Economic Review and Outlook

July 2016

Entering the second half of the year, market participants find themselves facing many familiar unknowns: whether the U.S. and global economies can maintain their muted pace of growth, the potential ramifications of a strong dollar, and the extent to which monetary policy can influence the markets. The political landscape remains a source of apprehension, as investors seek to understand the implications of Brexit and more broadly, global populist sentiment. Yet investor appetite for risk assets has been on the upswing. In this environment, we believe:

  • Despite signs of deceleration, near-term global economic expansion should continue. The pace is likely to be slow overall and uneven among countries.
  • Even as U.S. equities have rallied to new highs, downside risk management remains important given the political crosscurrents and macro environment.
  • Across asset classes, securities with higher quality attributes remain most attractive overall.Growth is likely to outperform, with select opportunities in cyclicals.
  • The global and U.S. economies are not facing imminent recession, but fiscal policy decisions will be crucial in defining the way forward. It will be hard to break out of a tepid-growth environment without policies and regulations that encourage entrepreneurship and responsible risk taking.
  • After years of aggressive monetary policy, central banks have limited room to maneuver effectively.

In the first weeks of the year, investors maintained a riskoff stance and crowded into a narrow group of stocks. As the quarter progressed, increased confidence in the U.S. economy, the likelihood of fewer Fed increases, and stabilizing commodity prices fueled a rally in emerging markets, high yield, and value and cyclical stocks. Growth equities gained a better footing during the second half of March, when Chair Yellen’s remarks called into question the strength of the global economy. Convertibles participated in the equity market’s ups and downs, with U.S. convertibles continuing to reflect the performance of small and mid-cap growth issuers.

FIGURE 1. GLOBAL ASSET CLASS PERFORMANCE, 2Q16
Past performance is no guarantee of future results. Source: Bloomberg.

This material is distributed for informational purposes only. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the information mentioned, and while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable. NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE

U.S. equities.Employment and manufacturing data, as well as signs of wage growth, support our view that the U.S. economy can continue expanding at a pace consistent with recent years, albeit at a lower rate historically seen at this point of the business cycle. The direct impact of Brexit is likely to be contained and provided the dollar doesn’t spike, the U.S. economy should be able to maintain its course. We share in the view that the Federal Reserve is likely to forestall any interest rate increases for the foreseeable future, given the potential economic impact of Brexit and other related political uncertainties.

The stock market is likely to remain highly sensitive to economic releases and announcements, as participants seek to make sense both of the data itself as well as how it is likely to influence Fed policy. As the next earnings announcement season commences, guidance is likely to be cautious, especially for currency-sensitive companies. We are devoting particular focus to trends in capex spending, where the impact of euro zone uncertainties is yet to be determined.

FIGURE 2. “SAFETY STOCKS” HAVE REACHED EXTREME VALUATIONS

Investors’ preference for cyclical stocks has faded in the wake of Brexit, with dividend-oriented stocks leading the rebound as investors seek income. However, we are concerned that many of these “safety stocks” are trading at stretched valuations (Figure 2), without offering the long-term growth characteristics we seek. Looking forward, we believe the combination of choppy global growth and lackluster yields worldwide will lead investors to increasingly differentiate between growth versus value. Conditions should support a sustained period of outperformance for U.S. growth stocks with quality attributes, albeit with opportunities for select cyclicals.

Global and International Equities. As we noted, we are not calling for a global recession, but do believe that risk management will be especially important in this environment. Although central banks remain committed to monetary policy as required, the efficacy of their actions has become increasingly uncertain. Global yield curves have become much more flat, if not inverted (Figure 3) and absolute yields continue to come down with negative yields for Japan and German 10-year sovereigns. Meanwhile, muted world trade points to lower global growth (Figure 4).

FIGURE 3. FLATTENING YIELD CURVES, GLOBALLY
FIGURE 4. DECLINING WORLD TRADE

While Brexit is not shaping up to be the catalyst for a global financial crisis, we remain vigilant to a potential snowball effect of populist sentiment. These include already-scheduled elections and referendums, as well as calls for exit referendums in a number of other euro zone members. However, the results of Spain’s post-Brexit election suggest that populist momentum may be less than markets originally anticipated following the Brexit result, while the growing near-term economic concerns facing the UK may serve as a further deterrent. Additionally, we may see increased openness to compromises among euro zone members that give periphery countries more latitude. While we are concerned that conversations about the Italian banks haven’t gone particularly well, we are optimistic that an acceptable solution can still be reached.

Our strategy in Europe has lately focused on companies with higher quality attributes, such as strong balance sheets and good returns on invested capital. While we have pared exposure to the UK and euro zone more broadly, we continue to identify opportunities in both, including technology, consumer and health care companies with well-recognized global brands and geographically diversified revenue streams. We’re more cautious on UK and euro zone companies that are more dependent on cyclical tailwinds to drive earnings growth, and those that would be more vulnerable to declining business and consumer confidence. We are maintaining exposure to European financials, but are generally underweight in banks, instead preferring beneficiaries of a low interest rate environment, such as real estate names.

