In light of the market volatility in recent months, we thought it might be a good time to check the gauges in our car and provide a periodic review—a summarized highlight of various asset classes we operate in.
We might have been considered geniuses if we’d decided that an already-low Treasury yield of 3.0% or so wasn’t already low enough and was poised to hit 1.8%. That was not, in fact, the case. The probabilities were just not stacked in that direction of lower rates, for a number of reasons, and we were not alone in this view at the time. The S&P downgrade of the U.S. government counter intuitively caused a flood of cash away from risk assets into Treasuries, causing them to become even more expensive/lower-yielding. Over the last several years, investments in agency mortgage-backed securities have offered better coupons and valuations, so that is the direction we took—which worked when intermediate-term bonds did well.
We recently shortened duration in that portion of the portfolio while keeping that agency exposure and yield similar. The Rydex inverse government bond position provided us with portfolio insurance, essentially, against rising rates. Like any insurance, this is something that must be paid for, and poor performance was that price. Since our overall duration in fixed income is now lower, this insurance has now been removed. All-in-all, we’re underweight the asset class—these historically low rates at the very minimum push us to other areas from an opportunity cost standpoint alone.
Valuations and interest rate spreads in corporate debt have looked to be a more attractive bet than other portions of the bond market. Our current positioning reflects allocations to intermediate-term corporate bonds, floating rate bank loans, high yield bonds and convertibles. While the floating rate position has yet to gain traction (since rates have fallen and not “floated” upwards), we believe absolute yields and overall valuations here are attractive. Rates are comparable to those of longer-term debt and internal dynamics in the bank loan market may strengthen results over the next several years. High yield debt suffered a bit during the recent volatile weeks, but fundamentals remain strong. Defaults have continued to improve, which has been a tailwind for lower-quality debt of all kinds. Higher coupons, such as those in investment-grade corporate and high yield, tend to act as a bit of a buffer against any rising rate activity, and will continue to benefit from an absolute return standpoint in a flat or falling rate environment.
Compared to many slower-growth areas in the developed world (such as Japan and the Eurozone), higher interest rates, improving market breadth and liquidity, as well as underlying/increasing fundamental strength of several nations in the emerging world—in both fiscal balance sheets and currencies—have resulted in conditions that may offer ongoing attractive bond returns. Tilts in these directions continue to look appropriate to us, as does an allocation to “local market currency debt,” which is a much newer asset class but offers the benefits of high yields and potential currency appreciation without the interest rate risk of longer-duration debt.
In the large-cap world, we have discussed many times the attractiveness of well-known blue chip companies, such as Procter & Gamble, Johnson & Johnson, and others. With underlying fundamental strength, large amounts of cash held on the books and strong earnings, we feel this area offers compelling value from a risk-to-reward standpoint. These characteristics alone should help provide us better “all-weather” performance if the current period of slow overall growth continues. If we take the volatility and market fear over the recent months, we have seen the dividend yield on the S&P 500 rise above the 10-Year Treasury yield—unheard of in recent decades. What this tells us is that equities overall are pricing in a dire environment (that we do not foresee occurring) and, based on these valuations, the upside is extremely compelling.
We are currently overweight large-cap, as we continue to feel that the fundamental quality of these companies is not being appropriately recognized. Additionally, a slow growth environment should point to outperformance of these more diversified, globally-focused firms.
Mid-cap stocks have been a strong growth engine in the portfolio for several years, and fit a unique niche. Earnings growth on a company-specific basis has been strong, debt levels have improved from where they were in 2008, and financial stability overall is better than it’s been in years. These factors of strong potential growth and better foundations than small cap, as well as a flurry of merger and acquisition activity has enhanced returns. Being light in small-cap, by contrast, due to valuations in that space that are less compelling and higher degrees of exposure to a slower-growth U.S., has helped portfolio performance in recent months, as the high “betas” here have resulted in very poor small-cap returns that we’ve been able to sidestep.
The international stock universe, of course, can also be divided into developed and emerging nations. European markets, particularly financials, have been decimated by fear—due to the uncertainty surrounding the debt crisis, namely with Greece, and uncertainty of policy decisions. We are currently at a normal weight in foreign equities overall, with a significant tilt to emerging markets, which is where global growth is and has been centered. We continue to believe this is the appropriate tilt to make, although the extreme pessimism and attractive valuations in developed nations has created a more compelling opportunity. In fact, several managers we utilize have been making moves toward these ignored areas, such as mainland Europe and Japan, where bottom-up opportunities have been apparent despite the broader macroeconomic stagnation.
Increased transaction activity and improved sentiment (possibly due to the notion that real estate can act as an inflation hedge) spurred U.S. REIT returns upward significantly from trough levels. Foreign REITs lagged for a variety of reasons: in Europe, political uncertainty and pessimistic climate; in Asia, economic slowing and higher interest rates. Our underweight here is valuation-driven (U.S. has not been cheap from a valuation standpoint since the 2008 crisis), but the REITs we do own are focused on the Asia-Pacific area, where we think prices are most reasonable.
