BlackRock expects a rise in U.S. yields. Muhlenkamp anticipates more volatility in U.S. stocks. The No-Load Investor does not see emerging markets as an opportunity now. S&P likes Oppenheimer Main Street Select fund. Schwab recommends bond barbells. Barclays expects more bumps in emerging markets.
Sovereign Bonds: Reassessing The Risk-Free Rate
Governments are in the business of promises and delivery. Promises include those made to purchasers of their debt as well as the beneficiaries of their borrowing. The beneficiaries — largely welfare and social spending recipients — are voters, which makes breach of promise a serious political risk. Yet the current position in a number of countries is unsustainable. Debt levels, servicing costs, longevity and a natural political objection to excessive transfer payments to non-domestic investors suggest strongly that: a) not every investor can be repaid at par, and b) not every beneficiary can be made whole in real terms.
At the same time, there is some good news: Government promises take a long time to crystallize. This means that governments have time to make fiscal adjustments, and that default — if defined by missing an actual payment — is likely to be a rare occurrence. Willingness to pay matters more than ability to pay.
Governments, of course, have a range of tools available with which to put off the ugly day of reckoning. Among those from the past likely to reappear are financial repression and the concept of soft default.
Financial repression — perhaps better described as captive capital — takes many forms. Regulatory reforms, changes in investor priorities and the simpler form of enforced asset preference delivered by targeted asset purchase programs all increase demand for government debt relative to other assets on a partially price-insensitive basis. We expect that these trends will persist in indebted nations. One obvious conclusion is that these nations will have low nominal growth (because of enforced asset preferences) and lower nominal interest rates (in part to ensure the cost of debt service remains manageable).
Soft default should also become more prevalent in the years ahead. This could take the well-worn route of rescheduling payments or providing cross-national guarantees. Other forms of soft default involve rescheduling obligations to beneficiaries and realigning fiscal policy. Certainly, an easier path politically is to focus on lenders first and default on beneficiaries (your citizens) only when absolutely necessary. History suggests that an increase in resource transfer to non-domestic investors of more than 2% to 3% of GDP, accompanied by austerity programs and benefit rescheduling, is rare.
Markets have become quicker to punish and slower to forgive poorer-quality issuers. The speed with which the PIIGS (Portugal, Ireland, Italy, Greece, Spain) crisis in Europe blew up has left many investors unwilling to give risky sovereign issuers the benefit of the doubt. This arises in part from the status of government debt as near-money and the pain inflicted on issuers when this status appears to be remotely at risk. The market reaction will also likely remain swift given that the regulatory cycle forces many investor groups to eschew risk even where return appears reasonable. And, of course — as Europe reminds us — a sovereign debt crisis becomes a banking crisis very quickly, and will continue to do so where bank capital ratios increasingly rest on sovereign debt prices, volatility and liquidity.
This means that a robust approach to the assessment of sovereign risk has become even more essential. It also means that investors must assess risk of one issuer relative to another. Some factors are more important than others — including maturity profile, domestic/foreign ownership balance, issuer credibility and general financial depth. Many of these are slow moving in nature; in the short term, liquidity and volatility will continue to provide the early warning signs for investors.
Turning to the largest single risk-free asset in the world — US Treasuries — we are not doom-mongers. The US fiscal deficit is a serious issue. The apparent political logjam at the federal level contrasts with the real progress being made at state and municipal levels in addressing entitlement spending. While the maturity profile is less advantageous than for other G7 countries, the scope for financial repression is considerable, the nature of many of the liabilities is long term and the financial system is deep enough to sustain the position for a long time. The price for this — low nominal rates and low nominal growth — may, of course, be another issue. But we do not believe in a bond buyer’s strike in the United States, but rather expect a normal (and muted) natural cyclical rise in yields.
We remain convinced that for many countries the risks of actual default are very low, but also believe that the burden of proof for risk-free status has risen considerably and that the vigilance required to monitor this risk has increased. Additionally, our assessment is that domestic political pressures in highly indebted countries should form an important point of focus for investors going forward. For these countries, interest rates and growth potential should remain lower for longer, and this should equally be the case for higher-quality issuers whose debt will be in material demand. As a result, it seems likely to us that returns for low-risk assets will remain low, and that investors should exercise extreme caution as a result.
Ron Muhlenkamp, Muhlenkamp & Company
In our newsletter of three months ago, we gave brief reviews of the main economic drivers we saw in the world economy, namely, the United States, Europe, and China. In the first quarter of 2011, we’ve had to add two more: Japan and Libya.
We wrote: In the U.S., the economy continues to expand at a modest rate as consumers continue to save a greater proportion of their incomes. This increased saving by the consumer, however, is being offset by increased borrowing by the government. While the headline’s focus has been on the federal government borrowing, it is state and municipal borrowing that is likely to trigger the next financial panic. Many states and municipalities have made pay and pension promises they simply cannot keep. Meanwhile, companies have been reluctant to hire because, for most of the year, the costs of employing people had been scheduled to go up, particularly for taxes, regulations, and health insurance. Since the November elections, present tax rates have been extended which should help increase employment.