In regard to Japan, economic surprises have been on the downtrend over recent months, and a strong yen is a headwind for an export-oriented economy. However, the potential for further monetary policy could help support export industries and beneficiaries of reflation, and we are more likely to see the fiscal policy we believe is essential for sustainable growth.

Since the mid-February low, we have become marginally more bullish on emerging markets (see a transcript of our recent webcast for more). Economies with lower-quality fundamentals have continued to performed well, but we remain concerned about the downside associated countries such as Russia and Brazil. We are maintaining our emphasis on countries that are less tied to commodity prices and those which are moving toward higher levels of economic freedoms. Prospects look relatively good in Indonesia and India, both of which have cut interest rates. We are also watching the Philippines with great interest, as new leadership looks set to continue with economic reforms. In regard to China, we continue to believe the government has the tools and levers it needs to prevent a hard landing in the near term. Our focus in China remains on technology and consumption, areas that we believe can benefit from the country’s transition to a more balanced consumer-driven economy.

Convertible Securities.During the quarter, convertibles outpaced equity markets and we believe convertibles’ hybrid stock-bond attributes remain compelling, given the equity market volatility we expect and our concerns about traditional fixed income securities, where sovereign bond yields are paltry to negative.

We are maintaining our focus on convertibles with balanced risk/return attributes, seeking to use short-term volatility as an opportunity to add to our favorite positions. We remain selective within the higher equity sensitive portion of the market, particularly on areas where we believe there is a smaller margin of safety in underling equity valuations.

We continue to find many opportunities within the technology sector, where we have identified securities with attractive convertible structures, solid balance sheets, strong fundamentals and favorable long-term secular growth prospects. Within the more yield-oriented section of the convertible universe, we have found opportunities in REITs and select convertible preferreds issued by banks. We have been and expect to remain underweight cyclical areas, such as industrials, energy and materials. Even in our global convertible portfolios, direct exposure to the UK and Europe has been relatively low. We are closely evaluating that exposure as well as U.S.-based positions with significant European exposure.

Although year-to-date global issuance of $38.0 billion is not as strong as it was a year ago, it remains healthy, supported by an uptick of activity in June. Of particular note, the quarter saw one of the largest convertible deals in history, issued by a Chinese internet company. Although emerging markets issuers represent a small portion of the convertible market today, we believe this recent deal represents an exciting milestone in the evolution of the global convertible market.

High Yield.Although market participants sold off “risk” assets in the two days following the Brexit vote, oil prices rallied back to close the quarter near $50, providing a continued tailwind to commodityrelated issuers. The high yield asset class was further supported by the significant decline in Treasury yields, which maintained their levels even with the late-month bounce in “risk” assets. The high yield market is now up over 15% since mid-February, which puts 2016 on pace to be the best year for the asset class since 2009.

We expect limited fundamental impact on the U.S. high yield market as a result of Brexit, given that the majority of revenues for issuers are generated in the U.S. With more than $4 trillion of euro debt trading at negative yields, the high yield asset class still offers attractive yields relative to other opportunities. Even so, increasing default rates and deteriorating fundamentals should prompt added vigilance to credit risk.

We believe security selection will be increasingly important during the months to come. Investors have historically demanded a spread above default losses well in excess of current levels, which may temper high yield returns over the next year. In this environment, we expect higher-quality, more fundamentally stable credits to outperform, and we are positioned accordingly. Rather than pursuing the highest income without regard to fundamentals,we continue to seek out attractive risk/reward opportunities, including rising stars—issuers that are positioned for an upgrade to investment grade status. (For more on our views, please see our monthly high yield snapshot.)

Alternative Strategies.Volatility during the first half of the year affirmed the potential benefits of strategies that utilize complex volatility trades. For example, options-based strategies provided us with opportunities to capitalize on the conditions that the markets gave us. Given our view of continued volatility, we believe the return profiles of select alternative approaches (such as market neutral and covered call) may be compelling substitutes for traditional fixed income investments, where risk/return profiles give pause. Even though yields are low globally, interest rate risk exists in all environments, which we believe supports the case for strategies structured to avoid duration risk. Elsewhere in the alternative spectrum, long/short approaches may further overall diversification, without the associated risks of the most duration sensitive bonds.

Conclusion.We’ve seen U.S. markets reach new highs over recent days and believe there are continued opportunities for risk assets, globally. Even so, investors should remain selective and prepared for volatility. As we have observed in the past, periods of ebullience can give way to brisker sell-offs when sentiment falters. Whether markets are rising or falling, we encourage investors to let discipline, not emotion, guide decisions. By collaborating and drawing on our range of specialties, we believe our teams are well positioned to identify opportunities and manage the risks in the global economy.

contributions

John P. Calamos, Sr.

