GW&K QUARTERLY INVESTMENT REVIEW 3Q13
By Harold G. Kotler, CFA
As I sit in Jerusalem at this writing, I am struck by the Israeli way of governing relative to our recent experiences in the United States. In the U.S., we have lived with George W. Bush's and Barack Obama's line in the sand versus the Israeli position of "act without warning." Israel is a country that does not bow easily to public opinion-the need to survive outweighs the need to debate. When Israel attacked Iraq's nuclear site in 1981 and then Syria's nuclear site in 2007, they gave no warning and there was no public debate. Maybe survival needs that kind of decisive approach. History reveres leaders who galvanized public opinion-Teddy Roosevelt, Franklin Roosevelt, Harry Truman-and condemns those who cowed to consensus.
I don't want to turn this letter into a political commentary, so I will make my point. In the last few weeks both President Obama and Federal Reserve Chairman Ben Bernanke have caused great confusion by not properly telegraphing their shifts in policy. Obama was a moment away from punishing Syria's Assad regime for using chemical weapons, and Bernanke had prepared the world for some type of monetary tapering. Neither happened. Both decisions could have been entirely appropriate-negotiation is always preferable to military action and few appreciated just how fragile this economic recovery has been. But both men missed an opportunity to lead and both have invited needless speculation on where we go from here.
We have learned to steer clear of attaching too much weight to near-term events. In fact, last quarter I argued that our economy could not sustain a meaningful rise in long-term interest rates. The recovery had been built largely on a revival in the housing industry and the wealth effect that would create. When mortgage rates jumped 1%, re-financings all but disappeared and new mortgage applications dropped significantly. Unemployment is still uncomfortably high at 7.3% and the labor market is still dealing with the structural problems we've discussed in prior commentaries. The fact is, this economy has no room for error and Bernanke was probably right to postpone tapering. In trying to be open and transparent, however, he only whipsawed the bond market and drew investor attention away from focusing on the fundamentals of the economy.
So are policies of transparency appropriate in an untidy world with no square corners? Maybe leaders should talk softly and carry a big stick, and maybe we as investors should not base decisions on short-term expectations.
We at GW&K were struck by some of our newer bond client relationships who wanted to run from the bond market, clearly not understanding how rising interest rates help active bond managers to perform better in the long run by capturing higher yields. In fact, scores of investors fled the bond market in favor of cash. They decided that earning nothing on their money for an undetermined period of time was better than earning 3% to 4% over a determined period of time. Apparently, zero times X is better than 3% to 4% times seven. Why? Because zero is a predictable flat line, while the 3% to 4% over seven years is an unpredictable cyclical line. Many investors consider this uncertainty too risky, as if they were traders under constant pressure to read the tea leaves. This demand for transparency is as unnecessary as it is problematic. Investments fluctuate over time. Don't overreact to every swing in sentiment.
So now, since the Fed's latest decision to hold off on tapering, interest rates have fallen and the stock market has been fluttering. The headlines change but the fear continues. So what should an investor do? NOTHING. The whole reason a portfolio is diversified in the first place is because the world has shifting sands. Why else diversify? If we were Andrew Carnegie's "wise" man, putting all our eggs in one basket and watching the basket, then diversification would not be necessary. As professional money managers, however, we are committed to maintaining discipline, managing risk, and pursuing appropriate returns in all environments. Only an entrepreneur with his or her own money should make the big bets and concentrate capital the way Carnegie envisioned. That is not our job. Our focus is on risk-adjusted returns-we measure return versus risk. Having done this for 47 years, 39 years of that at GW&K, I believe we have seen enough to understand the sometimes complex tradeoffs between risk and return, and how to balance those forces while taking our clients' perspectives into full consideration.
The United States fortunately confronts no life or death decisions (i.e. survival), such as those faced by Israel, so policies can be more publicly deliberated. On the other hand, there might be a lesson to be learned from Israel: don't confuse transparency with predictability. Transparency may seem to light the road, but roads bend. I hope leaders begin to act with greater subtlety instead of tripping over their transparent words. We as a society and as investors need to respect the complicated world we live in and allow leaders to be less direct without losing confidence in them.
THIRD QUARTER 2013 MARKET OVERVIEW
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MUNICIPAL BOND STRATEGIES
Municipal bonds posted positive returns in the third quarter thanks to a strong September rally that stopped a four month selloff in its tracks and reversed more than half of the year-to-date losses accumulated through August. Municipal bonds had been battling a growing negative sentiment since May, when broader interest rates first began rising after the Fed floated the idea of tapering their quantitative easing program. Large and sustained mutual fund outflows followed and negative headlines from Detroit and Puerto Rico did not help matters. By the first week of September, 10-year municipal bond yields had climbed as high as 3.04%, nearly 140 basis points above their early May lows, a historic selloff that stood with the post-Lehman backup as the worst correction in the last 25 years.
