Indexology^® Blog

Ever since the Fed released its tsunami of credit, credit markets have rallied the most since the depth of the Global Financial Crisis. Continued central bank actions have driven the already existing trend toward demand for higher-yielding assets, helping companies issue debt with fewer lender safeguards and covenants. With the Fed willing to support the markets and be the buyer of last resort, credit spreads have tightened since March 2020.

The option-adjusted spread (OAS) of the S&P U.S. Investment Grade Corporate Bond Index and the S&P U.S. High Yield Corporate Bond Index reached a YTD peak on March 23, 2020, while returns hit a low on March 19. Leveraged loans’ spread to Libor, as measured by the S&P/LSTA Leveraged Loan Index, topped out at L+980 on March 20.

Multiple Fed actions aimed at calming the markets led to the continued tightening of credit spreads. Though YTD spreads are wider than the beginning of the year for all ratings categories, the indices are substantially tighter since March 31, 2020, and have continued to tighten month-to-date as seen in Exhibit 2. The BBB category and all the high-yield indices have tightened by 150 bps or more, with the riskiest and lowest-rated CCC+ & below having tightened by 353 bps. CCC loans are more than double the CCC+ & below high-yield bonds when it comes to the spread change since March 31, 2020.

Just over these past few days, spreads have generally reversed direction, heading wider. This may be the beginning of a key reversal in the past rally experienced over the past weeks. Investment-grade debt issuance has trailed off, and the messaging from the Fed and economist centers around weakness, unemployment (20.9 million at the end of May 2020), and the heightened possibility of an economic downturn just as cities and states struggle with the questions of how to open up from the quarantine.

Exhibit 6 shows the total rate of return performance for the investment-grade and high-yield indices and the rating and industry subindices.

Stock markets continue to rally globally, ascending a wall of poor economic data and significant negative sentiment.  Concern that current price levels are unjustifiable is widespread: 78% of respondents to the most recent Bank of America Global Fund Manager Survey believe that the market is overpriced, the highest level since the survey began in 1998.  Are current levels truly that far off base?

One response to this question is a relative one: with benchmark yields near all-time lows, the growth potential of equities has become more attractive.  Stocks are up, in other words, because rates are down.   This affirms financial theory: the lower the discount rate, the greater the present value of future earnings, and thus the greater value of company equity (all else equal).  And while individual company discount rates differ, the overall interest rate environment drives them all.

Growth’s outperformance of Value offers further support for a yield-based perspective on valuations.  Since July 6, 2007, when the 10 year U.S. Treasury closed at 5.19%, yields have plummeted, as has Value’s relative performance.  Valuations of growth stocks, by definition, rely on earnings projections in the distant future, which gives them a higher sensitivity to discount rates.  That Growth’s relative performance seems to be following U.S. Treasury yields offers another indication of the wider equity market’s current sensitivity to rates.

Stimulus efforts have also been fundamental to the recovery in equities.  In the U.S., the Federal Reserve’s balance , and is poised to continue to grow until the economy is firmly back on track.  Other central banks have taken a similar approach, including the Bank of Japan (BoJ), the European Central Bank (ECB), and the People’s Bank of China (PBoC).  Combined, those four central banks have added ~$4T to their balance sheets since the end of February; that’s more than Germany’s annual GDP.   These efforts have propped up the valuations of riskier assets, including stocks, by pushing investors up the risk curve in search of returns.

Central bank efforts have mitigated, but not erased, the impact of the global lockdown: historically weak data have poured in, highlighting the economic (and human) impact of the pandemic.  While troubling, these data are inherently backward looking; they highlight the past, in part because they are often reported with a significant lag. Equity valuations, on the other hand, are forward looking, attempting to encompass the value of all future cash streams generated by a business.  It is possible, in other words, to believe that the future is bright despite being surrounded by dismal current data.

