November Investment Commentary
- We answer questions about the broad investment environment and discuss some of our portfolio exposures in this month’s commentary. Highlights from a few of the answers are given below.
- The most recent central bank actions have not led us to revise any of our scenario assumptions nor have they changed our view on the likelihood of different scenarios playing out. While these accommodative policies are likely to impact the shorter-term path of some key variables, at this point they don’t meaningfully change the range or distribution of our estimated five-year outcomes.
- The fiscal cliff is one of many near-term risks we need to be cognizant of when managing portfolios. However, there are a number of ways the situation could unfold and we are not positioning our portfolios for any particular fiscal cliff outcome. We continue to focus on assessing longer-term fundamentals and valuations, rather than trying to outsmart the market in predicting short-term macro events.
- We surveyed our bond managers for their views on inflation. While they generally see inflation as a longer-term risk versus an imminent threat, they are taking it into account in their management of interest-rate sensitivity and in their overall portfolio positioning. We have also incorporated this potential scenario into our own portfolio risk management.
- We continue to hold a slight overweight to Europe though valuations are not as attractive as they were in June. We have not increased our emerging markets overweight due to our ongoing concerns about China’s growth.
Hurricane Sandy, the upcoming elections, and economic uncertainty all weighed on U.S. markets in October, as stocks reversed course after strong gains in the third quarter. Larger-cap stocks lost 1.9% and smaller-cap stocks declined 2.2%, with value faring relatively better than growth. Turning abroad, European stocks had a positive month, up 1.6%, despite signs of further economic weakness in the eurozone. Emerging-markets stocks slipped 0.4%. Year to date, U.S. and international stock returns remain in the double-digits.
On the fixed-income side, U.S. investment-grade bonds were virtually flat in October and foreign developed-market bonds fell 0.6%. Both indexes have low single-digit gains year to date. Emerging-markets bonds rose 0.5%, and are now up nearly 13% year to date.
Research Team Q&A
We regularly use a question-and-answer format to address questions from readers about our investment views and current strategy. This format permits us to address a range of different topics and allows readers to focus on areas of interest. This Q&A piece was worked on jointly by members of our research team and tackles questions received during the past several weeks. We have grouped the questions into broad categories for convenience.
Central Bank Actions and their Impact on Stocks
Does the seemingly constant central bank action lead you to think you’ll have to revise which scenario is your base case, or the assumptions underlying the scenarios you’re currently considering?
Our scenarios and assumptions are not set in stone. Over time, we expect to revise the assumptions underlying our five-year scenarios and we may also change our assessment of the likelihood of the different scenarios playing out. It’s certainly possible that central bank actions and policies could be a factor contributing to a change in our assumptions, particularly with respect to our interest rate and inflation inputs. Our readers will recall that earlier this year we reduced our endpoint interest-rate assumptions in some of our scenarios given the depressed level of real yields, and our expectation that the Federal Reserve will want/try to continue to keep them low in order to support asset values and debt reduction. (In our base-case scenario we reduced the 10-year yield at the end of year five from 6% to 5%, and in our deflationary scenario we reduced the yield assumption from 4% to 2%.)
But as we wrote in our third quarter commentary, the most recent central bank actions—QE3 and OMTs (outright monetary transactions)—have not led us to make any more changes. While these accommodative central bank policies are likely to impact the shorter-term path of some of the key variables underlying our scenarios, at this point they don’t meaningfully change the range or distribution of our estimated five-year outcomes.
Many experts are claiming that the stock market rally has plenty of legs. Do you agree, and how does this impact your view on equities?
While central bank behavior may be leading investors to buy stocks and other riskier assets, we don’t view that as a fundamental or sustainable driver of market returns over the next five years. In order for us to change the key assumptions that underlie our estimates of stock market returns over the next five years, we’d need to believe the central bank actions will have a sustained and significant impact on corporate earnings growth, and we are far from having that view.
On the other hand, it may be more reasonable to think that ongoing aggressive central bank action could have a positive impact on the market valuation multiple. In other words, even if you don’t think there will be a meaningful impact on earnings from central bank actions, one might argue that the multiple the market is willing to pay for those earnings should be higher, because interest rates will remain repressed at very low levels for a very long period of time. And lower discount rates should imply a higher valuation, i.e., a higher P/E. This is something we’ll be thinking more about and assessing in the months ahead. But, in general, we will be cautious about changing our normalized valuation multiple assumptions. We already incorporate a range of valuation multiples across our key scenarios, and in our sensitivity analysis we look at a range of P/E multiples within each scenario to see how changes in the multiple impact the estimated five-year return.
With the stock market moving higher, can you give an update on your fair-value range for the S&P and your next buy/sell trigger points?
