Global Market Analysis Spring 2014

Transcription

1 Spring 2014

2 Our portfolio investment team is constantly monitoring the global marketplace and will make adjustments to our model portfolios as opportunities to enhance risk and return are identified. We regularly evaluate traditional asset classes and alternative investments and assess potential benefits of changes to our model portfolios. Each year we evaluate our portfolios asset allocations based on an analysis that focuses on relative valuations and historical returns. I. Strategic Capital Markets Assumptions (CMAs) There are many different approaches employed by institutional investors and consultants in constructing well diversified asset allocation models. The strategic asset class allocations are constructed using a twostep approach. First, a building blocks methodology is employed in which capital markets assumptions - expected returns, standard deviations and correlations - are estimated for the various asset classes using time-tested approaches favored by many institutional investors. Second, the principles of Modern Portfolio Theory are applied to develop an optimized set of asset class portfolios. In keeping with the framework of our management approach, the investment team continues to apply tactical views to fine-tune the asset allocations. These tactical biases which are designed to favor asset classes perceived to be historically undervalued while underweighting those trading at historical premiums have then been implemented. II. Identify Opportunities Within the Equity Allocation Within the equity asset class, we evaluate relative P/E ratios to determine the attractiveness of each market segment. The P/E ratio is the weighted average of the P/E ratios of the stocks included in an index. The P/E ratio of a stock is calculated by dividing the price of the stock by its trailing 12 months earnings per share. When a stock s earnings per share is very small or even negative, the stock s P/E ratio will be high and potentially meaningless. Therefore, for our analysis we capped the P/E ratio at 50 to keep the data useful. The Relative P/E is calculated as: Relative P/E of Index XYZ = (P/E of Index XYZ)/ (P/E of Benchmark Index) A relative P/E below 1 indicates that Index XYZ has traded at a discount compared to the benchmark index, while a relative P/E above 1 indicates that Index XYZ has traded at a premium compared to the benchmark index. We compared the MSCI EAFE, MSCI EM, and Russell 3000 indices to the broad global equity market (represented by the MSCI ACWI), and compared the Russell 1000, Russell 2000, Russell 3000 Growth, and Russell 3000 Value indices to the broad U.S. equity market (represented by the Russell 3000 Index). The results of the analysis are provided in the following table: 2

3 Valuation of Equity Market Segments as of 3/31/2014 Index Category Current Relative P/E Average Relative P/E 15Yr Difference Premium/Discount to Broad Market Index. Benchmark of Comparison MSCI ACWI Global Equity N/A Relative to MSCI ACWI MSCI EAFE Developed Intl Equity (0.07) Discount Relative to MSCI ACWI MSCI EM Emerging Markets Equity (0.07) Discount Relative to MSCI ACWI RUSSELL 3000 INDEX US Equity Premium Relative to MSCI ACWI RUSSELL 3000 GROWTH US Growth Equity Neutral Relative to Russell 3000 RUSSELL 3000 VALUE US Value Equity Premium Relative to Russell 3000 RUSSELL 1000 US Large Cap Equity Premium Relative to Russell 3000 RUSSELL 2000 US Small-Mid Cap Premium Relative to Russell 3000 In summary, our analysis has shown that: The relative valuation of the U.S. equity market has pushed higher over the past year, and compared to the historical average it is at a slight premium. The developed international markets relative valuation is slightly lower than last year. It is at a discount to historical average. The relative valuation of emerging markets has also come down over the past year; falling from a historical average slight premium to a discount. U.S. growth equities relative valuation, which has been at a discount over the past few years, has crept higher and is now in line with its historical average. U.S. value equity did not change much and remains at a slight premium to its historical average. The relative valuation of U.S. small cap equities pushed considerably higher and is overpriced compared to its historical average. U.S. large cap equity also increased over the past year and is now at a slight premium to its historical average. On the following pages, we will provide a more indepth analysis on the relative valuations and outlook between the various equity market segments. a. U.S. Equity vs. International Equity Over the past year the U.S. equity market (represented by the Russell 3000 Index in blue on the chart below) has seen its valuation increase compared to the rest of the world. Its relative P/E vs. the global equity market (represented by the MSCI ACWI) has pushed higher and is now above its 15 year average. Although not robust, the U.S. economy has continued to show improvement over the past year. The employment situation also enjoyed steady improvement, adding jobs every month, while the unemployment rate has come down; falling below 7%. Employment, of course, has been one of the key metrics the Federal Reserve ( Fed ) has used to determine the aggressiveness of its monetary policies. The housing market continues to provide support to the economy, as low mortgages rates based on the Fed s accommodative monetary policies have persisted. Corporations have been rewarded with growing earnings, although recent results have shown some weakness. The improvements shown in the economy have prompted the Fed to decide to implement a tapering of its quantitative easing program. In addition, the Fed transitioned to a new chairman in the first quarter with Janet Yellen assuming leadership of the central bank, taking over for Ben Bernanke. The U.S. equity markets started the year with a negative slide based on several concerns: the prospects for slowing growth in emerging economies, the unwinding of the accommodative monetary policies would start sooner than expected, and uninspiring economic data to start the year. By the end of the quarter the markets were able to recover, as economic trends began to improve and expectations on the Fed s intentions became clearer. 3

