Quarterly Review and Strategy Update

Transcription

1 Quarterly Review and Strategy Update June 30, 2015 Summary The Federal Reserve is not likely to raise rates until later this year or even sometime in U.S. equities remain a core allocation in our recommendations. In particular we like small and midcap exposure to the domestic market. Growth in Europe is being fostered by lower oil prices, cheap financial leverage and currency depreciation. We expect to see European equity markets to follow through on these positives. Mutual fund flows to emerging and frontier equity markets have been negative and suggest investor sentiment is poor. With higher interest rates in the U.S. on the horizon, we want to make sure the credit allocation in our client portfolios is prepared, so View Capital Advisors, LLC 2000 McKinney Ave, Suite 600 Dallas, TX Tel: Fax: Warren Paddock, CFA wpaddock@view-cap.com Now is a great time to update your investment objectives and risk profile with your Client Advisor. Page 1

2 Introduction In the second quarter of 2015, slower growth in China and a potential Greek exit from the European Monetary Union created turbulence for an already complicated investment landscape. Outside the U.S., monetary policy remained very stimulative. Meanwhile the Fed indicated publicly its plans to raise the Fed rate -hopefully, without creating a panic in the investment markets. The U.S. dollar moderated but remained at a strong level while oil prices stabilized somewhat before finally falling again over concerns of Iran s oil supplies opening to the global market. Below this overlay, equity markets continued to perform relatively well. U.S. High Yield and Leveraged Loans held up nicely while other interest rate sensitive asset classes such as investment grade bonds and REITs underperformed. Hardest hit were energy and energy related sectors such as Master Limited Partnerships. Asset Class Returns Q2 YTD (9.1) (6.1) (0.0) (1.1) (1.2) (1.0) (1.8) (2.7) (3.0) (0.0) (0.8) Small Growth Converts Intl Equity Large Growth EM Equity Leveraged Loans High Yield Preferred S&P 500 Small Value Muni Govt Corps Large Value EM Bonds HY Muni FM Equity Intl Bonds REITs MLPs (11.0) (0.1) (0.5) (0.6) (1.0) (1.9) (3.2) (5.4) (5.4) (10) (5) 0 5 (15) (10) (5) Page 2

3 Investment Strategy With China and Greece dominating headlines, our preference for equity investments is tempered by the level of risk associated with various equity asset classes. U.S. equities remain a core allocation in our recommendations. Specifically, we like that small and mid-cap stocks generally have greater exposure to the domestic market and therefore are less harmed by revenues subject to exchange rate risk. Additionally, small cap returns should continue to benefit from increasing levels of stock buybacks, which are up 4.5% YTD and from continued M&A activity. EBITDA growth has been modest so far this year for small caps at only 2.8% YTD and 6.9% year over year, but it is likely that 2015 is following a similar path as last year when poor 1Q GDP of -2.1% contributed to a slow first half of When U.S. GDP rebounded in the second half of 2014, small caps followed along with a strong pickup in year over year EBITDA growth of 8.2% due to their higher exposure towards domestic growth. At the moment, small cap multiples of 13x EV/EBITDA are high compared to the average of 11x, so there is some risk in valuations. A Fed rate hike could put a cap on multiples and cause the equity market to generally be more volatile. However, history has shown the equity market to be positively correlated to interest rate hikes until the 10 year Treasury approaches 4%, and we believe the equity market will continue moving upward after any initial adjustments caused by volatility. Monthly S&P 500 Returns and 10-Year Treasury Rates 2-year rolling correlation, May June % 2% 4% 6% 8% 10% 12% 14% 16% 10-Year Treasury Rate Correlation Coefficient Source: Standard & Poor's, Federal Reserve Bank of St. Louis Another direct beneficiary of higher interest rates will be net interest margins at banks. Combined with low deposit costs and very low credit costs, banks should perform quite well. Because of this we think exposure to small and mid-cap banks will perform well in the coming rising rate environment. Page 3

