241(a)(11) and related rules. DCM-23-47
It is commonlypresented in the media that the higher the GDP growth means the market will have higher performance. In this article, we test this commonly held view using the Heckman Global Allocation Model.
The Heckman Global Allocation Model uses a smart beta(factorased) approach to allocating the global markets using a set of 13valuation and macro-economic investment factors. The model can evaluate theefficiency of each factor for allocating markets on a standalone basis as well combination of factors. We tested on a standalone basis for allocating markets both forecasted GDP for thecurrent year (since one does not know actual GDP until way into the followingyear) and forecasted GDP for the next year using monthly data from January 1990through September 2. (Source: Heckman Global and Consensus Economics)
For each factor we calculated a score for every market each month based on how high the market’s forecasted GDP growth (for current year or next year) is relative to the average market. Starting with benchmark country capitalization weights, we re-balance the portfolio by assigning overweights to markets with higher-than-average forecasted GDP growth and underweights to markets with lower than average forecasted GDP growth. Each country gets an overweight or underweight allocation relative to the benchmark that is roughly in proportion to the difference between its score and the cross-market average score (with restrictions on the maximum allocation possible to small markets to avoid unrealistically large exposures). The portfolio is updated each month and performance returns (gross of transactions costs) are calculated monthly. Returns are then measured relative to the relevant universe benchmark returns.
Results of Standalone Backtests
The annualized alpha for overweighting markets on a standalone basis testing both measures of GDP forecasts (current year and next year) is shown in Figures 1 and 2. The tests were done across the MSCI All-Country World (ACWI) markets which include both the developed and emerging markets, across the MSCI World markets (the developed markets), and across the MSCI Emerging markets. The alpha was negative whether we tested forecasts for the current year or for next year. In other words, the media hype that higher GDP forecasts for a market translate into higher returns relative to other markets does not necessarily hold up.
Disclosure: This publication is provided by Heckman Global Advisors (“HGA”), which is not an independent entity but is a Division of DCM Advisors, LLC, a registered investment adviser. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors, LLC vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM Advisors, LLC and are subject to change without notice. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. Copyright © 2023 DCM Advisors, LLC. All Rights Reserved. These materials are the exclusive property of DCM Advisors, LLC. Unless otherwise expressly permitted by DCM Advisors, LLC in writing, please do not distribute, reproduce or use these materials for any purpose other than internal business purposes solely in connection with the management of investment funds or investment products that are sponsored or advised by you. This publication is not considered a Research report under FINRA Rule 2241(a)(11) and related rules.
There has been a lot ofdiscussion on the strength of the U.S. dollar over the past several years andits relationship with rising interest rates. The common belief is that when interest rates in the U.S. rise, the dollar will strengthen. SinceDecember 31, 1988 through August 31, 2023, we have looked at thereal exchange rate [1]ofthe U.S. dollar, which compares the valuation trend of the U.S. dollar relativeto its trading partners and its relationship with changes in the Fed fundsrate. The change in Fed funds rate which we measured is the difference between the Fed fundsrate and its 24-month average. Below is a chart of the two – U.S. dollar realexchange rate valuation and changes in Fed Funds rate.
Below is a table of the correlation between real exchange rate valuation and the change in Fed funds rate. For the whole time, the correlation is low . However, if the period is broken up into periods when the Fed policy has been tight, then the correlation is overall positive.
** Our data only starts late in that tightening cycle
Heckman Global's Conclusion: When the Fed policy has been tight, the valuation of the real exchange rate of the U.S. dollar tends to be positively correlated with changes in Fed Funds rate.
[1] The real effective exchange rate index as a weighted average ofthe CPI-adjusted exchange rates of the U.S. with respect to its six largesttrading partners. Our real exchange rate valuation factor is measured as thedeviation, in percent, of the most recent level of the U.S. dollar realexchange rate from its six-year moving average.
Disclosure: This publication is provided by Heckman Global Advisors (“HGA”), which is not an independent entity but is a Division of DCM Advisors, LLC, a registered investment adviser. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors, LLC vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM Advisors, LLC and are subject to change without notice. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. Copyright © 2023 DCM Advisors, LLC. All Rights Reserved. These materials are the exclusive property of DCM Advisors, LLC. Unless otherwise expressly permitted by DCM Advisors, LLC in writing, please do not distribute, reproduce or use these materials for any purpose other than internal business purposes solely in connection with the management of investment funds or investment products that are sponsored or advised by you. This publication is not considered a Research report under FINRA Rule 2241(a)(11) and related rules. DCM-23-92
Risks, whether global coming from a global crisis, such as the Covid pandemic and high inflation, or local, such as a controversial presidential election, can be reflected in the level of Credit Default Swaps (CDS) on government debt. The CDS reflects the perception of sovereign default risk but also can reflect economic and geopolitical risks which can in turn affect equity markets. The Covid pandemic, high inflation, a global slowdown, the war in Ukraine, build-up of global debt, and the recent rise in oil prices are some of the recent global risks. In March 2023, during the lead up to the U.S. debt ceiling crisis, we gave an analysis of 5-year CDS spreads around the world. Looking at the CDS markets currently, what are they telling us about risks of the global markets?
Most noticeably, U.S.CDS started to rise in April 2022 connected to the debt ceiling crisis and the banking sector stress and reached a local peak in March 2023. It is currently rising again with the possible government shutdown.
Italian CDS tends to be an outlier. It rose dramatically during the early days of the Covid crisis in 2020 and rose again in July 2022 with the resignation of Prime Minister Draghi and the subsequent September 2022 election of Meloni. German and French CDS tend to be low and steady, rising modestly during the early days of the Covid.
U.K. CDS rose dramatically in September 2022 connected to Liz Truss’s budget proposal. U.K. CDS has subsequently declined but stabilized.
Japanese CDS are low and steady, rising modestly during the early days of the Covid pandemic. Indian CDS tend to be higher than those in China, Korea, and Japan. They spiked during the early days of the Covid pandemic. Chinese, Indian, and Korean CDS spreads started to rise again in the Spring of 2022 with first the possible default on U.S. debt and stayed elevated in the Fall of 2022 with rising global interest rates and risk of a U.S. recession. Subsequently they have declined.
In general, Latin American CDS spreads tend to be higher than for Asian emerging markets. Over the period looked at, Brazil’s CDS spreads tend to be higher than most other markets causing our scaling for CDS to be increased on this graph. All three Latin American CDS rose during the early part of the Covid pandemic and also, like Asian CDS, rose during the Spring/Fall of 2022 with the possible default on U.S. debt, rising global interest rates, and risk of a U.S. recession. Like Asian CDS, spreads have declined since the Fall of 2022.
Turkish CDS is perennial outlier causing the scaling of the graph to be increased even beyond Latin America. Turkish CDS rose during the Covid crisis in 2020 and again considerably in the Spring 2022 with the Russian invasion of Ukraine. They rose again during the Turkish Presidential election in Spring 2023 but have fallen since then. Hungarian and Polish CDS rose in the Fall of 2022 most likely with the increase in inflation and proximity to the war in Ukraine. Czech Republic CDS have been narrow and steady.
Conclusion
Globally CDS spreads are currently tending to narrow, except for a modest increase in two important markets - U.S. and China. The modest widening for the U.S. is possibly explained by the looming government shutdown. For China, it can perhaps be explained by the Chinese economic slowdown and real estate crisis. We are hoping that the risks in both these markets can be contained.
Disclosure: This publication is provided by Heckman Global Advisors (“HGA”), which is not an independent entity but is a Division of DCM Advisors, LLC, a registered investment adviser. The region and sector allocations recommended herein are solely those of HGA and may differ from those of other business units of DCM Advisors, LLC. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors, LLC vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM Advisors, LLC and are subject to change without notice. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. Copyright © 2023 DCM Advisors, LLC. All Rights Reserved. These materials are the exclusive property of DCM Advisors, LLC. Unless otherwise expressly permitted by DCM Advisors, LLC in writing, please do not distribute, reproduce or use these materials for any purpose other than internal business purposes solely in connection with the management of investment funds or investment products that are sponsored or advised by you. This publication is not considered a Research report under FINRA Rule 2241(a)(11) and related rules. DCM-23-77
It seems that with the rise of social media and business news channels one would hypothesize that the time period for measuring momentum as a factor in allocating equity markets has gotten shorter. This analysis looks to see if using 3-month momentum would have added value to country allocation – especially over the most recent years.
The Heckman Global Equity Allocation Model uses a smart beta (factor based) approach to allocating the markets. Currently, in the Heckman Country Allocation Model, we use 13 investment indicators which fall into the categories of valuation, growth, risk, monetary policy, and momentum. Under momentum, we currently use momentum measured over the last 12 months for each market. This analysis tests whether shorter term momentum (3 months) would have added value as a factor for country allocation. In other words, if one overweights markets with higher 3-month momentum and underweights markets with lower 3-month momentum, would this strategy have outperformed the relevant MSCI index return.
In the Heckman Global Equity Allocation Model, we calculate a score for every market each month based on the indicators. Using momentum as an example, we start with MSCI benchmark country capitalization weights, and we rebalance the portfolio by assigning overweights to markets with higher-than-average momentum and underweights to markets with lower-than-average momentum. Each country gets an overweight or underweight allocation relative to the benchmark that is roughly in proportion to the difference between its score and the cross-market average score (with restrictions on the maximum allocation possible to small markets to avoid unrealistically large exposures). The portfolio is updated each month and performance returns (gross of transactions costs) are calculated monthly. Returns from the strategy can then be measured relative to the relevant MSCI benchmark returns.
In this analysis, we constructed the 3-month momentum factor in two ways: in local currency terms and in $US terms. There were two country universes tested: MSCI All-Country World universe (developed and emerging) and MSCI Emerging Market universe. We divided the alpha into 10-year periods since January 1989 and with the most period being January 2019 through July 2023 – obviously less than 10 years.
For the MSCI ACWI universe, as can be seen from the Charts 1 and 2, a positive alpha was produced for the first two ten-year periods from January 1989 through December 1998 and January 1999 through December 2008. However, for January 2009 through December 2018 and the most recent period of January 2019 through July 2023, this factor for country allocation would have produced negative alpha relative to the MSCI ACWI Index return.
Chart 1
Chart 2
For the MSCI Emerging Universe, as can be seen from the Charts 3 and 4, the 3-month momentum factor measured in local currency would have outperformed from January 1989 through December 2008. This is not the case of the $U.S. 3-month momentum factor since it underperformed during the January 1989 through December 1998. In addition, since January 2009, there is no clear pattern for outperformance over the MSCI Emerging Market Index either when the 3-month momentum is measured in local currency or in $U.S.
Chart 3
Chart 4
Do earnings estimate revisions at the country level predict future country returns? We examine whether the one-month upward earnings estimate revision ratio (defined as the total upward earnings estimate revisions over the last month for all companies in a market divided by total number of earnings estimate revisions - both upward and downward in a market) is an indicator of future returns or a momentum indicator of what has just happened in the markets.
To answer this question, for each of the MSCI Developed and Emerging markets, we correlated the one-month upward earnings estimate revision ratio with the market returns over 7 periods using monthly data:
- Previous 6 months
- Previous 3 months
- Previous month
- Concurrent month
- Next month
- Next 3 months
- Next 6 months.
We cover 23 developed and 24 emerging markets as defined by MSCI. The study utilizes a database of one-month upward earnings estimate revision ratios and returns covering a 30-plus year period from January 1990 through March 2023 for most developed markets and from January 1992 through March 2023 for many emerging markets. The chart below shows the average correlation of one-month upward estimate revisions with market returns over the 7 different periods of time.
The chart shows that the one-month upward earnings estimate revision ratio at the country level tends to be a proxy for a momentum factor – with analysts in aggregate basing their optimism or pessimism for earnings estimates on the market performance in the past. In other words, when markets have done well, analysts turn positive on company-level earnings estimates. The strongest correlation of the one-month upward earnings estimate revision ratio is with the performance of the market over the last 6 months.
These results suggest that markets are forward looking, and stock prices reflect future earnings prospects. Stock prices sense the improvement in the business prospects of companies and move up in anticipation, and in a similar manner stock prices sense the decline in outlook for company earnings and move down. Stock prices lead analyst behavior, and analysts possibly take their cues about future company performance from the recent behavior of stock prices.
The analysis is based on time-series data for each market. Nonetheless, in our experience in working with earnings estimate revisions at the country level for comparing markets, we have found that upward earnings estimate revisions tend to predict which markets will do well going forward cross-sectionally. In other words, markets with higher earnings estimates revisions tend to outperform markets where earnings estimates are being lowered. This is one of the factors in our country allocation framework. Based on this analysis, this investment factor should be placed in the Momentum category.
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Disclosure: This publication is provided by Heckman Global Advisors (“HGA”), which is not an independent entity but is a Division of DCM Advisors, LLC, a registered investment adviser. The region and sector allocations recommended herein are solely those of HGA and may differ from those of other business units of DCM Advisors, LLC. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors, LLC vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM Advisors, LLC and are subject to change without notice. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. Copyright © 2023 DCM Advisors, LLC. All Rights Reserved. These materials are the exclusive property of DCM Advisors, LLC. Unless otherwise expressly permitted by DCM Advisors, LLC in writing, please do not distribute, reproduce or use these materials for any purpose other than internal business purposes solely in connection with the management of investment funds or investment products that are sponsored or advised by you. This publication is not considered a Research report under FINRA Rule 2241(a)(11) and related rules. DCM-23-35
The risks on the global scene, including the recent meltdown of Silicon Valley Bank, Signature Bank, stress on Credit Suisse, still high inflation, a possible global recession caused by tightening monetary policy, the war in Ukraine, build-up of global debt, including US debt ceiling impasse, and the trade war with China can be reflected the level of CDS (Credit Default Swaps) on government debt. We have measured the value of 5-year CDS on government debt for each of the developed and emerging markets.
What is the CDS market (as of March 15, 2023) telling us now about risks?
Below are the charts of the value of CDS for regions of the world.
Most noticeably, U.S.CDS has risen since April 2022, likely connected to the debt ceiling impasse and most recently by the banking sector stress. While not rising to the heights during the Great Financial Crisis, it has risen to levels not seen since 2011/2012 during the tail end of the Great Financial crisis and during the impending 2013 budget showdown.
Continental Europe CDS has been low and steady since the European debt crisis in 2011/2012 and has barely risen with the Credit Suisse turmoil.
U.K. CDS rose dramatically in September 2022 connected to Liz Truss’s budget proposal. U.K. CDS has subsequently declined.
Japanese CDS also rose during 2011/2012 but subsequently has been pretty muted since then.
Emerging Markets CDS tends always to be higher than the developed markets. It has risen since March 2022, most likely connected to the invasion of Ukraine, the rise of the U.S. dollar, and most recently by the US banking stress.
From these charts, it appears that currently CDS in Continental Europe, UK, and Japan are below those of the U.S. The major concern is around the U.S. the budget impasse and the most recent banking stress.
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Disclosure: This publication is provided by Heckman Global Advisors (“HGA”), which is not an independent entity but is a Division of DCM Advisors, LLC, a registered investment adviser. The region and sector allocations recommended herein are solely those of HGA and may differ from those of other business units of DCM Advisors, LLC. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors, LLC vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM Advisors, LLC and are subject to change without notice. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. Copyright © 2023 DCM Advisors, LLC. All Rights Reserved. These materials are the exclusive property of DCM Advisors, LLC. Unless otherwise expressly permitted by DCM Advisors, LLC in writing, please do not distribute, reproduce or use these materials for any purpose other than internal business purposes solely in connection with the management of investment funds or investment products that are sponsored or advised by you. This publication is not considered a Research report under FINRA Rule 2241(a)(11) and related rules. DCM-23-23
Since the beginning of 2023 (through January 25, 2023), many international equity markets have outperformed the U.S. market. There have been reports in the media about the attractiveness of international equity markets. The arguments for international equities tend to go as follows:
- International markets are cheaper than the U.S.,
- European GDP growth is not falling off a cliff, and
- Inflation is falling which implies that the Fed, in all likelihood, will be reducing rate hikes and the tradeweighted dollar which has been weakening since October 2022 will continue to weaken.
To address one of these arguments: do international equities look cheap relative to U.S. equities? Below are charts of valuation of regions relative to the U.S. For the valuation 1 metrics, each region is displayed as a ratio of the region’s valuation (trailing price-to-earnings or forecasted price-to-earnings) relative to the U.S. The U.S. is in the denominator.
In terms of trailing P/E, most regions outside the U.S. have tended to trade below the U.S. over the last decade. Europe (ex UK) has been trading at a discount relative to the US market pretty consistently since June 2015, the UK has been trading at a discount since Sept. 2017, Japan at a discount since November 2013, and Emerging Markets since September 2010. In other words, most of the international regions have been trading a trailing P/E discount to the US through most of the U.S. mega-cap market dominance between 2015 and 2021.
Similarly for forecasted P/E, Europe (ex UK) has historically traded below the forecasted P/E for the US since 1995 but since March 2015 has traded systematically below the U.S. valuation. The UK has been trading at a discount since November 2016 with the discount getting larger over the last 5 years, Japan at a discount since April 2013, and Emerging Markets since July 2011.
Currently all the international regions displayed are trading at a discount to the US equity market. Much of the divergence in the last 5 years was due to U.S. mega-cap outperformance. It does offer the opportunity for the international valuations in the future to revert closer to par with the valuations of the U.S. market through relative price appreciation.
In terms of trailing P/E, most regions outside the U.S. have tended to trade below the U.S. over the last decade. Europe (ex UK) has been trading at a discount relative to the US market pretty consistently since June 2015, the UK has been trading at a discount since Sept. 2017, Japan at a discount since November 2013, and Emerging Markets since September 2010. In other words, most of the international regions have been trading a trailing P/E discount to the US through most of the U.S. mega-cap market dominance in between 2015 and 2021.