4 Equities of non-u.s. developed countries (represented by the MSCI EAFE Index in blue on the chart below) have seen their valuations drop over the previous year. The discount to their 15 year average has widened. In the Eurozone, economic gains continued to be slow but steady as the region recovers from its deep recession, where unemployment rates reached record highs. The region has been balancing tight fiscal policies with loose monetary policies by the European Central Bank (ECB) in an effort to stabilize its economy. The result has been that internal demand has stagnated somewhat and that future growth will come from exports. In the 1st quarter, real GDP increased a relatively modest 0.3% on a quarter-over-quarter basis, but policymakers were encouraged that it represented the third consecutive gain. The ECB remains concerned about downward pressures on the region s economy and stated that it will take necessary action to provide stability to the economy. The developed markets in the Pacific region have struggled to keep pace with Europe and the U.S., as concerns about slowing growth in the region s emerging economies weighed on those markets. In Japan, the equity markets kept up with Europe in 2013 but struggled at the start of 2014, due in part to uncertainty about the impact of the consumption tax hike at the beginning of April and concern about a reactive rather than a proactive Bank of Japan to provide monetary support. Although the growth prospects for the non-u.s. developed countries have fortified over the past year, it is our belief that the risk to the growth within the those markets is still higher than compared to the U.S. The ECB has pledged help to support the region, but harmonizing the fiscal policies on the continent is an ever-present obstacle to success. In addition, the non-u.s. developed markets have shown increased correlation to the emerging markets in the current cycle, and weakness to those emerging countries remains a sizeable risk. U.S. equity is shown to be at a premium to historical values, however, growth prospects, although not expected to be robust, are less at risk than the other global markets. Optimistic investors have pushed U.S. markets higher, increasing the risk for a pullback. Global economic shocks are always a concern to both the U.S. and global markets, such as if the situation in Ukraine is unable to be resolved, or worse tensions escalate. As the result of our analysis, we will slightly underweight our allocations to U.S. equity and slightly overweight allocations to non-u.s. equity. While valuations point to the non-u.s. markets being at a sizable discount to the U.S. equity, we think the growth and stability of the U.S. market offset that valuation difference. b. Developed International Equity vs. Emerging Markets Equity Emerging markets underperformed developed markets during 2013, and the valuations in these regions have drifted lower during the past year. They now represent a discount versus their 4