4 As global equities follow the U.S. on the path of recovery, we see opportunities to increase allocations in places such as Europe. While this is a step out on the risk spectrum compared to investing in U.S. equities, we remain encouraged that growth in Europe is being fostered by lower oil prices, cheap financial leverage, and currency depreciation. We continue to believe the European quantitative easing program initiated by Mario Draghi in the first quarter of this year will support the re-pricing of European equities just as the Federal Reserve s quantitative easing policy lifted equity markets here in the U.S. Looking for reenforcement of our thesis, we find it encouraging to see the money supply M1 increasing. Historically, growth in M1 money has preceded equity market returns by six months. Money Supply as an Indicator of Stock Market Returns Euro Real M1 (6 month lead, % change yoy); STOXX 600 (% change yoy) 20% 15% 10% 5% 0% -5% Euro Real M1 STOXX % Euro Real M1 STOXX 600 Source: ECB, Morningstar 100% 80% 60% 40% 20% 0% -20% -40% -60% -80% Corporations and households in Europe have responded to cheaper interest rates, and banks have begun to grow their loan portfolios. Credit expansion often precedes earnings growth and the chart below indicates Europe is at the beginning of such a cycle. Assuming profitability improves, we expect European equities to continue higher the rest of the year. Credit Demand and EU28 GDP Growth Net % of Banks Reporting Positive Loan Demand; GDP Growth Credit Demand GDP Growth y/y -200 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 Consumer Corporate Housing GDP Annual Growth Rate Source: Eurostat Page 4

5 Emerging and frontier equity markets have continued to underperform our expectations this year. Uncertainty about China s rate of economic growth and recent equity market sell off has spilled over to the rest of the Asian equity markets. Mutual fund flows to emerging markets have been negative and suggests investor sentiment is poor. While we think there are many long term positives to investing in this asset class, one potential near term risk would be a rapid appreciation of the U.S. dollar (potentially caused by the Fed raising interest rates), which would hurt emerging equity returns during such a currency move. However, if our thesis on U.S. economic growth and the emergence of European economic growth is intact, then the resumption of demand for emerging market exports should not be far behind. Given the poor performance of emerging and frontier market equities, valuations are not pricing in this future growth. We believe building and maintaining a long term portfolio allocation to emerging and frontier equities is prudent; however, its times like these that tries the discipline of such an allocation. Within the spectrum of credit assets we are selective about our recommendations in light of the Federal Reserve s interest rate hike program. Janet Yellen s recent public comments clearly indicate a willingness to raise interest rates this year. For credit asset classes that carry a higher level of exposure to interest rate risk (as opposed to credit risk), we prefer to avoid getting caught up in any potential rush for the exit. With the U.S. in an era of historically low interest rates and considering the expansion of the U.S. credit market since the 2008 financial crisis from $18.4 trillion to $30.8 trillion (including U.S. treasuries, mortgages, CLO s ABS, agency debt and investment grade and high yield corporates), we remain concerned investor fund flows could negatively affect returns. That said, credit assets still have a place in portfolio construction in this environment. We believe buying and holding investment grade corporate bonds to maturity and investing in leveraged loans are a good way to preserve capital and will generate a reliable level of income in what we see as a low default environment. On the periphery of a core credit strategy, asset classes such as distressed credit in both the U.S. and Europe are good areas to pick up additional return in the form of higher yield and capital gains. The liquidity of credit markets The long anticipated push to higher interest rates by the Federal Reserve has given investors lots of time to think about how credit markets will react to a rising rate environment. Over the last few years we have seen brief periods where credit markets have pulled back based on anticipated Fed actions, energy prices, or increased macro volatility such as this last spring. In the past, bond dealers or market makers were thought of as a buffer to such volatility. However, since the credit crisis of 2008 dealer inventories have dropped significantly, which has led Page 5

6 many strategists to suspect a new dynamic potentially increasing volatility in the credit market. The truth is, market making activities by dealers were never meant to save the market from falling when there is a large imbalance of buyers and sellers. As the chart below depicts, there has been a significant change in dealer inventories compared to pre-crisis levels. Primary Dealer Inventory ($billion) $300 $250 $200 $150 $100 $50 $0 Source: Federal Reserve Bank of New York Unfortunately, there are some distortions in the reporting methodology for dealer inventory levels as reported by the New York Federal Reserve, but the big difference in inventory levels today compared to pre-crisis is the disappearance of bank proprietary trading. Even though proprietary trading was a separate activity from market making, inventory levels reported by banks aggregated both together. Today s increased regulatory environment has forced bank proprietary trading to shut down and thus the dramatic difference in dealer inventory as expressed by this graph. At today s level of inventory, dealers are not in a situation to influence credit markets during volatile periods. In 2014, dealer positions in investment grade and high yield credit combined averaged $18.7bn, which is less than one day s average trading volume of the market last year ($19.9bn). The breakout of high yield alone tells the same story. Dealer daily inventory of high yield in 2014 averaged $6.7bn while the markets trading volume was $6.9bn. The disappearance of bank proprietary trading is interesting because it marks the exit of a market participant that bought and sold bonds; it contributed to the liquidity and pricing dynamic of the market. However, this is not to say that the credit market has suffered a loss of liquidity or price discovery. In fact, the U.S. credit market has grown significantly from its pre-crisis levels. In 2007, investment grade and high yield credit assets had a total par value of $1.2 trillion, and by the end of 2014 total par value was $2.4 trillion. Bank proprietary trading has been supplemented by other investors in the credit market. For example, Page 6