Similarly for forecasted P/E, Europe (ex UK) has historically traded below the forecasted P/E for the US since 1995 but since March 2015 has traded systematically below the U.S. valuation. The UK has been trading at a discount since November 2016 with the discount getting larger over the last 5 years, Japan at a discount since April 2013, and Emerging Markets since July 2011.
Currently all the international regions displayed are trading at a discount to the US equity market. Much of the divergence in the last 5 years was due to U.S. mega-cap outperformance. It does offer the opportunity for the international returns in the future to revert to closer to par with the valuations with the U.S. market.
Trailing P/E Ratio: International vs. U.S.
Forecast P/E Ratio: International vs. U.S.
Disclosure: This publication is provided by Heckman Global Advisors (“HGA”), which is not an independent entity but is a Division of DCM Advisors, LLC, a registered investment adviser. The region and sector allocations recommended herein are solely those of HGA and may differ from those of other business units of DCM Advisors, LLC. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors, LLC vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM Advisors, LLC and are subject to change without notice. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. Copyright © 2018 DCM Advisors, LLC. All Rights Reserved. These materials are the exclusive property of DCM Advisors, LLC. Unless otherwise expressly permitted by DCM Advisors, LLC in writing, please do not distribute, reproduce or use these materials for any purpose other than internal business purposes solely in connection with the management of investment funds or investment products that are sponsored or advised by you. This publication is not considered a Research report under FINRA Rule 2241(a)(11) and related rules. DCM-23-9
The Heckman Global Allocation Model for Emerging Markets uses a smart beta (factor based) approach to allocating the markets. In the Heckman Country Allocation Model, there are 14 factors utilized in the model.
Using dividend yield as an example of a factor, we calculate a score for every market each month based on how high the market’s dividend yield is relative to the average market. Starting with MSCI Emerging Market benchmark country capitalization weights, we re-balance the portfolio by assigning overweights to markets with higher-than-average dividend yields and underweights to markets with lower than average dividend yields. Each country gets an overweight or underweight allocation relative to the benchmark that is roughly in proportion to the difference between its score and the cross-market average score (with restrictions on the maximum allocation possible to small markets to avoid unrealistically large exposures). The portfolio is updated each month and performance returns (gross of transactions costs) are calculated monthly. Returns are then measured relative to MSCI Emerging Market benchmark returns.
How have each of the factors performed for Emerging Markets Allocation in 2022?
Two of the Value Indicators would have strongly outperformed the MSCI Emerging Market Index with the strongest indicator being dividend Yield. An emerging market portfolio based solely on this measure — overweighting markets with high dividend yields and underweighting markets with low dividend yields — would have outperformed the MSCI Emerging Market Index by 690 basis points. Overall, the strongest factor was terms-of-trade trend which measures export prices relative to import prices over the last 18 months. This factor would have overweighted energy and materials exporting markets early in 2022 when prices were rising for these commodities. The next two strongest factors were changes in nominal short-term interest rates over the last 24 months and real exchange rate valuation. Changes in nominal short-term interest rates would have overweighted markets with the lowest changes nominal short-term interest rates and underweighted markets with the highest nominal short-term interest rate changes. Likewise, the real exchange rate valuation factor would have overweighted markets with the undervalued real exchange rates and underweighted markets with overvalued real exchange rates. Of the 14 indicators only 2 substantially underperformed the MSCI Emerging Market benchmark – overweighting markets with low price-to-book ratios and underweighting markets with high price-to-book ratios and overweighting markets with current account surpluses relative to GDP and underweighting markets with a low current account surplus or deficits relative to GDP.
Russia effect on factor performance
Russia was part of the MSCI Index until early March. If Russia were taken out of the MSCI Index for the whole year, all the Value Indicators would have outperformed the MSCI Emerging Market Index. The performance of both Beta and Sovereign Yield Spread Change would have been lower if Russia were taken out of the MSCI Emerging Market Index at the beginning of the year since they were good Risk indicators of the impending “Russia Risk”.
Disclosure: This publication is provided by Heckman Global Advisors (“HGA”), which is not an independent entity but is a Division of DCM Advisors, LLC, a registered investment adviser. The region and sector allocations recommended herein are solely those of HGA and may differ from those of other business units of DCM Advisors, LLC. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors, LLC vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM Advisors, LLC and are subject to change without notice. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. Copyright © 2018 DCM Advisors, LLC. All Rights Reserved. These materials are the exclusive property of DCM Advisors, LLC. Unless otherwise expressly permitted by DCM Advisors, LLC in writing, please do not distribute, reproduce or use these materials for any purpose other than internal business purposes solely in connection with the management of investment funds or investment products that are sponsored or advised by you. This publication is not considered a Research report under FINRA Rule 2241(a)(11) and related rules. DCM-22-85
The Fed is meeting on September 20-21 and is expected to announce its 5th rate hike in this cycle. It is a commonly held perception that when the Federal Reserve is tightening, risk assets, including growth stocks and emerging market equities, suffer. Growth stocks could be affected due to more distant and less certain cash flows on average than the broader market. Emerging markets are particularly vulnerable to higher U.S. interest rates as cash flows out of emerging markets affecting their equity as well as fixed income markets.
As we have stated in previous studies, market participants should be aware that the relationship between U.S. monetary policy and equity returns is often not straightforward. For example, between June 2004 and June 2006, the Fed raised the fed funds rate 13 times from 1.00% to 5.25% and the MSCI Emerging Market Index went up 84% on a cumulative basis. The converse can also hold. The financial crisis which started in 2007 is an extreme example of an inverse relationship between Fed Reserve policy and emerging market equity returns. Between August 2007 and December 2008, the Federal Reserve cut the fed funds rate 8 times from 5.25% to 0.25%, yet the MSCI Emerging Market Index fell over 46% cumulative.
This analysis explores how growth stocks and emerging market stocks have fared 6 months after the 5th rate hike during the five tightening cycles since 1988, which is when the MSCI Emerging Market Index started.
The figure shows the return 6 months out of the Russell Growth and the MSCI Emerging Market Index after the 5th rate hike. The Russell Growth had positive returns in the following six months 3 times out of the 5 episodes and the MSCI Emerging Market Index had positive returns only in 2 out of the 5 episodes. The large downdrafts in the MSCI Emerging Market Index during the 1994 and 1999 rate hikes were associated with emerging market currency crises. It was a period when many emerging market currencies were tied to the US dollar. We would expect this pattern might not repeat following an upcoming 5th fed fund rate hike since most emerging market currencies have become free floating and thus less vulnerable to hikes in U.S. rates.
Investing involves risks and you may incur a profit or a loss. Past performance is no guarantee of future results. There is no assurance that any trend will continue or repeat. Periods shown represent the results of the U.S. Russell 1000 Growth and MSCI Emerging markets for six months following a fifth rate hike (ignoring neutral/hold periods). The five 5-increase cycles presented occurred between March and August of 1988, February and August of 1994, June of 1999 and March of 2000, June and December of 2004, and December of 2015 and December of 2017. Across the six-month periods for which performance is shown the tightening cycles continued, with between 1 and 4 additional fed rate increases during the performance measurement periods shown.
DISCLOSURE: This material has been prepared and issued by Heckman Global Advisors (HGA), a division of DCM Advisors, LLC (DCM), and may not be reproduced or re-disseminated in any form. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training.
This document has been prepared for informational purposes only and is not a solicitation of any offer to buy or sell any security, commodity, futures contract or instrument or related derivative (hereinafter "instrument") or to participate in any trading strategy.
This material does not provide individually tailored investment advice or offer tax, regulatory, accounting or legal advice. The securities discussed in this material may not be suitable or appropriate for all investors. Prior to entering into any proposed transaction, recipients should determine, in consultation with their own investment, legal, tax, regulatory and accounting advisors, the economic risks, and merits, as well as the legal, regulatory and accounting characteristics and consequences of the transaction. You should consider this material among other factors in making an investment decision. This information is not intended to be provided to and may not be used by any person or entity in any jurisdiction where the provision or use thereof would be contrary to applicable laws, rules or regulations.
The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM and are subject to change without notice. Foreign securities can be subject to greater risks than U.S. investments, including currency fluctuations, less liquid trading markets, greater price volatility, political and economic instability, less publicly available information, and changes in tax or currency laws or monetary policy. These risks are likely to be greater for emerging markets than in developed markets.
The Russell 1000 Index measures the performance of the 1,000 largest companies, which represents approximately 92% of equity market capitalization. The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. Morgan Stanley Capital International (MSCI) indexes are unmanaged market capitalization-weighted indexes. Indices are not available for direct investment. Investment in a security or strategy designed to replicate the performance of an index will incur expenses, such as management fees and transaction costs, which would reduce returns.
Source: MSCI. Pursuant to our agreement with MSCI, the MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use it may make or permit to be made of this information. Neither MSCI, any of its affiliates or any other person involved in or related to compiling, computing or creating the MSCI information (collectively, the “MSCI Parties”) makes any express or implied warranties or representations with respect to such information or the results to be obtained by the use thereof, and the MSCI Parties hereby expressly disclaim all warranties (including, without limitation, all warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential or any other damages (including, without limitation, lost profits) even if notified of, or if it might otherwise have anticipated, the possibility of such damages.
The commonly held perception is that when the Federal Reserve is raising the Fed funds rate, equity returns are lower than when the Fed is easing. It is also a commonly held perception that value sectors, such as Utilities, Energy, Financials. will do better than growth sectors, such as Information Technology and Consumer Discretionary, when the Fed is raising the Fed funds rate. This is because higher interest rates resulting from Fed tightening are thought to have less of an effect on value stocks with their relatively more stable and predictable cash flows than on growth stocks with more distant and less certain cash flows.
However, market participants should be aware that the relationship between U.S. monetary policy and equity returns is often not straightforward. The headline recognizes that Fed tightening is likely to result in lower stock prices, but that other factors — in this case expected earnings or growth of the economy — may offset the effects of the tighter policy. For example, between June 2004 and June 2006, the Fed raised the fed funds rate 13 times from 1.00% to 5.25% and the U.S. market went up 19%. The converse can also hold. The financial crisis which started in 2007 is an extreme example of the inverse relationship between Fed Reserve policy and equity returns. Between August 2007 and December 2008, the Federal Reserve cut the fed funds rate 8 times from 5.25% to .25%, yet the U.S. stock market fell over 37%.
Figure 1-4 below shows for each of the four Fed funds rate hikes since 1999 the US sector returns while the Fed was raising the Fed funds rate. Also next to each of these is the amount that the Fed raised rates. (For the current episode, the Fed is most likely not done will continue raising the Fed funds rate).
- During the tightening 6/1999 - 05/2000, when the Fed raised rates only 1.5%, the growth sectors, Information Technology and Consumer Discretionary, had higher returns than the value sectors, Materials and Consumer Staples. For some of this time, the TMT bubble was still holding on.
- During the tightening 6/2004 – 6/2006, when the Fed raised rates 4.0%, sector returns went in the opposite direction with value sectors tending to outperform growth sectors. Energy, Materials, and Financials did better than Information Technology and Consumer Discretionary.
- During the 12/2015 – 12/2018 episode, when the Fed Fund rate was raised only 2.0%, this was reversed with Information Technology and Consumer Discretionary doing better than Consumer Staples, Energy, and Financials.
- Starting in 3/2022, in this latest round of Fed tightening where the Fed has raised rates around 3.0% and is still not finished, value sectors, Energy and Consumer Staples, have fared better than growth sectors, Information Technology and Consumer Discretionary.
Conclusion:
It appears that the relationship between U.S. monetary policy and sector equity returns is often not straightforward. There does appear to be some relationship between the amount the Fed raises the Fed funds rate and how well the different sectors do – with growth faring worse and value faring better when the Fed has to raise rates agressively to slow the economy and bring down inflation.
Unionization has been in the news a great deal recently. Christian Smalls, the hip hop co-founder of the Amazon Labor Union, and Jaz Brisack, the Rhodes Scholar Starbucks barista and union organizer, are media favorites and Progressive heroes. Senator Bernie Sanders gushed “that there’s no greater example of the growing grassroots movement for economic justice on the job…[which] could well be the beginning of a resurgent and powerful trade-union movement in this country.”
Are we on the cusp of a game changer or is this much ado about nothing?
Unionization in the US has been in steady decline for decades. Only 6.1% of private sector workers were union members last year, about one-third of the rate in 1983 when data collection started.
However, in a July 13th press release, the National Labor Relations Board boasted that the number of petitions requesting elections for union representation so far this year is up 58% from the prior one. A closer look is telling. At best, the number of petitions this year will reach the peak of 2198 in 2015. Moreover, the average size of the bargaining units in elections in recent years has been about 60 workers.
Despite all the hoop-la about unionization at Amazon and Starbucks, the number of union elections remains small, and the number of American workers involved in these unionization efforts is tiny. Bernie Sanders’ ‘resurgent movement’ is a long way off.
However, there might be more to the story. The Gallup poll indicates that approval of labor unions has been rising since the financial crisis. In 2021, the approval rating reached 68% of Americans, the highest reading in over 50 years.
To understand what’s going on, we need to go back to the large and deep recession that followed the financial crisis in 2009. The recession had a particularly severe effect on the young. Men and women graduating from school and entering the job market in those years had a tough time finding positions and many spent extended periods of time searching for a first job.
Economists point out that there are ‘scarring effects.’ The cohort that entered the job market in the crisis was scarred by the experience. This phenomenon is not new; research shows that there are persistent effects on the employment rates and wages of those who enter the labor market during a recession. Now, over a decade after the financial crisis, many Millenials find themselves approaching mid-life without the experience and know-how that enables them to find high wage positions and satisfying careers. Moreover, their level of dissatisfaction was exacerbated by the Covid recession in 2020.
The increased interest in unionization on the part of young college educated Americans (starting with the Rhodes scholar barista) is genuine. There is a generation of young Americans that has been bruised by the ups and downs of the economy. Recessions are not just temporary blips in economic activity. Although the overall job market has largely recovered (total non-farm employment in June is just 0.3% less that the pre-pandemic peak), there are many people who have been permanently scarred by the financial crisis and pandemic recessions.
There are some good reasons for the recent interest in unionization. But as real as the damage done by recession experiences might be, it is unlikely that we are seeing the the start of a revolution in American labor relations.
DCM-22-37
With high inflation, the Fed increasing rates to cool inflation, the Russian invasion of Ukraine with its impact on energy prices and agricultural prices, there is the obvious risk of a recession in the U.S. On average, recessions tend not to be kind to the equity markets. During all U.S.recessions since 1873 and using the Schiller S&P price index series, equity price returns have averaged -8.4% with the range being -79.3% (the Great Depression) to 31.0% (recession of 1926-1927). However, coming out of a recession, returns tend to do better. Measured six months after the end of a recession, U.S. equity price returns have average 15.2% with the range being -4.5% to 69.8%. Six months after the end of a recession, equity returns have been positive for the investor in 28 of the 30 recessions since 1873 - hence, 93% of the time.
Of course, in general, one does not know the exact dates a recession starts or ends until after it is over. However, through most of it, one is aware that a recession is happening. For the purpose of this analysis, the exact dates of recessions are from the National Bureau of Economic Research (NBER), which is an American research organization known for providing start and end dates for recessions in the United States. From the NBER website, “the NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”.
The question is when to start to be optimistic about the U.S. equity market during a recession. For that, we have looked to the 3-month change in ISM’s Manufacturing Purchasing Managers Index (PMI). We have data on the PMI starting in December 1978, Most of the time the PMI 3-month change is a small number (both positive and negative). During a recession, the 3-month change can become a large negative percentage, but when the economy is coming out of a recession, the 3-month change can become a large positive percentage. For starting the measurement of the performance of the U.S. equity market coming out of a recession, the signal we use is the first month in which the 3-month change in the PMI turns positive 10%1 or more. This positive change can happen during a recession or shortly after it ends. (although we do not know the NBER official date of the end until sometimes months later). Once we have the PMI signal, we measure the performance of the U.S. equity market over the next 6 months. The performance of the market is shown in the figure below.
S&P Price Returns 6 Months After PMI Change > 10%
Recession Dates on X-axis
As can be seen from the chart, during each of the recession since 1978, six months after the 3 month change in the PMI has changed by 10% or more, returns to the U.S. equity market have been positive and have averaged 11.5%
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
DCM-22-33
The commonly held perception is that when the Federal Reserve is tightening, emerging market equities suffer both in absolute terms as well as relative to US stocks. It is thought that emerging markets are particularly vulnerable to higher U.S. interest rates as cash flows out of emerging markets, affecting their equity as well as fixed income markets.
As we have stated in previous studies, market participants should be aware that the relationship between U.S. monetary policy and equity returns is often not straightforward. For example, between June 2004 and June 2006, the Fed raised the fed funds rate 13 times from 1.00% to 5.25% and MSCI Emerging Market Index went up 84%. The converse can also hold. The financial crisis which started in 2007 is an extreme example of the inverse relationship between Fed Reserve policy and emerging market equity returns. Between August 2007 and December 2008, the Federal Reserve cut the fed funds rate 8 times from 5.25% to .25%, yet the MSCI Emerging Market Index fell over 46%.
This report explores how emerging market stocks have fared 1 month, 6 months, and 12 months after the Fed first starts raising rates and midway through the fed funds rate hiking cycle. (One does not know the midway point at the time but only after the Fed stops hiking rates.) The analysis starts in 1988 which is when the MSCI Emerging Market Index started.
What happens after the start of each episode of fed fund hikes?
