Over the past year bond market liquidity—the ability to quickly redeem an asset for cash without moving the price much—has gone from an obscure, seldom-mentioned topic to one of the financial press’s favorite fears. Worries centered on high-yield exchange-traded funds (ETFs), with pundits and prominent investors frequently warning they operate on the illusion of liquidity. We’ve addressed this issue several times on MarketMinder (here, here and here). I won’t rehash those points in full, but for a quick refresher, regulatory changes made bond dealers less willing to hold large inventories and act as intermediaries. This, pundits theorize, makes bonds less liquid. Compounding the issue is the increased use of ETFs that promise equity-like liquidity but are backed by much less liquid bonds. This “mismatch” is the alleged liquidity illusion, and many claim a high-yield selloff and the accompanying high volumes will reveal a rough reality: that investors can’t redeem quickly without accepting dramatically lower prices. Yet despite a deep correction and record volumes in high-yield ETFs in 2015, we’ve seen no signs of liquidity issues. High-yield ETFs’ liquidity isn’t an illusion. These fears miss ETFs’ ability to create very real liquidity of their own.
To better understand why these liquidity concerns are false, let’s first consider bond ETFs’ size relative to their underlying benchmarks. High-yield ETFs are a fairly new investment tool—the first launched in 2007. Since then, they have gained popularity and, as of November, had over $42 billion in assets.[i] Yet despite the rise in high-yield ETF assets, they represent only a small portion of the US dollar-denominated high-yield market. In other words these ETFs are too small to dictate what happens to the overall index—it’s the other way around.
Exhibit 1: Total Value of High-Yield ETF Assets as a Percentage of High-Yield Index Market Value
Pundits have taken to calling the Bank of Japan’s latest policy trick—negative interest rates on central bank deposits—a Jedi Mind Trick. But BoJ Governor Haruhiko Kuroda seems to have a different pop cultural inspiration when he stated last year: “I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘the moment you doubt whether you can fly, you cease forever to be able to do it.’ Yes, what we need is a positive attitude and conviction. Indeed, each time central banks have been confronted with a wide range of problems, they have overcome the problems by conceiving new solutions.”
Trouble is, in Peter Pan, flying also required magic fairy dust, and neither quantitative easing (QE) nor negative interest rates qualify. They’re more like forcing banks to walk the plank.
The BoJ’s massive QE program, now coupled with negative interest rates on new excess reserves, has pushed Japanese yields negative all the way out to 10-year maturities. Negative yields are intended to make Japanese Government Bonds (JGBs) unattractive—effectively a “tax” on savers (lenders)—promoting consumption or investment in higher yielding or riskier assets. Yet in the short term, it has done the opposite.
Stop me if you’ve heard this one: China is slowing, and that spells trouble for the world economy. I’m going to go ahead and presume the vast, vast, majority of readers are familiar: A slowdown in Chinese economic activity has been feared for years and was an enduring concern in 2015. Investor anxiety surrounding the world’s second-largest economy was widely blamed for a mid-year global equity market correction. But in an interesting twist, while China slowed, the eurozone—which many consider an economic quagmire to this day—sped. And, given the eurozone’s larger aggregate GDP, the acceleration has more than made up for a slower China in the last two years.
Fears of a seemingly unending European malaise the last several years suddenly faded this summer as China’s fast growth slowed. Facts were inconvenient— it didn’t seem to matter much that:
1. The slowing was largely government-orchestrated and has been occurring for years.
Editors’ Note: Our discussion of politics is focused purely on potential market impact and is designed to be nonpartisan. Stocks don’t favor any party, and partisan ideology invites bias—dangerous in investing.
Are drug prices running rampant? After The New York Times reported on Sunday that a small private Pharmaceuticals firm, Turing Pharmaceuticals, jacked up the price of a 62-year-old drug by 5,000-ish percent, that question has sparked a media firestorm.[i] Monday, partly in reaction to the news, Democratic Presidential front-runner Hillary Clinton fueled further debate by vowing to “deal with skyrocketing out-of-pocket health costs and particularly, runaway prescription drug prices.” All week, media articles aplenty have focused on the issue and wondered whether Federal price controls are necessary to put a lid on the rise. But whatever your opinion of the sociological merits of this plan or drug prices, price controls in general have a long history of causing more harmful unintended consequences—including dinging stock prices—than any positive they may bring. That being said, pharmaceutical price controls seem unlikely to come to fruition any time soon.
