BlackRock reviews its accuracy for the year so far. Barclays advises on building a muni porfolio. Raymond James sees reasons to buy.
Bob Doll, BlackRock
At the halfway point of the year, we thought it would be appropriate to take a look at the predictions we made at the beginning of 2011 to see where we stand.
1. US growth accelerates as US real GDP reaches a new all-time high.
US real gross domestic product growth reached a new all-time high in the first quarter of 2011, so we have already gotten the second half of this prediction correct. The first half will be dependent on the degree to which the US economy is able to accelerate in the second half of this year.
2. The US economy creates 2 million to 3 million jobs in 2011 as unemployment falls to 9%.
Employment trends have been uneven so far in 2011, but as of the halfway point of the year, the pace of new jobs growth is above the midpoint of our 2 to 3 million mark. By the end of the year, we are expecting unemployment to be somewhere between 8% and 9%.
3. US stocks experience a third year of double-digit percentage returns for the first time in over a decade as corporate earnings reach a new all-time high.
In the first half of the year, US stocks appreciated by 6%, so if we are fortunate enough to see that pace continue, US equities would experience double-digit gains for the year. Regarding the second half of this prediction, earnings should reach a new all-time high in the third quarter.
4. Stocks outperform bonds and cash.
Again, if the first half of the year is any guide, we are on track to get this prediction correct since stocks have outperformed bonds and cash over the first six months of 2011.
5. The US stock market outperforms the MSCI World Index.
It is close, but as of the midpoint of the year, US stocks have outperformed the MSCI World Index (which was up 5.3%). Although there are a number of risks facing US markets, the same can be said for international markets as well, and we think US stocks remain better positioned than their developed market counterparts.
6. The United States, Germany and Brazil outperform Japan, Spain and China.
As of now, a basket of our “outperform” countries has outperformed a basket of our “underperform” countries on a year-to-date basis.
7. Commodities and emerging market currencies outperform the dollar, euro and yen.
Commodities are in positive territory for the year and have outperformed developed market currencies. Additionally, emerging market currencies have been stronger than developed market currencies to date.
Elizabeth Fell, Barclays Wealth
The Degree of Risk in the Municipal Market Today
The municipal bond market has experienced a turbulent few months. In reaction to heightened credit and interest rate risk, individual municipal investors have been selling all or a portion of their holdings. The selling pressure is clearly illustrated by dramatic municipal bond fund outflows (Figure 1). During the 12 weeks ended February 4, municipal bond funds experienced $35.8bn in outflows. 1 Over the near term, we expect increasing stability, but this stability is a function of below average new issuance rather than renewed confidence in the market place.
With only $12.2bn in new issuance in January, the lowest monthly volume since January of 20001, the selling by bond funds was partially balanced by limited supply. We believe that lower than typical issuance will continue into 2011 and will support the supply and demand picture. The absolute level of new issue municipals will remain below historic averages, in our opinion. In the short term, municipal rates will probably be driven higher with continued negative fund flows and rising Treasury yields. And we expect the specter of credit and rate concerns to be present in the municipal market place for the foreseeable future.
As industry experts continue to counter negative news about public sector finances and panic around municipal defaults subsides, we expect to see buyers returning to the market. Some buyers who prefer the buying opportunity a dislocated market represents may be concerned that “the municipal opportunity” is over. True, credit spreads tightened in January and bond prices rose, so for investors with strict yield targets, we recommend patience.
While buying opportunities may not be as widespread as in late 2010 and the first few weeks of 2011, we believe municipal bonds should continue to be a part of an investor’s portfolio. Most investors use municipals as a portfolio foundation. Taking on excess risk in municipals is unnecessary and portfolio risk should instead be taken in other asset classes. For clients currently invested, now is an excellent time to evaluate and adjust investments to ensure they have the right quality, ratings, and diversification.
Developing a Municipal Bond Portfolio Committed to a Strategy of Stability and Preservation of Capital
Investors should continually evaluate and be selective about the securities they hold in their municipal bond portfolio, but such attention is especially critical today. The key features to be considering are: duration, liquidity, credit quality, and diversification.
Duration—as a measure of a portfolio’s interest rate risk—is a critical risk area for municipal investors today. Barclays Wealth recommends a portfolio that is structured around a targeted duration of five to seven years. With the Federal Reserve on hold for the foreseeable future, a spike in interest rates substantially above today’s levels looks unlikely. Additionally if risk, either macroeconomic or geopolitical, increases unexpectedly, safe haven assets such as US Treasuries and high quality municipals will rally.
Consistent with our view that investors should be underweight cash and short-maturity bonds in their overall allocation, we recommend that investors consider selling one-, two- or three-year bonds and adding duration in the intermediate range. These short duration assets provide little return to the investor and act more like cash equivalents. We encourage investors to review their portfolios for holdings that may have rolled down the curve over time.
There are investors who are finding yields in the 5% range a very attractive inducement to go out longer in duration. Such a strategy brings with it higher levels of interest rate risk. Investors willing to take on a large degree of interest rate risk should also be prepared for greater price volatility.
