GW&K QUARTERLY INVESTMENT REVIEW 3Q14
By Harold G. Kotler, CFA
While too many people around the world are living with turmoil and war, most Americans remain disinterested in world events, focused instead on their own problems, their own daily routines, their own financial concerns. There is a real disconnect with events happening beyond our shores. This attitude can be frustrating for those of us who feel a sense of responsibility to understand and even engage with the world.
It often takes flagrant actions to force changes in attitudes. The thought that NATO would create a large "Fast Response Force" comand that member nations would consider increasing their defense spending up to 2% of their GDP in response to Russia's invasion of Ukraine is quite remarkable. Had Vladimir Putin been a little less pugnacious, I believe NATO would have been like the frog in hot water, passive and unconcerned, until Putin had achieved his goals. There are parallels to ISIS. Beheading innocent people makes it impossible for governments to avoid facing the crisis. I remember the disturbing photograph of a South Vietnamese general executing a Viet Cong prisoner in 1968. The image appeared on the front page of newspapers around the country and public opinion against the war became overwhelming.
Americans seem to be on a different planet. Very few understand what is happening around the world, and even less care. Obviously there are subsets of our population with great passion, but unfortunately, the majority, interested only in their lifestyle, need horrific images to sway their attitudes.
The irony of these times is that our domestic scene is quiet. The economy plugs along at 2%-3% growth, unemployment drifts lower and family incomes stagnate. Interest rates, both short- and long-term, remain low. Stocks drift higher. The little we hear out of Washington is mere political squabbling. We all hope for legislation to address the country's many structural problems, such as underinvestment in infrastructure, swelling entitlement programs and tax code complexities, but that won't happen anytime soon.
So what should you do with your money? How do you approach investing in a complicated world of fully valued markets?
I see established trends continuing. The Middle East will continue to boil, Putin won't change, and the areas of the world that are growing will continue to grow. Money will continue to move into the U.S. as a haven of relative calm. Here in Boston, a real sleeper among leading U.S. cities, we are becoming less provincial, our world class medical institutions and universities becoming an increasing draw for the aging wealth around the world. This will lift our real estate market and boost our local economy, a reminder that opportunities never disappear, they just move to unexpected quarters.
But, even so, we can no longer expect the consistent returns on stocks, bonds and real estate that existed in the past. As values increase, returns on investments decrease. Like bonds today, the future will hold lower rates of return for most asset classes. But low returns are better than no returns. We can't simply wish for better times and move to the sidelines, as so many have sat out the equity bull market of the last five years, and the bull market in bonds the last twenty. Cash (liquid assets) is never the answer. Sitting in cash is like refusing to get out of bed in the morning, afraid of facing the day.
I have been hammering away at the same themes for a long time now but in a slowing, mature, debt-ridden economy, you need to continue to seize opportunities and be willing to accept decent returns with some volatility. The world stage is not going to be an easy place.
We should be thankful for our protected continent, but we need not be isolationists. We can invest here and abroad because the world has many opportunities. We need to think globally as we live locally. A successful investor always looks ahead, focusing on inevitable change and development. Obsessing on today where the only answer appears to be hiding in cash is no way to build wealth. Running away from the present problems in the world only creates losses. Being "safe" doesn't exist. Either one is out front or left behind-there is nothing else. I find too many financial institutions are willing to protect the status quo, too comfortable investing for safety and predictability. That is too bad because it removes the responsibility given to them of trying to invest for the future.
THIRD QUARTER 2014 MARKET OVERVIEW
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MUNICIPAL BOND STRATEGIES
Municipals posted a third consecutive quarter of solid returns, driven mostly by the combination of low supply and accelerating demand for tax-exempt paper. Third quarter issuance dropped to its lowest level in thirteen years, trailing even the anemic pace of last year, which was held back by the disruption from the taper talk. Meanwhile, demand surged, pushed higher by the need to reinvest seasonally high coupon and maturity payments. When new deals hit the market, investors clamored for allocations, leading to large oversubscriptions and lowered yields during order periods. As bonds became free to trade, investors in the secondary market only reinforced the trend, bidding up prices to get in on the action. This dynamic, in place all quarter, helped municipal Firmbonds outperform the Treasury market at every major point on the curve.