For those interested in the details of Mrs. Clinton’s plan, here are the major proposals:
Market liquidity is usually a pretty banal subject, garnering little attention. But in the last year, it has gone from being a dry afterthought to being the subject of frequent articles claiming it’s a major concern, particularly in the bond markets. So much so, that Bloomberg’s Matt Levine had a running section of his daily link wrap titled, “People Are Worried About Bond Market Liquidity” for months and rarely ran low on articles to share. It is now bigger news when there aren’t “People Worried About Bond Market Liquidity!” So what is market liquidity, and are the recent fears justified—or overblown?
Market liquidity refers to how easily an asset can be bought or sold without dramatically impacting the price or incurring large costs. It’s a defining feature separating asset classes, a key consideration for investors. Some financial assets, like listed stocks, are easy to buy or sell with little price impact and small commissions—they’re “liquid.” Conversely, commercial real estate takes time to sell and likely includes high commissions and significant negotiations—it is “illiquid.” For most investors, particularly those with potential cash flow needs, liquidity is an important facet of any investment strategy.
Bonds are among the more liquid investments available for investors, though liquidity varies among different types. Treasurys, among the deepest markets in the world, are highly liquid. Corporates and municipals are less so, and some fancier debt is actually quite illiquid.
Flags fly in front of the Parthenon in Athens. Photo by Bloomberg/Getty Images.
After five years of Greek crisis, two defaults and going-on three bailouts, many still fear a contagion across the eurozone. While default and “Grexit” risk persist, the risk of a contagion has fallen significantly over the last few years. The eurozone economy is improving, foreign banks hold less Greek debt, bank deposits aren’t fleeing other peripheral nations, and euroskeptic parties poll well behind traditional parties across the eurozone. Greece’s problems are contained and shouldn’t put the broader eurozone at risk.
|By Fisher Investments Editorial Staff, 03/27/2015|
In Friday’s third revision to Q4 US GDP growth, one thing that seemed to catch a few eyeballs was a drop in US Corporate Profits[i], which some hyperbolically labeled “the worst news.” Others claim a “profit recession”—whatever that means—looms. But here is the thing: A down quarter for corporate profits is not unusual amid a bull market. Here are two charts to illustrate the point. The first shows the Bureau of Economic Analysis’ measure of corporate profits excluding depreciation. The second includes depreciation. The gray bars indicate bear markets and the blue dots denote a negative quarter of profits in a bull market. As you can see, such dips aren’t exactly rare and occur at random points throughout a bull market and expansion.
Exhibit 1: US Corporate Profits After Tax Without Inventory Valuation and Capital Cost Adjustment
Thursday marked the beginning three days of voting across the 28 EU nations in the first European Parliamentary (EP) elections since 2009. Also, the first pan-EU elections since the eurozone’s debt crisis and 18-month long recession that ended in mid-2013. When the polls close, voters are expected to add more euroskeptics—members of parties favoring less federalism and, in some cases, leaving the euro. With euro jitters still lingering in the background, some suspect this will rekindle breakup fears anew. However, polls suggest euroskeptics gain some ground but fail to shift power away from more traditional European political parties. The movement toward a more integrated Europe likely continues and, with it, support for the common currency likely remains strong. Should polls hold true, the biggest influence I believe the euroskeptics may have is pressuring the pro-euro groups on economic policy.
European Union Government
European Council: Heads of each EU member state with no formal legislative power. The Council defines general EU political directions (and addresses crises).
European Commission (EC): Executive body of the EU, consisting of a President (elected by the European Parliament) and 27 commissioners selected by the European Council and the EU President. They are responsible for proposing legislation, implementing decisions and addressing day-to-day EU operations.
European Parliament (EP): Directly elected legislative body of the European Union (five-year terms). The EP is an approval body. They do not initiate legislation, instead voting on and amending European Commission proposals. The EP directly elects the European Commission President and confirms the European Commission after its formation.
There will be slight structural differences in Parliament, regardless of the voting. Between 2009’s election and this year’s, the EU ratified the Lisbon Treaty, altering the structure of the body, modestly reducing the influence of larger nations like Germany. The EP will consist of 751 seats, 15 fewer than before. Representation will still be based on population, but with certain caveats. The Lisbon Treaty caps each member state at a maximum of 96 and mandates a minimum of six seats to all. This will automatically reduce Germany’s standing from the present Parliament and slightly boost the power of small EU nations. However, national distribution isn’t really at issue in the race. It’s much more about pro-euro versus euroskeptic.
|By Christo Barker, 03/28/2014|
It seems the IRS is going global, a development that has some pundits up in arms about potential stock market impact. The Foreign Account Tax Compliance Act (FATCA) is what I’m referring to. Under FATCA, the IRS is moving toward taxing US citizens’ offshore financial activity, including money held in banks abroad—effectively eliminating “tax havens” for US citizens. US expatriates and foreign banks are up in arms. The law conflicts with local banking laws in other countries, and banks have responded by simply slashing access to banking services for Americans living abroad. But while it creates hassles, barring a big international regulatory blowback, the law doesn’t seem poised to create many ripples for stocks.