For investors using a managed solution, ensure your duration targets are aligned with those of your selected manager. For investors in individual municipal bonds, a review of duration could be in order.
Today’s environment raises the possibility of liquidity risk, or more precisely stated the risk of illiquidity. For greater diversification, investors should look to include bonds from large issuers and well-known obligors with higher levels of liquidity. In many cases, the largest, most liquid issuer may be the state itself, but we also recommend bonds backed by well-known essential service revenues. Smaller, and in many cases, more local entities often have less appeal to institutional buyers which limits the potential purchasing pool. That, combined with fiscal headwinds at the local level, informs our preference for well-known, larger issuers.
One of the initial triggers of the recent sell off and spike in volatility was credit concerns. While we reiterate our view that widespread defaults are a low likelihood, we do recommend maintaining strict quality controls in all municipal bond portfolios. Investors should look to upgrade the quality of the issues they hold in their portfolios. We use the ratings and outlook for ratings as well as the quality of the revenue stream to do so.
Researching the supporting revenue streams of individual issues is important to evaluating the viability of a suitable investment. Investment should only occur in municipal bonds supported by long-term, ongoing streams of income such as toll revenue, sales tax revenue, and power revenue. Bonds that receive revenue streams from “projects” and health services should, broadly speaking, be avoided.
Diversification on a geographic as well as an economic basis is a newer wrinkle in portfolio construction and maintenance, but investors need to have strict diversification controls in their portfolios.
Geographic Diversification: Home state bias in municipal portfolios is a function of the tax benefit available at most state levels. With fiscal stress elevated and in some locations at fever pitch, investors, even those with a high state tax burden, should look to other states. For instance, a New York portfolio holder should consider allocating a portion of his municipal bonds to other states such as Minnesota, Wisconsin, Washington, and Tennessee. Investors looking for diversification to help limit portfolio volatility may want to consider avoiding issuers with lagging recoveries such as California, Illinois, Nevada, and Puerto Rico. In these states, the spread against the AAA curve (Figure 2) is relatively high and investing in them adds significant headline risk exposure. When choosing issues away from one’s home state, we recommend considering state unemployment levels, tax collection, spending rates, and pension liabilities, which all can be used to help determine whether a particular geography is stable or facing a slower recovery.
Economic Diversification: Municipal bond investments also expose investors to regional industries, and it is equally important to diversify this exposure. For example, New York municipal bond investors are heavily exposed to an economy based in financial services. Such a bond investor should diversify by buying Texas or Alaska municipal bonds, for example, two issuers who both provide exposure to an economy heavily influenced by the oil industry. We recommend that municipal bonds outside of the investor’s home state comprise up to 25% of the municipal bond portfolio, though the exact percentage will vary based on home state recovery and risk tolerance/tax sensitivity of an investor.
Market volatility has been the headline and many municipal investors have reacted by selling. Barclays Wealth recommends that clients take a more measured approach. Municipals should remain a part of an investor’s overall portfolio, but investors should be selective when building a municipal bond portfolio: consider duration, liquidity, credit quality, and diversification of holdings to support a strategy of stability and preservation of capital.
Jeffrey D. Saut, Raymond James
I’m back; back from what my analysts refer to as the “death march” through Europe. Why a “death march?” It’s because you see portfolio managers (PMs) all day in one city and then jet off to do the same thing in another city the next day. For example, last Tuesday I saw three different accounts in Zurich in the morning (an hour meeting each), spoke to about 40 PMs over lunch, saw two more accounts in the afternoon, and then flew to Vienna to speak at a dinner for 12 PMs. The next day I did the same thing in Geneva before flying that evening to Milano, but I digress. My sojourn began two weeks ago with an opening salvo in London. After doing CNBC Europe, and seeing accounts, I hosted a dinner for 15 PMs. It was an interesting exchange of ideas and after copious amounts of wine I stopped the various conversations and asked each attendee what their biggest fear was. The responses went like this: 1) fund managers that only use mutual funds and exchange trade funds (ETFs); 2) investing is practiced in a too complicated a
fashion when it should be easy; 3) a military coup in Greece; 4) inflation goes down instead of up; 5) China sells half of its Treasury Bonds; 6) Europe and the U.K. don’t tackle their pension problems; 7) there is blood in the street, but the markets trade higher; 8) most of the unemployed are un-hirable; 9) the EU doesn’t stay together; 10) water; 11) I used to worry about Ireland, but I don’t anymore (now that’s funny); 12) over regulation; 13) if the EU breaks up, what happens to the boom in German exports; 14) the fact that only 11 residents in Greece declared annual incomes of one million Euros or more; and the best – everyone is so negative that when the blue skies arrive they will be ignored.
Indeed, I visited 10 European cities over the last two weeks, and spoke with roughly 200 PMs, most of which were bearish and/or very bearish on U.S. equities. Their fears centered on our country’s debt situation, the dollar, and most importantly, the debt ceiling. It seems there is a genuine belief in Europe that the U.S. debt ceiling won’t be increased, leading to a default with an attendant rating downgrade. The Europeans don’t understand the political gamesmanship currently being played that will be resolved with a debt ceiling increase at the “last minute.” Nor do they understand the political consequences of social security checks stopping and public services shutting down. This becomes even more glaring 15 months before a Presidential election.
