Gonzalo Pángaro, T. Rowe Price
We believe the weakness in emerging market stocks stems from inflationary pressures and rising interest rates in developing countries. Recent political upheaval in Egypt and widening antigovernment protests in the Middle East have raised fears that the political unrest could have an adverse impact on stock prices in other emerging markets. However, we believe the outlook for emerging market stocks remains solid and the factors driving long-term expansion in emerging markets have not changed, in our view.
Rising inflation and tighter monetary policy weigh on sentiment.
We believe the recent underperformance of emerging market stocks reflects investors' concerns about accelerating inflation. The recent surge in global food and commodity costs has spurred fears that central banks in developing countries, including China, India, and Brazil, will continue to raise interest rates to combat inflation, which will hurt economic growth.
We believe the recent decline in emerging market stocks reflects a natural correction after the large gains in 2009 and 2010. Recent U.S. economic data have been increasingly positive and bolstered the attractiveness of U.S. and other developed markets stocks compared with emerging market stocks, which had a very strong run in the past two years.
The concerns about inflation and tighter monetary policy in emerging markets are near-term headwinds that may lead to some underperformance or sideways trading as global interest rates revert to normalized levels, in our view.
Egypt unrest highlights the political risk in some emerging markets
Unrest has spread across the Middle East and North Africa in the wake of mass protests that forced Egyptian President Hosni Mubarak out of office on February 12. Activists have been staging antigovernment demonstrations in Yemen, Bahrain, Libya, Jordan, and Algeria, with some demonstrations turning violent.
The political risks of investing in certain countries in the Middle East and North Africa have risen meaningfully over the past month and contributed to the heightened risk aversion toward emerging market stocks overall.
Long-term positive trends offset near-term headwinds
Rapid urbanization, the explosive growth of a consumer class, favorable demographics, and the need to invest in new infrastructure are some of the trends that we believe will underpin growth in emerging markets. These are secular trends that will develop over the course of many years, even as political unrest may lead to heightened risk aversion in the short term.
We continue to have a positive view of the outlook for emerging market stocks. It is important to note that emerging markets overall continue to have relatively strong and stable political frameworks and that the current uncertainty is taking place in select authoritarian countries in the Middle East and North Africa.
Julian Callow, Barclays Capital
Developments in the past week emphasise the importance for all governments to demonstrate credible fiscal consolidation plans. European governments received a wake-up call on this issue a year ago, but the end game has yet to play out: most countries are still in the early stages of an unprecedented collective bout of deficit cutting (while we appear to be heading towards a showdown for Greek and Portuguese fiscal policy this quarter). As well, the historic decision by S&P to place US sovereign debt on credit watch is a reminder that no country can ignore putting in place a robust framework for fiscal sustainability.
The latest IMF fiscal monitor signals that, of the major economies, it is the US and especially Japan, which face particular challenges to stabilise and ultimately turn around their rapidly escalating ratios of net debt to GDP. For example, the IMF projects that on unchanged policies the US net debt/GDP ratio will reach 86% by 2016 (from 64.8% last year), while the Japanese ratio will reach 164% (from 117% last year). In contrast, on the IMF projections the French and UK ratios would peak in 2013 (at 80.6% and 79.5%, respectively), before gradually declining, with the German ratio set to peak next year at 54.7%. Even before this year’s tragic developments, Japan’s net public debt ratio was much larger than its net international investment position (57% of GDP in 2009): ultimately radical changes in both fiscal and monetary policy seem likely to be required to place its net debt ratio on a stable long-term trajectory. Meanwhile, the US federal government has so far had a relatively easy ride, with the Fed buying $80bn of Treasuries per month during the second phase of large-scale asset purchases (LSAP). Even this has not been sufficient to soak up the full net federal borrowing requirement ($829bn in the past six months), but it implies that when LSAP ceases (most probably on schedule at end-June), markets will need to absorb a much larger flood of net issuance, which could constrain riskier assets during H2. Markets will be paying particular attention to next Wednesday’s inaugural Fed press conference, which will afford Chairman Bernanke the opportunity to shed light on the policy direction beyond June. While there are clearly many options available to the Fed during H2, we think that the initial path would be to maintain the size of the Fed’s balance sheet, by reinvesting the proceeds of MBS redemptions into Treasuries.