Founder, Chairman and Global Chief Investment Officer

John P. Calamos, Sr. is Chairman and Global CIO of Calamos Investments, a firm he founded in 1977. With origins as an institutional convertible bond manager, the firm has grown into a global asset management firm. Mr. Calamos is often quoted as an authority on risk-managed investment strategies, markets and the economy. He received his B.A. in Economics and an M.B.A. in Finance from the Illinois Institute of Technology. He joined the United States Air Force after graduation and served as a combat pilot during the Vietnam War.

John Hillenbrand, CPA

Co-CIO, Head of Multi-Asset Strategies and Co-Head of Convertible Strategies, Senior Co-Portfolio Manager

As a Co-Chief Investment Officer, John Hillenbrand is responsible for oversight of investment team resources, investment processes, performance and risk. As Head of Multi-Asset Strategies and Co-Head of Convertible Strategies, he manages investment team members and has portfolio management responsibilities for those investment verticals. He is also a member of the Calamos Investment Committee, which is charged with providing a top-down framework, maintaining oversight of risk and performance metrics, and evaluating investment process. John joined Calamos in 2002 and has 24 years of industry experience. Prior to joining Calamos, he served as an equity research analyst at Credit Suisse First Boston and ABN AMRO and as an Account Manager - Business Credit Group at Continental Bank. John received a B.B.A. in Public Accounting from Loyola University and an M.B.A. in Analytic Finance from the University of Chicago Graduate School of Business. He is also a member of the American Institute of Certified Public Accountants.

David P. Kalis, CFA

Co-CIO, Head of U.S. Growth Equity Strategies, Senior Co-Portfolio Manager

As a Co-Chief Investment Officer, David Kalis is responsible for oversight of investment team resources, investment processes, performance and risk. As Head of U.S. Growth Equity Strategies, he manages investment team members and has portfolio management responsibilities for our U.S. growth equity strategies. He is a member of the Calamos Investment Committee, which is charged with providing a top-down framework, maintaining oversight of risk and performance metrics, and evaluating investment process. David joined the firm in 2013 and has 24 years of industry experience. Prior to joining Calamos, he was a managing partner at Charis Capital Management (CCM), a long/short equity firm he founded in 2010, which focused on small- and mid-cap equities. Previously, he was Senior Vice President/Portfolio Manager – Small and Mid Cap Growth Equities at Northern Trust Global Investments, and a Partner and Portfolio Manager at Segall Bryant & Hamill (SBH), a Chicago-based investment partnership. He received a B.A. in Economics from the University of Michigan.

Nick Niziolek, CFA

Co-CIO, Head of International and Global Strategies, Senior Co-Portfolio Manager

As a Co-Chief Investment Officer, Nick Niziolek is responsible for oversight of investment team resources, investment processes, performance and risk. As Head of International and Global Strategies, he manages investment team members and has portfolio management responsibilities for international, global and emerging market strategies. He is also a member of the Calamos Investment Committee, which is charged with providing a top-down framework, maintaining oversight of risk and performance metrics, and evaluating investment process. Nick joined the firm in 2005 and has 14 years of industry experience, including tenures at ABN AMRO and Bank One. He received a B.S. in Finance and an M.B.A. from DePaul University.

Eli Pars, CFA

Co-CIO, Head of Alternative Strategies and Co-Head of Convertible Strategies, Senior Co-Portfolio Manager

As a Co-Chief Investment Officer, Eli Pars is responsible for oversight of investment team resources, investment processes, performance and risk. As Head of Alternative Strategies and Co-Head of Convertible Strategies, he manages investment team members and has portfolio management responsibilities for those investment verticals. He is a member of the Calamos Investment Committee, which is charged with providing a top-down framework, maintaining oversight of risk and performance metrics, and evaluating investment process. He also is a member of the Calamos Office of the CEO, responsible for comprehensive oversight of business execution and strategic growth initiatives. Eli has 28 years of industry experience, including nine at Calamos. Prior to returning to Calamos in 2013, he was a Portfolio Manager at Chicago Fundamental Investment Partners, where he co-managed a convertible arbitrage portfolio. Previously, he held senior roles at Mulligan Partners LLC, Ritchie Capital and SAM Investments/The Hampshire Company. Earlier in his career, Eli was a Vice President and Assistant Portfolio Manager at Calamos. He received a B.A. in English Literature from the University of Illinois and an M.B.A. with a specialization in Finance from the University of Chicago Graduate School of Business.

Jeremy Hughes, CFA

Senior Vice President, Co-Portfolio Manager

Jeremy Hughes is responsible for portfolio management and investment research, focused primarily on high yield portfolios and other fixed income strategies. He joined the firm in 2013 and has 23 years of industry experience. Prior to joining Calamos, he was a portfolio manager at Aviva Investors in Chicago, overseeing global high yield assets. Previously, he held high yield portfolio management and trading roles at ABN AMRO, Allstate, Citigroup and Van Kampen. Jeremy received a B.S. in Finance from Miami University of Ohio.