5 historical average. The sluggish growth which has prevailed for the past several quarters in developed markets economies has had a negative effect on emerging economies, as they are dependent on demand from these countries. One risk that remains present is the negative impacts of fears on how the Fed s tapering decision would impact liquidity. In addition, emerging economies with current account deficits will be under pressure as U.S. interest rates rise. In China, policymakers have attempted to offset the global slowdown with monetary and fiscal stimulus. After starting 2013 off slowly, this helped the country s growth at end the year nearly reach its projected growth estimates. However, one of the risks for the outlook for China and the Asia-Pacific region generally is China s overheated property market, a byproduct of the monetary stimulus. China has been looking to move away from the growth at all costs mindset as they grapple with property market excesses and significant pollution in its most populous areas. Policymakers are considering setting a more modest growth target to achieve a goal of growth without negative consequences. c. U.S. Equity - Growth vs. Value Over the past year, growth has generally slightly outperformed value across the board, although both had strong absolute performance. In the current low growth environment, growth companies are well positioned to be rewarded by showing revenue and earnings growth. These companies have the ability to not only stabilize their business but to execute business plans and grow. Growth equities are fairly valued in comparison to its historical average, while the relative valuation for value equities is at a slight premium to its historical average. The charts below represent the relative valuations to the broad U.S. equity markets. Over the past year the gap of this valuation difference has tightened, and growth is only slightly more attractive than value. We will reduce our overweight to U.S. growth equities compared to U.S. value equities. We do think emerging markets will continue to be a driver of global growth, so prudent investment in the regions is an important part of a properly diversified portfolio. The valuations show strong relative value, but risks still remain, especially given their dependence on the global economy to drive demand. As a result, we will overweight our relative position in emerging markets. 5

6 d. U.S. Equity-- Large Capitalization vs. Smaller Capitalization The relative valuations of small cap stocks have gone up over the past year, and they are at an ample premium to their historical average. The relative valuation for large cap stocks compared to the overall market also went up this past year. It is now at a slight premium compared to the historical average. As indicated in the following chart, the relative P/E of small cap stocks (represented by the Russell 2000 Index) vs. the broad U.S. equity market (represented by the Russell 3000 Index) jumped higher during the last quarter of the 2013, maintaining that level during the first quarter of We think small cap stocks current valuation is expensive, while large cap stocks are reasonably valued. Small cap stocks have been benefitting from the sustained economic growth but are still more susceptible to any disruptions in the economic landscape. As a result of this analysis, we will continue to overweight large cap equities and underweight smaller cap equities. regions of the world. Precious metals was one of the weakest commodity sectors, as improving prospects of economic growth decreased demand for safe haven metals. Based on the S&P GSCI, valuations are in-line with historical averages, and we think diversified commodities provide a strong hedge against inflation. In addition, as global demand starts to pick up commodities will be buoyed and provide some potential appreciation. The current supply/demand picture for commodities, in general, does remain supportive of prices. While global economic expansion has slowed, there are still countries looking to spend money on infrastructure (including China), which could potentially drive demand for many commodities. Our broad exposure to commodities, gained through diversified index funds, serves to lessen the volatility that is emblematic of individual commodity positions. As a result, we will maintain a neutral position in our exposure to commodities. Commodity Valuations Represented by the S&P GSCI Index April 1999 March 2014 e. Commodities With overall global demand tapering during the past year, the broad commodity markets were under continued pressure from demand, and in general, most commodities saw week performance in However, many commodities sectors saw a bounce back during the first quarter of 2014, with investors perhaps discounting improving conditions in developing Source: Bloomberg f. REITs The real estate market provided muted returns during the past year, trailing the strong performing U.S. equity markets. After three quarters of negative performance (2nd, 3rd, 4th quarter of 2013), real estate did show signs of life, bouncing back in the 1st quarter of 2014 as one of the best performing sectors. Over the past year, the real estate market (represented by the Bloomberg REIT index in blue on the chart below) has seen 6