As of September 30, 2012, our fair-value range for the S&P 500 is 875–1,240, with a fair-value point somewhere around 1,125. The next trigger for us to further underweight stocks would be around 1,600, subject to new information and ongoing updates to our analysis.
U.S. Fiscal Cliff
Will you please run through a few scenarios around how the so-called “fiscal cliff” might play out based on policymakers’ actions?
While the fiscal cliff is obviously an important near-term event, we don’t think we have any unique insights into how it will play out, and it may also partly depend on the outcome of the election. Also, just to reiterate something we’ve talked about many times, we are not macroeconomists and we don’t spend our time trying to forecast gross domestic product or assessing how various fiscal cliff scenarios might impact GDP next year. And, most importantly, our asset class analysis and investment process is not based on short term or precise estimates of GDP, Treasury yields, or any other economic or financial variables.
Having said that, in managing our portfolios we do think about potential shorter-term risks, and the fiscal cliff is one of many that we need to be cognizant of right now.
In terms of potential fiscal cliff outcomes, there seem to be three broad scenarios:
Scenario 1: Politicians don’t reach any compromise and we go over the cliff at year end.
Scenario 2: Politicians reach a so-called “grand bargain” deal that involves a combination of near-term measures to mitigate the immediate hit to the economy from the tax increases and spending cuts, along with a credible bipartisan agreement to tackle our medium/longer-term structural debt and deficit problems.
Scenario 3: Politicians reach a last-minute deal before year end that enacts some fiscal tightening pieces of the fiscal cliff, but avoids the full impact, and kicks the can further down the road in terms of addressing the longer-term structural debt problem.
What near-terms risks from the fiscal cliff situation are you focusing on?
We are focusing on what scenario the market seems to be discounting and what might happen if things turn out differently. It seems pretty clear that the market consensus expectation is for Scenario 3: some form of shorter-term compromise after the election that avoids the full fiscal cliff and does not push the economy into recession next year, but also does not address the longer-term structural debt problems.
With respect to Scenario 1, we’ve now seen estimates that the impact of the full fiscal cliff would be in the range of a 4%–5% ($600 billion–$800 billion) hit to GDP in 2013. The Congressional Budget Office estimates that would cause GDP to shrink by 2.9% in the first half of the year—what the head of the CBO called a “significant recession”—and lead to negative 0.5% GDP growth for all of 2013. Therefore, if no compromise is reached the stock market will almost certainly be in for a rude shock—for example, we can all remember how the market dropped more than 15% during the debt-ceiling debacle in the summer of 2011. Treasury bonds would likely rally in that scenario as people sell riskier assets.
Alternatively, markets would probably react very positively if politicians effectively worked together and came up with a credible long-term game plan to bring down the country’s debt burden, but without killing the economy in the meantime. Given the highly partisan political environment, we don’t think anyone is holding their breath for this outcome. But that’s exactly what would make it a big positive surprise.
As our readers would expect, we are not positioning our portfolios for any particular fiscal cliff outcome—just as we are not positioning for any particular election outcome. Instead, we remain focused on assessing the longer-term fundamentals and valuations across asset classes, rather than trying to handicap political outcomes or outsmart the market in predicting short-term macro events. It is possible, although very unlikely, that we would make a major change to our scenarios based on how the fiscal cliff situation plays out over the next few months. But if, for example, there was a sharp market sell-off due to a negative fiscal cliff surprise, that might create an opportunity for us to increase our exposure to stocks.
Inflation and Portfolio Positioning
Do your fixed-income managers have concerns with respect to inflation?
In recent months, PIMCO’s Investment Committee has become increasingly concerned about the “tail risk” of inflation, but in their view the time horizon for this remains several years out. To the extent they are taking U.S. Treasury exposure, and in terms of where they are comfortable with duration, PIMCO prefers longer-dated TIPS. The returns on TIPS can benefit from upside inflation surprises, which hurt the returns of nominal-rate bonds as investors demand higher rates to maintain the same expected real rate of interest.
Jeffrey Gundlach of DoubleLine Total Return is skeptical that persistent inflation can materialize without a meaningful increase in real incomes for the median U.S. household. He says that in spite of the Fed’s bond purchases, there is no current transfer mechanism by which to transmit inflation into the economy without much higher consumption. Still, he thinks U.S. interest rates have bottomed and has therefore shifted the fund’s duration to an all-time low.
Loomis Sayles has also positioned their portfolios to guard against inflation, not because they think it is imminent, but as Dan Fuss has put it, they “don’t want to read about it in the paper.” This helps explain his fund’s exposure to the currencies of commodity-oriented economies such as Canada and Australia, as well as modest positions in a few high-dividend stocks. The reported duration figures for Loomis Sayles Bond somewhat overstate the fund’s interest-rate sensitivity, as it currently holds no U.S. Treasurys, and its overall investment-grade exposure is well below that of the benchmark. However, Fuss and his team are also wary of credit risk at current price levels, so they are being very selective within the high-yield space. In recent months, they have increased the proportion of lower-rated credit in the form of bank loans. In addition to having floating rates, these are senior in the capital structure to unsecured high-yield debt.
