Stocks ended October with strong gains despite the Congressional budget impasse that shut down the government for 16 days and led to speculation about the potential for a U.S. default. (For more on this topic, see the commentary below.) As has been the case for much of the year, investors seemed more focused on Federal Reserve policy and the likely time frame for winding down quantitative easing. Economic data continue to indicate moderate growth—well below what would be considered a normal economic recovery—and very low inflation, suggesting to investors that the Fed may not begin to scale back its asset purchases until late this year or even 2014. Any expected increase in the federal funds rate has been extended well beyond that. In the interim, the Fed’s end-of-month decision to maintain its bond-buying program at current levels was treated as a nonissue by investors. Many companies reported quarterly earnings during October and market reaction was generally positive, also helping to boost stocks.
Guessing the direction of monetary policy is not part of our process, nor do we rely on short-term earnings reports as meaningful indicators of corporate health. (As we have discussed in prior commentaries, the quarterly “operating earnings” companies typically report is subject to wide variations in how each company comes up with its numbers. We believe longer-term earnings calculated in accordance with consistent accounting standards provide a more reliable gauge.) We evaluate stocks within our scenario framework, looking out five years at potential earnings growth and valuations across a range of economic environments we could reasonably encounter over that time frame. Our base-case view continues to suggest subpar returns for U.S. stocks—in the low single digits—which is why we remain moderately underweight. We elaborate on our approach to scenario analysis in the commentary below.
Among international markets, we’ve seen a modest rebound in emerging-markets stocks as U.S. interest rate fears have subsided, at least temporarily, and as China has seemed to show an improved economic outlook. Emerging-markets stocks kept pace with U.S. markets in October, though still trail significantly year to date. Developed foreign markets also gained in October amidst modest economic growth and low inflation internationally. In our view, emerging-markets’ potential returns are considerably higher than those of both U.S. and foreign developed markets over our five-year scenario period, which is why we continue to have a very slight overweight to emerging markets in most strategies.
In keeping with a strong month for stocks and risk assets, corporate bonds did well in October, particularly high-yield bonds that tend to somewhat mirror equity market trends. This month’s commentary also includes several questions related to our bond allocation.
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. Members of our research team worked on this Q&A piece jointly, and answered questions received during the past several weeks.
In the context of the recent government shutdown, and the budget and debt-ceiling debacle, will you please comment on the potential impact if the United States were to default? It doesn’t appear that you’re considering this as a probable event in your scenario analysis.
We certainly didn’t and still don’t see a U.S. Treasury default as a probable event because it is really not in anyone’s interest to default. But in the current political climate, it is not a zero probability either. Depending on how a technical default is handled by the Obama administration and the Treasury, and how quickly the situation is resolved, the impact on the financial markets and global economy could be anywhere from a brief negative shock to a sustained and severely negative outcome.
But no one really knows how it would play out, although one only needs to do a quick Google search to get plenty of opinions covering the gamut. Clearly, the consensus view is that even a technical default that lasts for any meaningful period of time (maybe beyond a few hours or days) could be catastrophic for the markets and the economy because of the role of U.S. Treasurys as the linchpin risk-free asset of the global financial market system. And that catastrophic outcome is exactly why people put a very low probability on a default actually happening, because why would we do that to ourselves?
The recent debt ceiling situation gives us the opportunity to again make the broad point that our response to questions on these types of topics (government shutdowns, debt ceiling debates, the outcomes of elections, the Federal Reserve’s next move, etc.) is to note that it is impossible to predict these things with sufficient confidence to justify making an investment bet on that prediction. Moreover, we would have to feel we have information the markets are failing to adequately price in for us to believe we could add value by making decisions based on these factors. In most cases, with issues like this, we are not going to believe that we have superior insight versus what the market is already reflecting and discounting. There may be times when this is not the case and we would take that into account in our decision making. But overall, as long-term investors we don’t try to add value predicting short-term outcomes that are inherently very difficult to predict and profit from.
What is relevant for our investment process is that the recent events out of Washington have not changed our fundamental longer-term outlook and the range of scenarios we think are most likely to play out. The debt ceiling debates and government shutdown certainly reinforce our view that we are investing in a time of extreme uncertainty, with unprecedented policy actions and political dynamics that only serve to exacerbate the fundamental economic uncertainty stemming from the aftermath of the 2008 debt crisis. We continue to view the macro risks as tilted to the downside, which is consistent with our somewhat defensive positioning, i.e., our underweight to equities in our balanced models.