Figures 1 and 2 below show, from the start of each episode of the Fed raising rates, the absolute return of the MSCI Emerging Market Index as well as its return relative to the Russell 1000 measured. Looking 6 months out from the start of the fed hiking rates, the MSCI Emerging Market Index had positive returns and outperformed the Russell 1000 in 5 out of 6 episodes. However, looking 12 months out from the start of Fed rate hikes, the picture is mixed. The MSCI Emerging Market Index had major downdrafts both in absolute and relative to the Russell 1000 in 1994 and 1997. Both years had major emerging market crises, especially in markets whose currencies were tied to the US dollar (the Mexican peso in 1994 and Asia currencies in 1997).
Figure 1
Figure 2
What happens after the midpoint of each episode of fed fund hikes?
Figures 3 and 4 below show, from the midpoint of each episode of the Fed raising rates, the MSCI Emerging Market Index in absolute terms and relative to the Russell 1000 Index. Looking 6 months out, the MSCI Emerging Market Index was positive and outperformed the Russell 1000 in 3 out of the 6 episodes. However, looking 12 months out, the MSCI Emerging Market Index had major downdrafts in after the rate hikes in 1994, 1997, and additionally in 1999 – years associated with currency crises in the emerging markets tied to the US dollar.
Figure 3
Figure 4
Conclusion
Looking 12 months out from the beginning of the middle of Fed rate hikes, the MSCI Emerging Market Index tended to have negative returns and underperform the Russell 1000 at times associated with the currency crises of the 1990s. It was a period when many emerging market currencies were tied to the US dollar. We would expect this pattern might not repeat during the upcoming fed fund rate hike since most emerging market currencies have become free floating and thus less vulnerable to hikes in U.S. rates. It appears that the down drafts did not occur with the rate hikes in 2004 and 2015.
Disclosures:
This material has been prepared and issued by Heckman Global Advisors (HGA), a division of DCM Advisors, LLC (DCM), and may not be reproduced or re-disseminated in any form. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
This document has been prepared for informational purposes only and is not a solicitation of any offer to buy or sell any security, commodity, futures contract or instrument or related derivative (hereinafter "instrument") or to participate in any trading strategy.
This material does not provide individually tailored investment advice or offer tax, regulatory, accounting or legal advice. The securities discussed in this material may not be suitable or appropriate for all investors. Prior to entering into any proposed transaction, recipients should determine, in consultation with their own investment, legal, tax, regulatory and accounting advisors, the economic risks, and merits, as well as the legal, regulatory and accounting characteristics and consequences of the transaction. You should consider this material among other factors in making an investment decision. This information is not intended to be provided and may not be used by any person or entity in any jurisdiction where the provision or use thereof would be contrary to applicable laws, rules or regulations. Any securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom.
The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM and are subject to change without notice. It should not be assumed that any recommendations incorporated herein will be profitable, will equal past performance or will achieve same or similar results. The country allocations recommended herein are solely those of the HGA division of DCM and may differ from those of other business units of DCM. The countries mentioned herein are covered by our proprietary top-down country allocation model and are included, together with any rankings and/or weightings, for illustrative purposes only. The representative countries and related information are subject to change at any time and are not intended as a specific recommendation for investment. Foreign securities can be subject to greater risks than U.S. investments, including currency fluctuations, less liquid trading markets, greater price volatility, political and economic instability, less publicly available information, and changes in tax or currency laws or monetary policy. These risks are likely to be greater for emerging markets than in developed markets. Certain investments may invest in derivatives, which may increase the volatility of its net asset value and may result in a loss.
Model, back tested or hypothetical performance information, and results do not reflect actual trading or asset or fund advisory management, and the results may not reflect the impact that material economic and market factors may have had, and can reflect the benefit of hindsight, on HGA’s decision-making if HGA were actually managing client’s money. The model performance is shown for informational purposes only and should not be interpreted as actual historical performance of HGA. Neither past actual nor hypothetical performance guarantees future results. No representation is being made that any model will achieve results similar to that shown and there is no assurance that a model that produces attractive hypothetical results on a historical basis will work effectively on a prospective basis. Clients should not rely solely on this performance or any other performance illustrations when making investment decisions. Actual performance may differ from model results. Any reference to performance information that is provided gross of fees does not reflect the deduction of management or advisory fees. Client returns will be reduced by such fees and other expenses that may be incurred in the management of the account. For example, a 0.50% annual fee deducted quarterly (0.125%) from an account with a ten-year annualized growth rate of 5% will produce a net result of 4.4%. Actual performance results will vary from this example. Further, Exchange-Traded Funds that track these MSCI indexes would be charged expense ratios that would reduce returns. Any chart, graph, or formula should not be used by itself to make any trading or investment decision.
Morgan Stanley Capital International (MSCI) indexes are unmanaged market capitalization-weighted indexes. The indexes do not reflect transaction costs or management fees and other expenses. MSCI index returns are calculated with dividends reinvested. Unlike the indices, the strategies described are actively managed and may have volatility, investment and other characteristics that differ from the benchmark index.
Source: MSCI. Pursuant to our agreement with MSCI, the MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use it may make or permit to be made of this information. Neither MSCI, any of its affiliates or any other person involved in or related to compiling, computing or creating the MSCI information (collectively, the “MSCI Parties”) makes any express or implied warranties or representations with respect to such information or the results to be obtained by the use thereof, and the MSCI Parties hereby expressly disclaim all warranties (including, without limitation, all warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential or any other damages (including, without limitation, lost profits) even if notified of, or if it might otherwise have anticipated, the possibility of such damages.
The US will not engage in military action in the Ukraine but will instead wage economic war, particularly with sanctions on the Russian financial system. To that end, the US and its allies have placed sanctions on Russian individuals and institutions.
What does that mean?
The sanctioned individuals will of course be unable to enter the US or access their assets in the US. Sanctioned businesses will be unable to ship any goods into or out of the US. Sanctioned banks will be unable to conduct any business with US financial institutions; they will be unable to borrow in the US, sell securities of any kind, or make transactions on behalf of their Russian customers.
The big question is whether these sanctions will cripple the Russian economy or just inconvenience it. The Russian oligarch who cannot get to Miami this winter will find some other place to park his yacht. The Russian importer is likely to find other sources for manufactured goods; if I-phones are unavailable, there will be Chinese substitutes in the Moscow electronics stores. If the Russian development bank needs to borrow, Russia will find rogue bankers in Beirut, Lagos, Dubai or elsewhere willing to do business. There will always be a rogue government or bank or exporter willing to channel resources to evade sanctions and take advantage of opportunities.
Sanctions might be a major inconvenience that will make the Russian economy stumble a bit. But that has been the case since some sanctions were introduced after the Crimean incursion in 2014. The example of Iran is instructive: extensive sanctions are painful but have not loosened the government’s grip on its people or changed its ideology.
What comes next?
There is an important additional step that gives sanctions a stronger bite. That is to place a financial blockade on Russia by denying Russian financial institutions access to SWIFT. The international community hesitated to take this step; it was noticeably absent from President Biden’s speech on Thursday afternoon. However, over the weekend some initial moves were announced
SWIFT (the Society for Worldwide Interbank Financial Telecommunication) is the Belgian based cooperative that links thousands of financial institutions around the world and is used for millions of cross border transactions daily. SWIFT is not a bank or an exchange; it is a platform for quickly, safely, and inexpensively making payments. Denying Russia access to SWIFT is the financial equivalent of a blockade. It would effectively close down Russia’s access to global finance and payments. Without access to SWIFT, efforts to evade sanctions would be much more difficult.
However, not all Russian banks will be shut out of SWIFT and there will be exceptions for certain critical transactions. Russia is a major exporter of oil and gas. There is ample capacity around the world to replace Russian petroleum exports over time. Crude oil prices that spiked to over $100 per barrel are likely to fall back. Nevertheless, oil prices are likely to remain elevated which will affect the American consumer at the gas pump and make it more difficult for the Fed to fight inflation. In addition to oil, Russia also supplies natural gas to Western Europe which would be more difficult to replace.
Thus, the willingness to isolate the Russian banking system comes with a big asterisk. Sanctions make exceptions for energy, Russia’s major export. Our European allies need to maintain an uninterrupted flow of energy and allow access to SWIFT to make payments.
What more can be done?
The Russian central bank has accumulated large foreign exchange reserves, over half a trillion dollars in gold and financial assets denominated in other currencies. Ordinarily these reserves would cushion the blow of sanctions. Russia could use these assets to support the value of the Ruble and protect the Russian economy. However, to do so the central bank would need to access financial markets to sell assets. An additional extraordinary step under consideration would be to sanction the Russian Central Bank directly and limit its access to financial markets. This move would further cripple the Russian economy.
Despite the asterisk for the energy industry, the financial sanctions already introduced by the U.S. and its allies will strike a strong blow to the Russian economy. Putin is trading the prosperity of the Russian people for his vision of a greater Russia.
Important Disclosures
This material has been prepared and issued by DCM Advisors, LLC (DCM), a registered investment advisor, for distribution to market professionals and institutional investor clients only. This document has been prepared for informational purposes only and is not a solicitation of any offer to buy or sell any security, commodity, futures contract or instrument or related derivative (hereinafter "instrument") or to participate in any trading strategy. Any such offer would be made only after a prospective participant had completed its own independent investigation of the instrument or trading strategy and received all information it required to make its own investment decision, including, where applicable, a review of any prospectus, prospectus supplement, offering circular or memorandum describing such instrument or trading strategy.
This material does not provide individually tailored investment advice or offer tax, regulatory, accounting or legal advice. The securities discussed in this material may not be suitable or appropriate for all investors. Prior to entering into any proposed transaction, recipients should determine, in consultation with their own investment, legal, tax, regulatory and accounting advisors, the economic risks, and merits, as well as the legal, regulatory and accounting characteristics and consequences of the transaction. You should consider this material among other factors in making an investment decision. This information is not intended to be provided and may not be used by any person or entity in any jurisdiction where the provision or use thereof would be contrary to applicable laws, rules or regulations. Any securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom.
The information contained herein is intended for informational purposes only and has been obtained from sources believed to be reliable, but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM and are subject to change without notice. It should not be assumed that any recommendations incorporated herein will be profitable, will equal past performance or will achieve same or similar results. The country allocations recommended herein are solely those of the Heckman Global Advisors (HGA) division of DCM and may differ from those of other business units of DCM. The countries mentioned herein are covered by our proprietary top-down country allocation model and are included, together with any rankings and/or weightings, for illustrative purposes only. The representative countries and related information are subject to change at any time and are not intended as a specific recommendation for investment. Foreign securities can be subject to greater risks than U.S. investments, including currency fluctuations, less liquid trading markets, greater price volatility, political and economic instability, less publicly available information, and changes in tax or currency laws or monetary policy. These risks are likely to be greater for emerging markets than in developed markets. Certain investments may invest in derivatives, which may increase the volatility of its net asset value and may result in a loss.
Model, back-tested or hypothetical performance information, and results do not reflect actual trading or asset or fund advisory management, and the results may not reflect the impact that material economic and market factors may have had, and can reflect the benefit of hindsight, on HGA’s decision-making if HGA were actually managing client’s money. Any reference to performance information that is provided gross of fees does not reflect the deduction of management or advisory fees. Client returns will be reduced by such fees and other expenses that may be incurred in the management of the account.
Advisory fees are described in Part 2A of Form ADV of DCM, and its affiliated individuals may, from time to time, own, have long or short positions in, or options on, any securities discussed herein. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or an interest in any Dinosaur Capital Management LLC investment vehicle(s). Any chart, graph, or formula should not be used by itself to make any trading or investment decision.
Morgan Stanley Capital International (MSCI) indexes are unmanaged market capitalization-weighted indexes. The indexes do not reflect transaction costs or management fees and other expenses. MSCI index returns are calculated with dividends reinvested. Unlike the indices, the strategies described are actively managed and may have volatility, investment and other characteristics that differ from the benchmark index.
Source: MSCI. Pursuant to our agreement with MSCI, the MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use it may make or permit to be made of this information. Neither MSCI, any of its affiliates or any other person involved in or related to compiling, computing or creating the MSCI information (collectively, the “MSCI Parties”) makes any express or implied warranties or representations with respect to such information or the results to be obtained by the use thereof, and the MSCI Parties hereby expressly disclaim all warranties (including, without limitation, all warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential or any other damages (including, without limitation, lost profits) even if notified of, or if it might otherwise have anticipated, the possibility of such damages.
The commonly held perception is that when the Federal Reserve is tightening, equity returns are lower than when the Fed is easing. It is also a commonly held perception that value stocks will do better than growth stocks when the Fed starts to tighten. This is because higher interest rates resulting from Fed tightening are thought to have less of an effect on value stocks with their relatively more stable and predictable cash flows than on growth stocks with more distant and less certain cash flows. The Fed has made known that it plans to raise rates, mostly likely starting in March 2022.
However, market participants should be aware that the relationship between U.S. monetary policy and equity returns is often not straightforward. The headline recognizes that Fed tightening is likely to result in lower stock prices, but that other factors — in this case expected earnings or growth of the economy — may offset the effects of the tighter policy. For example, between June 2004 and June 2006, the Fed raised the fed funds rate 13 times from 1.00% to 5.25% and the U.S. market went up 19%. The converse can also hold. The financial crisis which started in 2007 is an extreme example of the inverse relationship between Fed Reserve policy and equity returns. Between August 2007 and December 2008, the Federal Reserve cut the fed funds rate 8 times from 5.25% to .25%, yet the U.S. stock market fell over 37%.
This report explores how value stocks vs growth stocks have relatively fared 1 month, 6 months, and 12 months after the Fed raised fed funds rates. It looks at the relative returns when the Fed first starts to raise rates and midway through the fed funds rate hiking cycle. (One does not know the midway point at the time but only after the Fed stops hiking rates.) The analysis starts in 1982 since it does not make sense to go back further because the Fed started targeting interest rates only in 1982, and not in earnest until a couple of years later.
What happens after the start of each episode of hike of fed funds?
Figure 1 below shows the relative return of the Russell 1000 Value vs Russell 1000 Growth measured from the start of each episode of the Fed raising the fed fund rates. The Russell 1000 Value outperformed the Russell 1000 Growth in the last two episodes starting in December 2015 and June 2004. However, in the episodes before that when the Fed started to raise fed fund rates, the results were much more mixed. Value stocks do not always do better relative to growth stocks. One would have thought that as the Fed raised rates starting in June 1999 during the tech/dotcom bubble that value stocks would have outperformed immediately. This was not the case. Value stocks continued to underperform growth stocks 6 and 12 months after the initial rate hike.
What happens after the midpoint of each episode of hike of fed funds?
It may be hypothesized that it takes longer for Fed action to have an effect on the cost of capital and the relative performance of value vs growth stocks. Figure 2 below shows the relative return of the Russell 1000 Value vs Russell 1000 Growth measured from the midpoint of each episode of the Fed raising fed fund rates. Here the picture continues to be mixed. The Russell 1000 Value only outperformed the Russell 1000 Growth 2 times looking 6 months out and only 4 times looking 12 months out.
Conclusion
It appears that the relationship between U.S. monetary policy and equity returns is often not straightforward. Even though the financial press currently states growth will be underperforming value now that the Fed plans to raise the fed funds rate, the relationship has not shown a consistent pattern based on the historical data.
Our inflation blog last March was a warning to Millennials who have never experienced inflation that price stability should not be taken for granted. Still, we concluded that a repeat of the inflation experience of the 1970s was unlikely because the Federal Reserve has successfully anchored inflation expectations and technology trends continue to hold prices down. We were concerned about influences of the pandemic on inflation, but I was reluctant to take issue with the consensus view that pandemic related supply shortages and surges in demand were temporary.
The typical forecast in the spring was that CPI inflation for 2021 would be about 2.5%, somewhat more than the Fed’s 2% target. The accepted wisdom through the spring and summer was that inflation was temporary; once supply chain kinks were ironed out and goods producers caught up with demand, inflation would fall back to its pre-pandemic level or just a little bit more. That interpretation even earned a nickname – team transitory. On the other side there is the view that inflation is here to stay for some time. Team persistent includes some heavy hitters – former Treasury Secretary Lawrence Summers, former IMF chief economist Olivier Blanchard – as well as the monetarist cranks who have seen inflation lurking since the monetary expansion started with the financial crisis over a decade ago.
CPI inflation for December was announced a this month. Inflation for the 12 months ending December 2021 was a whopping 7.0%. Inflation is back. But who won: team transitory or team persistent?
Jay Powell, the Fed Chair, was one of team transitory’s strongest cheer leaders. In his August Jackson Hole speech, Powell ticked off all the reasons why he was confident in the Fed’s forecast that inflation was already on its way down, that team transitory was ahead. Three points stand out. First, the pandemic inflation was concentrated in a few sectors that were affected by supply chain problems. Second, wages were quiescent. And third, expectations were firmly anchored. Less than six months later, it would be hard to argue that any of the three are still true.
Inflation has already spread into most sectors of the economy. The detailed CPI data pointed to only a few sectors with moderate inflation rates such as rent, medical care, and air fares. The Atlanta Fed’s wage growth tracker showed wages growing around 3.3% in the first half of 2021 and increasing to 4.5% by year end. Inflation expectations have not changed a great deal but there are signs that things are pulling on the anchor. The five-year breakeven inflation on TIPS was 1.65% before the pandemic and is now 2.75%. The median inflation expectation from the NY Fed’s Survey of Consumer Expectations was about 2.5% before the pandemic for both a one-year and three-year horizon; it is now 6.0% and 4.0% respectively.
Team transitory misjudged the path of inflation in 2021. It was far larger and more persistent than anticipated. The fact is inflation is back and we need to reckon with it.
