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– June 10, 2015
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Fixed Income
The depth and breadth of the Great Recession left few sectors untouched. Fixed income markets and the banking system were certainly no exceptions and were in some ways at the epicenter of the financial crisis that unfolded. Given the severity of the recession and nature of the causes, it’s no surprise that unconventional policy responses were necessary. While these measures have no shortage of critics and unintended negative consequences, positive developments that resulted can also be seen. Among these are the very low interest-rate environment that persists today and continued demand for quality, fixed-income securities. As a result, nonfinancial corporate borrowers who have the need and ability to tap credit markets directly have been able to take advantage of interest rates near historic lows by issuing debt. This has let borrowers adjust funding sources to obtain the lowest costs and build the most advantageous capital structure.

As we noted in our analysis of the corporate sector last month, company balance sheets are generally healthy by historical measures of debt-to-net-worth levels. In addition, the low cost of capital has helped profit margins by lowering the interest expense associated with servicing debt and has allowed for better returns to investors.

Given this environment, it’s not surprising that nonfinancial corporate debt issuance has risen sharply since the end of the Great Recession and now stands at double the peak level before the downturn began (Chart 5). Furthermore, not only do issuers of low-cost debt benefit, but the financial services companies that help sell the debt benefit from the increased fee income associated with the additional issuance.

Commodities
Our analysis of commodities this month revisits the energy sector to provide an update on the price trends for crude oil as well as retail gasoline. When we analyzed the impact of falling crude oil prices in the January 2015 issue of Business Conditions Monthly (https://www.aier.org/bcm), we noted that Brent crude oil was $55.27 per barrel as of Dec. 31, 2014, according to the U.S. Department of Energy. So far for the month of May 2015, the average Brent crude price has been about $64.08 a barrel, up 16 percent since the end of last year. At the same time, the average retail gasoline price has risen from about $2.392 near year-end to $2.857 as of May 25, a roughly 19 percent increase. That puts the average retail price at the start of the summer driving season at about the average price for all of 2010 (Chart 6).

For U.S. consumers, rising gas prices over the past few months have hit their budgets, but when put in the context of the $3.633 per-gallon average pump price for the 2011 to mid-2014 period, before crude began to plummet, American motorists are still ahead.

For the economy and oil companies, the fallout from the crude oil plunge is still working its way through the industry. Employment in the oil and gas mining and related support industries has fallen by about 44,000 jobs. Orders for new capital equipment slid to an average of $2.1 billion a month for the seven months through March compared with a monthly average of $2.7 billion from 2011 through mid-2014—a roughly 20 percent decline. Yet domestic production and inventories remain near all-time highs.

The challenging question is where the price of crude will stabilize over the medium term.  Geopolitical forces still dominate the market. Decisions by OPEC members, particularly Saudi Arabia, will be critical, as will developments in the various politically unstable or less stable producing countries around the world.

U.S. Equities
The Standard & Poor’s 500 Index continues to post new record highs—more than 100 since 2013, including 10 this year. While some analysts and pundits may express concerns, disbelief, or outright panic, in our view the U.S. large-cap index remains well supported fundamentally by solid sales and earnings growth. In fact, the price-to-earnings ratio for May 2015 was 19.1, just slightly above the 16-19 range that has been most frequent since 1935.

However, not all sectors within the S&P 500 have performed similarly. Since 2004, financial stocks have trailed the overall market.  Within that sector, stocks are organized into four industry groups: banks, diversified financials, insurers, and real estate. For our analysis, we concentrate on the first three, as those companies provide typical financial services to consumers and businesses.

Among the three industry groups within the financials sector, all trail the overall S&P 500 and have yet to regain their average levels from 2004. All three continue to struggle with substantial crosswinds affecting their businesses.  On the positive side, the slowly improving economy has helped credit activity, improved overall credit quality, lowered delinquencies and write-offs, and boosted equity prices, among other things.  However, the low interest-rate environment is still detrimental to some, and banks in particular still face fines and penalties for violating various laws and regulations.  In addition, new rules, including increased capital requirements, weigh on some financials, such as banks. Overall, conditions would suggest support for further improvement for financial stocks, but progress may not be enough to close the performance gap with the broader market.  

Global Equities
The financial crisis and ensuing Great Recession in the U.S. had a substantial impact on the global economy and its financial system. The sharp contraction in the U.S. had several immediate effects on the global economy: Imports to the U.S. (exports for the trade partner) plunged by 20 percent, while global commodity prices tumbled by more than 60 percent, unemployment rose, and inflation fell.

In the financial markets, interest rates fell to historic lows and equity markets around the world plummeted. As the crisis unfolded, major financial institutions became insolvent or headed towards insolvency. Not surprisingly, stocks of financial companies sank as the earnings outlook collapsed and the risks associated with equity stakes rose sharply.

As we approach the sixth anniversary of the end of the Great Recession, much progress has been made among global financial companies. But just as with the various industry groups within the S&P 500 financial category, the performance of global financial shares is quite varied. Among the best-performing regional financial sectors has been Asia excluding Japan, as well as emerging markets. In both cases, financial companies had been through their own crises over the past two decades and as a result had tighter risk controls, which helped them to avoid excessive exposure to bonds caught in collapsing U.S. markets.

On the negative side, financials in both Europe and Japan have underperformed substantially, though for different reasons. The U.S. crisis touched off one in Europe, exposing weaknesses in its economies, banking systems, and fiscal policies that are still being dealt with today. In Japan, the multi-decade-long struggle to stimulate growth was exacerbated by the global crisis, resulting in weak performance among Japanese financials.

Overall, financials in Asia excluding Japan and in emerging markets may be the safer companies among global financial shares.  As discussed above, U.S. financial stocks may have room for improvement as the domestic economy picks up.  Sector shares in Europe and Japan may be the riskiest opportunities among global financials but may also offer the greatest upside potential.

Next/Previous Section:
1. Overview
2. Economy
3. Inflation
4. Policy
5. Investing
6. Pulling It All Together/Appendix


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