Indeed, since November, employment has increased at a modest rate as employers see a two-year extension of current tax rates. The pressures on state and municipal finances have become visible with demonstrations in capitol buildings and legislators boycotting votes by fleeing to other states. What we’re seeing is just the beginning.
In our quarterly newsletter published in October 2010, (‘Memorandum #96), we stated, “Yes, our pension plans own stocks and bonds. Politically, we still argue about ‘us’ versus ‘them.’ In reality, it is now ‘us’ versus ‘us.’” On the following pages, we’ve updated data that I’ve monitored for over 25 years. Many who want to raise taxes on corporations believe that corporate stocks and bonds are owned by “the rich.” In fact, much of corporate stocks and bonds are owned by pension funds.
In ‘Memorandum #97, we also wrote: In 2010, the shocks to the markets and the financial system came from Europe. Since the adoption of the euro currency in 1999, a number of countries have taken advantage of low interest rates to spend money well beyond their tax receipts. In 2010, the “chickens came home to roost.” Greece, in the spring, and Ireland, in the fall, required bailouts by other members of the European community. Much of the sovereign (country) debt is held by European commercial banks across the continent, which likely forced these banks to sell other assets. We do know that, recently, markets in Europe, the U.S., and elsewhere declined when the sovereign debt problems came to the fore. Many European countries are adopting budgets that rein in government spending, (much like Canada did in 1995), but it is not yet clear that their citizens will accept the budgets instead of rioting in the streets. So the European crisis is not over.
Since then, Portugal has joined Greece and Ireland on Europe’s “sick list.” Again, the European crisis is not over.
We added: The swing member of the international community is now China. While China amounts for only 9% of world GDP (Gross Domestic Product), it is over 40% of the GDP of “emerging markets.” After the meltdown of the fourth quarter of 2008, when many governments (including the U.S.) adopted plans for economic stimulus, China stimulated more than others. Much of its stimulus went into useful infrastructure, but a lot also went into real estate of a bubble character. (If you want to see a beautiful ghost town, look up Ordos, China on Google Maps.) Adding stimulus is easy, removing stimulus is tricky; China has now begun removing stimulus.
China continues to remove stimulus and to raise interest rates (five times so far) to keep inflation under control. True to form, the Chinese economy is slowing and Chinese stocks have been declining.
More recently, of course, we’ve witnessed the earthquake and tsunami in Japan and the addition of Libya to the list of revolutions in the Middle East. The catastrophe in Japan will divert their resources from what they might otherwise have done to a focus on reconstruction and may change their mix of energy going forward. The revolutions in the Middle East (while probably necessary if the area is ever to join the list of developing nations), create further uncertainty which is most visible in the price of energy.
Meanwhile, our federal government is spending $3.6 trillion ($3,600,000,000,000) while collecting $2.0 trillion ($2,000,000,000,000) per year in taxes, borrowing the deficit balance of $1.6 trillion ($1,600,000,000,000). When you spread these amounts over roughly 100 million American families, federal spending averages $36,000 per family per year, federal tax receipts average $20,000 per family per year, and the federal deficit now averages $16,000 per family per year. This is the legacy we’re leaving our children and grandchildren. Currently, our politicians are arguing about whether to cut spending by $400 or $600 per family per year.
With all of this going on, some of our clientele have expressed surprise that stock prices have moved up strongly in the past six months. We believe this has been due to several factors:
* Attractive prices six months ago; we believe that prices, in general, are now fair.
* Modest continued growth in the U.S. economy.
* Quantitative easing of $600 billion in purchases by the Federal Reserve (QE2); this is scheduled to end as of 6/30/11.
The first two causes were fundamental. Quantitative Easing is simply pouring money into the market. We fear the effect is likely to be temporary and may, in fact, be detrimental in the longer term.
Our response in the past six months has been to be nearly fully invested in companies with strong balance sheets and strong income streams. With stocks, on average, now appearing fairly priced, we suspect that prices will be even more volatile going forward.
No-Load Fund Analyst
Stocks continued their upward march in the first quarter, with large-caps gaining almost 6%, while mid- and small-cap stocks posted gains approaching 8% (see table on back cover for index returns). Overseas, returns were not as strong, though still good. Developed-market foreign stocks were up more than 3%, while emerging-market equities gained just under 2% for the quarter. Domestic high-quality, intermediate-term bonds didn’t fare as well, barely gaining ground in the first quarter, while foreign bonds did a bit better, with developed-market government bonds gaining 0.7% and emerging-market bonds climbing by almost 3%. As a result of our conservative bias, the reasons for which we explain in our commentary below, our model portfolios generally trailed in the quarter. We are willing to accept underperformance in a strong up market because we don’t believe current valuations provide adequate return to compensate us for the risks we see, and so this is not unexpected or concerning to us. Our track record is very strong over the long term; this success stems from our willingness to invest based on our longer-term convictions.
