GW&K QUARTERLY INVESTMENT REVIEW 4Q13
By Harold G. Kotler, CFA
Interest rates will not rise significantly from here. In fact, they might not rise at all. In the last 25 years, there have been four periods of rising rates that alarmed markets and inspired pundits to call the end to what has now been a thirty-year secular decline in yields.
To listen to the crowd on CNBC or the talking heads mesmerized by every communique out of the Federal Reserve, you'd think the bull market was officially declared over. Again. For the last twenty years, I have written about the dangers of progressively lower rates and have taken action to protect clients' portfolios from a trend that has been in place now for the better part of my career. Now the question becomes: so you were right, but what now? Rates are so low, they cannot possibly go lower. Wrong! Of course they can go lower. No one thought short-term rates could go below the 1% Greenspan engineered in the wake of 9/11 and yet, ten years later, there they are-next to zero. So with the Fed now scaling back their bond buying program (tapering), the world believes that rates will find a natural level, much higher than what now exists. No-not necessarily. There are plenty of reasons for rates to stabilize where they are (or even go lower), none of which get a mention in conventional wisdom. Start with the level of inflation, which is approaching zero as the global economy and advances in technology rapidly drive down prices. Consider the huge amount of debt that has been paid down, refinanced or written off these last five years, a trend still firmly in place. Look abroad for examples of other developed economies experiencing similar issues and take note of how things have turned out there. Appreciate the pain of money market investors, sitting around waiting for rates to rise while earning zero on their "investment," only to hear that the Fed is determined to hold rates lower for longer. What do you suppose their response will be? A steep yield curve must look awfully enticing by now. The world is awash in liquidity which needs to find a home. Who's to say the bond market won't be one of those destinations?
I have written about the Japanese deflation experience of the last twenty years. At right is a chart of Japanese and U.S. Treasury bonds with a ten-year maturity. These are actual numbers and not predictions. I have dropped the U.S. trend lines back by ten years to see if the Japanese experience is a leading indicator for us.
Our fathers and grandfathers worried about the Depression returning after World War II, and many could never leave that terrible time behind. This generation risks making the same mistake in terms of the fear of inflation. In 1973, OPEC turned the world upside down by taking control of their oil fields. In many ways, it was the birth of modern inflation. Today, serious observers are talking about U.S. energy independence and even exporting liquefied natural gas if the government lets go of 1973 policies. Additionally, conservation policies have effectively reduced the level of energy as a percentage of our gross domestic product (GDP), meaning the 1973 crisis should stay where it belongs-in the history books.
If you're looking for inflation in wages, there is little chance you'll find it. Mercedes Benz employees in Germany recently petitioned the company to unionize their counterparts in North America so that the pay scale of U.S. workers would be in line with that of the German workers. The Germans were motivated by the company's decision to move production of the C-Class sedan to a factory in Alabama. But efforts to organize in the U.S. have met continued roadblocks and attitudes toward unions seem to be getting more adversarial and not less. Part of that is the collective bargaining protocols written into U.S. labor laws and part of that is a recognition of the long hidden burden of guaranteeing future benefits. Suffice to say, the cost-push wage inflation cycles of the past won't be resurfacing anytime soon.
The world is changing fast. The most obvious advances are in technology and medicine. But there is also a real evolution occurring in almost every area of our society. We have seen states move dramatically to adjust pension liabilities formerly viewed as sacrosanct. We have witnessed companies aggressively scouring the far corners of the world, once closed to them ten or twenty years ago, looking for new markets for their products. And we have observed a marked shift toward the use of capital rather than that of labor. This trend has been hidden somewhat by corporate uncertainty, stemming from fiscal dysfunction and monetary innovation. But as Washington achieves some semblance of stability by passing a budget deal and the Fed winds down some of its more ground-breaking programs, capital investment should follow in short order.
The financial crisis was a scary milestone and many still live with these fears. But we are in a new and growing economic world where globalization will keep inflation very low and investment opportunities will expand as the world's population moves to a more sustainable lifestyle. Don't continue to live looking into the rearview mirror. OPEC was forty years ago, 9/11 was twelve years ago, and the financial meltdown was five years ago. The world will never be perfect, but even with these difficult times we recover, move on and improve.
Enjoy the stability of interest rates and the rise of risk assets around the world. Stay the course and look forward, not back.
FOURTH QUARTER 2013 MARKET OVERVIEW
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MUNICIPAL BOND STRATEGIES
The municipal market posted mixed returns in the fourth quarter amid a significant steepening of the yield curve. Months of speculation regarding an eventual tapering of the Federal Reserve's quantitative easing program, officially announced in December, caused retail investors to seek shelter in shorter duration paper. Tax-exempt yields from five years and in actually declined over the quarter while rates longer than five years moved higher. The hardest hit area of the curve was the ten year, where rates increased 23 basis points. Yields out long rose less than half that amount, benefiting from low supply and extremely cheap valuations versus Treasuries coming into the quarter.