The pandemic inflation was triggered by some unusual and temporary phenomenon, but team transitory did not realize that once set in motion the inflation process is off and running. By the end of 2021, inflation had spread to all sectors of the economy. Wage inflation started to increase, possibly because of pass-through effects from prices and also as a result of the unusual pandemic labor market. Although there are now 3.3 million fewer people employed than before the pandemic, the labor markets are tighter than at any time in recent history. People are quitting jobs for higher paid positions in unprecedented numbers, workers have stayed out of the labor force and firms are desperately looking for applicants. The inevitable increase in wages will feed back on to the inflation rate this year.
Team temporary fans point to earlier inflation episodes that were driven by supply constraints such as the few years after World War II when price controls were relaxed, returning soldiers were eager to spend and production was only slowly shifting to a peace time setting. Inflation quickly rose to 20% very briefly in 1947 and disappeared by the end of 1948.
The analogy is far from perfect. The current inflation episode has been spreading through the economy even as supply chain problems ease. There is an inflation dynamic rippling through the economy. It will be pushed forward by wage inflation and barely held back by the Fed. As businesses and individuals experience this, they will adjust their expectations, and the inflation anchor might break loose.
Inflation is back. We said so hesitantly in the spring; we are sure of it now. Prior to the pandemic, policy makers fretted about their inability to get inflation up to the 2% target. Those days are gone. But I don’t think we are on our way to a decade of punishing inflation like the 1970s. Although the Fed might be reluctant to withdraw support for the economy, it has a much better understanding of how to conduct policy and much greater credibility than it did 50 years ago. Nevertheless, the policy tightening that is widely expected to begin in a few months will take at least year to impact inflation. With the dynamic underway, the new normal inflation rate will probably be in the range of 3-5% for the next several years.
Disclosures: The comments contained herein are the opinions of the author, a consultant to DCM Advisors, LLC, and may not represent the opinions of DCM Advisors. Comments are provided for informational purposes only and are subject to change without notice. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance.
These materials are the exclusive property of DCM Advisors. Unless otherwise expressly permitted by DCM Advisors in writing, this information should not be distributed to any other parties.
DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
In the Global Financial Crisis, the Fed quickly dropped interest rates to zero and introduced new unconventional approaches to monetary policy. The first of four rounds of quantitative easing began in November 2008. Once started, the Fed had a hard time ending its purchase programs without creating instability in the financial markets.
In May 2013, Fed chairperson, Ben Bernanke appeared before the Joint Economic Committee of Congress and suggested that the Fed could start tapering its bond purchases ‘in the next few meetings.” His remarks caused the well known ‘taper tantrum.’ US interest rates rose in anticipation of a policy change and funds flowed out of emerging markets. As a result, the Fed hesitated and the actual tapering did not begin until January 2014 and asset purchases ended in October. All in all, there were about $4 trillion in asset purchases through the four rounds of QE and the Fed’s balance was five times larger than its pre-crisis level.
The tantrum had only a small effect on US interest rates. As seen in Figure 1, the 10 year Treasury rate rose after Bernanke’s announcement and then fell through 2014. There were larger effects in emerging markets. Net private capital inflows into emerging markets fell about 20% in 2014. Emerging market equity returns in the two years after the taper tantrum speech were -1% compared to +24% in developed markets. Moreover, there was wide variation among emerging markets. Returns in this period were positive in China but both Brazil and Russia experienced losses of about 30%.
Why should investors be interested in the taper tantrum episode at the end of the great recession? The Fed resorted to the same unconventional monetary policies when the Covid pandemic occurred. Interest rates were quickly dropped to zero in March 2020 and the Fed embarked on almost unlimited asset purchases. The Fed balance sheet now (October 2021) stands at $8.56 trillion, twice the pre-pandemic level. In recent months, the Fed has been buying $120 billion of government and mortgage securities. With the economy in recovery, inflation exceeding expectations and the pandemic waning, the time to reverse course is fast approaching.
Will there be another taper tantrum when the Fed begins to taper starting this month? Which emerging market economies would be more seriously affected? It is hard to answer the first question although we do know that Fed officials have worked hard to prepare the markets with numerous speeches hinting that tapering is coming. To answer the second question, we can refer back to the 2013 taper tantrum and ask which macroeconomic indicators were related to differences in emerging market equity returns. We will look at the performance of five key indicators in 2013 and then examine how emerging markets stack up today:
- Current Account / GDP
- International Reserves / GDP
- Real Exchange Rate Overvaluation
- External Debt / GDP
- Growth in Domestic Credit / GDP
For each indicator, Table 1 shows the correlation of the indicator level prior to May 2013 with emerging market equity returns in US dollars in the subsequent two-year period.
Table 1
Countries that started the period with a current account surplus tended to perform better. The ratio of international or FX reserves to GDP is a less reliable indicator. For the countries shown the correlation of future returns with the current account to GDP ratio is 0.44 and for the international reserves it is 0.13 (though this rises to 0.39 if one big outlier, Egypt, is removed).
We expect that countries with overvalued real exchange rates will underperform. If the exchange rate returns to normal, the depreciation results in negative equity returns in dollar terms. Table 1 show that this relationship was weak in the 2013 episode.
The last two indicators are credit measures. Table 1 shows that countries with high levels of external debt to GDP tended to underperform; the correlation with equity returns was -0.43. There is also a strong negative correlation (-0.55) between growth in the ratio of domestic credit to GDP and subsequent equity returns.
The last two indicators are credit measures. Table 1 shows that countries with high levels of external debt to GDP tended to underperform; the correlation with equity returns was -0.43. There is also a strong negative correlation (-0.55) between growth in the ratio of domestic credit to GDP and subsequent equity returns.
Table 2
The five indicators were reasonably informative in distinguishing the equity market winners from losers following the 2013 taper tantrum. With tapering starting this month, these same indicators might tell us which emerging markets are vulnerable to the effect of higher US interest rates and capital flow reversals that might affects the equity returns in 2022. Table 3 shows the most recent values for each of the five indicators and the composite index (using the weights that performed well in 2013).
With recent central bank emphasis on policy communication (‘forward guidance’), a repeat of the 2013 taper tantrum might be unlikely. Nevertheless, emerging markets might be vulnerable and some more so than others:
- As a group, emerging markets are more resilient than they were in 2013. There is less variation across countries in the composite score (the last panel of Table 3).
- The countries which exhibit the most vulnerability in 2022 are Turkey, Egypt, Chile and Columbia.
- The observed vulnerability might be priced in already. For example, equity returns in Egypt and Columbia in 2020 were about -20%.
Table 3: Indicators and the Composite Index Today
Disclosures: The comments contained herein are the opinions of the author, a consultant to DCM Advisors, LLC, and may not represent the opinions of DCM Advisors. Comments are provided for informational purposes only and are subject to change without notice. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. These materials are the exclusive property of DCM Advisors. Unless otherwise expressly permitted by DCM Advisors in writing, this information
should not be distributed to any other parties
Disclosures: The comments contained herein are the opinions of the author, a consultant to DCM Advisors, LLC, and may not represent the opinions of DCM Advisors. Comments are provided for informational purposes only and are subject to change without notice. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. These materials are the exclusive property of DCM Advisors. Unless otherwise expressly permitted by DCM Advisors in writing, this information should not be distributed to any other parties.
Most investors are aware that returns on dividend-focused stocks are affected by interest rates. Dividend yields do not actually move in lock-step with either long-or short-term interest rates, and as can be seen in Figure 1, and can diverge from one another for extended periods of time, with ramifications for relative returns. Given that the Federal Reserve has been on an interest rate targeting regime since the mid-1980s, it is natural to ask how Federal Reserve policy actions have affected the returns of dividend-focused stocks. Specifically, we set out to explore whether it has historically been preferable to invest in dividend-focused stocks when the Fed monetary policy is easy rather than tight. In order to do this, we compared dividend-focused stocks both to the alternative of investing in fixed income as well as to investing in the overall market as represented by the S&P 500.
Figure 1. Dividend yields, the Fed funds target rate, and 10-year U.S. Treasury yields
Monetary policy and investor preferences. In devising tests of how monetary policy affects returns on dividend-focused stocks, it is reasonable to start by exploring the mechanism through which interest rate changes lead to investor actions. For many years, financial theorists argued that investors should not care about whether their returns came in the form of dividends or capital gains. If an investor needed cash he or she could always sell stock. In recent years, however, researchers have focused on what is called the “clientele effect,” in which different groups of investors (the clienteles) prefer different dividend policies. Examples of investors who may prefer to hold dividend-paying stocks include retirees living on fixed incomes and endowments prohibited by trust agreements from “invading principal” to support their spending.
Researchers have found evidence that some investors tend to “reach for income,” shifting into assets that provide high current income when interest rates are low.1 They have also documented the tendency of high-dividend equity funds to receive inflows when interest rates fall, which seems to drive up the prices of high-dividend stocks.2 The picture that emerges is that when the Fed reduces interest rates it induces investors who wish to preserve income to shift into dividend-focused stocks from interest-paying substitutes such as money market instruments and bonds.
The tests. For dividend-focused stocks, we included in this analysis two well-known dividend-oriented strategies—investing in dividend growth stocks and investing in high dividend stocks. As a proxy for dividend growth strategies, we look to the S&P 500 Dividend Aristocrats Index3 which consists of a list of companies—mainly well-known, large-cap, blue-chip companies—in the S&P 500 with a track record of increasing dividends for at least 25 consecutive years. As a measure of the returns to a high dividend strategy we looked at the DJ Select U.S. Dividend Index4 a broad market index which tracks stocks with the highest dividends.
As a measure of returns on fixed income substitutes for dividend-focused stocks, we looked BBB-rated corporate bonds (by far the largest segment of the U.S. corporate bond market); a broad basket of all widely-traded bonds, including corporates, U.S. Treasuries, and mortgage-backed securities; and U.S Treasuries. To represent these products, we used Bloomberg’s US Corporate Investment Grade Index, the Barclays Aggregate U.S. Total Return Index, and the Bloomberg US Treasury Total Return index, which includes Treasury securities with maturities of over one year. We also looked at the returns on the S&P 500 because some commentators and investors are inclined to judge the performance of dividend-focused stocks against other kinds of equities.
Measuring the Federal Reserve’s policy stance. Fed-watchers and the Fed itself have long debated about whether the central bank’s policy stance is easy or tight. Although the Federal Open Market Committee, the policymaking body of the Federal Reserve, has often characterized its policy as “accommodative” or as “needing additional firming” in its post-meeting statements and minutes, this description is subjective. In particular, it does not distinguish between the stance of monetary policy (easy, neutral, or tight), or whether the FOMC is easing, on hold, or tightening. The distinction between the stance and direction of change in policy, moreover, is not always clear. Sometimes the market, interpreting a hike in the Fed funds rate as the beginning of a new tightening round, will react immediately, raising interest rates across the entire term structure of bond yields. In cases such as these, the market has responded to an initial change in policy by tightening monetary conditions, possibly for months to come, without further Fed action. Some researchers have used the Fed funds rate or the discount rate as a measure of the stance of Fed policy, but policy rates, money market rates, and bond yields have been on a multi-decade downward trend, making comparisons of interest levels across years questionable. A 5% Fed funds rate today would represent an unambiguously tight policy stance; that rate would not have seemed especially tight in mid-1997 when 10-year Treasury yields were 6.5% and GDP was growing at a 4.7% annual rate. What is needed is a measure of Fed policy relative to a measure of neutral monetary conditions.
In our tests we used as an indicator of monetary policy the difference between the Federal funds rate and R*, a measure of the “neutral” short-term interest rate — one that is consistent with GDP growing at its long-term potential rate and stable inflation. If this difference was less than -.5 (half of one percent) we classified monetary policy as easy, if between -.5 and .5 we considered policy to be neutral, and if greater than .5, we considered it tight. As can be seen in Figure 2, both the Fed funds rate and R* have been declining on trend, but have differed from one another substantially for extended periods of time.5
Figure 2. The Fed funds rate and R* — the neutral rate of interest
Our indicator does not take into consideration quantitative easing – the massive buying of bonds by the Federal Reserve in an effort to reduce long-term interest rates. However, quantitative easing has coincided with exceptionally low Fed funds rates. Indeed, the Fed launched quantitative easing in late 2008 as the Fed funds rate approached zero and the Fed became concerned it had lost its effectiveness as a policy tool. Thus the low Fed funds rate, in absolute terms as well as relative to R*, still signals easy monetary conditions.
We compared returns when investing in equities vs fixed income for the various monetary policies:
- Invest in equities when monetary policy was easy, otherwise invest in fixed income;
- Invest in equities when monetary policy is neutral, otherwise invest in fixed income;
- Invest in equities when monetary policy is tight, otherwise invest in fixed income.
The table below shows the total return of the strategies for each of the equity and fixed income products.
Source: Bloomberg, Heckman Global Advisors
Conclusions:
The data indicates that, in general, the strategy of investing in equities versus fixed income during times of monetary easing has been higher than using this strategy for equity investing during times of monetary neutrality or tightness. Also, during monetary policy easing, investing in dividend focused equity strategies using this strategy has a higher return than investing in the S&P 500 using this strategy.
1 Daniel, Garlappi, and Xiao, “Monetary Policy and Reaching for Income,” Journal of Finance (June 2021).
2 Jiang and Sun, “Reaching for Dividends,” Journal of Monetary Economics (November 2020).
3 The S&P 500 Dividend Aristocrats Index was launched in May 2005. Performance data before that date was backfilled.
4 The DJ Select US Dividend Index was launched on November 3, 2003. Performance data before that was backfilled.
5 See Laubach and Williams, “Measuring the Natural Rate of Interest,” Review of Economics and Statistics (November 2003). Their R* is a real interest rate. Because market participants are more familiar with nominal interest rates we converted R* into a nominal rate by adding to it the expected one-year inflation rate from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters.
Important Disclosures: This material has been prepared and issued by DCM Advisors, LLC (DCM), a registered investment advisor, for distribution to market professionals and institutional investor clients only. This document has been prepared for informational purposes only and is not a solicitation of any offer to buy or sell any security, commodity, futures contract or instrument or related derivative (hereinafter "instrument") or to participate in any trading strategy. Any such offer would be made only after a prospective participant had completed its own independent investigation of the instrument or trading strategy and received all information it required to make its own investment decision, including, where applicable, a review of any prospectus, prospectus supplement, offering circular or memorandum describing such instrument or trading strategy.
This material does not provide individually tailored investment advice or offer tax, regulatory, accounting or legal advice. The securities discussed in this material may not be suitable or appropriate for all investors. Prior to entering into any proposed transaction, recipients should determine, in consultation with their own investment, legal, tax, regulatory and accounting advisors, the economic risks, and merits, as well as the legal, regulatory and accounting characteristics and consequences of the transaction. You should consider this material among other factors in making an investment decision. This information is not intended to be provided and may not be used by any person or entity in any jurisdiction where the provision or use thereof would be contrary to applicable laws, rules or regulations. Any securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom.
The information contained herein is intended for informational purposes only and has been obtained from sources believed to be reliable, but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM and are subject to change without notice. It should not be assumed that any recommendations incorporated herein will be profitable, will equal past performance or will achieve same or similar results. The country allocations recommended herein are solely those of the Heckman Global Advisors (HGA) division of DCM and may differ from those of other business units of DCM. The countries mentioned herein are covered by our proprietary top-down country allocation model and are included, together with any rankings and/or weightings, for illustrative purposes only. The representative countries and related information are subject to change at any time and are not intended as a specific recommendation for investment. Foreign securities can be subject to greater risks than U.S. investments, including currency fluctuations, less liquid trading markets, greater price volatility, political and economic instability, less publicly available information, and changes in tax or currency laws or monetary policy. These risks are likely to be greater for emerging markets than in developed markets. Certain investments may invest in derivatives, which may increase the volatility of its net asset value and may result in a loss.
Model, back-tested or hypothetical performance information, and results do not reflect actual trading or asset or fund advisory management, and the results may not reflect the impact that material economic and market factors may have had, and can reflect the benefit of hindsight, on HGA’s decision-making if HGA were actually managing client’s money. Any reference to performance information that is provided gross of fees does not reflect the deduction of management or advisory fees. Client returns will be reduced by such fees and other expenses that may be incurred in the management of the account. Advisory fees are described in Part 2A of Form ADV of DCM, and its affiliated individuals may, from time to time, own, have long or short positions in, or options on, any securities discussed herein. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or an interest in any Dinosaur Capital Management LLC investment vehicle(s). Any chart, graph, or formula should not be used by itself to make any trading or investment decision.
Morgan Stanley Capital International (MSCI) indexes are unmanaged market capitalization-weighted indexes. The indexes do not reflect transaction costs or management fees and other expenses. MSCI index returns are calculated with dividends reinvested. Unlike the indices, the strategies described are actively managed and may have volatility, investment and other characteristics that differ from the benchmark index.
Source: MSCI. Pursuant to our agreement with MSCI, the MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use it may make or permit to be made of this information. Neither MSCI, any of its affiliates or any other person involved in or related to compiling, computing or creating the MSCI information (collectively, the “MSCI Parties”) makes any express or implied warranties or representations with respect to such information or the results to be obtained by the use thereof, and the MSCI Parties hereby expressly disclaim all warranties (including, without limitation, all warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential or any other damages (including, without limitation, lost profits) even if notified of, or if it might otherwise have anticipated, the possibility of such damages.
Fiscal policy is made by Congress and when a deficit occurs, the Treasury finances it with bond sales. Monetary policy is conducted by the Federal Reserve that independently pursues its legislated objectives – price stability and maximal employment. However, in a little more than a decade we have witnessed two enormous challenges - the Global Financial Crisis (GFC) and the Covid-19 pandemic - to the way economic policy is conducted. As a result, it is now hard to tell monetary and fiscal policy apart.