You’ve previously stated that your five-year fundamental outlook for emerging-markets hasn’t changed, but do you consider other time periods in your analysis? For example, it seems you could improve returns and/or manage risk over a period of less than five years by adjusting your positioning until you have more clarity on how the situation will possibly unfold.
First, one pertinent detail that was addressed in our Third Quarter Investment Commentary is that something has changed in the past few months in our analysis of emerging markets. We are now explicitly modeling in risk factors associated with China as part of our base-case scenario for emerging-markets stocks. Previously, it was implicitly acting as a safeguard and prevented us from adding more to emerging-markets stocks.
That said, taking this example further, we can assume the questioner is asking if we’d consider removing our very slight overweighting to emerging-market stocks and selling our small position in emerging-markets local-currency bonds based on shorter-term analysis.
First, it is important to remember that we are only one percentage point overweighted to emerging-markets stocks based on our strategic look-through analysis of the emerging-markets exposure we get from our international and dedicated emerging-markets funds. And, as we noted in our Third Quarter Investment Commentary, we view our small position in emerging-markets local-currency bonds as a strategic hedge against the risk of a U.S. dollar decline and related inflation.
On considering other time periods in our analysis, we don’t know how emerging markets will perform in the short term. They could underperform in the short term but they very well might outperform too. Our assessment of prospective returns of any asset class is based on an investment horizon of five years or longer, and that will not change. But, we also manage to specific 12-month downside thresholds, the magnitude of which varies depending on the model. Based on our current assessment of emerging-markets’ risk and reward, we think it makes sense to stick to our current emerging-market allocations. However, if we come to believe that shorter-term downside from emerging markets could be more than we currently think and that it may lead us to violate our 12-month risk thresholds, we may unwind some of our emerging-markets stock and/or bond positions in our conservative portfolios.
How often do you revisit your economic scenarios and the impact they’d have on asset classes? What types of factors or events would cause you to add, remove, and/or change the existing scenarios?
We are continuously thinking about the assumptions underlying our asset class return estimates and the broad scenarios that we think are most likely to play out over the next five years. We don’t frequently change the five-year macroeconomic assumptions in each scenario but that does not mean we aren’t frequently considering and stress-testing other assumptions that underlie our asset class return models. And particularly with regard to our equity models (U.S. stocks, emerging-markets stocks), we do adjust underlying assumptions and inputs more frequently—they aren’t dependent on us making a formal change to the broad macro scenario assumptions.
There is no hard and fast rule as to when we revisit the scenarios or what would cause us to change them. What is more likely to change over time, rather than the broad macro scenarios themselves (broadly defined as base case, bullish, and bearish), is our assessment of the relative likelihood of each scenario playing out. For example, as we’ve moved further from the depths of the 2008 financial crisis, we’ve come to assign a lower likelihood to the debt-deflation scenario playing out.
Can you provide your current thinking on your underweight to small-cap stocks?
We have been underweight to U.S. small-cap stocks versus large caps for several years, going back to 2006. Up until the recent quarter, when small caps experienced strong outperformance, it’s been close to a wash for our portfolios as the relative performance of small versus large has tended to cycle up and down since the onset of our tactical underweight. While the position hasn’t had much of an impact from an attribution perspective, our thesis there really hasn’t changed over the years and it still stands today. Our assessment is that small caps in aggregate are overvalued relative to large caps, and as you know we believe large caps are overvalued on an absolute basis. We expect to see more downside risk from small caps in the event of an economic or earnings downturn, even independent of the relative valuation. So we put the valuation and downside together and we think it makes sense to have an underweight to small cap relative to large cap within our overall U.S. equity underweighting.
Anecdotally, we’ve spoken with a number of fund managers and some of the small-cap stock pickers that we have a lot of respect for have been saying for a while and continue to say, and demonstrate in their portfolios, that they’re finding it more and more difficult to find compelling small cap stocks to buy. A number of the more valuation-sensitive small-cap managers are holding more and more cash in their portfolios.