Our change in strategy a bit from a GSCI index-tracking vehicle to one with significant “alpha” generation from futures selection and underlying collateral has improved returns in this space over the better part of 2011. Despite volatility over the summer, along with other risk assets, relatively strong commodity prices from a variety of geopolitical and weather factors in 2011 have helped returns here overall, and expect that, especially if inflation pressures build, the case for commodities exposure continues to be strong. Despite the volatility of that asset class individually, its usefulness as a diversifier in portfolios is among the best available over time.
Volatility, while unnerving, also provides us opportunity to “reset,” take a step back and determine how things look right now and from a forward-looking basis.
Sometimes we are asked the question of what we are “doing” in portfolios in times like this when news events and conditions get challenging. It is important to keep in mind, that in asset allocation portfolios especially, macro themes guide positioning more than do short-term events. Short-term trading offers you the excellent opportunity to be as wrong as you are right—since, as you know from our comments over the years—following the herd often feels right at the time but can result in missed opportunities. If the decision includes “going to cash,” clients have the ability to make a knee-jerk/possibly wrong decision twice, rather than just once, as the second decision to jump back into “the markets” often occurs after a recovery has long since begun. Valuations are a fundamental component, and these tend to move in a contrary manner—as certain assets become cheaper, they become more attractive. You typically won’t get every asset class or position correct, but, over time, you will tend to perform well (and often much better than market averages and competitors). On the other side, diversified asset allocation portfolios help clients minimize the damage from being “wrong”—something they often forget.
So, why are we not more bearish like so many others? Post-2008’s crisis, the corporate sector has strengthened significantly. Production levels in areas such as housing and auto production are already at low levels, so there is not as much “excess slack” that might allow for a further deterioration in conditions (such as if the economy had been expanding at a much faster rate initially, then declined). This flattening-out process tends to act as a risk-reducer, in a sense, since there is less room to deteriorate. This is not to say we are completely out of the woods, as challenges in the world continue strain sentiment and we are certainly not seeing “robust” growth. However, there are several tailwinds—oil prices are significantly lower (in contrast to earlier in the year), sales numbers in many industries continue to increase at a steady pace, profit growth is healthy and business sentiment survey results are moderate to strong (not weak, as you’d expect if a recession were inevitable). The problem is uncertainty in global growth (as usual) and, particularly, uncertainty in government policy. Confidence-inspiring leadership in both the U.S. and Europe seems to be the element lacking.
Housing starts declined 5.0% month-over-month in August, which was a bit larger than consensus—and mostly led by large declines in multi-family. However, year-to-date, single-family starts are largely unchanged and multi-family starts are up by nearly 50%. Building permits unexpectedly rose to an annualized level of 620,000 units. Overall, single family activity is still very stagnant, while multi-family overall has improved a bit.
Existing home sales rose 7.7% (month-over-month), a bit larger than expected, and near a level seen in late-2007/early-2008. The months’ supply of homes dropped from 9.5 to 8.5, and the median sales price was essentially unchanged (while down about 5% from the previous year).
The FOMC announced a somewhat unusual plan, referred to as “Operation Twist,” in which $400 billion of treasury debt is being reshuffled—essentially short-dated bills are being replaced on the Federal Reserve’s balance sheet by longer-maturity notes and bonds, in an ongoing attempt to bring down long-term interest rates. Unfortunately, the market’s reaction was not optimistic—especially in the financial sector, where this yield curve flattening has been interpreted as a potential negative for banks. Additionally, it may not be especially effective from a stimulus standpoint.
The index of leading economic indicators was up +0.3%, showing weak growth, and mostly stemmed from improved financial conditions—including low interest rates.
Weekly initial jobless claims were down slightly for the week, -9,000 to 423,000, largely in line with consensus. Continuing claims were also down.
It was another volatile week for equities and risk assets of all kinds as stocks experienced their worst week since October 2008. The S&P lost –6.5% for the week, while small caps were down nearly 9%. The best performing sectors were the defensive group, such as utilities and telecom, while info tech also performed well; energy and materials vied for the worst. The MSCI-EAFE and MSCI-EM were down -12% and -16% for the week, respectively, made worse by a flight toward the dollar. Unsurprisingly, some of the more commodity-oriented emerging market nations (such as Russia) fared the worst, while “safe haven” countries like Japan and Switzerland weathered the week much better, with only -4% declines or so.
The current yield on the 10-Year Treasury moved from 2.08% to 1.81%, pushing bond returns into the positive in a large “risk-off” and pro-US Dollar environment. The BarCap Aggregate gained over 0.50%. Foreign developed market bonds were mixed, while emerging market debt lagged substantially. Again, flight-to-quality was the key theme of the week.
REITs had a difficult week similar to small cap equities, which is not a surprise considering the more concentrated universe. Commodities, represented by the GSCI, were down -9%, as various members across the group—oil, gold, copper, silver and agricultural contracts were down strongly on perceived lack of demand in the event of further global slowing.
Until Next Time
Karl Schroeder, RFC, CSA, CEP
Investment Advisor Representative
Schroeder Financial Services, Inc.