However, the impact of this would be very modest: for example, were the Fed to be entirely passive, then its balance sheet would diminish, via redemptions, at a rate of roughly $15- $20bn a month – effectively, a minor degree of tightening (the Fed has estimated that $500bn of asset holdings is roughly equivalent to a 50-75bp reduction in the fed funds rate). Whereas we continue to expect that the Fed will maintain a highly accommodative monetary policy, given the still-elevated unemployment rate and soft housing market, while the Bank of Japan may eventually need to undertake further easing, in most other regions central banks are set to remain in tightening mode. In emerging economies this is likely to continue to take the form of a mix of options, including in some cases permitting a somewhat stronger pace of currency appreciation, as well as changes to reserve requirements, capital controls and administrative guidance. The latest set of Chinese data signals that additional tightening measures are likely to be implemented, including further interest rate increases and, increasingly possible, permitting a somewhat quicker pace of currency appreciation. In general Chinese economic indicators have yet to signal much slowdown, particularly industrial production. Central bank officials in most emerging markets are set to face a long battle to anchor inflationary expectations and cool down price pressures without triggering a hard landing.
Similar considerations are also uppermost for West European central banks, though generally less-strong economic conditions (not least on account of substantial fiscal tightening) are moderating the pace of monetary normalisation. Some ECB officials have been signalling that the next policy rate increase could come as early as June, although in our view the Governing Council would be better advised at least to await the outcome of the bank stress tests (in late June) as well as the next fiscal decisions from the Greek and Portuguese parliaments. Meanwhile, the latest MPC minutes signal that the BoE is still some way off undertaking its first interest rate increase, on account of ongoing concerns about the strength of domestic demand (we now expect the first hike in August rather than May). Nonetheless, rising inflation expectations serve to underline that it is not just governments that need to confront potential issues of credibility. Governments need clear fiscal sustainability frameworks, while central banks also will need to ensure that their monetary frameworks are well understood and regarded as credible. Here, the rises in US inflation breakevens should be a concern for the Fed – which is likely to respond by attempting to educate markets why it believes the recent rise in headline inflation should prove transitory.
Patrick Chrysler and Arman Gevorgyan, Rogers Casey
BEST IDEAS, BETTER RETURNS?
The expression “best ideas portfolio” is one that we hear often when evaluating investment managers within the longonly equity space. The expression is most often used by managers to describe portfolios that are concentrated and represent the highest conviction ideas of the individual(s) managing the portfolios. Allowing the manager to focus on his or her best ideas should lead to higher alpha, or at least that is the pitch from the investment management community.
In some cases, the best ideas or concentrated portfolio is a sub-set of a more diversified portfolio managed by the same portfolio manager(s). For example, Manager XYZ may offer two U.S. large cap value strategies managed by the same team and employing the same investment process. The concentrated version may hold 30-50 stocks, while the diversified version may hold 60-80 stocks. Although not often included in the marketing pitch of these concentrated strategies, it is expected that they will also deliver higher risk in the form of tracking error and/or volatility of returns.
We recently completed a review of the performance of these paired strategies. Our goal was to determine whether concentrated strategies have delivered higher excess returns than their diversified counterparts, both on an absolute and risk-adjusted basis. Additionally, we sought to examine differences in volatility and fees across the paired strategies. As a point of clarification, we did not seek to examine the merits and effectiveness of all concentrated equity strategies. Our analysis focuses solely on those equity strategies that are offered both in a concentrated and diversified version.
We used Investment Metrics’ EQuest® database to identify investment strategies that offer a concentrated and diversified version within the long-only equity space. In order to be included in the study, we required that the paired strategies be managed by the same team, using the same investment process. Additionally, we required that both strategies were active as of September 30, 2010, and had a concurrent track record of five years or more. We limited our analysis to five investment manager peer groups:
U.S. Large Cap Value
U.S. Large Cap Growth
U.S. Large Cap Core
We excluded Small Cap, Mid Cap, and Emerging Markets Equity peer groups from our analysis due to the small number of paired strategies within each. While we completed a thorough review of the aforementioned peer groups, we do not claim to have captured the entire universe of paired strategies meeting our criteria. However, we do believe it represents a meaningful, representative sample. In total, we identified 57 pairs that met our criteria, 30 of which also possessed a concurrent 10-year track record.
As part of our analysis, we calculated five-year and ten-year returns statistics for the paired strategies, including portfolio returns, standard deviations, tracking error, and information ratios. We also measured the statistical significance of the differences in the pairs’ returns using the T-test and compared differences in relative and absolute risk measures. Finally, we collected and analyzed fee data for the paired strategies.
Our analysis confirmed our suspicion that concentrated strategies have had mixed results vis-à-vis their diversified counterparts. On average, concentrated strategies have delivered very slight excess return advantages, at a slightly ower information ratio. This held true over both a five- and ten-year period.