Is the new normal of very large government deficits and an apparently ever-expanding central bank balance sheet a source of concern?
The figure shows the federal government deficit as a percent of GDP for the past 50 years. From 1970 to 2008, there were deficits in almost every year, but they only occasionally approached 5% of GDP and on average the deficit was 2.4% of GDP. In the GFC, 2009, the deficit soared to 9.8% of GDP. It came down in subsequent years but began to creep up with the Trump tax cuts and soared to 14.9% of GDP in the Covid crisis last year. The Congressional Budget Office estimates that it will be 13.4% this year.
Traditionally, fiscal conservatives held sway in Congress and resisted large deficits. Many liberal economists argued that the fiscal responses to the GFC first by both the Bush and Obama administrations were not big enough and as a result the post-crisis recovery was sluggish. However, fiscal conservatism was nowhere to be seen when the Trump administration pushed through tax cuts in 2017 and when Congress responded to the spring 2020 COVID shutdown by generously and aggressively supporting the economy. Looking past the COVID crisis, there is an increasing awareness that climate change warrants responses that might entail large federal expenditures. Significant government deficits are likely to be baked into the new normal landscape.
Publicly held federal debt has increased from less than $4 trillion at the turn of the century to about $10 trillion in 2010 and over $21 trillion now. As a fraction of GDP, it had not exceeded 50% from the end of World War II until the GFC; it topped 100% in the first quarter of 2021.
Figure 1. Federal Surplus or Deficit [-] as a Percent of Gross Domestic Product (GDP)
Just because something is bigger than it has ever been before does not mean that it must come down. Many countries have higher debt to GDP ratios; in Japan it reached 100% in 2007 and now stands at 184%. The real test is whether a country has difficulty financing its deficits. The Treasury sells untold amounts of bills and bonds without any difficulty. If there was any hint of resistance, we would see it in higher interest rates. The 10-year government bond rate was almost 4% prior to the GFC and has averaged 2.35% since. In both Japan and the US, countries with large corporate and personal saving, government deficits are the sensible way to maintain expenditure and provide important public goods.
Still deficit sceptics will be alarmed and argue that the US can finance its deficits easily because of the dollar’s ‘exorbitant privilege.’ That is the role of the US dollar as the world’s reserve currency and as the unit of exchange for most international trade crates a global demand for dollar assets. Moreover, the demand for safe assets in uncertain times makes it easy for us to issue new dollar debt. The deficit sceptics worry that the Euro and the Yuan might be working hard to take away our exorbitant privilege and that our excessive debt issuance might hasten a loss of confidence in the dollar. Global politics being what they are, it is hard to imagine that other currencies are poised to take over the global role of the dollar soon.
Further, the sceptics will point to the Federal Reserve’s rounds of quantitative easing (QE) both after the GFC and during the COVID crisis and argue that the Fed is helping to finance the deficits. The Fed pays for its purchases of government securities by creating bank reserves. The figure shows that government debt owned by the Federal Reserve Banks almost quadrupled from 2007 to 2017 and doubled again between 2019 and early 2021. The share of all Federal debt owned by the central bank increased from 8% in 2017 to 19% in Q1 2021.
The QE related expansion of bank reserves provides the ability and incentive for banks to make loans and buy assets which leads to deposit creation. Not surprisingly the money supply has increased rapidly. M2 more than doubled between the start of the GFC and early 2020, and it has increased an additional 27% since March 2020.
Figure 2. Federal Debt Held by Federal Reserve Banks (Billions of $)
The expansion of the Fed balance sheet and of the money supply is less worrisome now than it would have been a few generations ago. First, M2 is more of a portfolio choice for individuals and corporations than the transactions medium envisioned by 20th century monetarists. Thus, the causal link from money to inflation has long been broken. Second, the Fed has new tools, such as the interest rate paid on reserves, that it can use to neutralize the effect of QE prices. By paying interest on bank reserves, which the Fed only introduced a decade ago, banks have less of an incentive to use the reserves
Nevertheless, QE and the expansion of the Fed balance can be concerning. First, it drives up asset prices which can create instability (bubbles) in housing and equity markets. Second, the money-inflation monetarist nexus may be broken but it has not disappeared altogether. The potential for inflationary pressures to emerge remains and is already being exacerbated by real sector bottlenecks and shortages. If inflation persists at current levels, above the Fed’s 2% target, increases in interest rates might be called for. In an economy that is still fragile in the wake of the pandemic, the Fed might be unwilling to act.
Both Congress making fiscal policy and the Federal Reserve making monetary policy face serious challenges. Congress moves slowly but the tides are changing and there is a realization that fiscal policy is the proper tool to wield in the face of Covid and climate challenges. We will see a measure of this new reality in just a few months. The suspension of the debt ceiling expired at the end of July and the Treasury, as it has before, is using extraordinary measures to make sure that the legal limit is not breached. However, these measures will be exhausted before year end and Congress will have to show where it stands on the country’s fiscal needs.
As the ratcheting up of its balance sheet seen in the figure indicates, the Federal Reserve is finding its addiction to quantitative easing hard to break. The Fed may be too eager to throw liquidity at any sign of a problem. In fact, the most important responses to the Covid crisis were the fiscal ones taken by Congress which, perhaps uncharacteristically, stepped up to the bat. The Fed on the other hand continues to act as if it is the only game in town. Its QE policy, monthly bond purchases of $120 billion, continues today. Pumping liquidity into the economy is a valuable crisis response but now QE might be a source of fragility and potential inflationary pressures as Fed officials dither about how and when to taper the purchases.
Disclosures: The comments contained herein are the opinions of the author, a consultant to DCM Advisors, LLC, and may not represent the opinions of DCM Advisors. Comments are provided for informational purposes only and are subject to change without notice. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. These materials are the exclusive property of DCM Advisors. Unless otherwise expressly permitted by DCM Advisors in writing, this information should not be distributed to any other parties.
With the Federal Reserve starting to talk about raising interest rates, a concern has been that higher U.S. interest rates might be associated with a short run strengthening of the US dollar. What might higher interest rates and a stronger dollar mean for U.S. dollar returns from equity investments outside the US.? To begin, dollar rates of return could fall in all markets. Moreover, there might be additional effects in emerging markets where they might find it difficult to pay off dollar-denominated debt and are unable to refinance as money flows out due to rising yields in the U.S. Emerging market economies can be faced with a vicious cycle of poor US dollar returns in markets in which the currency is depreciating.
This paper looks at the historical record of when the US dollar strengthens over several months, which might happen if the U.S. Fed raises rates, what happens to U.S. dollar returns in the non-U.S. markets over the next month, 3 months, 6 months, and 12 months. For example, is it true that where the US dollar has been strong over the past 3 months relative to the local currency, do those equity markets do poorly in subsequent months in U.S. dollar returns relative to the U.S. equity market?
In this analysis, for each non-US developed market and each emerging market, after the US dollar strengthened over the previous three months relative to the foreign market’s currency, the U.S. dollar return for that market was subtracted from the U.S. market return. This is what will be called the “alpha” for each market. These alphas were computed after 1 month, 3 months, 6 months, and 12 months after the U.S. dollar strengthened. For all the markets, the returns were based on their respective MSCI dollar return indices. The alphas for the 1 month, 3 months, 6 months, and 12 months after U.S. dollar strengthening was averaged over 10-year periods for each set of markets as well as over several individual crisis years. In order to take out the bias which might arise during periods in which the U.S. market outperformed other developed and emerging markets, whether the U.S. dollar was strengthening or weakening, we did the same calculations for each non-US developed and emerging market 1, 3, 6, and 12 months after the US dollar weakened. We subtracted the two alphas – the average alpha when the U.S. dollar was strengthening minus the average alpha when the U.S. dollar was weakening. Figures 1, 2, 3, and 4 show the difference in alphas during the period of U.S. dollar strength minus periods of U.S. dollar weakness. Note, a positive number indicates the average return was higher in the non-U.S. markets than the U.S. market when the dollar was strengthening vs when the U.S. dollar was weakening and a negative number indicates the opposite – the average return was lower in the non-US market when the dollar was strengthening vs when it was weakening.
Figure 1
1-Month Alpha in Non-US Mkts over US Market During Times of U.S. $ Strength Minus U.S.$ Weakness
Figure 2
3-Month Alpha in Non-US Mkts over US Market During Times of U.S. $ Strength Minus U.S. $ Weakness
Figure 3
6-Month Alpha in Non-US Mkts over US Market During Times of U.S. $ Strength Minus U.S. $ Weakness
Figure 4
12-Month Alpha in Non-US Mkts over US Market Subtracting Times of U.S. $ Strength Minus U.S. $ Weakness
Conclusions
- In the short run, non-US markets tended to perform worse relative to the U.S. market in the subsequent month after periods of U.S.$ strength than during periods of U.S.$ weakness
- However, this is not always the case, as shown for non-U.S. developed and emerging markets during 1985 -1994 period.
- Over longer periods, non-U.S. markets tended to perform better when the U.S.$ strengthened rather than when it weakened. An exception would be in years in which there were major currency crises in markets, such as during 1995-2004 which included the Asian Financial/Currency crises of 1997 and the Russian Financial/Currency crisis in 1998.
Important Disclosures: This material has been prepared and issued by DCM Advisors, LLC (DCM), a registered investment advisor, for distribution to market professionals and institutional investor clients only. This document has been prepared for informational purposes only and is not a solicitation of any offer to buy or sell any security, commodity, futures contract or instrument or related derivative (hereinafter "instrument") or to participate in any trading strategy. Any such offer would be made only after a prospective participant had completed its own independent investigation of the instrument or trading strategy and received all information it required to make its own investment decision, including, where applicable, a review of any prospectus, prospectus supplement, offering circular or memorandum describing such instrument or trading strategy.
This material does not provide individually tailored investment advice or offer tax, regulatory, accounting or legal advice. The securities discussed in this material may not be suitable or appropriate for all investors. Prior to entering into any proposed transaction, recipients should determine, in consultation with their own investment, legal, tax, regulatory and accounting advisors, the economic risks, and merits, as well as the legal, regulatory and accounting characteristics and consequences of the transaction. You should consider this material among other factors in making an investment decision. This information is not intended to be provided and may not be used by any person or entity in any jurisdiction where the provision or use thereof would be contrary to applicable laws, rules or regulations. Any securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom.
The information contained herein is intended for informational purposes only and has been obtained from sources believed to be reliable, but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM and are subject to change without notice. It should not be assumed that any recommendations incorporated herein will be profitable, will equal past performance or will achieve same or similar results. The country allocations recommended herein are solely those of the Heckman Global Advisors (HGA) division of DCM and may differ from those of other business units of DCM. The countries mentioned herein are covered by our proprietary top-down country allocation model and are included, together with any rankings and/or weightings, for illustrative purposes only. The representative countries and related information are subject to change at any time and are not intended as a specific recommendation for investment. Foreign securities can be subject to greater risks than U.S. investments, including currency fluctuations, less liquid trading markets, greater price volatility, political and economic instability, less publicly available information, and changes in tax or currency laws or monetary policy. These risks are likely to be greater for emerging markets than in developed markets. Certain investments may invest in derivatives, which may increase the volatility of its net asset value and may result in a loss.
Model, back-tested or hypothetical performance information, and results do not reflect actual trading or asset or fund advisory management, and the results may not reflect the impact that material economic and market factors may have had, and can reflect the benefit of hindsight, on HGA’s decision-making if HGA were actually managing client’s money. Any reference to performance information that is provided gross of fees does not reflect the deduction of management or advisory fees. Client returns will be reduced by such fees and other expenses that may be incurred in the management of the account. Advisory fees are described in Part 2A of Form ADV of DCM, and its affiliated individuals may, from time to time, own, have long or short positions in, or options on, any securities discussed herein. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or an interest in any Dinosaur Capital Management LLC investment vehicle(s). Any chart, graph, or formula should not be used by itself to make any trading or investment decision.
Morgan Stanley Capital International (MSCI) indexes are unmanaged market capitalization-weighted indexes. The indexes do not reflect transaction costs or management fees and other expenses. MSCI index returns are calculated with dividends reinvested. Unlike the indices, the strategies described are actively managed and may have volatility, investment and other characteristics that differ from the benchmark index.
Source: MSCI. Pursuant to our agreement with MSCI, the MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use it may make or permit to be made of this information. Neither MSCI, any of its affiliates or any other person involved in or related to compiling, computing or creating the MSCI information (collectively, the “MSCI Parties”) makes any express or implied warranties or representations with respect to such information or the results to be obtained by the use thereof, and the MSCI Parties hereby expressly disclaim all warranties (including, without limitation, all warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential or any other damages (including, without limitation, lost profits) even if notified of, or if it might otherwise have anticipated, the possibility of such damages.
Perhaps responding to the racial tensions that rocked the country last year, policy makers in the Federal Reserve system and elsewhere have taken note of the stark reality of racial disparities in income and wealth in the US. Despite declines in overt labor market discrimination and gains in educational opportunities since the onset of the Civil Rights movement over 50 years ago, the gaps between black and white household income and wealth are as large today as they were in 1950. In 2019, the typical household with a white head had more than six times greater wealth and twice the income than its black counterpart.1If it is time for policy to address racial wealth and income gaps, it is reasonable to ask whether the Federal Reserve has a role to play? Raphael Bostic, the President of the Federal Reserve Bank of Atlanta, suggests that there is a role for the Fed. He said last year that the Federal Reserve“can play an important role in helping to reduce racial inequities and bring about a more inclusive economy…[It] acts to create a foundation upon which businesses, families, and communities can thrive. Our success means that businesses can grow faster and hire more workers and that more innovation can be supported, which would mean more opportunities for African Americans and others who have not been as attached to the economy.“2
Mary Daly, President of the San Francisco Fed concurred. In a speech last year she asked:
“How can we build a society that delivers on the promise of equal opportunity and inclusive success? ”
Her answer started with “the Fed has a critical role to play. “ 3 President Daly also acknowledged that the Fed might have a role in generating economic inequality and importantly added that addressing inequality in the US will take more than just Fed action.1 The 2019 Survey of Consumer Finances, conducted by the Federal Reserve indicates that the average white (black) household has an income of $113,300 ($58,100) and net wealth $951,300($139,800).2 https://www.atlantafed.org/about/feature/2020/06/12/bostic-a-moral-and-economicimperative-to-end-racism3 https://www.frbsf.org/our-district/press/presidents-speeches/mary-c-daly/2020/october/isthe-federal-reserve-contributing-to-economic-inequality/2Even Fed Chair Jerome Powell indicates that the Fed might have a role to play in addressing distributional issues:“With regard to the employment side of our mandate, our revised statement emphasizes that maximum employment is a broad-based and inclusive goal. This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities.” 4Policy makers outside of the Federal Reserve are even more specific. Jared Bernstein, now a member of the the Council of Economic Advisors, suggested that the Federal Reserve’s traditional mandate to maintain stable prices and promote full employment should be expanded to include reducing racial disparities. On the campaign trail, Joe Biden said that:“The Fed has a profound impact on our economy. . . [it] promotes maximum employment, and stable prices. . . the Fed should add to that responsibility, and aggressively target persistent racial gaps in jobs, wages, and wealth. . . ”5The concerns of these policymakers are not surprising given the stark reality of economic disparities. However, my recent research shows that it would be a mistake to think that loose monetary policies can be instrumental in improving the lot of black families. Our research project examines how an accommodative monetary policy affects racial gaps in income and wealth.6 A common line of thinking regarding the role of monetary policy in addressing racial disparities is that an easy monetary policy with sustained low interest rates and ample credit expansion will lower unemployment rates and increase labor income. Importantly, it does so more for blacks than for whites. The gap between the unemployment rate of black and white households, which was over 8 percentage points at the end of the financial crisis, was about 2percentage points when the pandemic began. Indeed, the expansionary monetary policies that were introduced during the financial crisis and renewed during the pandemic had the beneficial effect of reducing the unemployment rate gap between blacks and whites.Our econometric research shows that an accommodative monetary policy shock, a 100 bp reduction in the Federal Funds rate, will reduce the gap between black and white unemployment rates by about 0.3 percentage point. With some reasonable assumptions about the earnings of the additional workers who find employment, we can estimate the effect on average earnings. Remember that the policy expansion will increase employment and earnings for all groups; we are interested here in the differential effect. That is, how much more does4 https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm5 https://www.rev.com/blog/transcripts/joe-biden-racial-equity-plan-speech-transcript-july-286 Monetary policy and racial inequality by Alina Bartscher, Moritz Kuhn, Moritz Schularick andPaul Wachtel, Federal Reserve Bank of New York Staff Report, January 2021.https://www.newyorkfed.org/research/staff_reports/sr959.html3black unemployment fall and how much does black average earnings increase relative to white average earnings. The monetary policy shock that reduces the unemployment gap by 0.3percentage points has a very small effect on the gap in average earnings. Our estimate is that reduces the gap between average black and white household annual incomes by about $100 or0.2% of the average black income.Moreover, a closer look at the effects of loose monetary policy on black and white households indicates that this earnings effect (the small reduction in the income gap) is only one part of the story. A loose monetary policy also increases asset prices, particularly for equities and homes, giving capital gains to asset holders. These portfolio effects disproportionately benefit white households because 75% of them own a home and 64% own equities while the corresponding numbers for black households are 46% and 35%.A one percentage point reduction in the Funds leads to increases in stock prices of almost 5%and house prices by a bit less. The wealth of the typical white household increases by about$30,000, about six times more than the gains to the typical black household. White households gain more from asset price increases because they are wealthier to begin with and are much more likely to own equities and other assets that rise in value when policy loosens.The run up of the stock market in the last decade – to a large extent driven by monetary policy– hardly benefited black households.There is no doubt that the accommodative monetary policies of the last decade reduced the gap between black and white unemployment rates and resulted in somewhat larger earnings gains for black households. But the earnings effects pale in comparison to the portfolio effects that widen the wealth gap. Capital gains from the same accommodative monetary policy increases the wealth of the average white household much more than the average black household. To better compare the earnings and portfolio effects, we show that the differential in capital gains will result in an additional $800 in consumption expenditures for white households compared to black. The differential portfolio effect on consumption is about eight times larger than the earnings effect.Our analysis does not bode well for the suggestion that reducing racial inequalities should be added to the mandate of the Federal Reserve. Such a mandate might make it impossible forthe central bank to tighten monetary policy when macroeconomic conditions call for it. With the instruments available – all of which work through effects on asset prices and interest rates– a central bank is not able to design policies to reduce the racial income gap without increasing wealth inequality. Clearly, this does not mean that achieving racial equality should not be a prime objective for policymakers. But the tools available to central banks might not be the right ones and might possibly be counter productive. Policy makers concerned with racial gaps need to look beyond the blunt tools of monetary policy and consider approaches that address racial gaps directly such as child tax credits and reparations.