7 its valuation decrease compared to the U.S. equity markets. Despite the decrease, the real estate market still remains richly valued compared to its historical average. The low interest rates environment has provided low borrowing costs, which has provided support to the real estate sector. In addition, the low interest rates have created additional demand for REITs, as investors look for yield-oriented fixed income substitutes. The economy has seen improvement over the past years, which is an important component for growth in the real estate market. Real estate is showing to be richly valued compared to its historic position, and the risk of rising interest rates is something we cannot overlook. As a result of this analysis, we will continue to underweight real estate within the portfolios. fixed income and Treasury securities in particular. The spread between global bonds and U.S. bonds has pushed lower over the past year. Non- U.S. bonds have now fallen slightly below their long-term historical averages, as investors seek areas to increase yield. European markets are more stable, and while the threat of a sovereign debt crisis flaring up has not been completely eliminated, it continues to diminish as the ECB provides support and the countries work to improve their fiscal health. Non-U.S. bonds are slightly overvalued compared to historical levels but continue to offer a yield spread in addition to currency diversification. Emerging market debt spreads currently are also just below their long-term historical average. Growth in these economies has been sluggish, but emerging markets did not experience the same debt problems that the developed countries had faced in the past few years; so they have not seen the same volatility. Currency remains an uncertain factor and has contributed to the volatility. The strength of the U.S. markets has kept money flowing into the dollar, but the accommodative monetary policy should put pressure on the dollar over the long haul. III. Identify Opportunities Within Bond Allocation a. International vs. U.S. Bonds The U.S. bond markets were driven by two major factors over the past year: anticipation about the Fed s tapering plans and the reach for yield by investors (both of which helped to move the interest rates higher). U.S. Treasuries and governments continued to show volatility based on the evolving economic picture but ended the year with negative performance. U.S. investment grade held up better but also provided negative returns. U.S. fixed income did experience somewhat of a recovery in the first quarter due to concern about the pace of economic growth and the situation in the Ukraine, as investors sought a safe haven and gravitated toward U.S. Mainly used for fixed-income products, the Option Adjusted Spread (OAS) measures the yield spread that is not directly attributable to a security s characteristics. Put simply, OAS is used to create an apples-to-apples comparison of different types of bonds such as a callable bond vs. a non-callable bond. Non-U.S. Bonds vs. U.S. Treasuries 10-Year Period Ending March 31, 2014 Blue line represents the Barclays Capital Global Aggregate ex-usd Bond Index Source: Barclays Capital 7

8 Emerging Markets Bonds vs. U.S. Treasuries 10-Year Period Ending March 31, 2014 Blue line represents the Barclays Capital Emerging Bond Index Source: Barclays Capital As a result, we will have a neutral position on our global bond exposure, and will not be increasing our exposure to emerging market bonds at this time. b. Duration Bias i. Taxable Bonds Yields on the short side of the curve still remain at historical lows. While the Fed has outlined plans to taper their bond buying from QE3, they have not given clear direction on when they might start to raise interest rates. Transitioning to a new Fed chairman will usually provide some period of unease; it was especially heightened during the transition from Bernanke to Yellen given the greater presence the Fed has played in the current economic environment. Bonds experienced some upward swings in yields after investors interpreted one of Yellen s speeches as an indication that rates would rise soon. She clarified her statements giving more assurance that the Fed s intent to keep rates low still has some time to play out and the economic picture would continue to factor into that decision. Over the past year, interest rates have gone up across the spectrum, but with a slight flattening of the yield curve as long-term bonds did not go up as fast. With the flattening the underlying interest rate risk to the long-term end of the curve has gone up marginally. As a result, we will maintain an underweight to portfolio s overall duration, investing in short and intermediate term maturity bonds and less duration sensitive sectors. ii. Municipal Bonds The municipal bond markets were down slightly during the past year, as interest rates in the municipal markets moved in step with the taxable markets and pushed higher. The sector did have a strong 1st quarter. Interest rates moved lower, and the yield spreads for municipals tightened. The supply and demand factors continue to support the municipal market, with strong retail demand chasing after weak supply pipeline. Puerto Rico made headlines as the tiny island commonwealth completed its record $3.5 billion bond issue. Investors and analysts have been concerned that as a result of an economy that has shrunk 14% since 2006, the territory would not be able to make payments on its outstanding $72 billion in obligations. The bankruptcy case of the City of Detroit was another issue that captured investor attention. There will continue to be trouble spots in the market that grab headlines; however, the overall health of the municipal market is quite strong. The value for long-term municipal bonds has weakened as the curve flattened out. Yields at the short end remain low, while the intermediate segment still shows some value. As debt reaches its callable option, issuers are continuing to take the opportunity to re-finance with interest rates at such low levels. This impacts the intermediate spectrum the most, as many of these re-financed situations occur in that segment. As a result, we will underweight our exposure to long-term maturities, as the relative risk to that portion of the curve is higher. c. Governments, Securitized, Corporate & High Yield Bias U.S. Treasury yields have come off their historically low levels, as investors start to gain confidence in the direction of the global markets. The Federal Reserve has also signaled that it will keep interest rates low for a long time, putting additional pressure on the short end of the curve. However, with economy showing signs of continuing to move forward and the Fed reducing asset purchases as part of its QE3 program, yields have begun to creep back up. The securitized sectors (i.e., Commercial Mortgage Backed Security (CMBS)) have seen their yield spreads trading below their historical averages; 8