We Are Not Perma-Bears, But We Are Cautious Now
For much of the last 13 years we have been cautious towards the stock market based on our assessment of market valuations and expected returns. This has frustrated our clients at times, the late 1990s being the most notable example, as the S&P and Nasdaq rocketed higher during the late stages of the tech bubble. We wrote about our market concerns at that time, and our caution proved to be warranted. Despite another bear market in 2008, all of our portfolio models outper formed their benchmarks during this period, though there were a couple of per-formance slumps along the way— notably in 1998 and 2008. Our analysis causes us to remain cautious towards equities today. >
As we reflect back and look forward, there are several points worth emphasizing.
1. Our long-term, valuation-driven and scenario-based approach has served us very well over lengthy time periods. Occasionally, over shorter time periods we can be wrong, too early, or blindsided by unexpected events (such as 9/11, natural disasters, geopolitics).
2. Even in the midst of multiyear periods where returns are low there are opportunities to add incremental value. In fact, these low-return periods are often characterized by heightened volatility that can offer occasional fat pitches in “risky” asset classes like equities, REITs, and high-yield bonds. We have been able to take advantage of a number of fat pitches in each of the last two cycles and they have contributed significantly to our return premium over the benchmark during this period.
3. We are not perma-bears. There have been extended periods over the past decade where our equity exposure was at a neutral level and/or our actual “equity like” exposure was at or above neutral (taking into account exposure to asset classes that have some equity-like risk such as high-yield bonds and REITs).
4. As we look ahead, we continue to see an unusually wide range of possible outcomes for the economy and stock market. The weight of the evidence continues to suggest mediocre to low returns for the financial markets over our five-year time horizon. We remain cautious and somewhat defensive.
Stock Returns—Why We Remain Cautious
Stocks are the primary asset class for taking on risk. So when expected returns from stocks are not attractive to us, our positioning is likely to be cautious—as it is today. To understand the potential upside for stocks it’s important to evaluate each of the factors that drives returns and how they might behave over our investment horizon. There are three key variables we assess: dividends, earnings growth, and changes in the price/earnings ratio. Our scenario analysis focuses on assessing each.
Dividends are the easiest to analyze. Today’s dividend yield is very low, so low that even strong growth in dividends paid will not make the dividend-yield a huge contributor to returns over the next five years. As we write this the S&P 500 currently yields about 1.8%. Compare this to the 25-year average of 2.3% and the 50-year average of 3.1%. Bull markets in the past have always begun with higher-than-average dividend yields. Since 1926, the only time the dividend yield was lower than it is now was during the period of elevated stock valuations during the late 1990s and early 2000s. It’s easier to capture strong returns over multiyear periods when more of the return comes from dividends.
Earnings growth is more challenging to assess and forecast. We’ve written extensively over the years about our scenario approach to identifying the potential range for earnings over our five-year investment horizon. We start with a general premise that overall economic growth is an important driver of earnings growth.
Over the very long term the rate of GDP growth and earnings growth has been similar, though there are shorter periods when the relationship has not held. It’s also clear from the chart that earnings are much more volatile than GDP and that earnings volatility has increased over time. Various factors have increased earnings volatility, including rising debt levels in the economy and in the corporate sector, as well as accounting changes and perhaps most important, a greatly increased tendency for corporations to take write-offs. (Note that these are reported or “GAAP” earnings, as opposed to so-called “operating” earnings, which exclude write-offs.)
Earnings have rebounded powerfully since the very deep trough in 2009. This rebound has been driven by cost cutting and government stimulus (neither of which will be sustained) and emerging markets’ growth, which we believe is likely to be sustained (though inflation in emerging markets presents a serious risk). Our scenario work suggests that, despite the sharp rebound in earnings, growth is likely to be subpar as the rest of the cycle unfolds. Subpar economic growth is consistent with historical outcomes in the aftermath of a financial crisis. This history dovetails with a key assumption influencing our analysis—that the excessive private and public debt cloud hanging over the economy will result in continued deleveraging and therefore a lower level of consumption than would otherwise be the case. Private debt has declined from its peak but remains historically high while public debt has spiked higher and will continue to increase given growing entitlement costs as baby boomers age.
In addition, profit margins are far above their average level of the past 30 years and tend not to stay elevated for long. This suggests that revenue growth will have to be exceptionally strong relative to expense growth in order to drive continued earnings growth. That would be a particularly impressive achievement in the face of the debt-related demand headwinds we foresee. Increased regulation and the likelihood of higher taxes also could challenge growth. So could unexpected economic events—such as growing instability in the Middle East (which triggered a rise in the price of oil) and Japan’s tragic natural disaster, which will have a temporary impact on the global supply chain and Japan’s growth rate.
Still, there are some offsetting positives. The most significant is the growth in the developing world, which is benefiting many U.S. companies. Our S&P 500 earnings assumptions for each scenario factor in a material emerging markets impact, but it is not enough to fully offset the other macro headwinds.