7 mutual funds and ETFs made up 15% of the investor base in high yield in 2007, and at the end of 2014 they represented 24% of the market. Below is a chart comparison of the investor base in the high yield market Foreign 7% Equity and Income 5% Investment- Grade 11% CBOs 7% Hedge and Other 9% Pension 20% High-Yield Mutual 15% Insurance Companies 26% 2014 Equity and Income 3.8% Investment- Grade 6.5% Foreign 15.7% Pension 23.0% Hedge and Other 3.1% High-Yield Mutual 23.6% Insurance Companies 24.3% A potential risk to the market today is whether investors in the high yield market are more or less homogenous in the way they trade the market. Investment flows into and out of credit mutual funds and ETFs are correlated, and the synchronization of their portfolio adjustments, during volatile market periods can reduce liquidity. If other market participants make similar adjustments then the reduction in liquidity can become dramatic. As an example, the chart below shows dealer inventory declining at the same time the high yield market sold off in October of 2014 and again in February So much for the theory that bond dealers act as market buffers! Primary Dealer Inventory ($million) $9,000 $7,500 $6,000 $4,500 $3,000 $1,500 $0 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Source: Federal Reserve Bank of New York Page 7

8 Conclusion In summary, our credit strategy is to be prepared for rising interest rates. To that extent we believe leveraged loans are an effective credit allocation. We would also allocate to fixed rate bonds as a hold to maturity strategy where the rate of return matches the needs of the portfolio. In the alternative credit asset classes, non-public floating rate senior credit will provide strong credit protection and a high rate of return, and we believe distressed European credit will provide an opportunity to invest higher in the capital structure but with equity like returns. On the equity side, we like U.S. equities as a core allocation and see Europe as a newer opportunity. Emerging and frontier markets remain volatile with poor investor sentiment, but a disciplined approach to allocation could take advantage of the low valuations. As always, now is a good time to reconnect with your Client Advisor to review strategy and asset allocation. Page 8

9 Disclosures VIEW CAPITAL RIA, LP Past Performance is No Guarantee of Future Results. This report does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this report may not be suitable for all investors. View Capital RIA, LP recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities ("related investments"). This publication was furnished on the condition that it will not form a primary basis for any investment decision. Each investor must make its own determination of the appropriateness of an investment in any securities referred to herein based on the legal, tax, and accounting considerations applicable to such investor and its own investment strategy. View Capital RIA, LP and its affiliate companies might do business that relates to companies covered in its market updates or reports, which may include but is not limited to specialized trading, risk arbitrage and other fund management, investment services and investment banking. View Capital RIA, LP makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change. With the exception of information regarding View Capital RIA, LP, reports prepared by View Capital RIA, LP research personnel are based on public information. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other affiliated firms such as VCA Securities, LP and View Capital Advisors, LLC, including investment banking personnel. Past performance is not indicative of future results. The above performance results have been provided by the investment manager and represent a composite of their actual investment performance for this style, actual individual account results may vary. We do not guarantee its accuracy or completeness, and such data may change without notice. Further information may be obtained directly from the investment manager. Other portfolio metrics are calculated by View Capital RIA, LP based on information we deem reliable and accurate. Results reflect realized and unrealized appreciation and the reinvestment of dividends and interest income. Taxes have not been deducted. Performance results represented are gross of fees. Fees, compounded over a period of years, will have an adverse effect on the value of the client s portfolio. The investment advisory fees are described in Part II of the Manager s effect on the value of the client s portfolio. Investment advisory solutions are provided by View Capital RIA, LP, a registered investment advisor. View Capital Advisors, LLC provides asset allocation and investment advisory services through its affiliated registered investment advisor, View Capital RIA, LP and provides trade execution services through its affiliate, VCA Securities, LP. Disclosures for Proposed Investment Managers The descriptions included in this report are not meant to be a complete description of the managers style and methodology and performance. The included descriptions do include alternative investments that may or may not be suitable for the clients investment profile. Please read the prospectus carefully before investing. Glossary and Index Definitions Alerian MLP Index (MLP) - The Alerian MLP Index is a composite of the 50 most prominent energy master limited partnerships calculated by Standard & Poor's using a float-adjusted market capitalization methodology. The index is disseminated by the New York Stock Exchange real-time on a price return basis (NYSE: AMZ). The corresponding total return index is calculated and disseminated daily through ticker AMZX. Barclays Capital U.S. Municipal Index The U.S. Municipal Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligations, revenue bonds, insured bonds, and prerefunded bonds. Many of the subindices of the Municipal Index have historical data to January In addition, several subindices based on maturity and revenue source have been created, some with inception dates after January 1980 but no later than July 1, In January 1996, Barclays Capital also began publishing a non-investment grade municipal bond index and enhanced state specific indices for Arizona, Connecticut, Maryland, Massachusetts, Minnesota, and Ohio. These indices are published separately from the Barclays Capital Municipal Bond Index. Page 9

