SUMMARY The U.S. economy is showing signs of real, if uneven, improvement. The market seems obsessed with whether the Federal Reserve (Fed) will taper its bond-buying program by the end of the year, but is not focused on the continued improvement of the overall economy….
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Jonathan Coleman, CFA Chief Investment Officer, Equities
Gibson Smith Chief Investment Officer, Fixed Income
We believe that the Fed will leave short-term interest rates near zero for the foreseeable future. We also believe that global central banks will keep a high level of liquidity in the system. We continue to monitor potential global risk, particularly in China and Japan, but believe both of these concerns will abate in the medium term and that markets will refocus on the recovery. We believe that security selection has become even more important, both in equities and fixed income markets, as valuations and interest-rate risk have risen. We see this environment as offering great opportunity to help maximize risk-adjusted returns and preserve client capital.
KEY POINTS
– From a macroeconomic standpoint, the U.S. is improving and Europe is showing signs of stabilization. China and Japan remain uncertain.
– We would not be surprised to see the Fed taper its bond purchases over the next 12 months, but short-term interest rates likely will remain anchored into 2015 and the Fed will remain overly accommodative.
– After a rally early in the year, equity markets may soon become trickier.
– We expect interest rates to move higher, but are reminded that this will include periods of higher and lower rate moves. We do not view this as a calamity for fixed income markets, but as an opportunity for active managers.
Economy: Substantive improvement
The U.S. economy is showing signs of real, if uneven, improvement. Hiring continues to gain traction and consumer sentiment is relatively strong. Regional manufacturing surveys have improved and the Institute for Supply Management (ISM) manufacturing index has moved above 50 (a reading indicating expanding activity). We would not be surprised to see the Fed begin to taper its quantitative easing (QE) program over the next 12 months, but highly doubt that it will terminate its aggressive accommodative policy. In light of the improving economic conditions, inflation remains low and disinflationary pressures have re-emerged, which should give the Fed room to keep short-term interest rates near zero for an extended period of time. The Fed is targeting a 6.5% unemployment rate as a turning point for policy. Most Fed policymakers don’t see that happening before 2015, and we take them at their word. We believe the Fed will err on the side of caution, and will not remove all stimulus until the economy is on a sustained upward glide path.
We believe there is substance to recent economic strength. Cheaper oil and natural gas inputs have enabled the start of a U.S. manufacturing renaissance, as well as energy independence. A sustained housing market recovery has boosted sales in a variety of related industries, from retailers to truck manufacturers, and lifted consumer confidence to its highest level in years. Increasing home prices and stronger equity markets are finding their way into more positive readings on consumer confidence. Companies have continued to generate massive amounts of excess cash, and we’re seeing them use that cash for stock buybacks; this tends to show that management teams have confidence in their businesses for the long term (and buybacks can be positive for equity markets in general, as they help increase earnings per share). We also are seeing more merger-and-acquisition activity, which historically has been correlated with a strengthening economy.
Meanwhile, problems in Europe have moved away from center stage, at least for the time being. While the region remains weak, we believe the European economy is stabilizing. Consumer confidence has been relatively stronger and various companies, including automakers, recently have reported improving sales. The fiscal and banking problems that dominated headlines for so long, while not fully resolved, have at least receded into the background. We are watching the Spanish housing market closely for signs of improvement.
Risks remain, of course. One is that the Fed will remove accommodation too quickly and choke off the U.S. recovery. However, we believe that the central bank will err on the side of caution, and will leave most accommodation in place until the economy is on stronger ground.
China is also a wild card, as we believe the risk of lower-than-expected economic growth there has risen. Our analysts visiting China have noted limited growth outlooks for many companies doing business in the region, due to a weaker economy and government austerity policies. There is also too much excess capacity in a number of industries that are important to China’s economic growth, including the cement, rail, steel and solar industries. We are watching for future policy responses from the Chinese central bank.