While much was made of Detroit's bankruptcy filing and Puerto Rico's possible descent to junk status, it was the Fed's May and June comments about reducing its asset purchase program that led to calendar year losses for just the third time since Reagan reformed the tax code in the early 1980s. The taper discussion triggered a stampede out of tax-exempt mutual funds that exceeded in magnitude even the 2010-11 period of outflows that was sparked by the infamous 60 Minutes Meredith Whitney episode. The heavy selling pressure was met by a buy side that lacked much conviction, as a year-long drop in new issue supply often sapped the market of necessary price guidance. This dynamic disrupted the usual seasonal patterns of supply and demand. Gone was the typical summer rally, September and October experienced rare rate declines and the usual year-end firming was not to be.
With the Fed approaching a historic transition from an emphasis on quantitative easing to a focus on forward guidance, volatility is probably inevitable. But underneath the broader swings in interest rates lies a municipal market that is remarkably healthy considering all the headlines touting the difficult nature of 2013. Credit fundamentals are as solid as they have been in some time. Tax revenues are on the upswing and now exceed pre-recession highs, even after inflation. Expenses have been reined in, due to balanced budget requirements, and rainy day funds are being replenished nationwide.
While a 1% rise in rates over the course of a year was unnerving for many, the value it created is compelling. Remember, we are less than 18 months removed from a ten-year Treasury rate of 1.39% and a ten-year municipal yield of 1.47%, both all-time lows in their respective markets. Now, not only are intermediate yields finally within shouting distance of their ten-year average level, but a significantly higher tax burden, with the expiration of the Bush-era tax cuts and the new Medicare surcharge, increases the importance of the tax-exemption. When you consider that municipals are also trading historically cheap to Treasuries, in some cases even nominally out-yielding them, it is easy to get excited about where we start the year. Investors don't even need to extend maturities to 20 years to lock in a 7% taxable-equivalent yield on a double-A municipal bond. Even supposing rates drift higher in 2014, which is far from certain, the value proposition offered by municipal bonds demands attention.
We methodically extended duration in 2013 as a significant rise in interest rates created opportunities along the yield curve. Throughout the year, we focused on selling our shortest maturities, which were our best performers. The entire front end of the curve was in high demand this past year as retail investors sought the security of shorter bonds in a period of increasing yields. We concentrated our purchases on maturities between 8 and 12 years that we felt offered more relative value.
In the end, we lengthened duration approximately half a year, a move consistent with our strategy of locking in higher rates during rising rate periods. In the meantime, we will keep harvesting carry and roll while making sure we retain the appropriate flexibility should an actionable catalyst materialize
TAXABLE BOND STRATEGIES
Economic conditions improved throughout the fourth quarter as a host of indicators, including employment, consumer confidence, durable goods, and new home sales reports, surprised to the upside. In light of the improved outlook for growth, the highlight of the quarter was the Fed's much anticipated mid-December announcement that it would begin to modestly reduce the pace of its asset purchase program beginning in January. At the same time, the Fed went out of its way to reinforce its forward rate guidance and reassure investors that interest rates would remain exceptionally low for a long period of time.
The steady stream of relatively good news coupled with investors' growing expectations for tapering in early 2014 resulted in a significant backup in longer-term interest rates. By year end the ten-year Treasury yield stood at its highest level since mid-2011. Given the Fed's commitment to the front end of the curve, short rates remained relatively anchored and two-year Treasuries essentially broke even on a total return basis during the quarter.
Despite the sharp rise in rates, the Barclays Aggregate Index posted only a modestly negative fourth quarter return of -0.14%. Strong relative performance from the investment grade corporate sector of 1.11% helped support these results, as a quarter-long rally saw spreads tighten to a post-crisis low. The high yield sector was the star performer, returning 3.58%. A brisk rally in the equity market, strong fundamentals, and continued support from the Fed drove investors to seek higher yielding securities. Treasuries posted a modest loss of -0.75%, while government-related securities broke even and returned a marginally positive 0.04%. Mortgage-backed securities delivered a slightly negative return of -0.42%.
For the year, every sector of the taxable bond market had negative returns except high yield. The sharp rise in interest rates drove a negative return for the Barclays Aggregate Index of -2.02%, its worst annual showing since 1999. In a year of many records, this represented only the third calendar year since the inception of the Aggregate Index in 1976 that total returns were negative.
In 2014, we expect to see slightly higher rates and modestly tighter spreads based upon a steady winding down of the Fed's massive quantitative easing program, an adequately improving economy, and low defaults. A major caveat for the market will be whether the Fed's "qualitative" approach to strengthening rate guidance will be sufficient to anchor rates as quantitative easing tapering begins. Any string of economic data that surprises to the upside could cause the market to re-price expectations quickly.
We remain approximately one-half year underweight duration relative to our benchmarks. While we expect rates to grind marginally higher next year, we believe we are approaching the upper bound for the ten-year Treasury (3.25%-3.50%) given the tenuous nature of this recovery, the lack of inflationary pressures, and the Fed's commitment to keep rates lower for longer.