Looking out over our five-year investment horizon, our wide range of possible S&P earnings results underscores the uncertainty inherent in today’s global macro environment. On the high side, our range reflects a return to normal growth, with GAAP earnings hitting $108, and on the low side, it reflects a return to recession and a deflationary environment dropping earnings to $58.
Changes in the P/E multiple (the price that stocks sell at relative to their earnings) can be affected by a number of factors, including: expectations for growth, the level of interest and inflation rates, and investor sentiment. One issue we keep in mind is that investors don’t like extremes of either high inflation or deflation. If they are worried about either of these, stock prices have tended to fall, taking P/Es lower. Our forecasts are influenced by historical P/E ranges with attention paid to P/E levels in various types of economic and market environments. In our scenarios P/E assumptions range from 12x earnings to 18x earnings (P/Es based on 12-month trailing GAAP earnings have averaged about 16.5x since the end of WWII).
This all nets out to a wide annualized return range for stocks of -8% (deflation) to 11% (return to normal) from a starting S&P level of just below 1300. While this is the broad range, we believe the evidence suggests stock market returns are likely to come in around the midpoint of this range—in other words, low single digits.
At the low end, we believe the deflationary scenario is not likely. The economy has been improving and the developing world is growing at a healthy clip and is now big enough to have a material impact on global growth. However, the deflationary scenario is not so improbable to justify dismissing it. At the other end, we also don’t view a return to normal as highly probable given the continued stress points in the economy including high public and private debt levels throughout most of the developed world, weakness in the labor market, and the threat of further declines in housing prices. Additionally there are the global risks of spiking oil prices, food and commodity-driven inflation in emerging markets, and now supply chain disruptions from Japan. It is true that the U.S. economy has clearly improved. This contributes to our view that continued subpar growth, not imminent recession, is the most likely scenario. However this recovery is unusually weak despite the fact that the downturn was so sharp (which normally results in an equally sharp rebound) and the fact that there has been massive fiscal and monetary stimulus.
The stimulus and quantitative easing are scheduled to wind down in coming months; it is not clear that the private sector is ready to take the baton and accelerate into a normal recovery mode. Consumer confidence is improved from its lowest levels but remains weak overall. Business confidence is back to normal levels, however, CEOs remain concerned about consumer demand. The labor market looks set to improve, but the improvement so far is at a rate that is not contributing enough to job growth (all measures of unemployment are historically quite bad—for example the U6 rate which measures the unemployed, underemployed, and “discouraged” workers is at an extremely high 16%).
In our view, the European equity markets remain similar to those in the United States with respect to overall fundamentals and return potential. Europe continues to struggle with its own debt crisis and economic challenges. The single currency greatly complicates policy management for a group of countries with entirely different economic fundamentals—a powerful Germany at one extreme and debt-plagued Greece, Ireland, and Portugal at the other.
Our modeling work suggests emerging-market equities will generate higher returns than developed markets over our investment horizon but with potentially higher short-term volatility. They are not currently attractive enough on a risk-adjusted basis to qualify as a tactical opportunity. The growing inflation risk in emerging markets has led them to underperform since late last year and is a near-term concern that we are monitoring.
There are risks to our view on equities and they mostly relate to “tail” risks—the risk that one of the more extreme outcomes plays out.
On the downside, we could be underestimating the odds of a deflationary scenario. If heavily indebted households and governments retrench, the resulting drop in aggregate demand for goods and services could send prices dramatically lower. Such bouts of deflation can be self reinforcing.
Policy risk in the United States and around the world is a major concern. How high might interest rates rise and what will happen to financial markets when the Fed stops buying U.S. Treasuries at the end of QE2 in June? It has purchased 70% of the new Treasury supply since last summer and PIMCO estimates that rates would be 1.5 percentage points higher without Fed buying. How will politicians address the deficit? The issue must be dealt with, but it is highly politicized and must be handled with intelligent policies and at the right pace. What is “right” is debatable but the increasing willingness of some politicians to consider tax and entitlement reform offers a little hope, though it’s difficult for us to have much confidence in the outcome of political debates these days. Despite these very real concerns we continue to believe that the strength and growing influence of the developing world and the resiliency and resources of the United States make the deflationary outcome a relatively low probability.
At the other extreme we could be underestimating the risk that inflation might spike considerably higher, driven by rising commodity prices due to emerging-market demand, further disruptions of oil supply, and by government policy that is left with no choice but to inflate away the debt problem (the alternative is politically unpopular tax increases and spending cuts). Somewhat higher inflation in the near term is quite possible due to rising commodity-driven import prices and we believe higher inflation is probable over our five-year investment horizon. But with sizable slack in the economy and no sign of upward pressure on wages (which would seem critical in order to generate a 1970s-style wage-price inflationary spiral), sharply higher prices don’t seem to be in the cards any time soon. (Aside from the inflation worry, rising commodity prices, if not passed through to the end consumer, imply a profit-margin squeeze to corporate earnings.) Never before in our investment careers (some going back more than three decades) have we felt the need to consider the possibilities of both deflation and inflation—this underscores the unusually high macro uncertainty.