In summary, we have a top-down view on small-cap valuations and downside risk from a broad market perspective, and we’re getting a fair amount of confirmation from several stock pickers who are finding it more and more challenging to find reasonably valued or undervalued stocks.
It seems that other investment strategists are seeing opportunities in developed international stocks. What is your most current thinking on Europe? Any reason to think we might see another fat pitch there?
Our model estimates European equities can generate excess returns of over four percentage points, annualized, over U.S. equities over the next five years. This suggests Europe is attractively valued, but we want a greater margin of safety before we’d consider it a fat pitch. Downside risk in Europe remains significant in our minds and warrants caution. While the risk of a eurozone break-up was lowered last fall when the European Central Bank said it will do “whatever it takes” to preserve the euro, it has not gone away. It remains unclear to us how a proper banking and fiscal union—necessary elements to remove this fat-tail risk—will come about given Germany’s continued resistance in accepting past liabilities and losses of peripheral banks.
It seems as if the number of available absolute-return-oriented products in the market has increased recently. Have you given any thought to raising your allocation to absolute-return-oriented bond funds and/or adding additional managers/strategies?
Yes, this is something we have been thinking about and continue to evaluate, both from the perspective of our overall mix between core bond funds and absolute-return-oriented bond funds in our balanced portfolios, and with respect to specific managers and strategies that we are evaluating.
Our focus in this regard is primarily on our most defensive portfolios, where our total fixed-income exposure is highest, but we haven’t made any new decisions to date.
It appears that the core bond funds you own, PIMCO Total Return and DoubleLine Total Return, have both extended their durations. Are you considering other “core” bond funds that have shorter duration?
The answer to the question is no. First, we have a lot of confidence in both of these funds and their managers. Second, we are not looking to micromanage the duration of our core bond exposure. As mentioned in our response to the earlier question about absolute-return-oriented bond funds, we are thinking about whether we want to increase our exposure at the margin to funds that are less tied to the Barclays Aggregate Bond index, and that have more flexibility around their duration positioning. But for our core bond fund exposure, we are very comfortable with the duration management of both of these funds. Again, part of the role of core bonds is to provide some return in a recessionary, deflationary, or flight-to-safety type of scenario, where high-quality bonds and longer duration are likely to be beneficiaries and traditional equity-risk assets are going to be hurt.
We’d also note that both funds outperformed the Aggregate Bond benchmark for the third quarter. PIMCO Total Return had particularly strong performance in September (gaining 1.8%) due in part to its yield curve and duration positioning, which enabled it to benefit from the Fed’s decision not to start tapering and the subsequent rally in the front-end of the yield curve.
Also, it’s worth noting that the duration of PIMCO Total Return as of the end of September stood at 4.4 years, which is down from 5.8 years at the end of June, 5.4 years at the end of July, and 5.1 years at the end of August. For comparison, the Aggregate Bond index’s duration was 5.5 years at the end of September, so PIMCO was one year below that.
DoubleLine Total Return’s duration at the end of September was 3.9 years. We recently met with Jeffrey Gundlach and discussed his approach to duration management, and we wrote about it in October in our fund update. Gundlach has varied the fund’s duration meaningfully over its lifetime, ranging from a low of 1.1 years in July 2012, to a high of 3.9, both now and back in March 2011. So the fact that the duration is 3.9 years today certainly doesn’t mean Gundlach is set on a higher duration for the fund on a permanent or long-term basis. It is a tactical decision on his part, and we are very comfortable giving both him and PIMCO/Bill Gross portfolio management discretion in that regard.
Given the relative underperformance of both PIMCO Total Return and Unconstrained funds compared to your other fixed-income managers year-to-date, does using PIMCO Unconstrained somewhat defeat the purpose, or reduce the potential benefit of choosing to invest in the absolute-return-oriented space? In other words, are you concerned that using PIMCO Unconstrained could detract from your tactical decision to invest in the absolute-return-oriented asset class?
PIMCO Unconstrained should incorporate PIMCO’s best thinking across the firm and that will also be the case, to a more limited extent, for PIMCO Total Return. More limited, because PIMCO Total Return is more constrained in terms of duration, sector exposure, currency exposure, etc. than PIMCO Unconstrained.
