Monday April 17

Stocks rose today to start the week off in positive territory after a disappointing week last week. The S&P 500 and the Dow Jones each rose 0.9% to 2,349 and 20,636 respectively. The KBW Bank index rose 1.9% and utilities rose 0.4%. Contributing to optimism today was data that showed that GDP in China grew 6.9% annually in the first quarter which was better than expected. Additionally data from Friday showed that CPI fell 0.3% on the month bringing the yearly change to 2.6% which was lower than estimates. Core numbers missed estimates as well. Retail sales data also missed expectations falling 0.2% on the month. It expected that earnings this season will be led by information technology and energy, and that companies with more global exposure will do better. Treasuries were little changed today as the flight to quality showed some slight signs of reversing. The two year Treasury yield fell 1bp to 1.20%. The ten year Treasury yield rose 1bp to 2.25%. The dollar was mixed on the day against peers. USD fell 0.3% against EUR to $1.0647. USD rose 0.3% against JPY to Y108.97. USD fell 0.3% against GBP to $1.2567. The Turkish lira appreciated 1.1% to TLR 3.667 after earlier rising as high as 2.9%. Oil prices were lower with WTI falling 1% to $52.67 and Brent falling 0.9% to $55.40.

The Fed is in the process of figuring out how it is going to unwind its balance sheet. That will provide more clarity to investors and have broad implications on Treasury markets, MBS markets, and asset allocation in general. The size of the Fed’s balance sheet ties into monetary policy accommodation for the economy, and given that the economy is on stable footing the Fed doesn’t need to provide as much accommodation. The Fed has identified late 2017 or early 2018 as the time to begin unwinding the balance sheet. The balance sheet has ballooned in size from less than $1tn in early 2009 to as much as $4.2tn currently. Based off of a paper that the Fed released in January the Fed could begin unwinding the balance sheet by reducing Treasuries at a faster rate than MBS with a terminal size of around $2.5tn not reached until the early 2020s. The reason the Fed’s total balance sheet size will have increased compared to pre-crisis levels is because the money supply, which is the liability for the Fed, has increased as well. By decreasing the average maturity of its assets the Fed has already been reducing some of the support for markets. Long maturity bonds provide more support to financial markets/ the economy since they are riskier assets and more risk assets price to long maturity Treasuries. At the end of 2013 the Fed held $750bn in Treasuries with maturities between 7 and 10 years which has fallen to $200bn by the end of 2016. That is set to decrease by half by the end of 2017.

Calpers is reconsidering its private equity allocations given all the fees it pays to the asset class. Calpers is the largest pension fund in the United States and currently manages $315bn in retirement plan assets. Of that total around $25bn is allocated to private equity. Last year Calpers announced that it was going to review its private equity allocations given that it wasn’t accurately able to track the fees it was being charged. At the same time it reduced the number of managers it allocated to by 66%. In 2012 Calpers allocated more than 14% of its portfolio to private equity however that has consistently been on the downward trajectory to around 9% currently. Fees are a big driver of this. Private equity has returned 12.3% for Calpers which is a large number. However gross of fees its returns would have been 19.3% according to data from Calpers due to 7% it paid in fees. That compares to fees in the low tens of basis points it paid for public equity and fixed income portfolios. Since 1990 Calpers has paid $3.4bn in performance fees to private equity firms. To prevent this Calpers is considering increasing their use of customized accounts which function similarly to an SMA. That would allow Calpers to work alongside PE managers but be the sole investor in its investment. Another option would be to acquire a private equity firm and have it operate internally.

One emerging market bond ETF is highlighting some of the downsides of all passive investing and how it might not be useful for every asset class. Emerging market bonds are far less liquid than an asset class like large cap US stocks, and the transaction costs are higher. That leads to more tracking error for EM ETFs compared to their benchmarks. That makes it more advantageous for active managers in this space. Fund flows to ETFs have lagged fund flows to active funds consistently since 2010 and active funds have also boasted higher performance over the last year and YTD. The largest emerging market bond ETF, managed by JP Morgan has lagged its benchmark by 4.92% over the last year due to the factors that make emerging market fixed income a harder asset class to make passive. Emerging market bond ETFs tend to hold only the most liquid names in the universe which comes at a premium for investors.

High demand for risky bonds in China persists in spite of efforts from regulators to control excessive speculation in the space. China has been trying to open up its capital markets to international investors however it is still underdeveloped by international standards due to a lack of a sufficient credit rating system as well as persistent mispricing of risk. To exemplify the latter risky debt has been outperforming recently even as defaults are expected to tick up. The spread between AA and AAA bonds in China is now just 49bp which is the lowest on record and down 40bp from last July. AA rated bonds in China covers a wide variety of issuers and is not comparable to the rating scale in the U.S. The PBoC has tried to curb such speculation by reducing the supply of loans made available to banks and by raising the cost of such short term loans. Tightening conditions has led to much less issuance but so far it hasn’t reduced the appetite for credit from investors. Given low new issue supply what is already existing becomes even more desirable. Companies are going to be under a lot of pressure later in the year to refinance existing debt given that 3.79tn yuan in bonds is set to expire this year. There’s been no improvement in credit fundamentals that justifies the tightening spreads, and if anything conditions have deteriorated. The demand for credit is also due to WMPs. Fundamentals are deteriorating as already 8 companies have defaulted this year compared to last year’s total of 16. Analyst anticipate that defaults this year will outpace last year’s total.

Monday April 17

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