Of course, current valuations are unlikely to be perfect.  Prices are generally wrong; they fluctuate more widely than the flow of new information would require.  More importantly, it is famously difficult to tell what the right price should be, and on what timescale the market might “correct.”  It’s arguable that declines in yields, coupled with fiscal and monetary stimulus, have produced a justifiable current valuation for the equity market.

The economic and societal effects of the COVID-19 pandemic accelerated secular trends that have been reshaping the commercial real estate industry for years. Core U.S. REIT sectors such as Retail, Office, and Residential, which once dominated the REIT landscape, have ceded ground to specialized REITs—particularly those owning data centers and cell towers. Industrial REITs have also increased in importance, supported by e-commerce growth.

As of Dec. 31, 2015, Data Center, Tower, and Industrial REITs (in aggregate) accounted for 17% of the Dow Jones Equity All REIT Index—a broad index covering U.S. equity REITs. By the end of 2019, their share of the index weight rose to 30%, and by the end of May 2020, these sectors represented more than 42%. Meanwhile, Retail REITs dropped from 19% to 5%.

The Retail sector, in particular, has been hampered by the growth of e-commerce, as demand for space in malls and shopping centers has diminished due to increased online shopping. One of the primary beneficiaries of this trend was Industrial REITs—many of which support logistics for e-commerce. Tower REITs benefited from strong demand for infrastructure to support growing wireless data usage, while Data Center REITs boomed from the growing need for high quality space to store servers and other computing equipment.

All these trends were sharply accelerated by the pandemic, which has driven a far larger share of economic activity online, spurring even greater demand for data centers, wireless communication, and industrial warehouses. Meanwhile, travel has come to a near standstill, leaving hotel occupancies at record lows. Companies are now rethinking how much office space they will need in the future, as remote working becomes more common, and retirees are rethinking the safety of living in retirement communities owned by Healthcare REITs.

These changes in sector leadership are also illustrated through the top constituents of the Dow Jones Equity All REIT Index. As of the end of May 2020, five of the six largest U.S. REITs were either Tower or Data Center REITs. Furthermore, Simon Property—the largest U.S. REIT for many years—no longer resides within the top 10. The industry has also become somewhat more concentrated over the years, spurring demand for capped versions of headline indices, such as the Dow Jones Equity All REIT Capped Index.

These transformations in the composition of the U.S. REIT market have, of course, been driven primarily by relative performance. Perhaps more than any other equities market sector, the dispersion of sub-sector returns within the Real Estate sector has been highly variable both in the short- and longer-term. As shown in Exhibit 3, Data Center and Tower REITs gained 20% and 18%, respectively, YTD through May 29, 2020, while Industrial REITs also posted positive returns. On the other hand, Retail and Hotels/Lodging dropped 51% and 48%, respectively.

These performance trends were remarkably similar directionally over the longer term. Between the end of 2015 and May 2020, Tower, Data Center, and Industrial REITs experienced cumulative gains in excess of 130%, while Retail and Hotels/Lodging declined sharply.

In our paper, Understanding REIT Sectors, published in January 2020, we highlighted how the U.S. REIT industry has expanded over the years beyond traditional property types to include a diverse set of companies driven by a wide range of underlying factors. The COVID-19 pandemic has shined a bright light on the evolution underway in the REIT industry.

I would like to extend a special thanks to Qing Li for her contribution to this blog.

The long-term impact of the COVID-19 pandemic on commodities markets is not yet known. There have undoubtedly been short-term impacts on supply and demand, ranging from a collapse in oil demand to supply disruptions at individual mines as a result of COVID-19 infections among mine employees.

The longer-term implications of these demand and supply shocks, while uncertain, will likely follow a well-trodden path that eventually leads to market equilibrium. What is less clear is the long-term impact on the commodity investment landscape. The negative price action in the WTI crude oil futures market in April 2020 may well force investors to rethink the standard narrative around investing in commodities.