But as so often happens in the municipal bond market, particularly during a thin trading environment that receives little price leadership from the primary market, selling became overdone and valuations grew stretched to the downside. High quality, 20-year municipal bonds were suddenly available at 5% yields, or 8%+ on a taxable-equivalent basis. Ratios versus Treasuries reached as high as 106% in the 10-year area and 120% in the long end. Investors responded by stepping back into the market, slowly reversing the tide of rising rates. When the Fed announced that no tapering of its quantitative easing program was forthcoming, the positive momentum quickly turned into a full-on rally. From September 5 through the end of the month, the yield on 10-year municipal bonds plunged 50 basis points to end the quarter at 2.54%, a round trip journey that left it two basis points lower than where it began the quarter.
In a quarter that saw Detroit file for bankruptcy, Chicago suffer a three-notch downgrade and Puerto Rico have their market access questioned in a Barron's cover story, the fundamentals of municipal credits actually improved. State tax revenues continued to grow, the latest figures surpassing pre-recession highs even on an inflation-adjusted basis. Rainy day funds are being steadily replenished. The Boston College Center for Retirement Research published a report asserting that pension funded ratios most likely bottomed in 2012. California, the largest issuer in the municipal market, had its GO rating upgraded by Fitch. Texas, another large issuer of municipal debt, was upgraded to AAA at S&P. In fact, Moody's improved their outlook for the entire U.S. states sector to stable from negative. All of which explains why credit spreads away from the high-profile pockets of distress remained fairly stable across the vast majority of the market.
Even with September's decline in rates, the municipal bond market remains cheap. Yields on high quality, 10-year paper have risen nearly 80 basis points since the beginning of the year and stand 107 basis points higher than November's cyclical lows. Yields on 15- year paper are up 112 basis points for the year and 150 basis points since November. The curve is still historically steep, producing attractive carry and roll potential in a stable interest rate environment. The Fed is actively signaling to the markets its commitment to low rates, not only at the short end, by emphasizing extremely dovish forward guidance, but also at the intermediate and long end, by postponing the taper and suggesting they will buffer any potential tightening in fiscal policy. Even if we see volatility pick up in the near term, it is difficult to see yields spiking meaningfully from here-the Fed simply doesn't have the tolerance right now for higher interest rates. And the market also seems more vulnerable to downside surprises in the economic data. All of which points to the necessity of guarding against lower rates while acknowledging the longer-run pull of a slow-healing economy that could eventually put upward pressure on rates. For us, that means neutral duration positioning, a bias toward higher quality credits and an emphasis on the carry and roll still offered by a relatively steep yield curve.
TAXABLE BOND STRATEGIES
Toward the end of the second quarter, Fed Chairman Bernanke seemed to signal that the FOMC was preparing to taper its $85 billion monthly bond buying program sometime in the "next few meetings." With many investors expecting a reduction in purchases as early as September, the market endured a nearly unprecedented rise in interest rates during the summer. But, in an unexpected turn, the Fed decided to keep the level of asset purchases unchanged at the September FOMC meeting, catching most market participants by surprise. Fundamental factors appeared to drive this decision, as the Fed stated that they needed more time to assess the impact of tighter financial conditions, the sustainability of Firmeconomic improvements, and the outcome of the looming fiscal showdown in Washington. This summer's disappointing labor markets reports were a likely indicator to the Fed that the broader economy is still too fragile to withstand higher interest rates. In addition to holding steady on its quantitative easing policy, the FOMC further cemented the accommodative stance of its forward guidance by suggesting that there will be no rush to hike rates even after normal economic conditions return.
Much of the quarter was characterized by a sharp rise in longer-term interest rates as the market braced for a September taper. Benchmark 10-year Treasury yields climbed nearly 50 basis points to 2.99% in early September. The decision to maintain stimulus came shortly thereafter, and, with investors fully embracing the Fed's forward rate guidance, 10-year rates rallied sharply to finish the quarter at 2.61%. The September rally erased total return losses for the quarter to date, as the Barclays Aggregate Index managed to squeeze out a slightly positive return of 0.6%. The yield curve steepened sharply as 30-year yields increased by 19 basis points. This left the difference between 5- and 30-year yields near its highest levels of the year at 230 basis points. Despite the increase in longer-term yields, Treasuries and Government-Related securities were able to break even and returned 0.1% and 0.3%, respectively.
Corporate bonds entered July near their widest spread levels of the year following the sharp selloff in June. Once investors became convinced that a gradual winding down of the Fed's quantitative easing program did not equate to an outright increase in the fed funds rate, spreads compressed throughout July and remained relatively range-bound for the rest of the quarter. High yield bonds were the best performing sector of the taxable bond market returning 2.3% while investment grade corporate bonds returned 0.8%. Mortgage-backed securities were the best performing segment of the Aggregate Bond Index and returned 1.0%.