Because we believe PIMCO has the ability to add value across the global fixed-income spectrum, we like gaining access to their expertise via PIMCO Unconstrained. But the same PIMCO house views—as determined by their Investment Committee—will be reflected in both funds, so to that extent the diversification benefit from owning both funds will be less than might otherwise be the case. To put some numbers to this, over the past five years, the two funds have had an average rolling 36-month correlation of 0.76; that’s higher than the average correlation of 0.63 between PIMCO Total Return and the Vanguard Total Bond Index fund. The average rolling correlation between PIMCO Unconstrained and the Bond Index was much lower, at 0.40. Some of our other absolute-return-oriented bond funds have had a slightly negative correlation to the core bond index. So those funds have provided more diversification benefit versus core bonds than PIMCO Unconstrained. But we own all of these absolute-return-oriented funds, not just based on their correlations, but also on our assessment of their overall return potential and their different investment opportunity sets and risk profiles.
We have been mildly disappointed with the performance of PIMCO Unconstrained over the relatively long period that we’ve owned it (we first bought it roughly five years ago), even though it has beaten the Aggregate Bond index. Frankly, we expected more alpha from it than we have gotten over that span. Given its flexible mandate to implement PIMCO’s best ideas (while taking risk into account of course), we also expected it to outperform PIMCO Total Return over the long term, which has not been the case so far. It has outperformed PIMCO Total Return during rising rate periods as expected. But the past five years have been a period of falling rates broadly speaking, and that has been a tailwind for PIMCO Total Return versus PIMCO Unconstrained.
Having said all of this, we don’t think owning PIMCO Unconstrained should detract from our tactical decision to own absolute-return-oriented bond funds. While it has underperformed some of the other absolute-return-oriented funds we hold in our portfolios, our original rationale for buying the fund remains intact and the lagging short-term or year-to-date performance doesn’t change that. We could very well see a period where PIMCO is the relative outperformer versus peers. Our view of the relative merits of PIMCO Unconstrained versus PIMCO Total Return has not changed, but we do continue to think about our overall exposure to PIMCO and it is certainly possible that we could reduce that exposure in the future in order to further increase our fixed-income manager diversification; however, it wouldn’t necessarily come from selling PIMCO Unconstrained.
With the pension concerns and recent bankruptcies, what is the argument to stay invested in the municipal bond asset class as opposed to investment-grade bonds? Can we really trust the creditworthiness of municipals as being investment grade anymore?
The fiscal health patterns of municipalities are idiosyncratic, not systemic. While municipalities can share similar demographic characteristics, you can observe meaningful differences of fiscal health between neighboring communities.
For example, the neighboring California cities of Stockton and Tracy both benefited from the housing boom, and suffered the same real estate crash. Yet Tracy was able to maintain reserve levels at 50% of their annual budget, while Stockton filed for bankruptcy. This shows how management plays a very important role, which is why assessing fiscal health and management can be key in fundamental analysis.
Overall, most cities are improving their fiscal shape, building reserves, and taking the necessary fiscal steps, including pension reform, which has occurred to some degree in 40 some states. This includes local municipalities, which are starting to benefit from higher property tax revenues as real estate values continue to increase. There are trouble spots, primarily at the local level, but overall we don’t think the creditworthiness of municipalities is in question.
As for why we continue to own municipals and not taxable investment-grade bonds in our tax-sensitive client portfolios, our return expectations for munis are only slightly below our return expectations for taxable bonds. On a tax-adjusted basis, munis continue to look more attractive.
What are your views on floating-rate loans given the large inflows into the asset class this year?