Recently I wrote “Allocating Emerging Markets Based on Value” (April 7, 2021). The analysis was based on the top-down strategy of overweighting cheap emerging markets and underweighting expensive emerging markets based on valuation indicators. The conclusion of the analysis was that over the “long-term”—between January 1997 and February 2021—allocation among emerging markets based on a number of valuation indicators would have led to outperformance over the MSCI Emerging Market Index. However, for the recent 10 years between March 2011 and February 2021, valuation of the market as an investment strategy for allocating emerging markets has not worked. The current paper tries to answer whether the same conclusion has been true for stock selection within the emerging markets. It compares the performance of value versus growth as investment styles for stock selection. In addition, since value and growth styles tend to cycle over time, the paper focuses on indicators which might help tilt an emerging market portfolio either to value or growth for stock selection.
As proxies for value vs growth for stock selection in the emerging markets, we compare the MSCI Emerging Markets Value Index and MSCI Emerging Markets Growth Index. The MSCI Emerging Markets Value and Growth Indexes both capture large and mid-cap securities exhibiting style characteristics across 27 Emerging Markets (EM) countries . The value investment style characteristics for the MSCI Emerging Markets Value Index construction are defined using three variables: price to book value, 12-month forward earnings, and dividend yield. The growth investment style characteristics for the MSCI Emerging Markets Growth Index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate, long-term historical EPS growth trend and long-term historical sales per share growth trend.
We use the start date of January 2001 which was when data was available on Bloomberg for the MSCI Emerging Markets Value and Growth Indexes. We compare two 10-year time periods for the MSCI Emerging Markets Indices. We also compare the US Russell Value and Growth Indices during these two time periods.
As can be seen from the Figure 1, the MSCI Emerging Markets Value Index outperformed the MSCI Emerging Markets Growth Index between January 2001 and February 2011.
1EM countries include Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Kuwait, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
Figure 1
Source: MSCI and Bloomberg
Figure 2 compares the US Russell Value and Growth Indices during this same time period. The US Russell Value Index outperformed the Russell Growth Index. The early part of this period included the bursting of the dot.com bubble.
Figure 2
Source: Russell and Bloomberg
We also looked at the cumulative performance of these Indexes over the last 10 years from March 2011 to February 2021. Looking at the last 10 years, both the MSCI Emerging Markets Growth Index and the US Russell Growth Index outperformed their respective Value indexes, (Figures 3 and 4).
Figure 3
Source: MSCI and Bloomberg
Figure 4
Source: Russell and Bloomberg
Since value and growth tend to perform in cycles, are there any indicators which might help in deciding when to overweight value vs growth for stock selection in the emerging markets? In the U.S., we found that there were several U.S. based indicators which had a positive correlation with the outperformance of the Russell Value vs the Russell Growth. Figure 5 shows the U.S. based indicators and their long-term correlation between January 1979 and February 2021 with Russell Value outperformance over Russell Growth over the next month, over the next 6 months, and over the next 12 months. The strongest correlation is with Next Year’s GDP Growth.
Figure 5
Source: Russell, Bloomberg, Heckman Global Advisors
Applying these same indicators to the emerging markets, we found many of the indicators had a positive correlation with the outperformance of the MSCI Emerging Markets Value Index vs Growth Index. These correlations are found in Figure 6. As noted above, the data for the MSCI Emerging Markets Indexes starts somewhat later than the data for the Russell Indexes. The indicators which seem the most consistent are 3-Month Change in the PMI, 3-Month Change in the US 10-Year Government Bond Yield, Citi’s Economic Surprise Index, Current Year’s Earnings Forecast, and Next Year’s GDP Forecast. Because of the strong trend downward in US Government 10-year and 2-year yields since the early 1980s, the high correlations with MSCI Emerging Markets Value versus Emerging Markets Growth were disregarded in the evaluation of indicators.
Figure 6
Source: MSCI, Bloomberg, Heckman Global Advisors
We also looked to see if momentum of the relative performance could be useful in helping guide whether to overweight value versus growth in the emerging markets. In other words, if a style outperformed over the last month, last 6 months, or last 12 months, would that be useful in predicting which style might do better in the future. Previously, we found when looking at the relative US Russell Value versus Growth performance what happened in the last 6 months (trailing relative returns) is the most useful for predicting future relative returns over the next 6 months and 12 months. These correlations are shown in Figure 7.
Figure 7
Source: Russell, Bloomberg, Heckman Global Advisors
We have applied the same methodology to relative performance in Emerging Markets. The results are shown in Figure 8. Here the results are even stronger than the results we found for the Russell Indexes indicating the role momentum plays in timing value versus growth in the emerging markets.
Figure 8
Source: MSCI, Bloomberg, Heckman Global Advisors
If we use the indicators currently to assess value versus growth in emerging markets, as of April 1, we would conclude from Figure 9 that conditions exist for value to outperform growth in the emerging markets.
Figure 9
Source: Heckman Global Advisors
Important Disclosures: This material has been prepared and issued by Heckman Global Advisors (HGA), a division of DCM Advisors, LLC (DCM), and may not be reproduced or re-disseminated in any form. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
This document has been prepared for informational purposes only and is not a solicitation of any offer to buy or sell any security, commodity, futures contract or instrument or related derivative (hereinafter "instrument") or to participate in any trading strategy.
This material does not provide individually tailored investment advice or offer tax, regulatory, accounting or legal advice. The securities discussed in this material may not be suitable or appropriate for all investors. Prior to entering into any proposed transaction, recipients should determine, in consultation with their own investment, legal, tax, regulatory and accounting advisors, the economic risks, and merits, as well as the legal, regulatory and accounting characteristics and consequences of the transaction. You should consider this material among other factors in making an investment decision. This information is not intended to be provided and may not be used by any person or entity in any jurisdiction where the provision or use thereof would be contrary to applicable laws, rules or regulations. Any securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom.
The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM and are subject to change without notice. It should not be assumed that any recommendations incorporated herein will be profitable, will equal past performance or will achieve same or similar results. The country allocations recommended herein are solely those of the HGA division of DCM and may differ from those of other business units of DCM. The countries mentioned herein are covered by our proprietary top-down country allocation model and are included, together with any rankings and/or weightings, for illustrative purposes only. The representative countries and related information are subject to change at any time and are not intended as a specific recommendation for investment. Foreign securities can be subject to greater risks than U.S. investments, including currency fluctuations, less liquid trading markets, greater price volatility, political and economic instability, less publicly available information, and changes in tax or currency laws or monetary policy. These risks are likely to be greater for emerging markets than in developed markets. Certain investments may invest in derivatives, which may increase the volatility of its net asset value and may result in a loss.
Model, back-tested or hypothetical performance information, and results do not reflect actual trading or asset or fund advisory management, and the results may not reflect the impact that material economic and market factors may have had, and can reflect the benefit of hindsight, on HGA’s decision-making if HGA were actually managing client’s money. The model performance is shown for informational purposes only and should not be interpreted as actual historical performance of HGA. Neither past actual nor hypothetical performance guarantees future results. No representation is being made that any model will achieve results similar to that shown and there is no assurance that a model that produces attractive hypothetical results on a historical basis will work effectively on a prospective basis. Clients should not rely solely on this performance or any other performance illustrations when making investment decisions. Actual performance may differ from model results. Any reference to performance information that is provided gross of fees does not reflect the deduction of management or advisory fees. Client returns will be reduced by such fees and other expenses that may be incurred in the management of the account. For example, a 0.50% annual fee deducted quarterly (0.125%) from an account with a ten-year annualized growth rate of 5% will produce a net result of 4.4%. Actual performance results will vary from this example. Further, Exchange-Traded Funds that track theses MSCI indexes would be charged expense ratios that would reduce returns. Any chart, graph, or formula should not be used by itself to make any trading or investment decision.
Morgan Stanley Capital International (MSCI) indexes are unmanaged market capitalization-weighted indexes. The indexes do not reflect transaction costs or management fees and other expenses. MSCI index returns are calculated with dividends reinvested. Unlike the indices, the strategies described are actively managed and may have volatility, investment and other characteristics that differ from the benchmark index.
Source: MSCI. Pursuant to our agreement with MSCI, the MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use it may make or permit to be made of this information. Neither MSCI, any of its affiliates or any other person involved in or related to compiling, computing or creating the MSCI information (collectively, the “MSCI Parties”) makes any express or implied warranties or representations with respect to such information or the results to be obtained by the use thereof, and the MSCI Parties hereby expressly disclaim all warranties (including, without limitation, all warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential or any other damages (including, without limitation, lost profits) even if notified of, or if it might otherwise have anticipated, the possibility of such damages.
To the chagrin of many value managers, value as an investment style for stock selection has not worked for much of the last ten years. This paper addresses how value has worked for allocating emerging markets. If one had overweighted cheap emerging markets and underweighted expensive emerging markets, how would that strategy have performed over long periods of time as well as the last ten years?
There are a number of measures of valuation. Using MSCI data at the market level, we have looked at price-to-book, trailing price-to-earnings, forecasted price-to-earnings, price-to-earnings relative to its 10-year average, earnings yield gap (difference between earnings yield and real short-term interest rates), dividend yield, and the CAPE (capitalization of the market divided by 10-year average earnings of the market).
We examine indicator performance based on tests of single-factor country allocation portfolios. Using dividend yield as an example, we calculate a score for every market each month based on how high the market’s dividend yield is relative to the emerging market average. Starting with MSCI Emerging Market benchmark country capitalization weights, we re-balance the portfolio monthly by assigning overweights to markets with higher-than-average dividend yields and underweights to markets with lower-than-average dividend yields. The portfolio is updated each month and performance returns (gross of transaction costs) are calculated monthly. Returns are then measured relative to MSCI Emerging Market Index returns. Below are the alphas of each of the value factors over a longer time period - from January 1997 through February 2021 and over the last ten years – March 2011 through February 2021. For the longer time period, January 1997 was chosen as a starting point since, at that point, there were over 20 emerging markets with valuation data
From the figures below, it can be seen that valuation at the market level as a factor for allocating emerging markets worked well over the longer time period but has not worked over the last 10 years. Three relatively inexpensive emerging markets over the last ten years (as measured by the average forecasted price-to-earnings) include Brazil, Turkey, and Greece. MSCI Brazil market has been dominated by Energy and Materials (each 25% of MSCI Brazil as of 3/1/2011). Greece has been dominated by Financials (55% of MSCI Greece as of 3/1/2011), but also during this period Greece was an epicenter of the European debt crisis. Turkey was dominated by Financials ( 56% of the MSCI Turkey as of 3/1/2011) and was subject to numerous political crises. More expensive markets which have done well over the last 10-years include Taiwan and India. Information technology was a large proportion of MSCI Taiwan Index (57% as of 3/1/2011) and was 18% of the MSCI India whereas it was 0% of the MSCI Turkey and MSCI Greece and 2% of the MSCI Brazil. Obviously, sector composition cannot explain all of the underperformance of value for allocating emerging markets over the last ten years. Economic, monetary, and political crises played a role as well.
We would expect that as economies recover, inexpensive stocks, sectors, including financials, energy, and industrials, and markets would come back into favor. This has been occurring in the U.S. equity market over the last 6 months. One could expect that as emerging market economies also recover, value as an investment factor could be a tailwind again for allocating among emerging markets.
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This material has been prepared and issued by Heckman Global Advisors (HGA), a division of DCM Advisors, LLC (DCM), and may not be reproduced or re-disseminated in any form. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request
This document has been prepared for informational purposes only and is not a solicitation of any offer to buy or sell any security, commodity, futures contract or instrument or related derivative (hereinafter "instrument") or to participate in any trading strategy.
This material does not provide individually tailored investment advice or offer tax, regulatory, accounting or legal advice. The securities discussed in this material may not be suitable or appropriate for all investors. Prior to entering into any proposed transaction, recipients should determine, in consultation with their own investment, legal, tax, regulatory and accounting advisors, the economic risks, and merits, as well as the legal, regulatory and accounting characteristics and consequences of the transaction. You should consider this material among other factors in making an investment decision. This information is not intended to be provided and may not be used by any person or entity in any jurisdiction where the provision or use thereof would be contrary to applicable laws, rules or regulations. Any securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom.
The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM and are subject to change without notice. It should not be assumed that any recommendations incorporated herein will be profitable, will equal past performance or will achieve same or similar results. The country allocations recommended herein are solely those of the HGA division of DCM and may differ from those of other business units of DCM. The countries mentioned herein are covered by our proprietary top-down country allocation model and are included, together with any rankings and/or weightings, for illustrative purposes only. The representative countries and related information are subject to change at any time and are not intended as a specific recommendation for investment. Foreign securities can be subject to greater risks than U.S. investments, including currency fluctuations, less liquid trading markets, greater price volatility, political and economic instability, less publicly available information, and changes in tax or currency laws or monetary policy. These risks are likely to be greater for emerging markets than in developed markets. Certain investments may invest in derivatives, which may increase the volatility of its net asset value and may result in a loss.
Model, back-tested or hypothetical performance information, and results do not reflect actual trading or asset or fund advisory management, and the results may not reflect the impact that material economic and market factors may have had, and can reflect the benefit of hindsight, on HGA’s decision-making if HGA were actually managing client’s money. The model performance is shown for informational purposes only and should not be interpreted as actual historical performance of HGA. Neither past actual nor hypothetical performance guarantees future results. No representation is being made that any model will achieve results similar to that shown and there is no assurance that a model that produces attractive hypothetical results on a historical basis will work effectively on a prospective basis. Clients should not rely solely on this performance or any other performance illustrations when making investment decisions. Actual performance may differ from model results. Any reference to performance information that is provided gross of fees does not reflect the deduction of management or advisory fees. Client returns will be reduced by such fees and other expenses that may be incurred in the management of the account. For example, a 0.50% annual fee deducted quarterly (0.125%) from an account with a ten-year annualized growth rate of 5% will produce a net result of 4.4%. Actual performance results will vary from this example. Further, ExchangeTraded Funds that track theses MSCI indexes would be charged expense ratios that would reduce returns. Any chart, graph, or formula should not be used by itself to make any trading or investment decision.
Morgan Stanley Capital International (MSCI) indexes are unmanaged market capitalization-weighted indexes. The indexes do not reflect transaction costs or management fees and other expenses. MSCI index returns are calculated with dividends reinvested. Unlike the indices, the strategies described are actively managed and may have volatility, investment and other characteristics that differ from the benchmark index.
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Inflation seems like a relic of a former age. It began to creep up on us during the Vietnam war era in the late 1960’s. An economic slowdown in 1968 brought it down but it came roaring back quickly leading President Nixon to introduce price controls when inflation exceeded 5%. The energy price shocks in the 1970s led to inflation outbursts, each one higher than the last and reaching a peak of about 15% in 1980. By that time the country was in despair as double-digit inflation made business and personal planning difficult and fraught with uncertainty. The nightmare came to an end with the appointment of Paul Volcker to lead the Federal Reserve by President Carter. A dramatic change in monetary policy led quickly to the deepest recession of the post-war period until the Great Financial Crisis and the resounding defeat of Carter in the 1980 election. Finally, by the mid-1980’s, inflation was largely tamed (see Chart 1).
You would have to be an aging baby boomer to have any memory at all of the inflationary experience that seriously disrupted the American economy a generation ago. The millennial generation, born as it ended, has no experience with inflation. Concern about the looming threat of inflation is shrugged off by a generation that does not have any experience to provide reason for concern (see Chart 2).
It is dangerous to forget the lessons of history. As a baby boomer, I tired quickly of my father’s warnings about the Great Depression – ‘turn off the lights, turn down the heat, you don’t know what it was like during the Depression.’ The Depression did not seem particularly relevant to my generation and many lessons of that era that were forgotten by policy makers which helped sow the seeds of the financial crisis in 2008.
Is a punishing inflation really out of the picture? Or have the millennials just forgotten about the history that they never experienced?
Our most important policy makers – President Biden, Treasury Secretary Yellen, Fed Chair Powell – are aging baby boomers who surely remember the Great Inflation. They tell us as much but they also tell us that there are strong and convincing reasons why inflation is not a problem.
Are things really different now? Or have we just forgotten the experiences of the baby boomers almost 50 years ago?
There is simply no evidence of inflation perking up once again. There are three occasions in the last 50 years when the US unemployment rate dipped below 4% -- in 1969, 2000 and 2019. In the first instance, inflation doubled; in the second it nudged up a percentage point and most recently it did not budge.
In the 21st century inflation does not respond to changes in economic conditions. There are a few reasons for this, starting with globalization. A global marketplace creates competitive pressures on American producers and workers that holds down inflation. Firms cannot increase prices when foreign competitors are breathing down their necks.