On the upside, we may be overestimating the magnitude of the deleveraging to come, or underestimating the potential for households to leverage up one more time. Moreover, emerging markets might have even more global macro influence than we give them credit for, and may themselves leverage up more than we expect. We could also be underestimating the willingness of the financial markets to allow the United States to inflate away its debt problem. But overall, we believe the “return to normal and perhaps beyond” outcome is also unlikely, particularly the willingness and ability of U.S. households to support consumption by taking on more leverage in an environment where lending standards have tightened considerably.
Alternatively, we may be underestimating the possibility of another low-interest-rate-triggered bubble, where investors are tempted to take more and more risk because of the skimpy yields available in the bond and money markets. Money market fund yields border on zero. The longer the economy can muddle through in a low-rate environment, perhaps the greater the potential for temporarily higher equity returns. This is by no means a far-fetched possibility—in our view it is already happening, with the stock market up over 20% since the Fed’s announced the second round of quantitative easing last summer. (In fact, an explicit goal of QE2 was to cause equity prices to rise with the aim of generating a positive wealth effect that would stimulate real economy.) However, if this happens in a big way and without strong business fundamentals supporting the higher stock prices, we expect it to end badly as bubbles always do. Ultimately interest rates will rise, removing the justification for holding riskier assets at high prices. If rates don’t rise it will mean that the deflation scenario is playing out, which obviously would be bad for stocks as well. In the meantime, the pain of foregone opportunity, given our underweight to equities, might sting for a while.
One last possibility is that well-run actively managed funds could enter a period in which a healthy return premium can be achieved relative to the overall market. We saw this briefly in 2009, but for much of the post-crisis period stock prices have been highly correlated, suggesting that investors were focused on asset-class-level macro factors rather than individual company fundamentals and valuations. Recently, correlations have been declining, which should be a good thing for stock picking. We’re not hugely confident in making this call and we don’t factor it heavily into our decision making, but it would not surprise us to see the equity funds we own significantly outperform their benchmarks over the next few years.
Ari Benginger, S&P Equity Analyst:
MUTUAL FUND PERFOMANCE LAGGARDS THAT ARE WORTH A LOOK
With the first quarter now squarely on the books, we think the month of April serves as an opportune time to gauge year to date performance of mutual funds. Earlier this month, we took a closer look at some S&P positively ranked mutual funds that were off to a good start with 2011 performance. This week, we take the opposite approach and review some positively ranked funds that have had a rough go in terms of performance so far this year. While no one likes an underperformer, we screened for mutual funds that have lagged peers year to date but still enjoy a positive S&P ranking, as we think these may offer an opportunity for investors.
Notably, S&P's Mutual Fund research on MarktetScope Advisor not only tracks performance, but also scrutinizes cost factors and underlying holdings through a variety of proprietary rankings that measure quality, value, and credit risk among other metrics. The ranking allows investors to look beyond short-term performance as the sole deciding factor, and it considers other positive metrics that could act as a catalyst for a fund. In our search for positively ranked names, we excluded all sector-focused funds, as they tend to perform more in-line with respective GICS sectors, and performance is less of a result of active professional management skills. Instead, we focused on the large-cap space that we think offers diversification. According to MarketScope Advisor's mutual fund screener, there were 150 domestic equity large-cap mutual funds that underperformed the S&P 500 benchmark year to date by at least 200 basis points, but only 30 of them are currently ranked by S&P Equity Research as a four- or five-star fund. We highlight three of those funds that qualified below.
Oppenheimer Main Street Select fund; Y As of April 8, 2010, this S&P four-star large-cap core fund generated a total return of 0.7% on a year to date basis, trailing its peer group average of 5.7%. Still, the fund has a strong three-year performance record that ranks in the second quartile of its peer group, with a total return of 1.6%, nearly double the 0.9% average registered by peers for the same period. Moreover, OMSYX has a low net expense ratio of 0.80%, about 40% below the peer average of 1.27%, and its recent dividend yield of 2.34% is above the peer average of 2.16%. Despite a relatively poor one-year performance record, OMSYX garners a positive performance analytics ranking driven by favorable rankings for S&P STARS and S&P Fair Value. The fund is fairly diversified with at least 8% of its portfolio composition spread across the GICS sectors of information technology, financials, consumer discretionary, energy, industrials, health care, and consumer staples, as of end of February.
Looking closer at the portfolio, we like that the fund's top-three holdings included S&P strong buy recommended stocks Apple, Chevron, and Celgene.