But even with municipal bonds plugging along in the outer realm of the fixed income kingdom, they were still heavily influenced by the larger forces at work in the broader markets. The Treasury curve underwent a massive flattening during the quarter, with 5-year rates rising 13 basis points while 30-year rates dropped 16 basis points. A steady dose of encouraging economic data led the short end to more aggressively prepare for the Fed's first rate hike while the long end was supported by falling global inflation, persistent geopolitical unrest and the pull of rock-bottom yields in Europe and Japan. The municipal curve followed the flattening trend, but not nearly to the same extent. The divergence came at the short end where retail's preference for short paper pushed 5-year tax-exempt yields down 3 basis points for the quarter, the opposite direction of their taxable counterparts. Yields in 10 and 30 years, meanwhile, declined 9 and 19 basis points, respectively, outdistancing the same points on the Treasury curve.
Municipal credit spreads tightened during the quarter, ignoring the more widespread "risk off" sentiment in the taxable market. High yield municipal bonds led the way, up over 5% for the quarter largely due to an upswing in Puerto Rico paper, which now dominates the space. The appetite for yield trickled down to the investment grade universe despite notable downgrades to Pennsylvania, New Jersey and Kansas. All three states suffered from their poor handling of pension obligations, though only New Jersey spreads saw a meaningful widening. But as the equally high profile upgrade of New York State demonstrated, there are cross currents at work in the municipal bond market and solid fundamentals continue to be the rule, rather than the exception.
With demand outstripping supply throughout the quarter, the resulting spread compression created an environment of minimal credit differentiation across issues. We took the opportunity to sell a few names that were fully priced based on their credit metrics and outlook. We focused on some weaker state GOs, selling at levels that failed to factor in potential downside. With the coming changes to pension accounting reporting for fiscal 2015, the headline risk for states that fail to adequately address their problems could be meaningful. We felt it best to get ahead of any prospective spread widening. We also continued to target 5-year maturities, and reinvested proceeds in 8-13 year maturities in order to take advantage of the yield pickup and roll benefits of a still historically steep curve. A modest backup in rates and a temporary supply spike in September provided the appropriate platform to execute these trades.
The resiliency of the municipal bond market may be put to a test in the coming months. We are entering a period that typically brings higher new issue supply at a time the broader market is focused on the termination of quantitative easing and the timing of the Fed's first rate hike. But municipals still offer compelling after-tax value and a high quality buffer against increasing volatility. The unique dynamics of a retail-dominated buy side and an immensely diverse group of municipal issuers present opportunities to exploit. We have always emphasized flexibility in our portfolio construction, which is especially critical in times of uncertainty. We will continue to make adjustments, reacting to changes in the curve, rates, and spreads. We will focus on protecting the downside, capturing growth opportunities and adapting to inevitable changes as they occur.
TAXABLE BOND STRATEGIES
Fixed income markets defied expectations once again in the third quarter, as positive economic data failed to neutralize worries about Fed rate hikes, geopolitics, and global economic growth. The quarter started out on a high note, with strong payroll data challenging the flight-to-quality narrative in place all year. But any worries about higher rates were quickly put to rest. Macroeconomic concerns returned to the forefront, and interest rates resumed their steady march lower. This reversal would repeat itself several times, as invariably each piece of good news (better-than- expected GDP growth, strong housing data, moderate language from the Fed) was followed by something negative (disappointing payroll numbers, deflation in the Eurozone, military actions in the Middle East). As a result, and despite plenty of volatility, interest rates ended the quarter close to where they began.
The yield curve flattened to a level last seen in early 2009. Short rates rose to their highest level in over a year on improving economic data, while the long end continued to rally due to a combination of the attractiveness of relatively high-yielding U.S. debt, benign inflation expectations, and moderate growth assumptions. The Treasury sector overall returned 0.34%, outperforming the 0.17% return of the Barclays Aggregate Index.
We expect market volatility to remain elevated. Investors will continue to parse every release of economic data in an effort to predict the exact timing of the Fed. As the date of the first rate hike approaches, the short end of the curve should remain under pressure, while the longer end should benefit from low inflation expectations and demand for the safety and relative attractiveness of U.S. debt. In addition to the prospect of higher rates, geopolitical tensions and global growth concerns will weigh on investor sentiment. Despite these risks, however, we maintain a constructive view of risk assets, as strong corporate balance sheets, an improving labor market, and ongoing (if slightly less robust) support from the Fed provide favorable conditions for spread product.
We are currently market-weight duration. Though we expect a modest rise in rates, particularly at the short end, we also expect to see the curve flatten, and therefore see value in the long end. We have maintained our preference for intermediate exposure because we believe the extra carry offers returns that more than compensate for the risk of rising rates at that part of the curve.
