Constructive Portfolios, an Expanding Economy and Steady Growth
The markets ended down across the board in the first quarter of 2005, with negative returns extended not only across the major domestic asset classes but also overseas, where most major foreign markets were down for the quarter as well in U.S. dollar terms. Many factors contributed to the market drop, such as the ongoing toll of the new regulatory burdens, rising oil prices, and concerns over inflation. The quarter was particularly disappointing for our strategies, as we remain constructive on the economy and positioned for equity sensitivity. We believe such positioning to be appropriate for the longer-term, despite this quarter's retrenchment: It is our view that mild inflation and rising interest rates are signs that the economy is strengthening, and that we are entering the steady growth, middle phase of the economic cycle. And since we think that asset allocation should take place in advance of any perceived risk, we are maintaining a consistent balance of risk and reward, rather than reactively reallocating in response to short-term events.
Rising energy prices took their toll on investor sentiment during the first quarter, as talk of even higher prices roiled the markets. As we see it, the current oil price is a cyclical spike, caused by the fact that the oil market is not a free market, and tinged with geopolitics. Many of the world's main producers, such as Russia, Venezuela, and Saudi Arabia, are not by any stretch advocates of democracy and are comfortable with oil prices being the fly in the ointment that crimps economic expansion, and by extension, economic freedom. If we look at the world's current consumption and its known reserves, we conclude that there is no shortage of oil, but instead only a short-term price squeeze. Right now, there are producers with strong pricing power, but there is no shortage of the necessary materials in the ground, and technology offers the promise of extending our access to what is available.
Oil prices coupled with inflation concerns during the quarter also raised questions regarding the strength of the U.S. consumer and businesses, but we see a consumer who is still in good shape and corporate cash flows are at record levels. We thus remain positioned for a market turnaround later this year, continuing to favor industries that can benefit from consumer and business spending. During the first quarter, however, this positioning had a negative impact, as our holdings in sectors such as technology declined. While a volatile sector, we believe our focus here will reward our strategies over the longer term, as the fundamentals appear healthy. For example, our outlook on the equity markets sees some longer term positive trends. The IPO and secondary markets are relatively strong, indicating businesses have a positive outlook on their prospects; merger and acquisition activity continues apace, and not just at the mega-deal level. Such activity, including strong earnings per share (EPS) and cash flow growth, should continue to boost the market. Based on current market valuations, we are biased towards growth names over value stocks and favor mid/large-cap firms over small-caps. Unlike large firms with multinational focus, smaller firms have less ability to participate in the global economic recovery.
Within the high-yield market, the new deals that came out in March were often priced above range, indicating a cooler reception by the marketplace. Although yields in this arena remain lower than conventional expectations for high yield bonds, it is important to remember that the yields are a reflection of low global interest rates and a low bankruptcy rate. Although we consider the group to be fairly valued relative to other asset classes, we are monitoring the current market for its risk/reward profile relative to other equity-sensitive opportunities, such as convertible bonds.
Among convertibles, we see the current market as a good opportunity to increase exposure, based on improving risk/reward profiles. In fact, we believe that pricing among convertible bonds is more attractive now than it has been for a number of years. With that said, the new issue market remains light, although terms have improved for long investors. Given the potential softening of the market for high-yield bond deals noted above, it is possible that businesses may turn to the convertible market for access to capital, providing a much needed boost to the market's overall volume.