Tributary Large Cap Growth Fund
This five-star large-cap core fund generated a year to date annual total return of 2.4% compared to the peer average of 5.7%, as of April 8, 2010. While the fund's one-year performance metrics lag peers, its three-year average annualized return was ranked in the top quartile of peers. The fund also has a portfolio turnover of 14%, well below the peer average of 69% and relatively long management tenure since mid-2007 inception. As of the end of February, FOLCX had 33% of its holdings in information technology, 16% in consumer staples, 13% in consumer discretionary, 10% in industrials, and 9% in health care. The fund's top-10 holdings included S&P positively recommended stocks Hewlett Packard, Whole Food Market, Pepsico, Praxair, Microsoft and Cisco.
Moreover, FOLCX has favorable characteristics for S&P Fair Value, S&P Quality Rank, and S&P Credit Rating.
Aston/MD Sass Enhanced Equity Fund
This four-star large-cap core fund lags its peer group in year to date performance, as of April 8, 2010, with a 2.69% annualized total return compared to a 5.7% peer average. The fund's three-year performance is favorable, however, with an annualized total return of 2.4%, considerably higher than the 0.9% return registered by peers. While the fund's expense ratio of 1.37% is slightly above the peer average of 1.28%, AMBEX does not incur a sales load and it generates a sharp ratio better than peers (0.22 vs. 0.18). As of the end of February, AMBEX had 19% of its holdings in information technology and roughly 14% each in the sectors of industrials, utilities, and health care. The fund's top-10 holdings included S&P positively recommended stocks CVS Caremark, MetLife, Pepsico, and FirstEnergy Corp. We note that the fund's dividend yield of 2.95% compares favorable to the peer average of 2.16%. Other positives include a low turnover ratio of 41% versus 69% for its peers and favorable characteristics for S&P Fair Value, S&P Quality Rank, and S&P Credit Rating. As seen from the above examples, funds that have underperformed peers year to date can still have many favorable characteristics that position it well relative to peers.
Rob Williams, Schwab Center for Financial Research
For most investors holding individual bonds, we're strong believers in using bond ladders—they're a great way to manage a host of challenges:
* Managing interest-rate risk while also generating higher income
* Portfolio diversification
* Creating a staggered return of principal to reinvest or to support spending needs
However, we know that many investors are wary of committing money to new bonds today—particularly to those with longer maturities. You may have let your bond ladder lapse, or have cash to invest and are just looking to re-enter the market in an uncomfortably low interest-rate environment.
A barbell—which allows you to focus on some longer-term bonds while keeping other money in short-term investments—may be a smart approach. Whether you have money to move back into the market or want to build a bond portfolio over time, here are some things to consider.
Ladders versus barbells
Most bond investors are familiar with bond ladders, in which individual bonds are purchased at staggered maturities over multiple years. This way, some bonds will always be maturing, while others invested for the longer term generate higher income. (Longer-term bonds usually yield higher coupon payments to compensate investors for uncertainties about inflation and future interest rates over a longer time period.)
By contrast, a barbell has two ends that are "weighted," with not very much in the middle, and typically involve a balance of long-term bonds and cash. This strategy takes advantage of higher coupon payments for bonds with long maturities while keeping money in cash and short-term investments for short-term liquidity or to reinvest if yields rise.
Benefits of a barbell in current interest-rate environment
Why focus new purchases on longer maturities instead of a more-typical ladder? We're a strong advocate of ladders and don't suggest you change course now if you have one today. However, if you don't have a ladder, or if you had one previously but haven't been reinvesting bonds as they've matured, a barbell strategy for new purchases may be a good way to move money back into investments to generate higher yields today.
Current yields on short-term bonds and cash are very low and not particularly appealing, even though price volatility is likely to be lower if rates rise. But, as maturities go longer, yields increase. The pace of the yield increase picks up quickly as you move from bonds with maturities between one and five years into bonds with maturities between five and 10 years. This sort of environment is known as a "steep" yield curve.
The pace of yield increases slows dramatically, however, after you move past 10 to 12 years (for most types of bonds). You get less bang for your buck for every dollar invested, but you commit your capital for a much-longer time horizon.
The risk of volatility in the value of bonds you hold increases quickly, however, as the maturities increase. Bonds change in value if market interest rates (yields) change, and the effect is more pronounced for bonds with longer maturities.
This choice of targeted maturities is a critical variable in successful bond investing. It's particularly critical today, given uncertainty about future rates and the low-yield environment, especially for the least-volatile, but lowest-paying, CDs and short-term bonds.
The effect of this steep yield curve is particularly pronounced now, as the Federal Reserve continues an aggressive campaign to keep short-term interest rates low. At the same time, longer-term rates have already risen, anticipating an eventual shift in Fed monetary policy, as well as expectations of inflation, worries about the US deficit and other factors.
The yield curve is particularly steep today due to these factors. And we worry about the heighted risk for bonds with much longer maturities, given the heightened volatility and lower payoff if yields in the market rise.
