SECOND QUARTER PORTFOLIO PERFORMANCE AND POSITIONING

Transcription

1 SECOND QUARTER PORTFOLIO PERFORMANCE AND POSITIONING In the second quarter, U.S. equities posted positive performance and were again the best performing asset class on a relative basis. With the majority of asset classes posting negative returns, any diversification outside of U.S. equities was a drag on returns. We simply did not own enough domestic stocks to keep portfolios positive for the last three months. Global bond investors were not spared as interest rates rose and credit spreads widened to varying degrees. Compared to the major bond indices, our relatively short duration bond exposure helped relative performance. Our non U.S. equity positions were hurt by the rise of the dollar and poor performance from emerging markets. Within the real assets category, MLP performance was a strong positive but was offset by lagging commodity equities. Our hedge fund exposure was a positive contributor. Throughout the quarter we tried to use market volatility to make incremental exposure changes. We scaled back on our MLP exposure in mid to late April after MLPs ran up about 20% for the year. We used those sale proceeds to add to our Oakmark Fund holding (U.S. equity). Later that same month, we added a new fund, the Eaton Vance Multi Currency Fund. The idea behind this investment was to take advantage of higher short term local market yields in emerging market countries and benefit from U.S. dollar depreciation. The timing of this initial investment may have been a bit premature as the U.S. dollar has continued to gain strength against practically all currencies except the Japanese Yen. In mid May, we sold our China ETF investment and used those sale proceeds to add to U.S. equity exposure. Finally, after the mid June market swoon we added again to U.S. and emerging market equities using structured products on a client specific basis. ASSET CLASS PERFORMANCE The table below shows the performance of the major asset classes for the quarter and the year. Domestic equities and MLPs dominated performance year to date. The performance gaps remain unmistakable. Most fixed income asset classes posted poor returns for the quarter dragging their performance into negative territory for the year. Real estate, commodities and commodity equities were also poor performers. TIPS and gold were punished as real rates rose sharply. Gold investors were dealt a particularly harsh blow as the metal was down 23% for the quarter and has lost 27% for the year.

2 Q YTD 2013 Q YTD 2013 FIXED INCOME INTERNATIONAL EQUITIES Municipal Bonds Developed Markets US Aggregate Emerging Markets TIPS US High Yield REAL ASSETS US Leveraged Loan N. American Natural Resources (equities) Dow Jones Commodity Index DOMESTIC EQUITIES REITs S&P MLP Index Russell Gold FED TAPERING Financial markets sold off in May and later in June following Fed Chairman Bernanke s post FOMC meeting press conference on June 19 th. In the past when the Fed discussed reducing stimulus (quantitative easing or QE ), equities and commodities dropped, the U.S. dollar rallied and bond yields pushed lower. This time all asset classes behaved as they have in the past, except this time bond yields spiked upward. The 10 year yield soared 24 basis points in 48 hours. The table below shows how major asset classes reacted in the 48 hour window of the June 19 th Fed Chairman s press conference. It is important to distinguish market reactions from market overreactions. For the bond market, the move seems reasonable as real yields rose from extremely low levels (negative, actually) to low but positive levels. The ten year Treasury ended the quarter yielding 2.48% or 84 basis points higher than its 2013 early May low of 1.64%. Comparing this to the last CPI print of 1.68%, real yields of 0.80% are still low compared to their long term average of 2.5%. The 10 year TIPS yield was negative starting in the fall of 2011 and was indicative of the market s fear of very slow if not negative GDP growth. Investors were actually willing to lock in a negative real return because the inflation adjusted returns of other investments

