What's Up This Week - Week of September 16th, 2019Submitted by Trace Wealth Advisors on September 18th, 2019
In this new blog format, I’m going to take three big market stories each week, boil them down to their most salient points, and hopefully help you understand how these events might impact you and your financial objectives. Here goes…
Repo markets have been in the financial news the last few days because the rates that borrowers pay in these markets has increased substantially which leads some to believe there is potentially pent-up stress in the credit markets.
What is a repo?
We’re glad you asked! A repo is an agreement between two parties whereby one party lends cash to another in exchange for an almost equal value of securities (oftentimes short term Treasuries). These agreements are in put in place because they allow those that hold assets but not a lot of actual cash (think hedge funds, banks, etc.) to easily access cash when they need it, rather than having to constantly sell securities to fund short term operations. On the other hand, it allows parties with lots of cash (think money market funds) to earn a small return while taking somewhat minimal risk, given that they are holding highly liquid and safe financial instruments in return for their lending the cash. Once the repo deal is consummated, the borrower agrees to repurchase the securities at a specified price on a mutually agreed upon date. The difference between the current price and the price at which the borrower agrees to buy the security is the repo rate.
So what happened?
In the last few days, repo rates have increased dramatically with no clear explanation available. There have been a few potential reasons offered, which include the fact that Monday was the corporate tax deadline (and many corporations moved money out of money market funds into cash) as well as the settlement date for a large U.S. Treasury auction. I would note that these are both common, known occurrences in the markets so the fact that the funding markets were caught so off guard does seem a little strange.
Repo rates are intended to remain in line with the Fed Funds rate (currently between 2% and 2.25%) but they moved as high as 5% on Monday and as high as 10% on Tuesday. This chart should give you a good sense of how out of line these moves are when compared to recent history:
Why should we care?
You probably shouldn’t care a whole lot…yet. In truth, this won’t really be a problem until it is a problem. That said, there are three primary reasons why this could matter:
- It could affect overall market sentiment and is definitely something that could make large investors reconsider the recent market strength and their overall positioning as a result. Equity markets have seemed to shrug this off as little more than just noise…so far.
- Banks rely heavily on the repo market to fund their daily operations and to satisfy their client demands for cash. At its core, the system relies heavily on faith and trust. If this trust is broken or temporarily impaired, it could create an ugly chain reaction. Go watch “It’s a Wonderful Life” again and you’ll remember what this is all about.
- This could alter Fed policy going forward as the central bank is already under pressure to use its balance sheet to stabilize the market. Should this repo market volatility continue, the reaction of policymakers will be an important factor to consider.
For now, let’s wait and see…
Oil prices have been incredibly volatile the past two days as one of Saudi Arabia’s largest oil facilities recovers from a terrorist attack over the weekend.
There was a coordinated terrorist attack in Saudi Arabia over the weekend that knocked offline roughly half the country’s oil capacity. Given that the Saudis are responsible for ~10% of global oil supply, this means that ~5% of the world’s oil supply went down. Initially, Houthi rebels in Yemen took responsibility for the attack but the US government initially pinned blame on Iran. Oil prices spiked the most in over 10 years on Monday, with near-term crude contracts settling up 14% on the day at $62.90/barrel. Saudi Arabia’s Energy Minister indicated yesterday morning, however, that the kingdom’s oil output will be back online and fully recovered by the end of this month, giving some calm to worried energy markets. Prices fell back yesterday after this news was released, with crude prices down over $4 on the day.
Why does this matter?
The primary concern from an investment perspective isn’t necessarily the immediate reaction in the price of oil over the past two days. Rather, investors are more concerned with two possibilities:
- The negative effect that a prolonged rise in oil prices could have on consumer spending here in the US. Consumer spending accounts for close to 70% of US GDP and so an increase in prices at the pump could have a negative effect on not only sentiment but also spending (think back to $100+ oil in 2008).
- The negative impact of continued geopolitical volatility in the Middle East. With the US and Saudi Arabia initially pointing the finger at Iran for responsibility for this attack, investors are concerned that a more serious conflict could start, with the possibility to roil markets as a result.
It remains to be seen whether either of these comes to fruition but the most recent news of the quick Saudi recovery is likely to be more positive than negative for markets.
It became official this week…there are now more assets in U.S. equity-based passive investing strategies than U.S. equity-based active management strategies.
So far in 2019, investors have added $88.9 billion to passive strategies, while redeeming $124.1 billion from active strategies, according to data from Morningstar. As a result, passive US equity strategies now have more money under management than active US equity strategies. This is a shift that has been ongoing for decades, but picked up steam in recent years as active managers continue to struggle.
Why does it matter?
There are a lot of pundits out there that will tell you that this limits “price discovery”. Their essential argument is that index funds just blindly buy stocks, regardless of their fundamentals which leads to a distortion in the prices of the underlying individual securities.
While it’s true that index funds don’t do any sort of fundamental analysis, this is a flawed argument for a variety of reasons:
- Passive investors are price takers, meaning they accept whatever price the market is offering at a given time. Active investors are really the ones who set prices.
- There is basically no evidence that active managers, in aggregate, show different characteristics than the indexes themselves. In other words, if you total up all of the active managers out there and average out the characteristics of the stocks they own, they basically look like the indices themselves. Nir Kaissar at Bloomberg wrote a great article about this earlier in the week
- If this argument was true, it would be a field day for active management! Cheap stocks would get way too cheap and expensive stocks would get way too expensive. The result would be easy pickings for active managers. Based on their results, it doesn’t appear that this is anywhere near the case.
Ultimately, the reason it matters for you is that passive investing makes it easier for you to diversify your portfolio and control costs. The investing world will continue to become a better place as the use of passive funds proliferates.
That’s it for this week…make it a great one!
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.