Can you provide an update on floating-rate loans and their role in your more conservative portfolios?
Floating-rate loans are performing well this year, performing above our beginning-of-year return estimates. Performance has been led by lower-quality CCC-rated loans, where midteen returns easily outperformed the mid-single-digit returns for higher-quality B- and BB-rated loans. The strong demand we’ve seen for risky assets this year is also resulting in strong issuance. Year to date through September 30, 2012, floating-rate loan volume was nearly $190 billion, well above the historical average.
Refinancing and repricings remain the focus of new issuance. Through September 30, 2012, nearly half of the new issuance has been earmarked to refinance higher-cost debt. With the ongoing refinancing efforts we’ve observed over the past few years, the “wall of debt” that was a big concern has been knocked down, the debt maturity calendar appears very manageable, and we expect loan defaults to be in the low single-digits for the next two years. Specifically our loan default estimates are in the 2% range for both this year and next, with an increase in subsequent years to varying degrees depending on the economic scenario we are considering.
On the demand side of the ledger, inflows into loan funds have been persistent for the last few months (15 consecutive weeks) and at the end of September, inflows totaled about $6 billion, about half the level for all of last year. The difference in year-over-year flows, we suspect, is partly due to expectations for interest rates to remain low.
Loan valuations, particularly for the higher-quality loans where we have our exposure (B- and BB-rated loans) are trading near par. So from current price levels, we expect our actively managed loan funds to earn their coupon plus a little something from capital appreciation if the managers can be opportunistic. This places our return estimate around 4.5% over the next year. While current price levels for loans don’t provide much if any potential for price appreciation, loans still provide our bond heavy portfolios with some protection in a sharp interest-rate spike scenario.
Would you consider adding a floating-rate loan allocation to your less conservative portfolios?
Our decision to add floating-rate loans to our most conservative portfolios was based on our 12-month stress-test analysis of how those portfolios might perform in a scenario where we assumed a sharp spike in interest rates. Our most conservative portfolios are heavily allocated to core, investment-grade bonds, so they had a higher risk of violating their 12-month downside risk thresholds in that type of scenario. Therefore, adding the floating-rate loan position to those portfolios made sense from a risk/return standpoint. However, our less conservative portfolios have much less core bond exposure, and our analysis indicated that they did not need the floating-rate loan position as an additional interest-rate hedge. Instead, in those models, we wanted to maintain our (smaller) core bond position as protection in the event of a recession or deflation scenario, where we’d expect rates to fall and core bonds to outperform floating-rate loans.
Have the actions by the ECB impacted the near-term risk associated with your European stock exposure? What is the relative attractiveness versus U.S. equities now?
Since we initiated an overweighting to Europe in early June, it has outperformed U.S. stocks. While relative valuations for Europe are not as attractive now as they were in June, we continue to think it makes sense to maintain a slight overweight to Europe in our portfolios. At present our models suggest an excess return of over 5% annualized for Europe relative to the United States, which historically has been an attractive time to overweight European stocks.
On the currency side, we have a fairly neutral view but remain cognizant of the downside risk it could have if the debt crisis in Europe worsens. That was one of the key reasons why we did not overweight Europe more in June, and that remains the case today.
The ECB’s recent commitment to buy sovereign bonds of peripheral countries through OMTs is positive in the sense that it buys Europe time to move forward on their fiscal and political integrations, which is what is ultimately needed. But the OMTs come with conditions, and they are important. Already, we are seeing some players vacillating. For example, some core countries are expressing reservations at paying for existing bad debts of peripheral countries’ banks, and are only willing to pay for future bad debts. But old bad debts are significant and if they are not taken off of weak sovereign balance sheets then the link between insolvent banks and worsening sovereign balance sheets may be difficult to break.
Our view remains that there is significant likelihood that the eurozone will not survive this crisis intact, and a lesser, but still material, probability that the breakup is disorderly, which would be a major shock to the global financial system and markets. The OMTs appear to have at least extended the potential time frame before a breakup, if not substantially reduced the risk of that ultimate outcome. As things now stand, the OMTs do not materially change our assessment of the range of potential outcomes and risks related to a potential crisis in Europe over the next five years. As such, it hasn’t impacted our portfolio allocations or asset class risk/return assessments.
Given lower estimated yields, can you provide your current view of your tactical allocation to emerging-market bonds?