We came into the third quarter with a slightly shorter duration profile than our benchmarks while maintaining overweight positions in high quality spread product. This strategy offers some protection against potentially rising interest rates without giving up income. If the pace of economic activity continues to strengthen and meet Fed expectations, bond investors in the short to intermediate part of the yield curve should eventually be rewarded with the opportunity to reinvest at higher yields. We expect current monetary policy to keep short to intermediate rates well anchored over the medium term. As such, our shorter duration is expressed in an underweight to the very long end of the yield curve, offset in large part by an overweight to exposures between three and seven years. We remain overweight the corporate bond sector as we are constructive on spreads heading into year end, and maintain a neutral allocation to the MBS sector.
We remain mired in a slow growth environment which seems likely to persist for the next few years. The labor and housing markets are still recovering, and inflation pressures are almost nonexistent. Meanwhile, the Fed has signaled they will continue to support the relatively fragile recovery for as long as necessary. In this environment, we expect interest rates to remain relatively range-bound over the next few months. The latest Fed policy decision has harnessed the momentum of rising yields, and, absent stronger economic data, longer-term interest rates should be relatively contained. On the other hand, it will be difficult for rates to rally substantially from here, as labor market conditions and housing market data would need to worsen materially.
The stock market continued its advance unabated at the start of the third quarter. But as interest rates continued their climb off the bottom, we saw stocks correct as fear that higher rates might choke off the economy crept back into the market. Then as investors returned from their summer vacations and economic data remained decent, the market once again resumed its upward climb. We saw a clear split between small and large cap returns near quarter's end, with small caps holding at record highs while large caps traded off modestly. For the full quarter large cap stocks held on to mid-single digit percentage gains, while small cap stocks were up in the double digits.
Large cap stocks had another solid gain in the third quarter, with the S&P 500 Index advancing 5.2% bringing the year to date return close to 20%. The more economically sensitive sectors such as Materials, Industrials and Consumer Discretionary posted the strongest gains, while the more defensive and higher dividend yielding sectors such as Telecommunication Services, Consumer Staples and Financials lagged. Small caps performed significantly better than large caps this quarter, with the Russell 2000 Index posting a double-digit return of 10.2%. This index is now up 27.7% year to date, or nearly 8 percentage points above large caps.
Looking forward, two issues loom large. As of this writing the government shutdown has just begun and investors are rightfully concerned about its impact on the market. The spending freeze will indeed hurt economic growth, but ultimately, as has happened many times in the past, the disagreements will be settled and the economic impact will dissipate. Should the lack of resolution on spending spill into the debate over raising our debt limit, we could indeed see greater economic impact and a sloppy stock market.
Tapering is the second major concern among investors. The Fed's decision to taper would be based on its perception of the sustainability of the economic recovery. Clearly the Fed does not view the economy as having improved enough yet to take such action. The Fed's commentary suggests tapering is less likely to begin soon, making the low interest rates associated with these accommodative monetary policies likely to continue for a more extended period of time.
While these issues are large and they are real, we believe investors should focus instead on the broad based evidence in support of continued economic growth. Home prices continue to increase, which has a positive impact on net worth, consumer confidence and spending. The uptick in rates has hurt mortgage volumes, and perhaps the level of new and existing home sales. This bears watching, as an important part of economic growth out of the recession has been the rebound in housing. Other indicators of economic growth include positive consumer, manufacturing and services survey results, improved industrial production, lower unemployment, reduced jobless claims, and solid retail sales. These positives have been achieved with minimal inflation.
Corporations continue to have solid profitability levels, moderate growth in earnings, and balance sheets flush with cash. Uses of corporate cash for capital spending, acquisitions, dividends and share buybacks are all supportive of continued market advances. However, we must consider that the run in stock prices has pushed up valuations. While by no means at extreme levels, we are now trading at about 16 times expected 2013 earnings. We expect another year of moderate growth, suggesting that valuations looking out one year are at a more reasonable multiple of about 15½ times earnings. We would argue that such a valuation level is still attractive when compared to other investment alternatives, and to the historical relationship between stocks and interest rates.
Fund flows into equities remain positive and may act as a continued tailwind for equity performance. Our biggest concern is not really the level of markets; but the fact that complacency and risk taking tend to sneak into markets when they only go up. We indeed can see this in our analysis of factors driving this year's performance. So while we never enjoy it when the markets are down it would nonetheless be viewed as a healthy way to remove excesses from the market. And given our style of investing for the long term in high quality companies selling at reasonable valuations we would use any period of short-term market weakness to add to our favorite positions.
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.