I tried to explain that Americans are pretty upset with all politicians, which is why the watershed mid-term elections showed a trend toward not electing professional politicians. Verily, I think the trend going forward is going to be electing people that have actually been in the private sector and know how to run a business. The era, in my opinion, of “the government is here to help you” is over.
That view was reinforced recently by a Rasmussen Survey that showed 72% of Americans favor the free market economy over one managed by the government. Accordingly, I think the constituency of Congress is going to change, with seven lawyers for every MBA in the House and eight lawyers for every MBA in the Senate, the time has come for practical people instead of professional arguers; maybe that is what the stock market is sensing.
The real surprise of the trip was a weekend in Warsaw, where I spoke to 18 pension fund managers. Poland’s economy, equity markets, and currency are booming. Said boom was fostered by some really good decisions from their practical government leaders years ago that have taken root. Cheryl and I took a four-hour private tour on Saturday with a gentleman that grew up under the Communist regime. He noted that he had to wait years to be able to buy a Yugo car. Now you see Volvos, Mercedes, and BMWs roaming the streets. The food at Warsaw’s best restaurants was terrific, with a typical meal costing $40 per person including wine. I wish we had time to make it to Krakow, hopefully on another trip. The people were fantastic; friendly, happy, willing to bend over backwards to help, and why not given the “boom” they are experiencing. In fact, the Warsaw experience makes me want to look at some of their banks for investment. To be sure, we were VERY impressed with Warsaw and can’t wait to go back.
The funniest experience of the trip came when we returned to London last Friday. I was again slated to spend the day seeing accounts; and sure enough, I spent the whole day doing just that. In the last meeting of the day, the PM said, as we adjourned the meeting, “I have read your missives for 11 years and always find them not only insightful, but entertaining, which is pretty rare on Wall Street. However, I REALLY like a man that is so self confident he can wear two different styles of shoe on each foot!” With that I looked down only to find I had spent the entire day walking around London with two differently styled black shoes and began to laugh. Apparently when I rose Friday morning, not wanting to awaken Cheryl, I dressed in the dark and put on one black English Brogue Wingtip and a black Ecco walking shoe. Alas, in this business it pays to be different, or rather “out of the box” (no pun intended).
Speaking of “out of the box,” the equity markets had been in a “out of the box” rally for the past few weeks, until Friday’s employment numbers. As our economist Scott Brown wrote: “Not good, and the markets were caught leaning the wrong way following Thursday’s better-than-expected ADP number (not the first time the market’s been faked out by the ADP report). There are no positive signs anywhere in this report. This report is a major disappointment (a negative for stocks and a plus for bonds), but it doesn’t really tell us much about what to expect in the second half of the year. The economy is likely to improve in the second half, but the pace may not be especially strong.”
I actually like the fact the numbers were disappointing since they are backward looking and because it will give us a chance to see how much downside traction the sellers will be able to muster. My guess is it won’t be much. This is confirmed by the astute Lowry’s organization, which writes:
“Lowry’s primary measure of investor Demand, the Buying Power Index, has decisively broken a downtrend dating to the February market high. In addition, the Short Term Index has broken a downtrend dating to late December ’10, while on a very short term basis, the 30-day moving average of Net Upside Volume has broken a downtrend [line] dating to mid January. These signs all suggest a change in pattern, that is, from weakening to strengthening Demand.
At the same time, Supply continues to contract, with the Selling Pressure Index recently at a new low for the bull market and at its lowest level since November ’04.”
My sense, therefore, is that the S&P 500 (SPX/1343.80) spends the next five to seven sessions vacillating between 1320 and 1350 until the equity markets’ internal energy is rebuilt for a move higher. Last week I suggested the SPX was extremely overbought based on a number of finger to wallet ratios and the 1340 – 1346 might contain the rally for awhile. Thursday’s perky ADP numbers allowed the SPX to better that level with a close of ~1353. However, Friday’s figures erased the Thursday thrust, as well as partially correcting some of the overbought condition. Consistent with these thoughts, I would continue to accumulate favorably rated stocks, many of which have been mentioned in these reports.
The call for this week: After three 90% Downside Days in June, July 1st registered a 90% Upside Day. That Upside Day was accompanied by a surge in Demand, as well as the steady increase in Demand that preceded it. Additionally, the New York Composite Advance/Decline Line is at a new rally high, implying the advance has been broad based. Then there is the D-J Transportation Average (TRAN/5548.66) that has traded to new all-time highs, registering one half of a Dow Theory “buy signal.” If the D-J Industrials (INDU/12657.20) march to a new reaction high above 12810.54 a full signal will be registered. All of this provides evidence that another rally leg appears to have begun. Clearly, I think the recent soft economic numbers are driven by one-off events like the weird weather, a 44% increase in gasoline prices, and the tragedy in Japan….my sense is that the SPX will spend a few sessions oscillating between 1320 and 1350 until the equity markets’ internal energy is rebuilt for a move higher.