The strong level of inflows into floating-rate loans is not surprising. Flows into and out of the floating-rate loan funds have been strongly correlated with the anticipated direction of interest rates. For example, in 2011, Wall Street consensus was that the Fed would start to gradually raise rates, creating strong demand for loans. When the Fed announced its plan to leave rates unchanged until 2013, loan funds experienced significant outflows. This year’s sharp rise in rates has again created strong demand for floating-rate loan funds. While not surprising, a consequence of this strong demand is that our return expectations have been incrementally lowered. There are two reasons for this. One, strong demand results in higher prices, and less upside. With prices now essentially trading at par, there is little room for price appreciation. (When we initiated a position in loans in early 2011, prices were in the low to mid-$90s.) Two, floating-rate loans have little in the way of call protection, meaning that in a declining or prolonged low-interest-rate environment, issuers are incentivized to pay off existing debt (typically at par or only a slight premium to par), and reissue new loans at a lower interest rate. Not only that, but in periods of strong demand, issuers are able to negotiate better deal terms in the form of lower LIBOR floors, which weighs on return expectations, as well as less-restrictive covenants. This backdrop has not been game-changing in terms of our return expectations. To provide a sense of how our five-year return expectations (under our base-case subpar recovery scenario) have changed, our returns have declined from 4.9% in January 2011 to 4.5% currently, which is slightly lower than we previously expected but still attractive relative to other types of fixed-income investments. We continue to believe that loan fundamentals, despite a slight increase in less-favorable deal terms, remain healthy, and that in the event of a strong, unexpected inflationary environment, loans will provide a level of protection for our fixed-income-heavy conservative portfolios, while also generating a competitive return with other core bond exposure and improving diversification. Should there be a pullback in loan prices, we would consider adding to existing allocations, and initiating a position in our less-conservative portfolios.
Would you consider adding a tactical allocation to REITs as a hedge against inflation? What are your current thoughts on the asset class overall?
To make a blanket statement that real estate investment trusts are a great inflation hedge would, in our opinion, be misleading. REITs, or even more broadly, real estate, can provide some level of inflation protection, but the effectiveness will depend on several different considerations, many of which will vary from cycle to cycle.
One consideration is the supply/demand characteristics. One lesson we can learn from the early 1990s is that real estate is not an effective inflation hedge when there is an oversupply of property, which has been the cause of many REIT cycles. High levels of vacancies make it difficult for landlords to raise rents, and in an over-inventoried market during an inflationary period, the cost of managing a property could increase at a faster rate than rents, making it a bad inflationary hedge. In the current real estate cycle, we don’t have an oversupply issue. So it’s possible that if inflation picked up, landlords could raise rents at a faster clip than expenses, providing some level of inflation protection. Even then, it is going to come down to lease terms by property type and geographic location. Geographically, well-located real estate in high-barrier-to-entry markets will typically have the best inflation protection characteristics. In terms of property type, short-lease durations such as those in hotels are better from an inflation hedge perspective as their rents change daily, while longer leases found in offices or malls have rents that are often locked in for years, making it more difficult to compensate for increasing costs.
There are also interest-rate considerations. The value of a building depends on the interest cost to finance it. Holding all things equal, as interest rates increase, the value of a building will decrease unless the cash flow increases enough to compensate for the increase in borrowing costs. If that’s the case, you won’t have a good inflation hedge. And to really do this analysis you have to know how much leverage is being used to finance buildings. We would also say that we have seen a lot of volatility with REITs. So REIT performance can be affected as much by general stock market sentiment as it can be by underlying property valuations. Take the recent decline that REITs suffered when interest rates increased. We saw dramatic outflows from income-oriented investments, including REITs, which seemingly had little if anything to do with changing fundamentals.
One last point we would make is that we have not had a high inflationary period since the beginning of the modern REIT era, which roughly began in the early to mid-1990s. Prior to then, the REIT universe was mostly mortgage REITs. So we would caution anyone from hanging your hat on historical studies. Overall, we would say that REITs could be a partial inflation hedge, but again, making a blanket statement about property as an inflation hedge would be misleading.
As for the current REIT environment, our view is that fundamentals are okay, but not great. We are seeing some net operating income growth, but it’s modest. Valuations are certainly more attractive after the decline that began in May. REITs are up roughly 3% year to date versus 20% for the broader equity market. So from a relative valuation perspective, they are more attractive now then earlier this year. Going forward, if we have a pause in rates, we would not be surprised to see REITs perform well in the short term. But that’s not how we make decisions, and over the longer term, REITs do not justify a tactical allocation at current price levels.
Can you please explain the role of alternatives in your model portfolios?