Moreover, inflation does not budge because expectations about future inflation are so firmly anchored. Price setters will not build-in price increases if they are convinced that there will not be any inflation, and that their competitors share that belief. Strongly held expectations are self-fulfilling.
Expectations are measured either from surveys of individuals or inferred from financial markets. Chart 3 shows two familiar measures. The blue line is the one year expected inflation rate from the Survey Research Center at the University of Michigan. The red line is the five-year ahead five-year expectation of inflation derived from financial market data. Longer term expectations have never exceeded 3% and have been below the Fed’s 2% inflation target in most recent years. The survey of individuals suggests inflation expectations have hovered around 3% for 30 years and have declined recently as the economy expanded.
Next, this time might be different because there are strong reasons why expectations are so firmly anchored. The Federal Reserve addresses its price stability mandate very differently now than it did during the Great Inflation. The Fed now specifies its inflation target – 2%-- and makes clear its commitment to have policy guided by that target. Further, confidence in the leadership of the Fed and its independence to act make the commitment credible.
A related issue is the role of monetary expansion. In the 1970s the link between money supply growth and inflation was much stronger than it is now and the Federal Reserve often lacked the tools or the willingness to control money expansion. Rounds of QE during and after the financial crisis led to large increases in the monetary base which were recently eclipsed by the credit expansion of the pandemic. However, the financial structure is now different. The Fed pays interest on reserves which neutralizes their impact. What’s more, the Fed stands ready to reverse the growth in the monetary base if credit expansion becomes inflationary.
Finally, there are some reasons long-term inflation will be restrained as a result of widely anticipated structural changes in the economy. It takes a long time for new technologies to move into the work place, change the way we do things and impact productivity. Electricity started to light things up late in the 19th century but it did not dramatically change the way businesses operate until the booming 1920s. Computers appeared on office desks in the 1980s but did not revolutionize the way we conduct our lives until the start of the 21st century. Similarly, artificial intelligence will make self-driving cars a reality and impact productivity and labor in many other ways over the next few decades. Such technological innovation will spur rapid growth and mitigate any inflationary pressures.
All in all, there might well be reason why there is so little concern about inflation. All of the economic expansions in the last 25 years have taken place without a hint of inflation. There is no reason think that the post-pandemic expansion will be any different. Policy makers are wiser and more able and willing to respond if inflation emerges. Further, the public is convinced that these commitments and capabilities are real which anchors expectations and holds inflation at bay. And finally, the longer-term prospects of technology-driven productivity growth provides reason for continued confidence.
So why do I keep thinking of my father and his Depression mentality that I mocked as a teenager? Because the lack of historical experience can let us put our guard down. Policy mistakes can happen, the public might resist any unpopular policies that are needed to fight inflation, concern for other important things such as income inequality might hamper policymakers eager to tighten monetary policy. And, if these things happen, then expectations can turn and confidence erode all too quickly. I don’t think it will happen anytime soon but I do think that it is important to make sure that millennials and their successors learn why inflation matters.
THE GREAT INFLATION
THE GREAT MODERATION AND BEYOND
INFLATION EXPECTATIONS
Note: Data retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/
DISCLOSURE: The comments contained herein are the opinions of the author, a consultant to DCM Advisors, LLC, and may not represent the opinions of DCM Advisors. Comments are provided for informational purposes only and are subject to change without notice. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. These materials are the exclusive property of DCM Advisors. Unless otherwise expressly permitted by DCM Advisors in writing, this information should not be distributed to any other parties.
As the U.S. market has hit new highs recently, there is some concern that we are in a stock market bubble. For the U.S. market as a whole1 as of January 31, 2021, the trailing price-to-earnings was 32x and the forecasted 2021 price-to-earnings was 23x. These valuations can be compared with the price-to earnings during the tech bubble of 31x. The long-term average of the U.S. market’s price-to-earnings since January 1970 has been 17x. No one knows when the U.S. market will next decline into bear market territory (decline of 20% or more). But there appears to be at least one dividend-oriented strategy which might help protect on the downside.
We looked at two main dividend-oriented strategies—Dividend Growth and High Dividend. As a proxy for Dividend Growth strategies, we used the S&P 500 Dividend Aristocrats Index2 which consists of a list of companies—mainly well-known, large-cap, blue-chip companies—in the S&P 500 with a track record of increasing dividends for at least 25 consecutive years; and as a proxy for High Dividend the DJ Select US Dividend Index3, a broad market index which tracks stocks with the highest dividend yields. In addition, we compare both indexes to the S&P 500 Index. Since data was available for DJ Select US Dividend Index starting in February 1992, we compared the performance of the three indexes from February 1992 through December 2020.
The table below measures the performance and standard deviation as well as the downside capture ratio of the two dividend strategies. The downside capture is the ratio calculated by taking the fund's monthly return during the periods of negative benchmark performance and dividing it by the benchmark return (in this case the S&P). The lower the downside capture indicates that the strategy goes down less than the benchmark during periods of negative returns. In addition to downside capture, the table also shows the return of the dividend strategies when investors arguably “needed downdraft protection most”—during the three Bear markets since February 1992, including the short-lived Covid crash between January and March 2020 (Bear markets so defined as having a peak-to-trough decline of 20% or more.)
1 Based on MSCI U.S. Index
2 The S&P 500 Dividend Aristocrats Index was launched in May 2005. Performance data before that date was backfilled.
3 The DJ Select US Dividend Index was launched on November 3, 2003. Performance data before that was backfilled.
It can be seen from the table below that dividend-oriented strategies have historically performed well relative to the S & P and done so with lower downside capture. Of the three Indexes, the S&P 500 Dividend Aristocrats Index had the lowest standard deviation. What can be seen from the table as well is that although both dividend strategies’ downside ratio was below 1.00, the S&P 500 Dividend Aristocrats Index had a decidedly lower downside capture (a good thing) than the DJ Select US Dividend Index.
In terms of the last three Bear markets, both dividend strategies had positive performance during the bursting of the tech bubble (peak to trough from 9/2000 through 10/2002). During the Great Financial Crisis (peak to trough 11/2007 through 3/2009), the S&P 500 Dividend Aristocrats Index went down less than both the S &P and the DJ Select US Dividend Index. In fact, the DJ Select US Dividend Index went down more than the S & P. This was due to the high composition of stocks such as Financials in the highest yielding cohort in the DJ Select US Dividend Index during this period. This helps account for the lower (e.g. better) downside capture of the S&P 500 Dividend Aristocrats Index than the DJ Select US Dividend Index during the Great Financial Crisis and since February 1992. Again, during the recent Covid market crash, the S&P Dividend Aristocrats Index went down less than the DJ Select US Dividend Index.
Based on the last three bear markets, higher quality dividend growth stocks as represented in the S&P 500 Dividend Aristocrats Index offered more consistent downside protection than the highest paying dividend stocks as represented by the DJ Select Dividend Index.
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
It is important to know that the highest dividend yielding stocks are not necessarily the best source either for consistent dividend income or equity returns. But amongst dividend paying stocks there is a great divide. There are other segments of dividend paying stocks which tend to have attractive yields and which also keep up with the returns of the S&P 500. Our research indicates this is particularly true today with yields on fixed income at historic lows.
One place to look for stable dividends is in quality companies with steady earnings and which tend to increase their dividends. As a proxy for these types of companies, we look to the S&P 500 Dividend Aristocrats Index which consists of a list of companies—mainly well-known, large-cap, blue-chip companies—in the S&P 500 with a track record of increasing dividends for at least 25 consecutive years. The performance of this index is compared to the DJ Select US Dividend Index a broad market index which tracks stocks with the highest dividend yields. In addition, we compare both indexes to the S&P 500 Index. Since data was available for DJ Select US Dividend Index starting in February 1992, we compared the performance of the three indexes from February 1992 through December 2020.
It can be seen from the table below that high dividend stocks have a long history of performing as well if not better than the S&P 500. However, some classifications of dividend stocks have outperformed others. Since February 1992, the total return of the S&P 500 Dividend Aristocrats Index has been higher than the DJ Select Dividend Index and the S&P 500 Index. In addition, it has done so with lower volatility, subsequently having a higher Sharpe Ratio. Even over the last ten years (January 2011 – December 2020) when it has been difficult for Value stocks to outperform the S&P, the S&P 500 Dividend Aristocrats Index has fared as well as the S&P 500 with less volatility.
- The S&P 500 Dividend Aristocrats Index was launched in May 2005. Performance data before that date was backfilled.
- The DJ Select US Dividend Index was launched on November 3, 2003. Performance data before that was backfilled.
Dividend paying stocks have a long history of outperforming the S&P. However, both in terms of potential higher returns and lower volatility, high quality dividend paying stocks appear to have divided and conquered the highest yielding dividend stocks.
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
Who’d have thunk getting it wrong could lead to better investment outcomes? Our latest research identifies how economists’ forecasts, while often wrong, are actually linked to a standout predictive indicator of Value’s future outperformance over Growth.
Several months ago, I published a research note “Value Conquers Growth Coming Out of a Recession.” This analysis tried to answer the question whether Value or Growth tended to do better as the U.S. recovered from a recession. Since 1979, using the 3-month change in the ISM’s Manufacturing Purchasing Managers Index (PMI) index of 10% or greater as a signal for when to start measuring performance of the Russell Value and Growth Indexes as the US economy came out of a recession, I found the Russell Value Index outperformed the Russell Growth Index at the end of 4 out of the 5 recessions1. The only exception was during the aftermath of the oil shock led recession of 07/90 - 03/91. The average outperformance of the Russell Value Index over the Russell Growth Index over the 5 recessions was 4.8% twelve months post recession’s end.
1For the recession of 07/90 – 3/91, 3-month PMI change of 9.1% was used.
Rather than just restricting the analysis to recession, I recently extended the analysis to look at what other indicators might help in making the decision of whether Value might do better than Growth (or vice versa Growth might do better than Value) overall– not just coming out of recessions.
Chart 1 below measures the performance of the Russell Growth vs Value since 1980. The blue line measures Russell Growth Index divided by the Russell Value Index and the grey lines the cumulative 12-month return differential each month between the Growth and the Value indexes. As can be seen from the chart, Growth has done better than Value especially during the two peaks: one around 1999/2000 and the other starting around 2010.
Chart 1
Chart 2 shows the correlations of various indicators with the forward 1-month, 6-month, and 12-month outperformance of Russell Value vs. Russell Growth. As can be seen from the chart, there are several indicators which have a positive correlation with the outperformance of Value over Growth and confirm the earlier study on the 3-month change in the PMI coming out of recessions.
The strongest indicator is GDP Forecast for Next Year. We have been collecting data on next year’s consensus GDP forecasts since 1990. It is always positive (economist are always optimists about next year), but there is some variation in the data. The average is 2.6% so if the GDP forecast for next year is higher than 2.6%, it tends to be relatively good for Value. As of the beginning of September, next year’s GDP forecast was 3.7%.
The next strongest indicator is Citi’s Economic Surprise Index.
“The Citigroup Economic Surprise Indices are objective and quantitative measures of economic news. They are defined as weighted historical standard deviations of data surprises (actual releases vs. Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that economic releases have on balance [been] beating consensus. The indices are calculated daily in a rolling 3-month window.”
Again, when Citi’s Economic Surprise Index is higher than average (-2%), returns tend to be better for Value. As of September 18, Citi’s Economic Surprise Index was 172.5.
The third strongest indicator is Current Year Earnings Growth Forecast. We have also been collecting this data since December 1987 – aggregating from bottom-up earnings estimates for all companies in the MSCI US Index. The long-term average Current Year Earnings Growth Forecast is 11% so if the earning forecast is higher than 11%, it tends to be relatively good for Value. However, as of the beginning of September, the Current Year Earnings Forecast is currently at -16% which is below the average of 11%.
CHART 2:
Correlation between Indicator and Relative Returns of Russel Value and Russel Growth
* Stats in 2003
The fourth strongest indicator is the 3-Month Change in the PMI which I used before for the analysis on recessions. When the 3-Month Change in the PMI is higher than average, it tends to be better for Value. The average is 0%, so if the 3-month change in the PMI is higher than 0%, it tends to be relatively better for Value. As of the beginning of September, the 3-Month Change in the PMI was over 30%.
Chart 3 shows the correlations of the future 1-month, 6-month, and 12-month out-/under-performance of Value vs. Growth with the trailing 1-month, 6-month, and 12-month out-/under-performance of Value vs. Growth. As can be seen from the chart, the strongest predictor for 6 months out-/under-performance and the 1 month out-/under-performance is the 6 months trailing out-/under-performance. There is some persistence to the Value vs. Growth performance. 12-month trailing out-/under-performance has the weakest correlation.
CHART 3
DISCLOSURE: This publication is provided by Heckman Global Advisors (“HGA”), which is not an independent entity but is a Division of DCM Advisors, LLC, a registered investment adviser. The country, region and sector allocations recommended herein are solely those of HGA and may differ from those of other business units of DCM Advisors, LLC. Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy any security or any interest in DCM Advisors, LLC vehicle(s). The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and its accuracy cannot be guaranteed. The comments contained herein are opinions and may not represent the opinions of DCM Advisors, LLC and are subject to change without notice. All investments are subject to the risk of loss, including the potential for significant loss, and it should not be assumed that any models or opinions incorporated herein will be profitable or will equal past performance. Copyright © 2017 DCM Advisors, LLC. All Rights Reserved. These materials are the exclusive property of DCM Advisors, LLC. Unless otherwise expressly permitted by DCM Advisors, LLC in writing, please do not distribute, reproduce or use these materials for any purpose other than internal business purposes solely in connection with the management of investment funds or investment products that are sponsored or advised by you
The July 2020 ISM’s Purchasing Manufacturing Index (PMI) published on August 3, 2020 was 54.2, and the 3-month change in the PMI was a whopping +31%. Several weeks ago, I published a research note which tried to answer the question whether Value or Growth tended to do better as the U.S. recovered from a recession using the 3-month change in the PMI index of 10% or greater as an indicator of when Value might start outperforming Growth.
Of course, in general, one does not know the exact dates a recession starts or ends until after it is over. Most of the time the PMI 3-month change is a small number (both positive and negative). During a recession, the 3-month change can become a large negative percentage, but when the economy is coming out of a recession, the 3-month change can become a large positive percentage. The signal that was used in the previous analysis was the first month in which the 3-month change in the PMI turned positive 10% or more after the start of a recession. The study measured the performance of the Russell Value and Growth Indexes over the next 12 months. Since 1979, using this PMI based signal for when to start measuring performance of the two Indexes, the Russell Value Index outperformed the Russell Growth Index in 4 out of the 5 recessions. The only exception was during the aftermath of the oil shock-led recession of 07/90 - 03/91. The average outperformance of the Russell Value Index over the Russell Growth Index over the 5 recessions was 4.8%.
With the 3-month change in the PMI at +30% at the beginning of August and based on the analysis of previous recessions, this signal could be pointing to the possibility of Value outperforming Growth.
Of course, in general, one does not know the exact dates a recession starts or ends until after it is over although through most of it, we know that we are in a recession. The question is when to start measuring the performance of Value vs Growth as the economy comes out of the recession. For that, we have looked to the 3-month change in the PMI. Most of the time the PMI 3-month change is a small number (both positive and negative). During a recession, the 3-month change can become a large negative percentage, but when the economy is coming out of a recession, the 3-month change can become a large positive percentage. For measuring the relative performance of Value vs Growth coming out of a recession, the signal we use is the first month in which the 3-month change in the PMI turns positive 10% or more. This positive change can happen during a recession or shortly after it ends. Once we have the PMI signal, we measure the performance of each of the Indexes over the next 6-months and the next 12-months.
1For the recession of 07/90 – 3/91, 3-month PMI change of 9.1% was used.
DISCLOSURE: Past performance is no guarantee of future results. The opinions expressed herein are those of Heckman Global Advisors, a division of DCM Advisors, LLC (“DCM”), and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. This material contains certain information that constitutes “forward-looking statements” which can be identified by the use of forward-looking terminology such as “may,” “expect,” “will,” “hope,” “forecast,” “intend,” “target,” “believe,” and/or comparable terminology. No assurance, representation, or warranty is made by any person that any of the assumptions, expectations, objectives, and/or goals will be achieved. Nothing contained in this document may be relied upon as a guarantee, promise, assurance, or representation as to the future. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
The coronavirus crisis has pushed the U.S. into a recession. Looking forward, whether the economic pattern for recovery is V shaped or U shaped, it would be helpful to gain insight as to whether Value stocks historically have done better than Growth stocks as the U.S. comes out of a recession. One can argue as the economy improves, Value stocks—which tend to be in cyclical industries and become inexpensive during a recessionary selloff—should benefit the most from economic recovery with earnings for Value stocks rebounding more dramatically than for Growth stocks.
In the 12 years since the recession of 2007-2009 (The Great Financial Crisis), Growth has outperformed Value substantially with new technology/new economy Growth stocks contributing to this outperformance. But what about looking out just 1-year or 6-months since that recession? And what about looking at all the recessions over the past 40 years? What can they tell us?
In this analysis, we compared the performance of the Russell Value and Growth indexes as the U.S. recovered from the 5 recessions (not including the current one) since 1979. Return data is available for the Russell Value and the Growth Indexes since January 1979. For the purpose of this analysis, the exact dates of recessions are from the National Bureau of Economic Research (NBER), which is an American research organization known for providing start and end dates for recessions in the United States. From the NBER website, “the NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”.