9 even reaching the low levels of the pre-2008 time period. With interest rates at these extended low levels, investors are looking for yield and have driven the spread down. Charts highlighting the yields of Treasury bonds and securitized bonds are provided below. The chart to the right highlights the quoted yield on the most recently issued 10-Year U.S. Treasury Bonds for the 10-year period ending 3/31/14. have been issued with lighter covenants, which can increase the overall risk to investors. Also, as spreads decrease, the sensitivity to rising rates increases. One of the biggest concerns for the bond markets is rising rates; and low quality bonds can provide additional diversification versus that risk, as they have less duration risk. The chart below highlights the Option Adjusted Spread between U.S. corporate high yield bonds (represented by the Barclays Capital U.S. Corporate High Yield Index) and U.S. corporate investment grade bonds (represented by the Barclays Capital U.S. Corporate Investment Grade Index). It also shows the average yield spread for these segments over the same time. Option Adjusted Spread and Average Yield Spread for U.S. Corporate High Yield Bonds and U.S. Corporate Investment Grade Bonds 10-year period ending March 31, 2014 The chart to the right depicts the Option Adjusted Spread of Securitized sectors (MBS, ABS, CMBS) for the 10-year period ending 3/31/14. n Average Yield Spread U.S. Corporate High Yield Bonds n Average Yield Spread U.S. Corporate Investment Grade Bonds n Option Adjusted Spread U.S. Corporate High Yield Bonds n Option Adjusted Spread U.S. Corporate Investment Grade Bonds Source: Barclays Capital Source: Barclays Capital U.S. corporate bonds provided strong relative returns in 2013, outperforming U.S. government bonds. Market volatility has come down during the past year, and credit spreads have compressed across all credit qualities, pushing below long-term averages. Corporate bonds are at a premium based on a historical perspective. As with other sectors of the market, investor demand for yield has driven spreads lower. The economy has grown, but growth rates have been lower than in past recoveries. Corporations balance sheets look healthy, and we do not believe that there is reason to think default rates will spike. But as investors have sought to increase yield, bonds The compressing spreads have made corporate bonds less attractive than they have been in the past few years. However, in this low growth environment they do offer clients a coupon spread and lower duration risk. As a result, we will be maintaining our overweight to corporate bonds and our overweight to lower quality bond exposure. d. Treasury Inflation Protected Securities (TIPS) Inflationary pressures have remained in check over the past year, and with interest rates creeping upwards, government-backed TIPS have trailed. Inflation continues to be a concern that 9