Importantly, we can ascribe little to no statistical significance to those concentrated strategies that have demonstrated superior results. More specifically, only two of the concentrated strategies with a five-year track record demonstrated superior results relative to their diversified counterparts, with statistical significance at a 90% confidence interval. The same held true for concentrated strategies with 10-year track records – two demonstrated superior results with statistical significance at a 90% confidence interval.
It is clear that the concentrated strategies within the sample analyzed did not deliver meaningfully different excess returns than their diversified counterparts. In fact, many of the concentrated strategies delivered lower absolute and risk-adjusted returns than their diversified counterparts.
In addition to looking at the average performance of concentrated strategies, we also calculated the batting average of the concentrated strategies, i.e., the percentage of concentrated strategies that demonstrated superior excess returns and information ratios relative to their counterparts.
The batting average for the concentrated strategies is not spectacular. Only 53% of the concentrated strategies bested their counterparts over the trailing five-year period – ignoring statistical significance. The average improves somewhat over the trailing ten-year period. However, we believe it is fair to state that investors were not generally rewarded with additional return by investing in the concentrated strategies within our sample.
We have established that the returns for concentrated strategies within our sample did not live up to expectations. Well, what about risk? Not surprisingly, the concentrated strategies demonstrated higher standard deviation of returns and higher tracking error. As demonstrated in Figure 5, the increase in absolute risk was negligible. However, the difference in tracking error was meaningful, exceeding 30%. In short, investors in the concentrated strategies picked up significantly more relative risk without much compensation in return.
Melissa A. Roberts and Elissa Niemiera, Keefe, Bruyette & Woods
Taking Some Heat Even If You Beat: KBW Bank Earnings Wrap-Up-
Summary--Banks began reporting 1Q11 earnings results, and we provide our initial review of these results for 28 banking institutions in our coverage universe, reviewing profitability, credit and growth trends. This small sample size limits our ability to draw conclusions from these initial results, which represent about 33% of our large-cap universe and 10% of our smid-cap universe. The preliminary trends are interesting nonetheless, and we analyze our sample by market capitalization, and if applicable, by whether the company has TARP outstanding or repaid TARP. We note that such segmented analysis is limited due to the small sample size, and is subject to materially change as more banks report.
In 82% of the initial 1Q11 reporters beat or met expectations. For our sample of 28 banks, on an operating-per-share basis, 20 banks (71%) beat consensus estimates, 3 (11%) met consensus estimates, and 5 (18%) missed consensus estimates. This is an improvement from 4Q10 and 1Q10 when 46% and 59% of the banks beat estimates, respectively.
Despite beating expectations, banks underperformed since 1Q11 earnings season began. From 4/12 - 4/19, large cap banks as represented by the KBW Bank Index (BKX) fell 3.5% while regional banks as represented by the KBW Regional Banking Index (KRX) declined 2.6%. Both the KRX and BKX underperformed the S&P 500 Index (SPX) over this time, as the SPX was basically unchanged, increasing 0.1%.
Oper. EPS increased 30% y/y and 4% q/q, as the large-cap banks saw operating EPS increase 34% y/y and 4% q/q while the smid-cap banks posted growth of 24% y/y and a q/q decline of 3%.
PTPP Earnings declined 2% y/y and 1% q/q, with 54% of the 28 banks posting y/y declines and 64% posting q/q declines. Smid-caps posted significantly weaker sequential results as PTPP earnings fell 9% and 80% of the 15 smid-cap banks posted q/q declines. n PTPP profitability metrics also decline. The median PTTP ROA is 1.64%, declining 4 bps y/y and 8 bps q/q. The median PTPP ROE is 14.89%, falling 131 bps y/y and 88 bps q/q. Smid-caps also posted weaker q/q results with median PTPP ROA of 1.54% reflecting a 16 bps q/q decline, and median PTPP ROE of 14.87% reflecting an 140 bps q/q decline.
Loan shrinkage continues for initial 1Q11 reporters. Average loans declined 2% y/y and are flat sequentially. Large-cap banks posted a larger rate of loan shrinkage with loans falling 6% y/y and 1% q/q.
Deposits increased 3% annually and 1% sequentially, driven by the large-caps which saw deposits increase 5% y/y and 1% q/q.
Credit trends remain favorable. The median NCO ratio decreased 48 bps y/y and 15
bps q/q to 0.80%. The median NPA ratio fell 30 bps y/y and 6 bps q/q at 2.71%. In addition, the median provisions to average loans ratio declined 32 bps y/y, and 11 bps q/q to 0.48%.
