Commentary

Third Quarter Overview

As the third quarter began, mixed economic data fueled investor apprehension. This anxiety drove a continuation of the saw-toothed markets of the second quarter, when stocks would rise for a few days or weeks, only to retreat again. By the end of September, however, the landscape was much changed. Markets gained a degree of traction, and major stock indexes around the globe posted good gains for the quarter. Convertible and high yield securities participated in the equity market upside during the period, earning respectable returns as well.

Despite media reports of decreased consumer spending, downward revision of gross domestic product (GDP) growth and higher year-over-year inflation, there was considerable good news in the third quarter. The Fed's decision in August to pause in its rate increases served to alleviate inflation and recession fears somewhat, and investors became cautiously hopeful of economic expansion. Corporate earnings remained robust. The release of strong consumer confidence data, in part a reaction to the continuing slide of gasoline prices, encouraged investors as well. And in a surprising turn, although new home prices continued to slip, new home sales actually rose in August.

Outlook

To us, it appears likely that the economy will experience a mid-cycle slowdown, much like the slowdowns experienced in 1965, 1985 and 1986, and 1995. Each of these slowdowns was preceded by Fed rate hikes that appeared to be early or directed at some excess building in the real economy or financial markets. In each case, the market reacted to the slowdown before the GDP reflected it—in other words, the market was a leading indicator.

In 1984, the Fed was raising rates and the S&P 500 Index began the year at 169. By mid-July, the index bottomed at 148 (a 12.4% correction), and then rallied to end the year at 166 for a -1.77% price return. Once the slowdown showed up in the GDP figures in 1985-1986, the market rallied in anticipation of a slowdown and more controlled growth. From January 1, 1985, to December 31, 1986, the market rallied from 166 to 247, a nearly 50% rise. By August of 1987, the index was at 328, representing a price rise of nearly 100% from when the Fed stopped raising rates. Half of the market move occurred during the mid-cycle slowdown.

Once again, in the 1990s bull market, the economy experienced a mid-cycle slowdown; and again, the slowdown was preceded by the Fed raising rates in 1994 with a GDP slowdown occurring in 1995. The market came into 1994 at 464 and closed the year at about 460 for virtually no price return. But during this same year that economic slowdown occurred and the Fed rate hikes stopped, the market began a huge sustained bull market that peaked at 1525 in March 2000—a 229% move.

Changes in GDP Growth and the S&P 500 Index
March 31, 1965 - December 31, 1969
March 31, 1983 - December 31, 1987
March 31, 1993 - December 31, 1997
Source: Bloomberg, LP. The S&P 500 Index is an unmanaged index generally considered representative of the U.S. stock market. Unmanaged index returns assume reinvestment of any and all distributions and, unlike fund returns, do not reflect fees, expenses or sales charges. Investors cannot invest directly in an index.

After officially pausing in August, the Fed may be near or at the end of its rate hikes. The market appears to be discounting a mid-cycle slowdown, treading water even in the face of very strong corporate earnings and solid GDP figures, much like the mid-cycle market run in the last two bull markets. Many times in the past year, we have said we believe the market will get back on track when the Fed is done raising rates. We believe this change is near.

A Shift in Leadership

One of the significant changes that occurred in past mid-cycle slowdowns was a shift from a pro-cyclical market to a more growth-oriented market. In each, the value and cyclical stocks that led during the early phase of the bull market were replaced by more traditional and stable growth stocks in the next phase. We believe this will happen again.

At a certain point in every economic cycle, top-line growth, pricing power and high utilization rates create a perfect storm, spurring eye-popping earnings growth rates for cyclicals. During these periods, earnings growth rates of more than 100% are not uncommon. But, the same forces that brought about the very high growth rates also shift and bring about huge negative swings in the earnings growth of cyclicals.

Early signs that a similar shift is underway include the changed fortunes of housing stocks. Down 50% from the earlier highs, housing stocks are once again priced as cyclical companies and not as secular high-growth companies. We believe that other cyclical "growth" stocks will follow suit, and may soon be re-priced by the market. Growth stocks, on the other hand, have significantly underperformed value stocks and cyclical stocks. The leadership change from cyclical to growth is generally followed by a dramatic—downward—change in the forward earnings-growth for the cyclical companies, while the more stable growth companies continue generating more of the same, steadier earnings growth.

Several catalysts favor a sustained shift toward growth: an end to Fed rate hikes, moderation of energy prices, slowing in the growth of housing prices, an increase in market volatility, moderation in consumer spending (especially high-end spending) and a decline in commodity prices. Most of these are present today; so if history is a reasonable guide, we should expect a change in leadership.