10 BofA Merrill Lynch Convertible Bond Index (Convertibles) - The BofA Merrill Lynch Convertible Bond Index tracks the performance of US dollar denominated convertible bonds issued in the US domestic market. In addition, qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $100 million. BofA Merrill Lynch Perpetual Preferred Securities Index (Preferred) - The BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of US dollar denominated preferred securities issued in the US domestic market. Qualifying securities must be rated investment grade (based on an average of Moody s, S&P and Fitch) and must have an investment grade rated country of risk (based on an average of Moody s, S&P and Fitch foreign currency long term sovereign debt ratings). BofA Merrill Lynch US High Yield Master II Index This index tracks the performance of below investment grade US dollar-denominated corporate bonds publicly issued in the US domestic market. BofA Merrill Lynch EM External Debt Sovereign Index This index tracks the performance of US dollar-denominated debt issued by sovereign issuers in countries belonging to emerging markets. BofA Merrill Lynch Mortgage Master Index This index tracks the performance of US dollar-denominated mortgage securities. BofA Merrill Lynch Municipal Bond Index This index tracks the performance of US dollar-denominated investment grade tax-exempt bonds. Credit Suisse Leveraged Loan Index This index tracks the investable market of the U.S. dollar denominated leveraged loan market. It consists of issues rated 5B or lower, meaning that the highest rated issues included in this index are Moody s/s&p ratings of Baa1/BB+ or Ba1/BBB+. All loans are funded term loans with a tenor of at least one year and are made by issuers domiciled in developed countries. JP Morgan Emerging Market Bond Index (EMBI+) - The Emerging Markets Bond Index Plus tracks total returns for traded external debt instruments in the emerging markets. The instruments include external-currency-denominated Brady bonds, loans and Eurobonds, as well as U.S. dollar local markets instruments. The EMBI+ is concentrated in instruments from the three major Latin American countries (Argentina, Brazil, and Mexico), reflecting the size and liquidity of these external debt markets. The non-latin countries are represented in the index by Bulgaria, Morocco, Nigeria, the Philippines, Poland, Russia, and South Africa. MSCI Emerging Market Index (Emerging Market Equities) - The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. As of March 2015, the MSCI Emerging Markets Index consisted of the following 23 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates. MSCI Frontier Market Index The MSCI Frontier Market Index is a free float-adjusted market capitalization index designed to measure equity market performance of the frontier markets. As of March 2015, the MSCI Frontier Markets Index consists of the following 24 frontier market country indices: Argentina, Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan, Kenya, Kuwait, Lebanon, Lithuania, Kazakhstan, Mauritius, Morocco, Nigeria, Oman, Pakistan, Romania, Serbia, Slovenia, Sri Lanka, Tunisia, Ukraine, and Vietnam. Russell 2000 Index (TR) - The best-known of a series of market-value weighted indices published by the Frank Russell Company. The index measures the performance of the smallest 2,000 companies in the Russell 3000 Index of the 3,000 largest U.S. companies in terms of market capitalization. Russell 1000 Index (TR) A market-value weighted indices published by the Frank Russell Company. The index measures the performance of the largest1,000 companies in the Russell 3000 Index of the 3,000 largest U.S. companies in terms of market capitalization. S&P 500 Index (TR) -Widely regarded as the best single gauge of the U.S. equities market, this world-renowned index includes 500 leading companies in leading industries of the U.S. economy. S&P 500 is a core component of the U.S. indices that could be used as building blocks for portfolio construction. It is also the U.S. component of S&P Global Total return (TR) provides investors with a price-plus-gross cash dividend return. Gross cash dividends are applied on the ex-date of the dividend. FTSE NAREIT US Real Estate Index Series The FTSE NAREIT US Real Estate Index Series is designed to present investors with a comprehensive family of REIT performance indexes that span the commercial real estate space across the US economy, offering exposure to all investment and property sectors. In addition, the more narrowly focused property sector and sub-sector indexes provide the facility to concentrate commercial real estate exposure in more selected markets. Data Source: Bloomberg, L.P., JPMorgan, BofA Merrill Lynch, Standard and Poors, Barclays Capital, Alerian, Morningstar Direct, MSCI Page 10