The median NIM is 3.63%, increasing 5 bps y/y and 1 bp q/q. Large-caps posted a lower median NIM of 3.27% and y/y shrinkage of 18 bps while remaining flat q/q.
Sudakshina Unnikrishnan and Kerri Maddock, Barclays Commodities Weekly
Amidst all the external noise surrounding the potential zenith reached for oil prices in the current cycle and the apparently mounting evidence of a significant slowdown in oil demand, prices have been subject to considerable levels of intra-day volatility. Yet, on the demand side, there is little in the way of solid evidence that oil demand growth has slowed down from the unsustainably high pace of growth seen in 2010. While the latest DOE data showed robust growth in the US despite record high retail prices for this time of the year, the release of extremely strong Chinese data cements our view further that the price threshold at which demand reacts has risen in the OECD and hasn't even been tested in the non-OECD.
Indeed, back in 2008, when oil prices soared towards $150/bbl, OECD oil demand had long been in decline already while the economic backdrop was worsening significantly, contrary to the current state. Non-OECD demand only reacted in early 2009 to the severe loss of liquidity and credit due to the financial crisis, rather than at 2008’s peak oil prices. Indeed, the preliminary March demand figures for China are pegged at 9.2 mb/d against a backdrop of an average price of Brent at $115/bbl, up y/y by 0.952 mb/d (11.6%). In fact, this is the sixth straight month of double-digit growth in Chinese oil demand, with Q1 demand averaging a solid 9.265 mb/d, up y/y by 1.1 mb/d.
As a result, to go even further beyond that and to suggest that global oil demand growth has now fallen below its sustainable pace would be more than premature, in our view. So far, demand response has consisted solely of price-induced movements along a demand curve, not any shift in the demand curve, and even the price-induced response has been sluggish and relatively slight so far. On the other hand, claims are also being made by OPEC nations about the oil market being oversupplied. Saudi Arabia’s oil minister ali-Naimi recently stated that the Kingdom had reduced its production by 0.8 mb/d in March from February’s 9.1 mb/d, despite most thirdparty estimates pegging the Kingdom’s production at around 9 mb/d for the month. Already, by EIA estimates, OPEC production is at its lowest since May 2004 given the loss of Libya, and Saudi production at about 8.4 mb/d would result in the lowest output in over 8 years. For a market to be oversupplied under these circumstances, demand must be lower by over 3 mb/d, in stark contrast to what the current data reveal.
The reality is that the market continues to run the risk of incorrectly equating Saudi sales to underlying production, as the short-run disequilibrium in the volume of actual sales is likely to be considerable. On the one hand, the short-run dislocations caused by a temporary shutdown of Japanese refining capacity, (without any reduction in oil product demand), created a knock-on effect on Saudi sales (averaged over 1 mb/d through 2010 and up to February 2011). On the other, the Libyan outage of light, sweet crude has caused a significant knockon effect as refiners seek appropriate replacement grades, with the ‘special blend’ manufactured by the Saudis from heavy, sour crudes, not surprisingly, receiving a lukewarm response. Further, the Libyan outage of very short-haul crude oil has necessitated tying up a significant proportion of incremental output in transit. In all, the level of OPEC output sold into the market may have been lower than underlying output, but to infer that lower sales of Saudi crude due to these specific factors amounts to lower oil demand would be a mistake, in our view. The market remains at a deficit at the margin given the loss of Libyan output with fundamental demand data showing little signs of fatigue just yet. The problem remains that the spare capacity currently held in the oil market is an extremely poor match for the lost crude, and thus it should not come as a surprise that the demand for that spare might be slightly more muted.
Vanguard, First Quarter 2011 Review
Despite considerable political, environmental, and fiscal uncertainty around the world, evidence that the U.S. economic recovery is on track continued to accumulate. The U.S. gross domestic product (GDP) grew at an annual rate of 3.1% in the fourth quarter of 2010. In addition, the corporate sector remained the most noteworthy source of strength. Both the manufacturing and nonmanufacturing sectors, as measured by the Institute of Supply Management, have maintained expansionary conditions at near record levels. Encouragingly, the employment situation has also shown hints of improvement, as more than 475,000 jobs were added to the economy in the first quarter and the unemployment rate ticked lower to 8.8% in March. While the addition of new jobs is something that many have long awaited, it will require many more quarters of meaningful job creation before the economy reaches prerecession employment levels.
Another pocket of weakness is the housing market. Fears of a double dip in this corner of the market escalated following the S&P/Case-Shiller report that showed home prices declining for the sixth consecutive month.