Yes, the yields of emerging-markets local-currency bonds have come down since we invested in them in August 2009. But their return potential remains attractive—mid- to high-single-digits—which stacks up well relative to U.S. stocks, which is largely the source of funding for our emerging-markets bond position. In the short term, as we have written in the past, there is downside risk in emerging-markets local-currency bonds during a period of rising risk aversion (most of this risk stems from the currency side). But longer term, we still view emerging-markets local-currency bonds as a good way to hedge the long-term risk of a U.S. dollar decline while getting an acceptable return.
Is a slowing Chinese economy and overall sluggishness in many emerging-market economies factored into your five-year asset-class return expectation for emerging-markets stocks?
The short answer is yes. For well over a year we have been concerned about a significant slowdown in the Chinese economy. Our concern stems from what we have seen as some unsustainable drivers of GDP growth, such as massive spending on fixed investments—in both industrial capacity and infrastructure. We believe a good chunk of this spending was wasteful and is unlikely to generate a satisfactory return. History suggests that such dynamics lead to crises, or at least to significant economic slowdowns. Given China’s importance as a growth driver for other emerging-market economies, and in fact for even the developed world, we have factored in this slowdown into our return and risk assessments. We believe a significant slowdown in China’s economy could result in a sharp cyclical downturn in other emerging markets. Our concerns regarding China have thus far prevented us from overweighting emerging-markets stocks more, even though in our assessment their long-term expected returns are far superior to U.S. stocks.
With today’s risk-free rate so low, and now expected to stay that way through 2015, have your expected five-year returns for your arbitrage strategies changed, or is it just the path of returns that may change in your view? Will you also please comment specifically on Arbitrage Fund’s performance so far this year?
Our five-year expected returns for our arbitrage strategies have not materially changed since we added the allocation to some of our portfolios in 2010. We have always had fairly modest return expectations for this position, in the low- to mid-single-digits in most environments, and that is still our expectation. When we talk to the team at Water Island Capital, who runs the Arbitrage fund, their return expectations are also in this range (around 4%–6%). However, given the very low Treasury-bill-rate environment that is likely to persist, they did recently tell us they are leaning towards the lower end of that range.
Treasury bill yields have been at exceptionally low levels since the fall of 2008, so we’ve already had four years of basically zero Treasury bill rates, and during this period Arbitrage Fund has generated an annualized return of right around 4%. Once Treasury bill rates start to rise—whenever that might be—it should be a tailwind for merger arbitrage returns.
The fund’s performance has been below expectations this year, driven by a subpar second and third quarter due to some individual deal breaks, regulatory issues, and other factors that delayed some deals from closing. And, in late October, the fund suffered additional downside volatility due to some surprising regulatory and political actions in Canada that impacted a couple of the fund’s larger positions. But our opinion of the Water Island team remains high and our longer-term risk and return expectations for the strategy have not changed.
More generally, we certainly don’t expect arbitrage strategies to keep up with stocks in a bull market.
Does Litman Gregory continue to evaluate whether or not to own gold in the portfolios, or have you moved on? In the past, you’ve mentioned that it may work well during times of inflation/deflation fears, which seem prevalent today.
We do continue to think about a potential role for gold in some portfolios given the current environment where central banks continue to engage in aggressive expansionary monetary policy such as we saw again in September from the Fed with QE3 and the ECB with OMTs. We continue to read and evaluate a wide range of views and analyses of gold from a variety of sources. We are certainly sympathetic to the view that central bank actions may lead to inflation surprises at some point and that currency debasement is part of a government’s toolkit to make debt deleveraging less painful. Of course, all currencies can’t depreciate against each other. But if gold is viewed as an alternative to fiat currencies, with a relatively inelastic supply, then logically the price of gold should appreciate relative to fiat currencies.
However, we already have positions in our portfolio that should benefit from dollar depreciation, such as our emerging-markets local-currency bond exposure. This position is also providing us with a nice yield, unlike gold which has no cash flow yield and where the return is purely dependent on someone else being willing to pay more for it than you paid, and so on. Also, the evidence we’ve seen regarding gold as an inflation hedge is mixed, although we don’t claim to have done an exhaustive review of the literature. On the other hand, the evidence does seem strong that gold performs well during periods of negative real interest rates, which is the situation we are in today, and we don’t expect real yields to move up any time soon. So that is a strong point in gold’s favor. But we still struggle over the lack of a fundamental valuation framework for gold, or any set of consistent components of return. Therefore we can’t confidently estimate a five-year expected return range for gold. We do know gold can be highly volatile, with significant shorter-term downside risk and that it doesn’t always provide diversification from stocks and other risk assets when you may want it the most. So gold could turn out to be a very expensive insurance policy at current prices.
Nevertheless, gold remains on our radar as a potential investment. However, we are focusing more of our time and attention on other asset classes or investment strategies that might also provide meaningful diversification and generate returns in an inflationary environment, and where we may have more confidence in assessing their potential returns and risks across various other scenarios as well.
—Litman Gregory and Francis Financial Research Team