Japan also bears watching. Japanese equity markets rallied earlier this year when Prime Minister Shinzo Abe began implementing a plan to revive the country’s economy with a 2% inflation target. But Japan’s unconventional monetary policy has exacerbated concern around central bank credibility and the possibility that other countries will follow its lead. Racing to devalue currency to improve competitiveness is not necessarily the path to success, and it may uncover other imbalances around the globe to which many investors are not yet paying attention. We believe some of this already has been seen in the recent corrections in many emerging-market debt markets. While “Abenomics” has been well received by financial markets and embraced by Japanese companies, success will be contingent on responses from other Southeast Asian central banks, as well as the ability of the Japanese consumer to move from saver to spender.
Equities: Beyond the “wall of worry”
In recent letters we’ve expressed a more bullish view for stock markets, but after sharp gains to begin the year, we think it gets trickier from here. Equity markets have essentially climbed a “wall of worry” over the last six months. Over the last nine months, we’ve seen several events spark temporary fear into the market. First it was the November 2012 U.S. presidential election, then the threat of falling off the fiscal cliff, then the potential impact of the sequester, and finally, concerns over Cyprus. Talking heads claimed these events spelled doomsday for the economy, but the market shrugged off each event and powered on. Now more speculative areas of the market, such as the Russell 2000 Index of U.S. small-capitalization companies, have hit all-time highs. P/E multiples have expanded as stock price appreciation has exceeded the underlying earnings growth of many companies.
Macroeconomic concerns have generally been out of the headlines and off the front page. We think this is just when investors should be a little more cautious. The recent rally has been driven in part by a belief that the Fed and other central banks will backstop equity markets by pumping liquidity into the system forever. In late June, we got a glimpse of what happens to stock markets when the Fed even hints at taking its foot off the gas: there can be a sell-off.
Our view on the economy and equity markets has not turned negative, just more balanced. Many positives for the economy still exist. For instance, cheaper oil and natural gas in the U.S., along with more competitive labor costs, are creating a manufacturing renaissance in the U.S. That’s a long-term benefit that could last a decade or longer. The U.S. housing market continues to be strong. In Europe, industrial companies are finally going through a painful restructuring that should right-size their businesses and make them more competitive on a global basis. European banks have also made significant strides in cutting costs and fortifying their balance sheets. But many of these longer-term dynamics have already been priced into stocks, or in other cases, they will take a long time to play out.
In the short term, businesses have put off spending on large IT projects, which has weighed on technology stocks. A number of industrial companies have reported slow order growth as the end markets they serve ordered ahead of expected demand and are going through an inventory adjustment phase. While we do not think stock markets are headed for a free fall, these signs tell us growth will be harder to come by going forward and we expect a pause in the dramatic rise we’ve seen in equity markets.
The challenge as equity investors is to find those companies that can decouple from the economy, control their own destiny, and put up strong growth even in the face of economic headwinds. Our analysts are still finding companies that benefit from a number of economically resistant, secular trends. For example in the health care sector, the Affordable Care Act is on its way, putting a greater focus on health care spending and changing the way many health care companies do business. There are beneficiaries from the change, including health care IT companies that are driving greater efficiencies to wring costs from the health care system. In the technology sector, enterprise IT spending may be down, but our analysts find a number of tech companies, such as 3-D printing companies, that help businesses speed up the time it takes to develop and bring new products to market. Meanwhile, the television industry is developing ways to measure the amount of viewing taking place on mobile and tablet devices. As media companies can better show the full reach of their programming, it should help them better monetize the content they produce. These trends, and others, can still drive outperformance for individual stocks, but a deeper, fundamental research approach will be needed to uncover the companies that benefit from them.
