Week in Review
Global equities trudged higher last week, led by emerging markets. Strength in the price of oil helped to stabilize commodity-producing emerging economies, and speculation of future easing from the People’s Bank of China contributed to explosive moves in Chinese equities. European and Japanese equities hit 15-year highs, and international markets continued to outpace the U.S.
Bonds felt the ramifications from higher stock prices, even as Federal Reserve minutes indicated no apparent hurry to raise rates. Following last week’s disappointing U.S. payrolls report, the Job Openings and Labor Turnover Survey (JOLTS) indicated the highest number of openings in 14 years – apparently these openings just aren’t being filled yet.
In corporate activity, Royal Dutch Shell oil agreed to buy BG Group in one of the largest oil and gas acquisitions in history. Industrial giant GE will sell off its GE Capital division and exit the finance business. Interestingly, GE Capital on its own would be the seventh largest bank in the country. Alcoa kicked off first quarter earnings season with strong results. The bulk of corporate earnings will be released in the weeks to come, with a number of large banks due to report this week.
Last summer, we set the stage for the possibility of fireworks in the Chinese equity markets. Well, the fireworks are certainly going off now. Chinese equity markets have soared nearly 20% year-to-date and over 8% in just the last week! It is worth exploring some of the nuances of the often misunderstood Chinese markets, and whether this recent price action is sustainable.
Chinese equities are listed on several exchanges around the world. Shares listed in Hong Kong or here in the U.S., as well as futures contracts traded in Singapore and Hong Kong, have all been accessible to foreign investors for a long time. Mainland Chinese equities, or A-shares, have only recently become available to foreign investors through a quota system of a specific amount of Chinese renminbi per day. The only investors who can access this system are a specific list of qualified institutions. Last year, a new program was launched – Hong Kong-Shanghai Stock Connect (or Link) Program – that allows for trading between mainland Chinese equities and qualified institutions in Hong Kong.
Several (genius) ETF sponsors have teamed up with these qualified institutions in Hong Kong to create ETFs that allow access to the previously inaccessible A-share (mainland) market. These have been met with great success. The “northbound” quota, or amount investable from Hong Kong to Shanghai on a daily basis, has been exhausted numerous times. However, on April 1, the Chinese government allowed for mainland retail investors (mutual funds) to invest in Hong Kong shares (“southbound”). This has led to a spur of buying lately that has helped to bring the two markets closer together, as the flow of money into the A-share market has led to a large premium. Basically, we have seen traditional Chinese ETFs outperform the A-share Chinese ETFs for the first time in a while.
What does all this mean? First, the efficient flow of capital into and out of countries separates developed from emerging markets. As the Chinese move closer to open investment, their markets will become more efficient. The recent massive run-up in mainland Chinese shares lately has happened before, and history shows it should be monitored carefully but may also have a long way to go. Fundamentally, Chinese equities are still some of the most undervalued in the world. The government has chosen to fight corruption and liberalize the financial system in lieu of wide-scale monetary stimulus, a longer-term positive for the economy. The demographic situation in China (and most emerging markets) is also much more supportive of long-term economic growth, especially relative to developed economies.
Last week’s announcement of Royal Dutch Shell purchasing BG Group was the largest merger and acquisition (M&A) deal year-to-date, even larger than Berkshire and 3G’s Heinz-Kraft merger. March marked one of the largest months for M&A activity in several years, following last year, which was one of the largest years for activity in recent history.
Increasing M&A activity is generally a sign that the business cycle is maturing. This is to be expected, as we have been in a recovery, albeit a slow one, for nearly six years. The absolute level of total deal volume is at noticeably higher levels, which some point to as being an ominous sign of a top. However, it is worth noting that as a percentage of GDP, the current level of M&A is well below past peaks, and as a percentage of corporate profits, the current level is nowhere near historical peaks.
Perhaps most importantly, nearly 54% of deals in the past 12 months have been done using cash, while only 8% have been done with stock. A boom in deals where companies are exchanging their stock for another company’s is typically a euphoric sign of “deal mania,” which we luckily have not seen. The current M&A boom is a positive use of the swelling corporate cash pile that has been devoted to buybacks or trapped overseas for years.
For the end investor, corporate M&A activity can be constructive for specific sectors involved in large deals. We’ve seen large acquisitions in consumer staples, energy, health care, and technology – all areas in which CLS has an emphasis. There are also now alternative ETFs focused on merger arbitrage, which can profit from large M&A activity and do so in a risk-managed way.
As CIO Rusty Vanneman, alluded to last week in his Monthly Market Review, momentum is the idea that an investment that has performed well recently will continue to do so. Momentum is considered a “factor” of returns, similar to value, low volatility, size, and so forth. MSCI’s definition of a factor is a characteristic that relates a set of securities and is important in determining their risk and return.
Momentum is measured using a variety of time frames, the most common being 3-, 6-, and 12-month returns. Often, these returns will subtract out the most recent month’s return. This is done to minimize month-over-month reversion, or a more technical term – “flip-flopping.”
One way to view momentum is as something to be respected. Investing on momentum alone can lead to some sharp drawdowns, but recognizing and harnessing momentum (or the lack thereof) can be important for portfolios. At CLS, we have several tools dedicated to identifying whether a security is exhibiting strong momentum or vice versa. When we review ETFs, we examine momentum statistics for each one. We review charts that show out/underperformance of several hundred asset classes versus appropriate benchmarks.
CLS is not affiliated with any of the companies listed above. While some CLS portfolios may contain one or more of the specific ETFs mentioned, CLS is not making any comment as to the suitability of these, or any investment product for use in any portfolio. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing.
The S&P 500® Index is an unmanaged composite of 500-large capitalization companies. This index is widely used by professional investors as a performance benchmark for large cap stocks. The Russell 3000 Index is an unmanaged index considered representative of the U.S. stock market. The index is composed of the 3,000 largest U.S. stocks. The Russell 2000® is an index comprised of the 2,000 smallest companies on the Russell 3000 list and offers investors access to small-cap companies. It is a widely recognized indicator of small capitalization company performance. The iShares MSCI Emerging Markets ETF is an exchange traded fund which seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of publicly traded securities in emerging markets, as represented by the MSCI Emerging Markets Index. The MSCI EAFE International Index is a composite index which tracks performance of international equity securities in 21 developed countries in Europe, Australia, Asia, and the Far East. The MSCI All-Countries World Index, excluding U.S. (ACWI ex US) is an index considered representative of stock markets of developed and emerging markets, excluding those of the US. The Barclay’s Capital U.S. Aggregate Bond® Index measures the performance of the total United States investment-grade bond market. The Barclay’s Capital 1-3 Month U.S. Treasury Bill® Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. The Equity Baseline (EBP) is a blended index comprised of 60% domestic equity (represented by the Russell 3000 Index) and 40% international equity (represented by the MSCI ACWI ex US Index), rebalanced daily. An index is an unmanaged group of stocks considered to be representative of different segments of the stock market in general. You cannot invest directly in an index.
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