Tuesday November 22

Stocks rose as indices continued to meet new records. The S&P 500 rose 0.2% to 2,202 and the Dow Jones added 0.4% to 19,023. Utilities and financials both rose roughly in line with markets. Modest increases in the dollar, easing Treasury yields, and firm oil prices all contributed to the optimistic tone in equities today. On that backdrop the 2 year Treasury yield was unchanged at 1.08% and the 10 year fell 1bp to 2.31%. 2yr vs 10yr flattened to 1.23%. The Dow Jones, the S&P 500, Nasdaq, and Russell 2k all hit record highs. The US dollar was modestly stronger against peers. USD rose fractionally against EUR to $1.0629. USD rose 0.2% against JPY to Y111.06. USD rose 0.6% against GBP to $1.242. The market for Fed funds futures continues to reflect a 94% chance of higher rates in December. WTI fell 0.6% to $47.93 while Brent rose 0.3% to $49.02.

Investors are positioning their portfolios to profit in the event of rising interest rates. Short positions in eurodollar futures hit $2.1tn last week which passes the record that was previously set in 2014. This a function of both expectations of the Trump presidency as well as expectations that the Fed will raise interest rates in December. It goes to show how quickly expectations can shift in financial markets. In the summer there was significant downward pressure on US interest rates and it was hard to imagine a scenario where interest rates were trending upward. Now the opposite is true just months later. The market for Fed funds futures is currently pricing in a 95% chance of higher rates in December, compared to just 12% in June after the Brexit. For 2017 investor expectations are roughly in line with the Fed’s in anticipation of two rate hikes next year.

The ECB is buying significant amounts of eurozone corporate bonds however companies appear to be taking the liquidity and not using it. The ECB has bought around $46.9bn in corporate bonds over the last five months, which has spurred issuance across Europe. The central bank hopes to stimulate growth, corporate spending, and corporate investment. However companies don’t see many opportunities for growth and investment and as a result aren’t efficiently using the money. The head of European credit strategy at Citi has said they don’t see the effects of corporate bond buying. However it may take a little longer to spill over into the economy. Companies have been saving the excess liquidity, as data has shown that Eurozone corporate savings is at the highest level in at least 22 years. Nonfinancial companies are sitting on $315bn in excess savings relative to their trailing 12 month spendings. For US companies that number is just $43bn. While US companies took liquidity from the Fed to invest in share repurchases that same trend has not migrated towards Europe. Companies have simply been putting money in the bank in spite of the fact that rates are either zero or negative. Capital expenditures and merger & acquisition activity is also low. Corporate bond issuance in the Eurozone has hit a record high since the euro’s inception in 1999. The ECB has said that it believes that the decrease in corporate spending is a function of economic uncertainty and the possibility for more protectionist attitudes around the world.

Profitability for emerging market countries is starting to improve after a prolonged period of deterioration. Emerging market profitability fell to just over 6% earlier this year, relative to 8.8% for developed markets. Before the financial crisis profit margins for emerging markets were significantly higher than those in developed markets hovering just below 10%. Post financial crisis that trend switched over and emerging market profits started to dramatically underperform developed market counterparts in 2011. However profitability growth in emerging markets has started to turn positive in the second half of 2016. Emerging market companies are now looking to more actively cut costs and manage their bottom line, whereas before they were able to rely on steady top line growth. Similarly as the commodity slowdown shows signs of easing that would also put upward pressure on emerging market profitability. Similarly Brazil and Russia are both in the process of coming out of recessions. With wages rising in the United States, profitability of US companies may start to shift lower. However emerging market profitability faces headwinds too, such as more protectionist attitudes that are taking place in developed markets.

Virtu Financial is one of the leading market makers in ETFs, and recently published a letter sent to the SEC urging it to look into some operational risks in that market. Virtu suggests that large inflows and growth into ETFs have outpaced operational improvements in the sector which poses risks for the company and its customers. In order to effectively make markets in ETFs, it relies on efficient communication and reporting when creation and redemption of ETF shares, and the NAV of funds. This becomes especially difficult close to market close, and Virtu must pass on those risks to customers in the form of a higher bid ask spread. Communication regarding creation, redemptions, and reporting of NAV is oftentimes reported through email, on portals, or over the phone. This creates a slow flow of information that presents operational risk for investors. The SEC also has discussed limiting derivative use within ETF structures. It would limit derivative exposure to 150% of total assets within the fund or 300% if it was for hedging purposes.

Tuesday November 22

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