10 has to be monitored as we go forward. As long as the Fed maintains its current accommodative monetary policy, the risk for inflationary pressures will be present. With that, the demand for TIPS has been high, as investors have been purchasing TIPS to provide some protection against future inflation. Yield levels are low, and at these levels TIPS are overvalued compared to historical averages. While we think it is important to be thinking about inflation, we feel the price of the securities is high. With inflation remaining in check and TIPS correlation to the Treasury markets having increased, we do feel at this time they court too much interest rate risk. As a result, we will not add an allocation to TIPS in our models. Some of the bond strategies may own some exposure to this category if they can find strategic points to enter the market. The chart to the right highlights the quoted yield on the most recently issued 10-Year U.S. TIPS for the 10-year period ending 3/31/14. i. Hedge Fund of Funds: A strategy whereby a money manager is diversifying across multiple alternative investment strategies via sub-advisors to seek different sources of returns. Portfolios will tend to have equity market betas in the range of 0.3 to 0.7 compared to the S&P 500. ii. Hedged Equity: A strategy that seeks to reduce overall equity portfolio volatility by hedging and varying net equity market exposure by going long and short individual equities, equity ETFs and derivative products. Money managers will tend to have equity market betas in the range of compared to the S&P 500. Strategies include long/short equity or using options to hedge equity market risk. iii. Multi-Strategy: A strategy whereby a money manager is diversifying across multiple alternative investment strategies within a portfolio to seek different sources of returns. Portfolios will tend to have equity market betas in the range of 0.3 to 0.7 compared to the S&P 500. iv. Equity Arbitrage: A strategy that seeks to benefit from variations in pricing differences between related securities. Examples of this include merger arbitrage, pairs trading, sector arbitrage and capital structure arbitrage. Portfolios will tend to have equity market betas in the range of 0.2 to 0.5 compared to the S&P 500. Source: Barclays Capital IV. Identify Opportunities Within the Alternative Asset Class The alternative asset classes available for investment within mutual fund vehicles have continued to grow and evolve. These liquid alternative asset classes can provide access to specialist money managers who employ unique approaches to diversify model portfolios, reduce risk through low correlation and enhance return through use of unique strategies. With that growth and the distinct risk/return profile offered by these types of securities, it has become apparent that further clarity of the strategies available for investment is appropriate. We have broken the alternative asset class into eight distinct sub-classes: v. Alternative Fixed Income: A strategy that seeks to exploit inefficiencies in fixed-income markets. Strategies can include long/short credit, long/ short duration, long/short interest rates and other uncorrelated fixed income strategies (e.g., credit strips, non-traditional bonds, etc.). Portfolios will tend to have fixed-income market betas in the range of -0.2 to 0.5 compared to the Barclays Capital U.S. Aggregate Bond Index. vi. Equity Market Neutral: A strategy that seeks to construct a portfolio of long and short equities by balancing out net long and net short equity exposure across the portfolio. Some managers implement this strategy by trying to isolate their stock-picking ability and targeting zero equity beta. Portfolios will tend to have equity market betas in the -0.2 to 0.2 range. Techniques used include statistical arbitrage, quantitative trading strategies and relative value trades. 10

11 vii. Managed Futures: A strategy whereby a portfolio invests directly into derivatives contracts such as futures, forwards and options. Many managers will position investments in trend following or momentum-based trading strategies. Managed futures generally manage assets using a proprietary trading system or discretionary method that may involve going long or short in futures contracts in areas such as metals, grains, equity indexes, and soft commodities, as well as foreign currency and U.S. government bond futures. Managed futures portfolios can have both volatile and uncorrelated returns to equity and fixed-income markets but have positive correlation to volatility in general (i.e., the VIX Index). Portfolios will tend to have market betas in the range of -0.3 to 0.3 to both fixed-income and equity market indexes. viii. Short Bias: An investment strategy that seeks to exploit a view of securities or markets that are overvalued by having a relatively high net short exposure to equity markets or through implementation of a tactical view to potentially profit from a declining equity market. Portfolios will tend to have equity market betas in the range of -0.4 to -1.5 to the S&P 500. We will be maintaining our exposure to alternative investments in order to provide the portfolios with exposure to strategies that can minimize the average value of risk, potentially mitigating downside risk. The best complements to our portfolio allocations include: allocations to Alternative Fixed Income, Equity Arbitrage and Hedged Equity. The combination of these portfolios will help diversify the portfolios and provide the potential for enhanced risk return profiles. Disclosure The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this analysis is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results. Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet PMC makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Index and Morningstar category performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolios. An investment cannot be made directly into an index. Portions of this analysis are based on past performance. Past performance is not a guarantee of future results. Portfolio changes discussed refer to asset allocations of model portfolios utilized in the management of accounts. Actual account holdings of client accounts may differ. 11