Moody’s: Higher Treasury Yields Expected as Equities Surge

Risk-on trades are powering into the new year, and John Lonski, Moody’s chief economist, thinks the benchmark 10-year Treasury’s yield will continue to rise.

In a research note, Lonski points to the stock market rally—the Standard & Poor’s 500 has advanced 4.5% thus far in 2018—and a drop in the junk bond composite yield this year, to 5.72% from 5.82%. That means investors are buying the bonds, whose price moves in the opposite direction from yield.

Stocks and speculative bonds are the quintessential risk-on trades, meaning investors have faith in their return potential, and are willing to stomach their higher risk.

The other part of that equation, certainly, is the out-of-favor risk-off trade, most typically the 10-year Treasury note, which the federal government stands behind and whose risk is judged by most as nearly nil. Demand for the 10-year has dropped, and its yield has risen to 2.64% as of Friday from 2.41 at year-end 2017. That, Lonski writes, is “largely in response to the upwardly revised outlook for real returns that are implicit to the equity rally and the drop by the speculative-grade bond yield.”

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Lonski expects continued increase in the 10-year’s yield until the stock market stagnates or junk yields climb, as represented by the spread between them and (lower) investment-grade corporate yields. Then investors would crowd back into the safer Treasury, and its yield would dip. Another sign of a possible shift toward lower T-note yields, he suggests: If there’s a slide in the industrial metals price index, which could herald economic weakness ahead. The S&P GSCI Metals Index is up almost 20% over the past 12 months.

The yield on the 10-year Treasury has come a long way since it touched 1.5% in July 2016, as the stock market moved sideways and oil prices were just coming out of an epic slump.

Tags: 10-Year Treasury, John Lonski, Junk Bonds, Risk-On Trade, Stock Market Rally

The debate over divesting from fossil fuel companies is scheduled to come to San Francisco on Wednesday, when board members of the city’s pension system are scheduled to decide whether to divest of around $450 million in stock of companies like Exxon Mobil, Royal Dutch Shell, BP, Chevron, and Conoco Phillips.

The board’s pending action at the $24 billion San Francisco Employees’ Retirement System follows a vow by New York City Mayor Bill de Blasio on January 9 that New York City’s $189 billion pension system would divest of fossil fuel stocks.

Such an action still needs to be approved by the boards of the five New
York City pension systems, who would need to determine the effects divestment would have on investment returns, noted New York City Comptroller Scott Stringer, who sat next to the mayor at the January 9 press conference. He said the goal was to fully divest from the $5 billion in fossil fuel investments in five years.

The San Francisco vote is being closely watched by other pension plans and institutional investors. If the board were to approve divestment of its portfolio of some 80 fossil fuel companies, it would be the largest such divestment made globally so far by institutional investors of fossil fuel stocks.

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Several European pension plans have divested of oil and gas companies, but the biggest divestment of around $100 million would be less than a quarter of a potential San Francisco divestment. In the US, divestment action so far has been by smaller pension plans, foundations, and endowments, like the District of Columbia Retirement System, which sold off $6.5 million in fossil fuel holdings in June 2016.

San Francisco board member Victor Makras, who introduced the fossil fuel divestment resolution back in the spring of 2017, said in an interview that divestment puts pressure on corporations that are major carbon emitters to change their policies and makes economic sense for the pension plan.

He said the fossil fuel stocks in the pension system portfolio combined saw a 3.8% annualized return for the 10-year period ending June 30, 2017, compared to a more than 80% gain for the S&P 500 during that same time period.

“The returns for fossil fuel stocks have been dismal over the last 10 years,” Makras said.

He said divestment would also send a powerful message.

“A giant like San Francisco divesting will have a significant impact on others divesting across the country,” he said. “As soon as we walk over the line and do it, others will have the strength to do it.”

But the pension system’s Chief Investment Officer William Coaker Jr. and the system’s investment consultant, NEPC, oppose the divestment.

Coaker in a 156-page report maintains that selling fossil fuel stock won’t diminish corporate carbon emissions, it will just change the ownership of the stock shares.

For its part, NEPC argues that fossil fuel stocks are a hedge during periods of inflation and have been one of the few groups of securities that performed well during those cycles in the past.

Most CIOs globally agree with Coaker. Investment officials of the two largest pension plans in the US, CalPERS and CalSTRS, both known for engaging corporations on their environmental policies, say such policies give them a seat at the corporate table to advocate change.

New York State Gov. Andrew Cuomo has called for divestment of the $200 billion New York State Common Penson Fund, but he does not have direct control of the fund. Its investment decisions are controlled by New York State Comptroller Thomas DiNapoli, who has said he has no immediate plans to divest.

The divestment exception is to a smaller subset of energy companies involved in the production of thermal coal, which is used for energy generation. CalPERS and CalSTRS have divested from those companies at the direction of the California Legislature and the San Francisco pension system has eliminated nine coal companies worth $155,000 from its portfolio.

Sources say the seven-person San Francisco pension system board is split on whether to make an overall divestment of fossil fuel stocks.

Markas believes board members will opt to approve the divestment at the Wednesday meeting under an amended resolution that would extend the original 180-day limit to divest, to a longer period of years.

“I believe there will be a majority supporting divestment as long as investment staff has control of the manner and timing of divestment,” he said.

A source familiar with the board of the San Francisco pension plan said that the change may be enough to convince Wendy Paskin-Jordan, the swing vote on the seven-member board, to approve the divestment plan.

Jordan, the wife of former San Francisco Mayor Frank Jordan who runs her own investment advisory firm, was appointed to the retirement board by San Francisco mayor Edwin Lee, who died of a heart attack on Dec. 11.

Lee had put out a statement that day in support of the San Francisco retirement systems’ divestment.

The San Francisco Board of Supervisors has called on the pension system to divest of fossil fuel stocks since 2013, but the board had not tackled the issue until last year.

Tags: Divestment, ESG, Fossil Fuels, San Francisco