Because of all of these dynamics, we see the best value today in bonds (be they US Treasuries, municipals or high-quality corporates) with maturities between eight and 12 years. This is the range to target, starting with a barbell strategy. Continue to keep some money in short-term investments—the other end of the barbell—to reinvest over time as Fed policy normalizes and short-term rates begin to rise.
First a barbell, then a ladder over time
Market prognosticators have been predicting dramatically rising yields for more than two years, but it hasn't happened to the degree projected by more the more-aggressive forecasters—at least not yet.
If you haven't been investing in new bonds but want to be—maybe you've hesitated while wondering how to invest in the current market—a modification of the barbell strategy can be used to build into a well-balanced, mature bond ladder over time. Keeping with our imagery, let's coin a new phrase and call it a "hammer"—a barbell with only one end: the part with the eight- to 12-year maturity target that you'll add to over time.
If you're nearing retirement (say 10 years out), buy a mix of Treasury, municipal and high-quality corporate bonds with maturities between eight and 12 years, and plan to hold them to maturity. Next year, buy more. The bonds you bought last year will be a year closer to maturity. In 10 years, you'll have a bond portfolio with multiple maturities. In short, you'll have built a bond ladder over time.
You'll benefit if interest rates do rise, effectively "dollar-cost-averaging" into rising yields over time. You also benefit from a proactive plan to build your portfolio and won't have waited too long to build the type of portfolio needed for a base level of income to support your retirement needs.
Other tactics to consider
With short-term rates so low and yields in the steep part of the yield curve more appealing, you could use other tactics to take advantage of the yield curve now. For example, you may have significant unrealized profits—meaning the value of your bonds have appreciated, but you've continued to hold them—on bonds maturing in the next few years. This is partly because short-term yields have fallen so low, pushing up the value of bonds purchased when yields were higher.
While you could be triggering a taxable event, consider swapping—that is, selling and reinvesting—some short-term bonds currently valued at significant premiums (the value of the bond over par) into bonds with more attractive yields with maturities between eight and 12 years. Of course, consider this tactic only if you won't need the principal from those shorter-maturity bonds soon, and make sure you understand the tax implications, if any.
Another tactic is the purchase of "kicker" bonds. These bonds can be "called" by the issuer and, for this reason, offer a significant yield premium compared to non-callable bonds. If rates drop they have a higher risk of being called, but if you believe rates will rise, call risk is less likely and you can benefit from higher yields now.
Donato Guarino, Roberto Melzi, Guillermo Mondino, Barclays Capital, Emerging Markets Outlook
Markets have continued to trade well, despite softer-than-expected US data and active sources of global risk. Given an anticipated mixed earnings season, a potentially noisy election in Nigeria that may maintain pressures on energy markets, and the approaching US debt limits and end of QE2, coupled with tight pricing, we prefer to tread with caution. Nevertheless, our positive outlook on inflows into the asset class leads us to maintain a modest bias towards remaining engaged.
Since the March Fed meeting, the US data flow has been somewhat softer than expected. Initial jobless claims increased (412k versus 380k expected), validating the soft trend, even though continuing claims continued to move lower. In response to the weaker data, Barclays Capital US economists lowered their estimate for US Q1 real GDP growth to 2.0% (from 3.5%), although the predictions for Q2 were increased to 3.5% from 3. The main driver was softer-thanexpected real consumption, affected by the higher inflation (particularly in food and energy prices).
Nevertheless, the soft readings also surely reflect bad weather conditions. Meanwhile, financial markets seem to remain focused on the growth outlook. In fact, external events that could have been a source of anxiety were surprisingly well absorbed. The Japan earthquake/nuclear threat that may have disrupted some production chains, political difficulties in the Middle East with their effect on oil prices and the still fluid situation in periphery Europe created only short-lived disruptions in risky assets. Equity markets provide further evidence that a strong growth outlook anchors markets, despite an anticipated mixed earnings season. Three spots remain hot in our radar screen. In the immediate future, we are concerned about Nigeria’s presidential election, which could increase anxieties in energy markets, as reflected in the significantly raised probability that oil moves higher). We also stay alert to potential swift movements in US Treasury markets in response to noise surrounding Congressional authorizations for indebtedness and the approach of the end of QE2. Finally, as highlighted in our Emerging Markets Quarterly, we still think that China’s restriction to credit creation might affect growth. In summary, while we remain engaged, we suspect that given current levels, bumpier roads in EM asset prices may be in store for the next few weeks. Furthermore, while we are constructive on medium-term technicals (mandates continue to be strong and put to work), positioning in some cases appears heavy, especially in some high yielding credits such as Argentina, USD/MXN and 1y receivers in Mexico. Therefore, we advocate a more cautious approach.