3 were feared to be even worse. The recent sharp rise in real yields is hardly a sign of rampant optimism, but rather indicative of a decline in pessimism among holders of longdated debt with miniscule real yields. The 10 year TIPS yield started the quarter at 0.64% and ended the quarter at +0.50%. Real yields at these levels are consistent with GDP growth of 1 2%. We expect interest rates to broadly follow economic growth and inflation from here wherever that may lead us. We continue to see the distribution of future fixed income returns to be negatively skewed and therefore maintain relatively short portfolio duration and a bias toward higher quality credit. On a short term basis, the stock market seems to have overreacted even considering the textbook inverse relationship between interest rates and equity valuation. Interest rates are still extremely low and it is difficult to envision how rates at these levels will choke off the housing recovery, cripple corporate earnings, or otherwise derail the global economy. Investors knew QE was coming to an end someday; the announcement brings clarity and reduces uncertainty with respect to the forward path of monetary policy. It is important to note that the Fed s path is very data dependent and the entire timetable subject to change if the economy proves to be softer than expected. In the long term, less QE is necessary and the roadmap to that eventuality must be passed over one way or another. Either way, fears of a newly hawkish Fed seem overblown as it is unlikely the most dovish Fed in the history of the institution would error on the side of monetary restraint and rigidly adhere to a plan that would squander gains that have been so difficult to create. The Fed s tapering timetable seems justified given the economic progress we have seen to date and the already significant and continually growing costs which an extremely large Fed balance sheet entail. If carried out as articulated, the tapering will end the Fed s most extreme monetary policy in its century of existence after five years of economic growth, a 2.4% drop in unemployment, and sharply higher home and stock prices. Starting the tapering program soon makes more sense than continuing QE as the adverse consequences of extremely low rates and an enormous and expanding Fed balance sheet are growing. Near zero interest rates obviously penalize savers. Such low interest rates also discourage lending. To the extent corporations and individuals expect rates to remain low for the indefinite future they have little incentive to borrow and make capital investments thus leading to stagnant growth. The Fed s problem in unwinding its enormous balance sheet is that even if they stick to the tapering program banks will have $2.5 trillion on reserve with the Fed by mid Unwinding will require the Fed to walk a narrow path risking inflation if they move too slowly and derailing growth due to higher rates if they move too quickly. Given the magnitude of this unwind the potential consequences of a policy mistake are significant. It is this policy risk that is partially responsible for our preference for liquidity and our measured conservatism.

4 ECONOMIC FUNDAMENTALS United States As the table above shows, the U.S. economy has been the strongest region among developed countries and a key driver of global economic growth. Strength in housing, autos, continued progress in jobs, post crisis highs in consumer confidence, rising household net worth and a narrowing federal deficit are all indicators of U.S. strength. Commodity prices have been subdued and consumer price inflation essentially non existent. The recent rise in interest rates poses a potential headwind to the economy if the rise gains momentum, but with rates still at historically low levels and confidence growing we expect the slow growth muddle through to continue. Europe European economic growth is still sub par with 2013 Eurozone real GDP forecasted to remain near zero. Inflation is expected to be restrained and unemployment is forecasted to rise to 12.6% in 2013 with only minimal improvement in While the headline numbers are weak there are some early indications that the economy is improving. The ECB pledge to be ready to act if economic data continues to deteriorate may not be tested after manufacturing data showed the downturn easing for a second consecutive month. Germany showed signs of stabilizing and even Spain saw a respite in its the rate of decline.

5 Besides improving manufacturing data, early encouraging signs include the closing of current account deficits in some of the periphery countries, rising car sales and increasing consumer confidence albeit from extremely depressed levels. China In 2012, China s economy grew at its slowest pace in 13 years. The economy so far this year has been weaker than forecast where 2013 growth is forecast to be about 7 8%. May manufacturing output fell for the first time since last October, falling in response to a second successive monthly reduction in new orders which suffered the steepest monthly decline since August of last year. New export orders fell especially sharply, dropping at the fastest rate since March With growth and inflation prospects lower, China s moderating commodity demand is also keeping commodity prices contained, which is sobering news for many commodity based economies many of which are emerging markets countries.

6 In the midst of this growth slowdown, China is trying to correct its property market excesses. After several years of rapid credit growth China s financial institutions are showing a lack of trust in each other. As we had seen in Europe in August of 2011 and during our financial crisis, interbank lending rates soared. On June 20 th, the Shanghai Interbank Offered Rate (SHIBOR) peaked at 13.4%. Despite the need of some banks for cash, the central bank refused to lend, allowing rates to spike and signaling its determination to restrain credit growth. Chinese stocks had their worst day in years as the Shanghai composite dropped 5.3% on June 24 th before the authorities stepped in to calm the markets. The crunch brought the inevitable comparisons to the U.S. financial crisis. But China s situation is different in several ways: 1) it has a very high savings rate, 2) its banks loans cannot exceed 75% of their deposits, and 3) the government owns the largest banks. The Chinese government will not allow the banks to fail and China has $3 trillion in foreign reserves which it can use to recapitalize them if necessary.

7 The news coming out of China these days has been consistently disappointing and as the GDP table at the top of this section shows, world GDP growth is highly dependent on China. No other sizable country or region has a higher growth rate than China s. The risk of further cyclical weakness is material as China is simultaneously reforming and trying to revive its economy. Reforming and reviving are not necessarily at odds with one another but the path is proving to be bumpy. Japan In Japan, while it is too soon to tell if Abenomics (government spending, aggressive central bank asset purchases and structural reforms) will work, it has shown some early wins with first quarter GDP revised up to 4.1% and a leading inflation indicator was positive for the first time since In June manufacturing rose to its highest level since February 2011 and higher than that of the Eurozone and China. Emerging Markets Emerging markets have been punished by several factors driving the MSCI Emerging Markets index down 20% from its late 2012 peak. Emerging markets were weighed down by the combination of a slowing Chinese economy, tapering by the Fed, a weaker yen, recent declines in EM company profitability, and public frustration over government policies resulting in riots in Brazil and Turkey. Higher bus fares in Brazil and destruction of a park in Turkey were the last straws. Much has also been made of the global economy rebalancing from one dominated by the West to one with a larger contribution from the emerging world. What we observe about world economy is that it is indeed rebalancing but the rebalance is not simply the rise of the emerging world and the decline of the West. Instead, it is the emergence of a few winners and many losers. In Europe, France, Italy and Spain are doing relatively poorly while Germany and some of the Nordic countries are faring far better. The U.S. refuses to fade into the global economic background. Over the past year, the U.S. economy grew at about the same pace as the global average for the first time since The United States is still the star among developed market economies. Among the emerging market BRIC nations only