We think of each alternative strategy as having a couple of key characteristics or attributes. The alternatives category contains a wide range of investments, including commodity strategies, real estate, and managed futures, all the way up to strategies we currently own in our portfolios such as arbitrage funds, which have much, much different characteristics than a long-only commodity index strategy, let alone private equity strategies and so forth. The way we’re thinking about alternatives for our portfolios currently are that they are going to be lower risk strategies, potentially much lower risk strategies than equities. This includes much lower downside risk, lower volatility, and we would expect the probability of negative returns over 12 months to be much lower than equities. So across a number of dimensions, the alternatives that we’re going to be looking at are lower risk than stocks.
Another key attribute is that they should have relatively low correlation to traditional asset classes such as stock and bond indexes, so by adding alternatives we should be meaningfully improving the diversification of the overall portfolio. This includes strategies that have different return drivers and risk factors than traditional stocks and bonds, so if there are headwinds to the performance of the stock or bond market, they wouldn’t necessarily be major headwinds to the performance of the alternative strategy. On a more tactical basis, our view is that equity returns over five years in our most likely base-case scenario are quite poor, in the very low single digits. Alternative strategies become even more attractive in this environment because we think you can get comparable or better returns than equities in our base-case scenario from a much lower risk strategy on the alternatives side.
So that’s generally how we view the role of alternatives. They provide a longer-term diversification benefit and, tactically speaking, should generate comparable or better returns with lower risk in the current environment. The key in our view is that you have to find managers in whom you have high conviction they can actually execute and achieve those risk-return objectives for their particular alternative strategies. And that’s easier said than done. There are more and more of these alternative-strategies funds being launched every day, and so, as always, we think the devil’s in the details. You need to really do the fundamental research to understand and confidently assess whether the manager that has what seems like a very attractive approach and a very compelling risk-return objective can consistently execute the strategy and achieve those desired results.
manager due diligence
Given the issues some BRIC (Brazil, Russia, India, China) countries are facing, investing in an index-based emerging-markets ETF like Vanguard FTSE Emerging Markets ETF makes us uneasy. While the diversification of the Parametric Emerging Markets fund has added value relatively speaking, are you close to identifying an active manager, or managers, in the space? If so, how will you fund these active managers?
We have expressed our desire to move away from the BRIC-heavy Vanguard FTSE Emerging Markets ETF for a few years. We added Parametric Emerging Markets to our portfolios in July 2012 in part to address that very concern, and as noted above it has added value since its inclusion. Our effort to find active emerging-markets stock funds continues. We have looked at many but they did not make the cut for various reasons. It is important we remain patient and invest in only those actively managed funds we believe have a high likelihood of beating an emerging-markets stock index. Having said that, there are two funds we are optimistic about, and one where we are close to completing our due diligence.
Funding for these emerging-markets funds would either come from the Vanguard ETF, Parametric, or a combination of both. Ultimately, we want a diversified exposure to emerging markets. So, the source of funding will in part depend on which emerging-markets funds we select and the investment opportunity set they give us exposure to. Another factor to keep in mind is that the Vanguard ETF has underperformed for at least a few years as the problems in the BRIC countries have been recognized and priced in by the market to at least some degree. So, tactically at least, it may not be a good time to be completely out of it either.
If U.S. equities have to drop about 20% in order for you to potentially unwind your current underweight, have you considered long/short domestic equity managers for your portfolios?
We’ve looked on a surface level at a few long/short equity mutual funds over the years, but have not found any of them compelling enough for us to dig deeper into yet. We continue to follow several of them as they build longer track records and to keep our eyes out for new funds that we think might be worth devoting our research time to doing deeper work on.
Generally speaking, a long/short equity fund run by a skilled manager would be great to have as part of one’s allocation to alternative investments.
Having said that, we don’t really see the connection necessarily between having a view that the market is overvalued and therefore we should consider a long/short fund for the portfolio. If we find a great long/short manager, we’d think we’d want to own them through most all market environments—depending, of course, on the client’s overall portfolio objectives. And conversely, we would never want to own a mediocre long/short manager no matter how overvalued we thought the market was. In that circumstance, we’d be better off just underweighting equities.
The Investment Letter is mailed quarterly to our clients and friends to share some of our views. Certain material in this work is proprietary to and copyrighted by Litman/Gregory Analytics and is used by Capital Trust & Associates, LLC with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.
Sam Alaoui and your Capital Trust & Associates, LLC Research Team.