Fixed Income: Rate risk increases
Longer-term interest rates rose sharply during the second quarter as markets contemplated the potential end of the Fed’s QE program. Central banks’ unconventional monetary policy has kept rates artificially low for years, and markets are realizing that this cannot be sustained forever. The Fed is clearly paying attention to increased leverage in the system as well as investors’ newfound aggressive risk taking (i.e., stretching for yield). The Fed hopes that risk asset markets, including equities and corporate credit, will transition from a liquidity-led rally to a fundamentals-led rally. We believe that this process is underway. The challenge for the Fed is to keep rates from rising too quickly and destabilizing the economic recovery it has worked so hard to promote for the past five years. As the economy gains stronger footing, the Fed will be given the opportunity to slowly remove its overly accommodative policy. We believe the Fed may begin tapering its Treasury bond purchases over the next 12 months, depending on the strength of economic data, but will leave short-term interest rates unchanged for an extended period.
While some investors may believe that rates will continue to move higher from here and that we’ve seen the end of the bull market in fixed income, it’s important to recognize that the impact of rising rates will not be uniform across all fixed-income securities. In our view, the biggest effect is likely to be on securities with 10 or more years to maturity. We view that segment of the yield curve as containing the greatest potential for capital loss and the greatest volatility. We have reduced exposure to longer-duration securities in an effort to buffer the effect of rising rates on our portfolios. Some corporate credit names tend to be more sensitive to interest rate changes than others, and we have reduced our exposure to those, as well. We also continue to look for opportunities in products that have served in the past as alternatives to government bonds and corporate credit, including bank loans and agency mortgage-backed securities.
As rates are trending higher and many investors calling the end of the 30-year bull market in fixed income, we are reminded that since 1980 we have seen 16 periods during which the 10-year Treasury yield rose by more than 100 basis points (1 percentage point). The 30-year bull market has hardly been a straight line up, with nothing but positive returns for fixed income investors — there have been periods of both angst and celebration, with the long-term trend being lower rates. Making bold calls that the bull market in bonds is over can grab media attention and create fear for fixed-income investors, but the reality is that markets are always in motion and creating opportunities. This environment reminds us of the importance of active versus passive management in fixed income and the importance of capital preservation in uncertain times. While we may be entering a period where interest rates trend higher over the longer term, in the short and medium term there will be new opportunities created by change.
Security selection in fixed income has become extremely important as valuations are stretched due to the search for yield and the risk of higher rates. In this environment, we believe that preservation of capital needs to take priority over aggressive return seeking. This is not to say that great opportunities have disappeared from the fixed-income market — they have not, and we are still finding them — but the universe of securities to select from today is much narrower than it has been over the last four years. Fortunately, a back-up in rates may have the positive effect of lowering fixed income valuations and opening up fresh opportunities for investing at more attractive levels in credits that we believe offer good risk-adjusted return potential. Change creates opportunity.
Because we tend to generate the majority of our excess return through security selection, we see this as a time of opportunity. Credit risk (i.e., the risk that borrowers will default) has been relatively low for years due to the excess levels of cash held on corporate balance sheets, and we believe that will continue. Importantly, returns this year will be significantly influenced not just by what we own but by what we have decided not to own. There are many securities (large issuers in our universe of securities) that offer very asymmetric risk profiles, weighted toward the downside. In our view, the key to success for the remainder of the year will be to drive performance through security selection while navigating interest rate volatility.
Outlook: Cautious while awaiting opportunities
Our equity team views recent market volatility, and the events that triggered it, as short term in nature. We pay attention to macro and political events, but do not base our investment strategies on binary events such as whether the Fed tapers QE on a certain date. Instead, we remain committed to finding attractively valued companies with strong, multiyear growth drivers. If volatility presents us with opportunities to buy equities at what we believe are attractive valuations, we will add to these positions in the coming months.
On the fixed income side, we anticipate a gradual rise in interest rates, but don’t view it as a calamity for fixed income markets. Periods of market repricing are normal and can create opportunities for active investors to buy securities at attractive valuations, reposition at different points along the yield curve and reallocate between asset classes, sectors and securities. We see this environment as a great opportunity to help maximize risk-adjusted returns and preserve client capital.
Source: ETFWorld – Janus Capital International Limited
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