Of course, in general, one does not know the exact dates a recession starts or ends until after it is over although through most of it, we know that we are in a recession. The question is when to start measuring the performance of Value vs Growth as the economy comes out of the recession. For that, we have looked to the 3-month change in the PMI. Most of the time the PMI 3-month change is a small number (both positive and negative). During a recession, the 3-month change can become a large negative percentage, but when the economy is coming out of a recession, the 3-month change can become a large positive percentage. For measuring the relative performance of Value vs Growth coming out of a recession, the signal we use is the first month in which the 3-month change in the PMI turns positive 10% or more. This positive change can happen during a recession or shortly after it ends. Once we have the PMI signal, we measure the performance of each of the Indexes over the next 6-months and the next 12-months.
1For the recession of 07/90 – 3/91, 3-month PMI change of 9.1% was used.
The first chart shows the differences between the total return of the Russell Value and Growth Indexes over the next 6-months after the PMI 3-month change was 10% or more. Since 1979, in the 6-months after the recession and using this PMI based signal for when to start measuring performance of the two Indexes, the Russell Value Index outperformed the Russell Growth Index in only 2 of the 5 recessions. The only significant outperformance of Value was during the aftermath of the 03/01 – 11/01 recession, which included the dot com bust in the early 2000’s.
However, if you are willing to look 12-months out, the picture changes. The second chart shows the differences between the total return of the Russell Value and Growth indexes over the next 12-months after the PMI 3-month change was 10% or more. Here the pattern is more favorable for Value. Since 1979, in 4 out of the 5 recessions and using this PMI based signal for when to start measuring performance of the two Indexes, the Russell Value Index did outperform Russell Growth Index. The only exception was during the aftermath of the oil shock-led recession of 07/90 - 03/91. The average outperformance of the Russell Value Index over the Russell Growth Index over the 5 recessions was 4.8%.
As of the end of May 2020, the 3-month change in the PMI was -14% so the signal is not pointing to Value outperforming Growth on a consistent basis as of yet.
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
The Emerging Market (EM) economies that came out of the 2008 financial crisis relatively faster than advanced economies are hard hit by a quadruple-whammy this time: the pandemic, capital outflows, economic recession, and debt crisis. In March 2020, more than USD100 billion flew out of the EMs. This analysis looks at the flight to safety of global investors and its impact on these economies that owe more than $8 trillion in foreign-currency debt.
The EMs have come a long way since the 1990s when they were unable to borrow in their own currency, a phenomenon dubbed “the original sin” by Eichengreen and Hausmann, which made them dependent on external financial conditions. Adverse global conditions could lead to capital flight and depreciation of their exchange rate, which pushed their economies into insolvency since the value of the debt burden rose in local currency. If foreign creditors lost confidence in the local economy, they could abruptly reduce the international flow of the capital in the economy. This phenomenon is also often accompanied by domestic residents increasing their investment abroad. Called a “sudden stop,” the abrupt reversal of capital flows would be often accompanied by recession and a currency crisis through a run on EMs currency. During the last several decades, however, following improved economic and financial management and strengthened banking systems, most EMs have been able to borrow in their own currencies. Yet, they now face another problem, the “original sin-redux” as described by Carstens and Shin: since the performance of investors in EMs in local currency is evaluated in USD, a depreciation of the EM currency is costly for investors. So, during an international crisis this heightened risk leads to capital flight and further depreciation of the currencies.
EM economies are no strangers to capital flight. In recent history, several episodes led to capital outflows from these countries. Since the Global Financial crisis, they have been hit by the Taper Tantrum when the Fed decided to stop quantitative easing, which led to a market selloff of EM currencies in a panic; a Renminbi devaluation that reduced its value against the USD for the first time in 20 years and rattled the markets; and the 2018 EM sell-off following global trade uncertainties and the strength of the USD. The market panic of this year has been more severe. As the spread of the coronavirus ripped through financial markets and fears of a recession gripped investors, capital flows to EMs collapsed at the onset of the pandemic. Although some of the outflows slowed down and new inflows took place since then, the decline has been much more severe than the financial crisis or any other episode of market disturbance to these economies (Figure 1).
FIGURE 1
Comparison of Portfolio Outflows Episodes
percent of International Investment Position
In conjunction with massive capital flight, the value of EM currencies collapsed. Since January 2020, the fall in EM exchange rates due to the pandemic-induced lockdown was compounded by plummeting oil and commodity prices, which adversely affected the exporters. The flight to safety by investors, who piled into the dollar as the virus spread over the continents, exacerbated the free fall of these currencies. Figure 2 depicts the change in the value of EM currencies since the beginning of each episode. In the first 90 days of the pandemic, the decline in the currencies was severe but more abrupt than the decline during the same period of the Great Financial crisis.
FIGURE 2
Comparison of currency depreciation episodes
bilateral EM rates against the US$
Not all countries have been impacted by capital flight in the same way. To examine this, we can consider variations in exchange-traded funds (ETFs). An ETF is a type of investment fund that consists of portfolios that track the price and yield of an underlying index. As such, EM ETFs are readily available and can give an understanding of the recent fluctuations in portfolio flows from these economies. Earlier in the year, most EMs, with the exception of the Philippines, have seen sharp declines in net ETF positions, which shows the extent of capital flight from these economies in March (Figure 3). The outflow was abrupt and substantial, paralleling the collapse of their currencies. Although the net positions subsequently improved, they remain well below the 2018 levels.
FIGURE 3
Exchange-Traded Funds
(year-over-year percent change)
As a result of these massive shocks, EM economies are grappling with the fallout from the pandemic, shutdowns, loss of cheap financing, a staggering recession both at home and abroad, and an inability to service their debt to foreign creditors. Despite the G20’s initiative to suspend debt repayment by the poorest countries, it does not cover debt owed to private creditors. Further, many EM countries are excluded from this deal; several of them are therefore facing risk of default as illustrated by Argentina’s May 22 default, its 9th since 2001.
To analyze the severity of default risk, various indicators are used to assess the vulnerability of economies to sudden stops. Typical indicators include the level of external debt as a share of exports, the ratio of debt service to international reserves, and the ratio of current account balance to GDP. In this analysis we will instead use the Guidotti-Greenspan rule, since it compares the country’s international reserves to its short-term external debt with maturity of one-year or less. If the ratio is greater than or equal to 1, then the economy has built sufficient reserves to weather a massive flight of short-term capital for one year (Figure 4).
FIGURE 4
Guidotti-Greenspan rule of reserve adequacy
Reserves/short-term external debt by remaining maturity
Source: SP Global Ratings, Sovereign Risk Indicators 2020 Estimates, as of April 24, 2020, and authors’ calculations.
Argentina and in particular Turkey stand out as having chronically inadequate international reserves to resist a sudden stop of capital flows. In 2020, South Africa fell into the same category of dangerously low reserves. India and Indonesia are currently in a relatively safe zone. They both have just sufficient reserves to cover a short-term crisis, although Indonesia’s ratio has been declining since 2017. If the EM crisis deepens, both of these economies are likely to suffer from a run on reserves. The other five countries, Brazil, China, Mexico, the Philippines, and Russia, have sufficient reserve adequacy without needing foreign borrowing for at least one year.
These conclusions should be evaluated against the current health crisis that the economies are facing. If a country’s health system is overwhelmed by infected people who need to be hospitalized, the opening up of the economy will only aggravate the crisis and delay recovery. Figure 5 displays total cases, cases per 1 million population, and tests per 1 million population.
FIGURE 5
Total cases of infection as of June 6/2020
Despite Brazil and Russia satisfying the reserve adequacy criterion, they have the world’s second and third highest numbers of cases respectively after the United States, and are ranked above all the EM countries in our analysis (first panel). Worldwide, Brazil is holding the second place even after accounting for the population; among the EM countries studied, it has the highest cases per 1 million people (second panel). Some political leaders argue that high numbers only reflect high rates of testing. If a country has high testing and high number of cases, then this is a valid argument. However, if there is low testing and a high number of cases, then this is not the case–in fact, the actual number of cases is likely to be even higher than the official numbers. In regards to testing, the worst performing countries in our sample are mostly those economies satisfying the reserve adequacy condition: Brazil, the Philippines, India, Mexico, and Indonesia (third panel). Argentina stands out as deficient on both reserve adequacy and testing. India and Indonesia, with low rates of testing and increasing numbers of infections, are in danger of facing adverse economic conditions and/or a financial crisis.
EM economies are facing a rare case of twin crises, economic/financial and pandemic. These crises potentially amplify each other, and therefore need to be addressed simultaneously. In addition, most of these economies depend for their exports on advanced economies, which experience themselves a major economic slump resulting from the pandemic and the lockdown. Countries that address the health crisis as seriously as the economic slowdown, by aiming at reducing infections through aggressively testing and tracing, are expected to fare better and return to attracting foreign investment in a virtuous cycle. By contrast, countries that prioritize solving the economic crisis by opening too soon over protecting people are in for a rough ride.
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
This research examines how dividend information can be used for allocating equity markets. We look at dividend yields and as well as trailing and forecsted dividend growth for equity allocation decisions among countries.
At the country level, the dividend yield is the ratio of total dividends paid out by all the companies in a country’s equity index to the market capitalization of the country’s index. Dividend growth at the country level is measured by the growth of total dividends for all companies in the country’s index. Trailing dividend growth measures the growth in total dividends over a trailing 12-month period. For the purpose of this research, forecasted dividend growth assumes that we know with perfect foresight dividends over the next 3 months. As an example of perfect foresight forecasted dividend growth, for the beginning of January 2009, growth of dividends is calculated as the changes in total 12-month trailing dividends at the end of March 2009 relative to the total 12-month dividends at the end of March 2008.
At the individual stock level, assuming the dividend is not raised or lowered, the yield will rise when the price of the stock falls, and it will fall when the price of the stock rises. Because dividend yields change with the stock price, it often looks unusually high for stocks that are falling quickly. This is also true at the country level. Dividend yields can be considered a value factor, like price-to-earnings and price-to-book. On the other hand, dividend growth can be considered a growth factor since growing dividends either for a company or at the country level can indicate growth in earnings as well as payouts in the form of dividends.
We tested dividend yield, trailing dividend growth, and forecasted dividend growth (1 quarter forward) as standalone investment factors within the Heckman Global Advisors (HGA) country allocation framework. The HGA framework forms portfolios by over or underweighting markets relative to their respective MSCI benchmarks according to how high they score on the investment factor that is being tested. Higher scores are given to higher dividend yields and higher dividend growth rates. Rebalancing is done at the end of each month, and returns adviser compared to those of the benchmark. We tested the efficacy of the factor within the MSCI AllCountry World (ACWI) universe.
The results of the analysis are below. Dividend yield, like most other value factors for allocating countries or individual equities, was an effective factor until 2008. Since 2009, dividend yield has not been effective. The same can be said for dividend growth based on trailing 12-month dividends. However, forecasted dividend growth (assuming perfect foresight in dividends over the next 3 months) has not only been strong before 2009 but has continued to add value for allocating markets since then. Dividend growth, especially if one can get some insight into next quarter’s dividends, seems to be strong growth factor for allocating global equities.
TABLE 1
Alpha of Dividend Yield, Trailing Dividend Growth, and Forecasted Dividend Growth
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss.Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
If the latest global shock from the Covid-19 virus pulls the US into a recession, what might happen to equity returns? For a historical perspective, we looked at price returns of the S&P 6 months before a recession, during a recession, and 6 months after a recession. The monthly return data starts with the recession in October 1873. The monthly returns are from the Schiller database which calculates stock price data as monthly averages of daily closing prices. The dates of recessions are from the National Bureau of Economic Research (NBER) which is an American research organization well known for providing start and end dates for recessions in the United States. From the NBER website, “the NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” Of course, in general, one does not know the exact dates a recession starts or ends until after it is over.
Below are the 3 graphs of the price returns of the S&P 6 months before a recession, during a recession, and 6 months after a recession.
Six months before a recession, the price returns have averaged -1.3% with the range being -19.3% to 20.4%. During a recession, the price returns have averaged -8.0% with the range being -79.3% (the Great Depression) to 31.0%. Six months after a recession, the price returns have average 14.9% with the range being -4.5% to 69.8%. As can be seen from the 3rd chart, six months after a recession have resulted in positive price returns for the investor in 27 of the 29 of times: hence, 93% of the time.
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
During the week of February 24th, there was over a week of broad, persistent selling in the global markets. Although we have not seen the coronavirus before and are not sure when it will be contained, we have seen such broad selling of the global markets from global shocks before.
A bear market is defined as market declines of at least 20%. During the steep declines during the week of February 24th, the return on the MSCI World Index did not fall into bear market territory but qualified as a market correction (down 10% or more). However, if the down draft continues into a bear market, it would be good to put bear markets into perspective. Since 1970 there have been 8 bear markets in the global marketplace. Below is a graph of the MSCI World Price Index from January 1970 through February 27, 2020. As can be seen on the graph, the last global bear market selloff was in May 2011 through September 2011(although during this episode the U.S. market did not go down 20%). This selling in the global markets was caused by anxiety that both Europe and the U.S were failing to fix their economic problems and the credit crisis was mounting in Europe.
During steep declines like the one which occurred during the week of February 24th, the investor needs to keep a level head. Since 1926, the S&P has returned 10.2%. Since the inception of the MSCI EAFE Index in January 1980, the MSCI EAFE Index has returned 9.3% as can be seen by the upward direction in the graph. This current market decline comes after the S&P Index returned 31% last year and MSCI EAFE returned 22.7% in 2019. It is very hard to time market corrections. It is even harder to time when to get back into a market after a correction or a bear market.
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
At the end of January 2020, the dividend yield of the US market* was 1.9%. This yield is currently higher than the 10-year Treasury yield of approximately 1.5%. Figure 1 shows the dividend yield of the US since the end of December 1969. It has been hovering around the 2.0% level since mid-2002. To put this yield in context, the average dividend yield of the US since December 1969 has been 3.0%. From mid-1974 through the end of 1985, the dividend yield tended to be in the 4% to 6% range. There were times when the US dividend yield went above 6.0%. For example, at the end of March 1980, it was 6.3%. However, from April 1980 on-ward, the dividend yield has been trending downward hitting low of 1.1% at the end of December 1999. During the Great Financial Crisis, the dividend yield rose to 3.3% (at the end of February 2009) due to the Bear Market decline, but by mid - 2009 the dividend yield was back down to the 2% level. The low dividend yield of the US has been partially caused by the long running US bull market, the high proportion of technology stocks in the US market, cash being used for stock buybacks, and low interest rates.
The dividend yield of the US can be contrasted with the dividend yield in the International markets. Since February 1973, the historical average of the dividend yield of the MSCI EAFE Index (developed markets, excluding the US and Canada) has been 2.9%, similar to the US historical average of 3.0%. However, early on, the average dividend yield of the MSCI EAFE Index was weighed down by the low dividend yield of the Japanese market during its bubble years and hoarding of cash by Japanese corporations. In order to show this, Figure 2 breaks out the dividend yields of the US, Japanese**, and German*** markets. It can be seen that the Japanese dividend yield was low during much of the Japanese market bubble. Since early 2008, it has been rising. In fact, as of the end of January 2020, the Japanese dividend yield of 2.3% has surpassed the US dividend yield. Since September 1995, the German dividend yield has been higher than the US dividend yield and is 3.0%.
We expect that the low dividend yield of the overall US market will continue although there are opportunities to choose stocks with higher dividend yields than the average. Overall, we also expect that the International markets will continue to offer opportunities for higher dividend yields.
*Based on MSCI US Index
**Based on MSCI Japan Index
***Based on MSCI German Index
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
Last year, much commentary was on Emerging Market equity and currency declines. The Federal Reserve raised rates four times in 2018. A stronger dollar increases the burden of servicing dollar-denominated debt for Emerging Market companies and sovereigns. As the global economic recovery became more extended, investors became increasingly focused on identifying credit problems that may derail the recovery.
So far in 2019 the commentary has changed. The U.S. Federal Reserve is on pause, and there is a growing consensus that it will start cutting rates. As a sign of less risk aversion towards Emerging Market, Emerging Market currencies and equities have been recovering.
Below is a chart of Emerging Market real effective exchange rates valuations (which take into account trading partners and the movement of currencies) during their trough in 2018 and currently in 2019. Emerging market currencies in countries with substantial vulnerabilities, such as Turkey, have strengthened substantially from their valuation troughs in 2018.
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss.Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
With 2Q earnings season underway in the U.S., the question arises as to what effect trade and the global slowdown are having on 3Q19 earnings.
Below are charts of 1-month upward company revisions (defined as number of companies with upward revisions divided by the total number of companies with upward and downward revisions) for the U.S., Japan, and Germany. All have been trending downward over the last year although earnings growth is still forecasted to be positive – around 4% globally for 2019.
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss.Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.
As the current bull market is now 93 months long (since 1970, the average bull market has lasted 56 months), the question naturally arises whether a market correction is due.
Putting this question in perspective, since 1970, there have been 8 “troughs” in the MSCI World Index returns (a “trough” being defined as market bottoms after declines of at least 20%). A majority of these troughs (5 out of the 8) have been associated with recessions (1973-1974. 1980-1982, 1990-1991, 2000-2001, 2008) and double-digit earnings declines.
Notice below the 5 market troughs that experienced associated recessions and double-digit earnings declines. Currently for 2019, global earnings are forecasted at 5% and GDP forecasts are 1.5% for developed markets and 3.4% for emerging markets. The conditions for a 20% decline in the global market do not seem baked in. This bull market could continue – assuming we do not experience any global shocks.
DISCLOSURE: The opinions expressed herein are those of DCM Advisors, LLC (“DCM”) and are subject to change without notice. This material is for informational purposes only and is not financial advice or an offer to sell any product. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. All investment strategies have the potential for profit or loss.Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. DCM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about DCM including its advisory services and fee schedule can be found in Form ADV Part 2, which is available upon request.