The new monetary policy paradigm
It is paradoxical that as some EM countries seem to be closer to recognizing that traditional tightening of monetary policy may be needed, the IMF is setting up for a weekend of discussions of capital controls, macro-prudential policies and FX intervention. While it is tempting to argue that the Fund is late to the game, the issues remain critical and promise to add to the uncertainty over the outlook of monetary policy and responses to inflation. The context appears particularly blurry, as EM FX policy seems to have changed in the past two weeks, with policymakers now seemingly more focused on inflation fighting and less on FX appreciation containment. Brazil is a case in point. On April 6, the government extended the 6% IOF tax to external borrowing transactions with a maturity of less than two years after having established the tax on one-year loans a week before. Finance Minister Mantega (who coined the “currency wars” phrase in late 2010) again mention his traditional line that more measures are in the pipeline, but the small magnitude of the initiative seemed to conceal the message that policies were effectively changing: Mantega reluctantly acknowledged that BRL strength was inevitable, given the economy’s bright outlook attracting flows and the USD’s weakening trend. While the BCB has continued intervening, signs of a policy-induced reversal of USD/BRL are no longer as credible. In fact, we now expect this cross to reach 1.50 in the next few months.
Meanwhile, Asian policymakers maintain their policy of gradual currency appreciation as their economies face increased inflation pressures. Malaysia’s central bank has intervened to reduce FX volatility and slow the pace of appreciation, and our sense is that while Indonesia’s central bank has attempted to arrest sharp moves, it has become more at ease with IDR strength. FX policy in EMEA, however, remains diverse, a reflection of heterogeneous macroeconomic conditions. We continue to see Poland, the Czech Republic and Hungary pursuing a hands-off approach, but Israel, Russia, Turkey and South Africa using FX intervention and/or macroprudential measures to limit capital flows and protect competitiveness. The influence of increased inflation risks on FX management is evident in Russia, while it may lead South Africa’s policymakers to be more tolerant of some FX appreciation in the short run. We believe Israel’s BoI is sympathetic to gradual FX strength, therefore maintaining FX interventions, and we do not discard the risk of more macro-prudential measures at the expense of rate hikes. EM FX seems to have responded to the change in approach, generally strengthening by more than what their sensitivities to global factors (namely, EUR/USD and VIX) would suggest. The only currency that has significantly underperformed is USD/PEN, thanks to idiosyncratic political noise. Meanwhile, the market perception about the government’s “new” approach to FX policy is evident in USD/BRL, which has declined about 300bp more than expected since the beginning of March. Similarly, significant inflationary pressures in Korea, together with a seemingly more open stance of the central bank towards FX appreciation, have led investors to sell USD more aggressively and, thus, led USD/KRW to outperform sharply.
What we like
FX: We still see value in tactical EUR/PLN shorts, although investor confidence in policy making should limit a decline beyond 3.90. Support arises from heightened expectations of rate hikes due to worse-than-expected inflation. We now expect more tightening this year. We warn against TRY longs, given worrying dynamics of the current account, its financing, and limited effect of macro-prudential measures on slowing down the economy. Our OTM put spread recommendation against USD still serves as a hedge for increased global risk aversion. While the risk-reward of short USD/Asia (especially KRW and SGD) positions is now less compelling, given the rally, we still think appreciation is in store in Q2. In fact, we recommend a 3m USD/MYR put spread (strikes: 3.0237 ATM and 2.94), partly funded by selling 3m USD/MYR calls (strike: 3.07) for a cost of 22bp. We now expect USD/MYR at 2.94/2.84 in 3m/12m. In LatAm, we recommend being short USD/BRL (target: 1.50), given the government’s “new” approach to FX policy and short USD/CLP (target: 460), as BCCh has refocused on fighting inflation pressures. Rates: We recommend payers in India and Korea. In the former, we like 1y payers, but think similar positions in 5y should benefit more from a significantly higher oil price. In the latter, the market is not pricing the three more rate hikes we expect, so together with the possible widening of the CD fix to the policy rate spread, front-end rates should trade higher. Meanwhile, BoK rhetoric indicates inflation risks remain and hikes are likely. In Indonesia, we like a 5y20y flattener. BI raised the holding period of SBIs from 1m to 6m, which effectively killed the secondary market for these bills. Long SBI investors moved into the front end of the government curve, causing a massive rally there: the 5y bond yield now trades at 6.5%, or 25bp below the policy rate. We remain paid 5y IRS in Poland. Negative inflation surprises should have implications for monetary policy, as NBP is just at the beginning of the tightening cycle. This week’s data releases (IP and PPI) will likely amplify the probability of rate hike in May. In Turkey, we maintain our 1y1y forward payer as a macro hedge. We do not expect the central bank to change the policy rate, but recent data show credit is not slowing down. This situation has negative implications for macroeconomic sustainability. In LatAm, we reiterate our view that Chile’s central bank has refocused on inflation fighting, so the recent sell-off in 5y breakeven inflation provides good entry points into a short position. We target 3.35%. In Brazil, we still like the mid-part of the Pre-DI curve, as the market continues to price a sufficiently bearish medium-term inflation outlook. That said, we see better entry points in the pipeline, as the market prices less than the 50bp Selic hike we expect on April 25 and there are risks of significantly worse-than-expected inflation readings.