8 China is growing faster than the emerging markets average. While China is slowing from 11% annual growth to 7 8% China still figures to be a major driver of the global growth, volatility notwithstanding. Smaller emerging countries, such as, Philippines, Nigeria and Turkey are rising and are likely to be the new emerging markets stars. Generalizing about the emerging markets is difficult but we see the secular bull case for emerging markets remaining intact even though the relative attractiveness of some of the countries may be changing: 1) continued robust growth of 5% on average, more than double that of developed market economies; 2) less reliance on developed market countries as a result of growth trade between EM countries, 3) the emergence of the EM consumer class, 3) significant foreign currency reserves held by EM countries that can be used to stimulate growth if needed; 4) fiscal surpluses among EM countries, 5) lower levels of leverage among EM sovereigns, and 6) consistently higher profitability of EM companies over the last decade. Emerging markets have recently entered bear market territory with a 20% peak to trough decline and are selling at 10X forward earnings, the cheapest valuations relative to the world since Currencies After falling about 5% against developed market currencies from its end of May peak the U.S. dollar has staged an impressive rally as interest rates moved higher. The dollar is up about 5% against a basket of emerging markets currencies since the beginning of May. Since 2008, the weaker dollar correlated with stronger equities. However, this correlation has broken down over the course of the last year.

9 Despite the recent U.S. dollar rally, we believe longer term currency fundamentals continue to favor emerging countries. Significantly better fiscal positions and higher local market cash yields both favor emerging currencies. The point at which U.S. rates stop rising and the decline in the Japanese yen levels off may be the point at which we see EM currencies rally. U.S. EQUITY FUNDAMENTALS The first quarter of 2013 saw record corporate earnings in spite of anemic revenue growth. Careful expense management and cost cutting has been a key driver and bodes poorly for material employment gains absent more robust revenue growth. Margins are at among the highest levels in recent memory and we wonder how much higher they can go given the already lean cost structures of corporate America. That said, Wall Street analysts are anticipating increasing margins this year and next as they derive their earnings estimates. This seems too optimistic in isolation. Few of the investment managers we speak with are as optimistic on margins as the analysts.

10 With the low in interest rates likely behind us, further P/E multiple expansion is difficult to bank on. Our framework still calls for revenue growth to be the key driver of business and stock price performance. Looking at the regional composition of corporate earnings we note that approximately 45% of company revenues are earned abroad. While global real GDP growth is expected to come in around % there are signs that Europe s nearly two year recession is abating. The remaining 55% of S&P 500 earnings may benefit from improved consumer confidence and the improving housing market. However, higher interest rates and Fed s tapering of QE pose a potential risk to growth. Revenue expectations are low enough at this point that any incremental positive revenue surprise may be greeted enthusiastically by investors.

11 CONCLUSIONS The Fed s QE tapering announcement caught investors by surprise. Markets have started the process of revaluing asset classes such that the previously distorted relationship between yield bearing assets and non yield assets is coming more in line with historical norms. A return to the old normal is too soon to call, but perhaps we have taken a step in that direction. We anticipate a continuation of the slow growth muddle through economy. The Fed s path to a more normal monetary policy will create volatility as an unwind this large is without precedent. Interest rates from here should reflect underlying fundamentals and more closely track the trajectory of nominal growth. At a minimum, the rebound in real rates, the drop in gold and rising consumer confidence are suggestive of a decline in pessimism. U.S. corporations have squeezed about as much growth as they can from profit margins. Incremental growth must now come from the top line growth. While little progress has been made with Europe s structural problems there are nascent signs a cyclical improvement is underway. In Japan, it is too soon to tell if Abenomics (government spending, aggressive central bank asset purchases and structural reforms) will work, it has shown some early wins. Developed market equities are neither overvalued nor undervalued. Emerging markets are now in bear market territory and may have overcorrected. China is dealing with a property bubble that has important implications but should not be confused with the U.S. subprime problem. Additionally, China s path to a more consumer driven economy is a difficult one and the transition is exacting a cost on not only China, but world GDP growth and commodities.