Investment grade corporates continue to offer attractive value, as their spread above Treasuries enhances returns and reduces exposure to rising rates. At 112 basis points, we think investors are being adequately compensated for the credit risk they are assuming, particularly given the strength of today's corporate balance sheets and the responsible financial policies among borrowers. Within the investment grade space, we continue to favor BBBs, which offer 46 basis points of spread relative to single-As for an acceptable level of additional credit risk. Additionally, we maintain our overweight exposure to the more cyclical sectors, which have been most significantly affected by negative sentiment and which we believe will be the largest beneficiaries of an economic recovery.
We remain overweight high yield in eligible strategies as well, given our expectation for low default rates, strong credit fundamentals, and continued demand for income. With high yield spreads at 424 basis points, their highest level in over a year, we believe both the carry and potential for spread compression offer attractive return potential and significant protection against rising rates. We remain neutral on mortgages, despite limited room for spread compression, because they offer a defensive alternative to credit markets.
It was a tale of two markets in the third quarter. The broad market was rather directionless throughout the period, ending with a modest gain. On the flip side, small cap stocks struggled from the start, with declines accelerating in September to finish the quarter down in the high single digits. This was the fourth quarter in a row where large caps outperformed, more than erasing last year's strong relative outperformance by small cap stocks. The economy showed good resilience, with the vast majority of economic news positive. Yet several international geopolitical and economic factors ranging from Russia's aggressive behavior, to conflict in the Middle East, Ebola in Africa, and slower economic growth in both China and Europe, seemed to have the upper hand as investors shunned risk and reduced their exposure to equities. So while we acknowledge the list of global concerns, the general trends toward moderate economic growth, low inflation and low interest rates would still argue for a positive stock market outlook in the quarters ahead.
The relative performance gap between large and small cap stocks continued to widen, with large beating small by 12.8% year to date. And the gap this quarter, at 8.5%, was the largest since the internet bubble period of 1998 and 1999. We would attribute this to a reversal of last year's terrific gains in small caps which pushed valuations above their long-term averages. As this valuation gap has now substantially closed, we are expecting more comparable performance among stocks of various sizes.
Our strategies all posted losses this quarter primarily due to the weak returns of small cap stocks. It was generally a risk-off quarter, which helped our small cap strategies relative to their benchmarks given the higher-quality nature of our holdings.
Our stock market outlook is still quite constructive despite the quarter's rather anemic stock price performance. While geopolitical events are creating a tremendous amount of headline risk, the overall economic backdrop remains positive. The list of positive indicators is quite long: jobs creation remains solid, the unemployment rate continues to tick down, the ISM Services and Manufacturing surveys are comfortably in expansion territory, and the Consumer Confidence Index reflects favorable spending expectations. We recognize that all of the economic data isn't positive. Slower economic growth outside the U.S. could impact the more export-oriented sectors of our economy. And new and existing home sales data remains sluggish even though home prices continue to advance.
The interest rate outlook appears to have created the greatest uncertainty among investors. While the Fed has made it clear that it will keep rates low until the U.S. recovery is considered self-sustaining, investors have already begun to anticipate higher rates. Perhaps this factor alone explains the more volatile behavior of stocks. Yet we see few signs of either inflation or excessive growth that would likely preclude higher rates. Indeed, inflation remains very tame around the globe, commodity prices continue to fall, and the strong dollar will make our imports less expensive. All these factors suggest medium- and long-term rates will likely stay low regardless of Fed activity. Yet none of this has kept investors from pulling a substantial amount of money out of equities, especially among smaller cap equity funds. While we cannot control investor behavior, we feel outflows will reverse themselves once investors focus on the relative attractiveness of stock prices.
Corporate profitability showed good improvement last quarter, and we expect good profit growth again this quarter. And the market continues to sell at a price/earnings ratio of under 16½ x 2014 estimated earnings. With earnings growth expected to continue, the market sells at a very reasonable 15½ x forward 12 months earnings. So as stock prices correct and interest rates stay rather benign, we believe stocks remain attractive relative to fixed income alternatives. If stock prices were to have a meaningful correction, corporations have the cash flow and debt capacity to continue with share buybacks, acquisitions and dividend payments as ways to enhance value for their shareholders.
We view ourselves as stock pickers, and regardless of the market's direction, our intent is to find well-managed companies with a record of consistent and sustainable growth that we can buy at reasonable valuation levels and hold for the long term. As such, we do not react to a market correction with fear; rather we use the opportunity to add to our favorite names at even better prices.
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.