For investors, it is extremely difficult to access the return streams of physical commodities traded in the spot market. The closest approximation is a strategy that invests in rolling front-month futures contracts. That is exactly what the S&P GSCI Crude Oil does. The headline S&P GSCI series of indices follows a rolling schedule that ensures that futures positions roll to the following month’s contract well before the expiration of the current contract. This ensures that investors do not hold any exposure as a futures contract enters expiration, which is particularly important for commodity futures that allow for physical settlement.

With that in mind, we examined the events that took place in the oil market in April and early May 2020. The S&P GSCI Crude Oil had already rolled into the June contract when the May WTI crude oil futures contract closed at USD -37.63 per barrel on the penultimate day of trading. The front-month rolling S&P DJI Commodities Indices that included WTI crude oil therefore did not directly contend with negative prices. Instead, they fell prey to the super contango in the WTI crude oil market.

When a futures curve is in contango, investors pay to roll futures contracts. Commonly referred to as a negative roll yield, contango results in a significant drag on index performance. Super contango occurs when the spot price for a commodity trades substantially below the futures price. Super contango usually occurs when storage space becomes scarce due to excess supply—meaning that the cost of carry (the cost of storing a physical commodity) increases. Exhibit 1 presents the impact of super contango on the WTI crude oil market by illustrating the difference in performance between the S&P GSCI Crude Oil spot return and the S&P GSCI Crude Oil Excess Return (ER) since the beginning of 2020.

The overarching lesson for investors from the oil market is that there are additional risks when investing in products that replicate price movements on a futures curve. The risk is particularly acute in extreme conditions when returns associated with the underlying product become magnified as futures prices react to market conditions.

In short, market participants need to be aware of the unique return streams associated with futures-based investment strategies, especially the investment implications of holding long-only commodity positions at the front of the futures curve during periods of extreme market stress.

The previous blog highlighted the significant shifts to passive investing in India. However, Indian passive trends have continued to favor plain vanilla indices due to their ease of understanding, rather than exploring alternative thematic indices, such as the S&P Kensho New Economies Indices or factor Indices. However, once the acceptability and acceptance of passive investment grows, the need for variety will arise. The simple progression would be toward factor play initially.

The month-end statistics for May 2020 revealed the parity of global and Indian markets in the quality factor. Companies with low leverage and high returns on equity have rewarded the quality factor. The S&P BSE Quality Index gained 2% in May 2020 and outperformed the S&P BSE SENSEX by 11%. The U.S., European, and Australian markets witnessed the same monthly trends (see Exhibit 1).

Taking a long-term perspective on any investment strategy is essential, including passive strategies. Exhibit 2 shows that market cycles over different time periods reflected different performance results for the quality factor, however, it was the long-term winner.

There is a need for more education and investor awareness on the benefits of passive investing. It is important that investors understand that passive investing involves an investment strategy that tracks or mimics an index. The advantages of diversification, low concentration risk, transparency, and lower costs strengthen the case for choosing this option. Index-based investing makes it easy for those who are not actively tracking markets by allowing them index-based returns.

Historically, Indian markets have been a pure active investing play in which funds were deployed by active fund managers in various strategies. With the dawn of passive investing, the value of low-cost indices with no active bias, consistent methodologies, and transparent rules started gaining attention. The SPIVA® (S&P Dow Jones Indices versus Active) India Scorecard added some more conviction to the passive claims. The SPIVA India Scorecard, which was first published in 2013, has laid witness to the fact that benchmarks have outperformed active funds. One such example has been the large-cap space that has witnessed a consistent 50% and above outperformance of benchmarks over active funds in the 5-year and 10-year investment horizons.[1]

The Indian passive wave has received the necessary nudge by initiatives from the Indian government, be it the Employees Provident Fund allocations to exchange-traded fund (ETFs) in benchmark indices, the disinvestment program being mobilized via the ETF route, or encouraging retail participation in fixed income via passive strategies. These initiatives have provided the necessary impetus to the passive market in India to gather more participation from product issuers and investors. While it is still early days for a wider selection and more innovative products, this is a great beginning to an optimistic growth trajectory for the Indian passive market.

[1] SPIVA India Year-End 2019 Scorecard.