While U.S. investors are closely monitoring the labor and housing markets, investors abroad are paying significantly more attention to inflationary pressures. Food prices, as measured by the United Nations Food and Agricultural Organization’s Food Price Index, have risen 37% over the past year. Other key commodities including oil (+27%) and cotton (+149%) also have risen considerably during that period. These increases have the potential to fuel inflation and hamper economic growth, but there are varying views on the risk of higher inflation. On one hand, citing measures like elevated levels of unemployment and a lack of wage inflation, the U.S. Federal Reserve has expressed minimal levels of concern about the threat of near-term inflation. On the other hand, many other central banks and governments—particularly in emerging markets—have expressed more concern about inflation. Considering that higher food prices have been cited as a contributor to popular uprisings throughout North Africa and the Middle East, the stakes are particularly high.
A key factor contributing to divergent views around inflation has been the level of impact food prices have on different countries. For example, food accounts for approximately 15% of the consumer price index (CPI) in the U.S. Meanwhile, food accounts for roughly 30% of the CPI measures in both Brazil and China. It’s even higher in India, where food accounts for 47% of the inflation calculation. Hoping to tame increasing inflationary pressures, the Reserve Bank of India raised interest rates eight times in the past year. The threat of higher inflation has led central banks and governments to tighten monetary policy in both developed economies—the European Central Bank raised rates shortly following the end of the first quarter—and emerging ones—including China and Brazil—to slow growth and limit damaging price increases to basic necessities like food.
Despite the unsettling macro developments throughout the first quarter, U.S. equity markets proved resilient. The effects of the violence in the Middle East and North Africa were evident in equity market volatility in February as markets declined shortly after posting their highest close since June 2008. Additionally, the natural and nuclear disasters in Japan pushed equity markets into negative territory in mid-March. However, stocks resumed their upward swing to end the quarter with an impressive 6.4% gain. Small-caps outperformed large-caps, value stocks fared best among larger companies, and growth stocks led the way among smaller-caps.
While all sectors advanced during the quarter, energy stocks (+17.0%) were the clear winners, as they benefited most from higher oil prices. Crude oil prices jumped partly because of continued strong demand from regions experiencing economic growth as well as fears of supply disruptions resulting from unrest in North Africa and the Middle East. The energy sector rallied broadly, with refining companies performing best, including Frontier Oil (+65%) and Valero (+29%). Marathon Oil (+45%) posted the largest advance among major integrated oil and gas firms. Besides energy, industrials (+8.8%) and health care (+6.7%) were the only other sectors to outperform the broad U.S. market. Consumer staples (+3.1%), financials (+3.3%), and utilities (+4.1%) all lagged the broad market.
Performance among health care stocks was refreshing for investors waiting for a turnaround in the much maligned sector. Managed health care and health care equipment makers helped contribute to the sector’s outperformance, while pharmaceutical companies, which have been weighed down by concerns over future patent expirations, continued to lag. UnitedHealth Group (+26%), WellPoint (+23%), and Intuitive Surgical (+29%) were among the top performers that helped offset poor performance from large pharmaceuticals, such as Merck (–7%) and Johnson & Johnson (–3%).
In the financial sector, performance was mixed as the Federal Reserve announced which banks were healthy enough to increase or resume dividend payments. J.P. Morgan Chase (+9%) advanced after gaining approval to buy back stock and increase its dividend fivefold, while Citigroup (–7%) and Bank of America (0%) lagged after being denied approval to increase their current $0.01-per-share dividends. Additionally, thrifts and regional banks weighed on performance, due to their outsized exposure to residential and commercial real estate and lack of geographical diversity within regions that have been slow to recover. Over the past several quarters, equities have drawn strength from continued reports of strong earnings and increased levels of cash accumulating on corporate balance sheets. The first quarter was no exception, as both of these trends continued to support merger and acquisition activity, dividend increases, and share buybacks. During the quarter, AT&T (+6%) announced the purchase of privately held T-Mobile USA, a deal that, if approved, will make AT&T the largest cellular provider in the United States. Warren Buffet’s Berkshire Hathaway (+4%) also announced an all-cash purchase of chemical company Lubrizol (+26%). In the technology sector, where many companies are flush with cash, dividend increases and buybacks were viewed favorably despite quarterly performance that in some cases did not reflect the positive news. Oracle (+7%) raised its dividend; Intel (–3%) raised its dividend and increased its buyback program; and Emerging market stocks have declined since the start of 2011 while the broad U.S. market as measured by the S&P 500 Index has gained about 6% through the end of February.
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