FATCA, now four years old, was conjured following a 2009 scandal, which revealed a major Swiss bank was helping well-to-do Americans dodge taxes. The backlash against the scandal peaked in 2010, when Congress passed FATCA as a provision of HR 2847, the Hiring Incentives to Restore Employment Act. An effort to boost US government tax revenue by broadening the base, FATCA also has some grassroots appeal as it carries the label of reducing tax dodging. FATCA was supposedly a means to get fatcats to pay their fair share. (My apologies for the pun.) Foreign banks were also not the most popular group in the immediate aftermath of the Global Financial Crisis.
Initially, FATCA seeks to provide the IRS information about US citizens’ and green card holders’ taxable accounts exceeding $50,000 in market value held at foreign financial institutions. International banks (Foreign Financial Institutions or FFIs) are required to ink a special deal with the IRS, under which they report all US taxpayers’ qualifying accounts and holdings. Account disclosure began January 1, 2014. After June 30, 2014, foreign banks will have to provide details regarding investment account holdings, and by January 1, 2015, FATCA’s full implementation will install a 30% withholding on US sourced income (salary/capital gains/interest/dividends).
|By Fisher Investments Research Staff, 12/10/2013|
In its second release, Q3 US GDP was revised up to a seasonally adjusted annual rate of 3.6%—the fastest growth in more than a year and among the quickest rates in the current expansion to date. However, most economists and pundits greeted the acceleration with a resounding thud. Under the hood, they claim, the data were not so hot. Reason being, the most notable contributor to growth was increasing inventories, adding 1.7 percentage points to the headline number. Some posit this means growth is hollow—after all, inventory change is open to interpretation. It could be due to slowing sales, a potential negative for profits and growth ahead. Or due to inventory build ahead of an expected pick-up in sales this holiday season. If the pessimists are right, one would expect wholesale inventory growth to sharply slow as we enter Q4. Yet Tuesday, the first inventory report of the quarter suggested no such thing: US wholesale inventories grew at their fastest clip in two years.
In October, wholesale inventories grew 1.4% m/m (3.3% y/y) vs. estimates of 0.3%. Both durables and non-durables stockpiles grew (0.4% m/m and 3.0% m/m, respectively.) So what gives?
While inventory growth undoubtedly contributed strongly to GDP in Q3, that never meant inventories were at historically high levels. As Exhibit 1 shows, the inventory-to-sales ratio isn’t overall elevated. Total goods and non-durable goods are at relatively low levels compared to history, and while durable goods inventories are somewhat higher relative to sales, they are not alarmingly high. In short, there is nothing suggesting inventory growth is unsustainable overall relative to the pace of sales. Of course, maybe inventory growth does slow in the period ahead, but it wouldn’t seem to be related to overall overstocked shelves. This is yet another factor illustrating the fact reality may be considerably better than skeptics presume.
Five years ago, on Black Friday 2008, quantitative easing (QE) was born. In its quest to battle the deflationary effects of the financial panic, the Fed launched the “extraordinary” policy of buying long-term assets from banks. In exchange, the Fed credited banks’ reserve accounts, believing the banks would lend off these reserves many times over—a big money supply increase to boost growth.
To date, through multiple rounds of (now infinite) QE, the monetary base (M0) has swelled by nearly $3 trillion. Yet this economic expansion has been the slowest in post-war history.
Exhibit 1: Cumulative GDP Growth
Is the UK housing market overheating, or is it merely the latest example of froth fears that are detached from reality?
Recent home price data and the UK’s Help to Buy scheme’s early expansion already have some UK politicians and business leaders wondering—some going as far as calling for the Bank of England to cap rising home prices. Taking a deeper look, however, I see a different story: Rapid housing price gains have been concentrated in London. Restricting overall UK housing with more legislation likely won’t fix that, and it probably won’t help spread London’s gains to UK housing elsewhere. More importantly, the fact UK housing gains aren’t widespread tells me a nationwide bubble neither exists nor is particularly probable—even with an expanded Help to Buy program.