In fact, since early August, the leadership has begun to change as many of the cyclical stocks that led the market in the first half of the economic expansion have considerably underperformed the more stable growth stocks.

We acknowledge that the market does not always follow the same pattern every economic cycle; and it could be different this time. It seems that the real risk in this cycle is the possibility of inflation not moderating, instead taking hold at higher levels, much like it did in the 1970s. If this were to occur, the economy would be weaker. However, as far as we're concerned, that risk is not high at this time: although commodity prices and energy prices have increased since the beginning of the expansion, the much larger bond valuations indicate to us that inflation is not a significant threat.

Additionally, we do not believe the U.S. economy is on the verge of recession. Although GDP growth has slowed from recovery levels, it is still quite respectable. In the past, simultaneous decreases in gasoline prices and bond yields (which we're seeing now) have often been associated with an increase in real consumer spending. Furthermore, recent wage hikes also support the possibility of increased consumer spending.

Strategy and Positioning

We are firm believers in remaining positioned for the long term and have long recognized the impossibility of predicting the exact timing of market shifts. Accordingly, we continue to position our portfolios ahead of events and market turns, rather than trying to chase them. Based on our economic outlook, we're emphasizing investments in companies with quality hallmarks—such as strong balance sheets, capable management and well-planned business strategies. We have found many opportunities to invest in these companies at very attractive prices.

Equity

As we enter the mid-cycle slowdown, we're favoring higher-quality, larger-cap growth companies in our equity portfolios. Many of these types of companies have seen a great deal of earnings growth in recent years that's not been reflected in stock prices, and also offering high return-on-capital, low debt-to-capital, good valuations and a reliable cash flow stream.

We're favoring health care industries that contain fast-growing, top-line businesses, such as pharmaceuticals, biotechnology and services. We're also increasing our weighting in some financial industries, such as asset managers, which should continue to grow as more baby boomers go into retirement. In telecommunications and technology, we're looking for efficiency enhancers and supply-side business models that can create their own demand in a changing market. Finally, we're reducing our holdings in cyclical sectors (such as industrials, materials and energy), which we believe will become less attractive as the shift toward growth takes hold.Global:

Global

In our assessment of investing opportunities around the world, we continue to follow trends we believe will have an increasing influence in the global economic landscape, such as the growing role of the emerging market consumer and the move toward outsourcing of labor to foreign countries. As within our domestic portfolios, in the international markets, we look for businesses with strong top-line growth, high return-on-capital, low debt-to-capital, good valuations and a reliable cash flow stream; we believe these types of companies hold the most promise during this phase of the market cycle.

Within developed markets, we've increased our allocations in Asia. In particular, we continue to add to Japan, although we're monitoring the country's new prime minister to see what his economic policies will be. In emerging markets, we're favoring emerging Asia and emerging Europe; we also hold positions in Mexico. In contrast, we are avoiding investment in other parts of Latin America, where the direction of many countries' economic principles concerns us.

Convertible

Valuations in the convertible markets improved over the period. Nonetheless, more room for valuation improvement remains, which should continue to benefit investors. Although new issuance was stronger for the third quarter than it has been for much of the year, redemptions remained fairly high. However, now that interest rates have moved away from historic lows, it is possible that companies seeking access to capital could be more inclined to consider convertible debt rather than alternatives such as straight high-yield bonds, particularly if the equity market can maintain its upward pace.

We're focusing on equity-sensitive issues so that we can continue to participate in the upward movement of the stock market. As in our equity strategies, we're favoring higher-quality, growth-oriented issues. At the same time, we're de-emphasizing cyclicals such as energy, industrials and materials; we believe cyclical businesses that owe their growth to volatile commodity prices or to recovery-level growth in the GDP pose higher risk today than more stable growth issues.

High Yield

The fundamentals of the high-yield market remain solid, and we believe the market looks fairly priced: defaults are low, corporate balance sheets are sound and companies have sufficient cash on hand to service their debts. As high-yield issues are typically more sensitive to stock market movements than to changes in underlying interest rates, these securities should benefit from upward movement in the stock market.

While remaining attuned to top-down concerns, we emphasize an issue-by-issue approach in our high-yield portfolios. We look for companies with good return-on-invested-capital and stable or improving credit; we also favor companies that may benefit from equity issuance or M&A activity. As in many of our other strategies, we have a bias toward sustainable growth companies over those with cyclical vulnerabilities.

We are avoiding distressed issues, instead positioning our portfolios with a bias toward securities in the higher-quality tiers of the high-yield universe. Given that the performance of high-yield bonds typically tracks the stock market, we are positioning our portfolios to take advantage of the asset class' equity-sensitive characteristics, relying on our research to determine the financial strength and prospects of issuing companies—and catalysts for upside.