Against this backdrop, the carry trade environment will persist, and credit should perform well. We remain overweight the intermediate part of the curve and continue to favor credit risk over duration risk. While we recognize that return opportunities from here are limited in corporate bonds, excess returns should be better than the alternatives. Fundamentals are solid and valuations are not yet at extreme levels. Higher yields should keep flows coming into the sector. We expect modest spread tightening as the economy continues to improve. In our opinion, the risks to corporate bonds would come from an unexpected monetary tightening, a spike in default rates, or sharply higher interest rates. None of these are likely in 2014.
In high grade corporates, we continue to focus on some of the widest spread industrial sectors, which should benefit the most from stronger global growth. Within the high yield sector, we remain invested in the higher quality BB/B-rated segment of the market. The limited interest rate sensitivity and low embedded default risk inherent to single-B rated bonds make them particularly attractive in an environment of heightened macro risks and the ongoing quest for income.
We continue to be relatively neutral in mortgage-backed securities. As interest rates rise, our primary concern shifts from prepayment risk to extension risk. We continue to emphasize higher-coupon, seasoned, specified-pools that should help protect us from any serious duration spikes.
Another quarter of solid performance caps off an exceptional year for equities! While the market experienced a few brief and shallow corrections, the direction was consistently positive throughout the quarter and the year. Unlike last quarter when smaller stocks dominated, returns for large cap stocks were up in the double digits while smaller caps were up "only" in the high single digits. Once fears of Fed tapering waned and the government shutdown was resolved, stocks attracted new interest from investors who had missed the rally, helping push markets to new highs. The fact that the economy continues to grow, corporate profits are still increasing, inflation remains tame, and equity flows remain positive only further helped the market along. We suspect these factors will remain in play for 2014 as well.
Large cap stocks posted a solid gain in the quarter, with the S&P 500 Index increasing by 10.5%. All sectors showed positive returns. As one would expect in a growing economy, the leaders were among the more economically sensitive sectors such as Information Technology, Industrials, Consumer Discretionary, Materials and Financials. For the year the S&P 500 Index gained 32.4%, the best calendar year return for this index in over 15 years.
Small cap stocks also posted solid returns in the quarter, with the Russell 2000 Index gaining 8.7%. As with larger caps, all sectors posted positive returns, with the economically sensitive sectors leading the way. Full year results for the Russell 2000 Index showed an impressive gain of 38.8%, well ahead of the large cap benchmark, and the fourth best year on record for this Index.
"We are a bit hesitant in continuing to voice a positive outlook after a five year bull market and the completion of one of the strongest years on record for stocks, but the positive factors remain too overwhelming to ignore"
We are a bit hesitant in continuing to voice a positive market outlook after a five-year bull market and the completion of one of the strongest years on record for stocks, but the positive factors remain too overwhelming to ignore. The issues that gave us concern a quarter ago have largely been resolved: a new bipartisan budget has been signed, and the Fed has begun tapering with little apparent impact on equities. The economy continues to grow, with signs of improvement evident in all economic sectors. We have seen acceleration in several economic measures such as GDP, consumer confidence and manufacturing. Unemployment has ticked down to 7% for the first time since the financial crisis in 2008. Home prices continue to rise. Inflation remains tame, with commodity prices still in decline, and the CPI and PPI registering only modest increases. Yet overall signs of improvement are still rather moderate, with the level of job growth and unemployment not yet good enough to suggest Fed policy is likely to change from its accommodative stance.
Corporate earnings remain strong, driven by both revenue growth and cost containment. It is likely that corporate profit growth will be greater in 2014 than it was in 2013. Consensus estimates among Wall Street strategists suggest the stock market is selling at a reasonable valuation level of 15.-16 times 2014 earnings. This valuation level is only slightly above long-term averages and, despite the uptick in interest rates, remains relatively attractive as compared to other investment alternatives. Corporate cash flows and cash balances remain high, suggesting continued use of cash to pay dividends, repurchase shares and make accretive acquisitions.
So what can go wrong with this positive outlook? Interest rates could continue their climb despite few signs of inflation. Tapering does remove some amount of demand from the bond market, and its ultimate impact on rates is difficult to forecast. Higher rates could impact the price investors are willing to pay for stocks, and could slow interest rate-sensitive economic activity such as housing. Tapering itself has its inherent risks, as the Fed must walk the fine line between the proper amount of tapering and its impact on the economy and interest rates. Lastly, market volatility remains low; a sign that there is some degree of complacency in the market. In such times, a short and perhaps sharp correction cannot be ruled out.
We expect to participate in up markets and, just as importantly, protect in down markets. Whether the market continues its winning ways or not, we remain committed to investing in the highest quality companies at reasonable valuation levels, using our investment expertise to find and hold onto these stocks for the long term.
This represents the views and opinions of GW&K Investment Management and does not constitute investment advice, nor should it be considered predictive of any future market performance. Data is from what we believe to be reliable sources, but it cannot be guaranteed. Opinions expressed are subject to change. Past performance is not indicative of future results.