While UK housing started slowly improving after Help to Buy began in April, the program has only been lightly used in the early going—suggesting the housing recovery is coming from strengthening underlying fundamentals and isn’t purely scheme-driven. In Help to Buy’s first phase, the government promised to lend up to 20% of a home’s value at rock bottom rates (interest free for five years, 1.75% interest after) to buyers with a 5% down payment—providing up to £3.5 billion in total loans. Only first-home buyers (of any income strata) seeking newly built houses valued at £600k or less could participate. The Treasury began a second (earlier-than-expected) iteration in October, in which it guarantees 20% of the total loan to lenders, instead of lending directly to the buyer. The program was also expanded another £12 billion for buyers purchasing any home (new or not).
|By Fisher Investments Research Staff, 11/26/2013|
With interest rates on everything from savings accounts to junk bonds at or near generational lows, many income-seeking investors are looking for creative or, to some, exotic means of generating cash flow. Some are turning to a relatively little-known type of security—master limited partnerships (MLPs). MLPs may attract investors for a number of reasons: their high dividend yields and tax incentives, to name a couple. But, like all investments, MLPs have pros and cons, which are crucial to understand if you’re considering investing in them.
MLPs were created in the 1980s by a Congress hoping to generate more interest in energy infrastructure investment. The aim was to create a security with limited partnership-like tax benefits, but publicly traded—bringing more liquidity and fewer restrictions and thus, ideally, more investors. Currently, only select types of companies are allowed to form MLPs—primarily in energy transportation (e.g., oil pipelines and similar energy infrastructure).
To mitigate their tax liability, MLPs distribute 90% of their profits to their investors—or unit holders—through periodic income distributions, much like dividend payments. And, because there is no initial loss of capital to taxes, MLPs can offer relatively high yields, usually around 6-7%. Unit holders receive a tax benefit, too: Much of the dividend payment is treated as a return of capital—how much is determined by the distributable cash flow (DCF) from the MLP’s underlying venture (e.g., the oil pipeline).
When the Fed kept quantitative easing (QE) in place last week, US investors weren’t the only ones (wrongly) breathing a sigh of relief. Taper terror is fully global! In Emerging Markets (EM), many believe QE tapering will cause foreign capital to retreat. Some EM currencies took it on the chin as taper talk swirled over the summer, and many believe this is evidence of their vulnerability—with India the prime example as its rupee fell over 20% against the dollar at one point. Yet while taper jitters perhaps contributed to the volatility, evidence suggests India’s troubles are tied more to long-running structural issues and seemingly erratic monetary policy—and suggests EM taper fears are as false as their US counterparts.
The claim QE is propping up asset prices implies there is some sort of overinflated disconnect between Emerging Markets assets and fundamentals—a mini-bubble. Yet this is far removed from reality—not what you’d expect if QE were a significant positive driver. Additionally, the thesis assumes money from rounds two, three and infinity of QE has flooded into the developing world—and flows more with each round of monthly Fed bond purchases. As Exhibit 1 shows, however, foreign EM equity inflows were strongest in 2009 as investors reversed their 2008 panic-driven retreat. Flows eased off during 2010 and have been rather weak—and often negative—since 2011.
Exhibit 1: Emerging Markets Foreign Equity Inflows
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Longstanding fears surrounding high-yield bond ETF liquidity are detached from the data.
The Bank of Japan’s latest attempt at stimulus probably won’t do much.
Slowing Chinese economic growth is being offset by an ignored-but-accelerating eurozone.
Capping prescription drug prices would be a negative for the industry, but even if the idea became legislation, it isn’t likely to pass through the political gauntlet.
Bond market liquidity is a hot topic, but fears seem overblown.
Market Wrap-Up, Thursday, February 11, 2016
Below is a market summary as of market close Thursday, February 11, 2016:
- Global Equities: MSCI World (-1.2%)
- US Equities: S&P 500 (-1.2%)
- UK Equities: MSCI UK (-2.4%)
- Best Country: Australia (+0.8%)
- Worst Country: Italy (-4.6%)
- Best Sector: Consumer Discretionary (-0.2%)
- Worst Sector: Financials (-2.6%)
Bond Yields: 10-year US Treasury yields fell -0.01 percentage point to 1.66%.
Editors' Note: Tracking Stock and Bond Indexes
Source: Factset. Unless otherwise specified, all country returns are based on the MSCI index in US dollars for the country or region and include net dividends. Sector returns are the MSCI World constituent sectors in USD including net dividends.