Things that Go Bump in the Night and "Fat Tails"
"This is precisely the type of market we have been anticipating: a period of slower economic growth in which investors more fully recognize the value of businesses with higher-quality, sustainable growth rates."
In the first quarter of 2007, volatility returned to the markets overnight—emanating from Hong Kong, on the back of Alan Greenspan's comments about the potential for a recession in the U.S. markets. A sharp market correction in China and more significant downturns in other overseas markets ushered in another round of recession worries and lengthened the list of economic concerns. Meanwhile, the slide of the sub-prime mortgage market and the deflation of the housing bubble further unsettled investors.
As investors evaluated the more volatile landscape, signs of changing leadership in the domestic equity market emerged. Concerns over weaker economic growth have prompted investors to reassess the risks in the market, and specifically, the prices they have paid for the securities they own. For example, in 2006 and during the first months of 2007, the market rewarded stocks with lower long-term earnings growth prospects. After the market correction in February, however, investors began to favor quality companies with higher earnings growth prospects. This is precisely the type of market we have been anticipating: a period of slower economic growth in which investors more fully recognize the value of businesses with higher-quality, sustainable growth rates.
Within the convertible market, issuance was strong, driven primarily by a robust March. Although speculative-grade issues outperformed for the quarter overall, higher-grade convertibles performed more closely in line with speculative-grade issues in March— echoing trends in the equity markets. The high-yield market also saw strong issuance during the quarter, and defaults remained low. Lower-quality credits outperformed the higher tiers of the high-yield universe for the period.
Against a backdrop of solid global economic growth trends and ample liquidity, international markets advanced. Broadly speaking, international equities outpaced the U.S. market, with developed markets leading emerging markets. Among the positives in Europe, business confidence data released at the end of the quarter reached a six-year high, employment trends were favorable, and corporate restructuring has continued. Japan's economy gained traction, and posted compelling fourth-quarter GDP growth supported by encouraging gains in consumer spending. Meanwhile, many emerging economies continued to benefit from strong money flows and increasing global commodity prices.
Outlook
"While the increase in equity market volatility may be unnerving to some, it is actually more common than not. During recent years, investors have grown accustomed to unusually low volatility in the equity markets. In fact, until February, the Dow had its longest run in 50 years without a 2% daily drop."
Although politics are heating up across the globe and volatility is increasing, the financial markets still look favorable. While many were unnerved by the events of the first quarter, we continue to believe a recession is not imminent. Recessions and bear markets are generally the result of policy mistakes and systematic financial shocks, neither of which we believe has occurred. That is, the "bump in the night" coming out of Asia does not seem to foreshadow a real threat. We believe that the bump is just a warning—and a sign of the delicate trade relationships that drive the global economy.
What we are seeing in the housing and high-risk mortgage markets is not unexpected either. We'd note that the bond market seems to have taken matters in stride, as evidenced by the lack of movement in debt spreads which persisted during the quarter.
Last May, volatility roiled the markets, and many investors feared recession was at the door. That summer, we shared our view that the volatility was a normal correction in a bull market (a quite survivable "black bear" threat), and not the beginning of a new bear market (a more fearsome "grizzly bear" attack). While much has changed in the past three quarters, this recent correction should be contained as well.
Since the correction in the second quarter of last year, we have been calling for a mid-cycle slowdown. The fourth quarter of 2006 and the first quarter of 2007 have certainly seen a slowdown: Fourth quarter gross domestic product (GDP) growth of 2.5% was below the full-year growth of 3.3%. The housing market has declined dramatically from its peak in 2005, high-risk mortgage default rates have soared and corporate earnings have slowed.
So, then, why do we believe this is a slowdown and not a recession? The economy has continued to demonstrate remarkable resiliency. Although consumers have felt the pinch of high energy prices, they also have benefited from much higher wage growth and a tight labor market. Household net worth has continued to climb. Even with a slowdown in housing-related construction and manufacturing, overall payroll gains continued to be strong, helped by a healthy service sector. Against this backdrop, consumer spending should stay robust, as income gains and employment correlate best with consumer spending. (Consider that February's personal spending data came in at an above-expected 0.6%.) Largely, consumers appear to have abundant access to credit. Corporate balance sheets are sound. Given expected earnings growth in the 7% to 9% range for this year, we view the decline from double-digit earnings growth simply as a return to more normal levels.
The Opportunity of "Fat Tails"
The return of volatility to the markets should have an impact on more risky assets and will likely lead to a more normal risk premium. High-risk debt seems especially vulnerable to a markdown in asset values, though not a severe correction. We believe equity markets may become more volatile with return distributions exhibiting "fat tails." This is another way of saying the number of days with large percentage market moves—either up or down—could increase significantly. The fat tails of the return distribution are in fact very normal because the distribution of market returns is anything but normal. The last three years have been abnormally tame from a market volatility standpoint; therefore, risk premiums have narrowed.
It is rare to have prosperity without risk. Otherwise, everyone would be wealthy. Fat tails can produce both higher risks and higher return potential. So, we believe the shift to potentially greater volatility is actually a positive for active portfolio management because the increase in volatility corresponds to an increase in opportunity.
The Fed: Orchestrating A Selective Slowdown
Over the last few years, the Fed has raised rates from 1% to 5.25%. By doing so, the Fed has sought to reduce leverage in the financial markets and deflate the real estate asset bubble. As short-term adjustable-rate mortgages have rolled to higher rates and new fixed-rate mortgage rates have moved upward, it should come as no surprise that the sub-prime mortgage market—the most risky segment of the mortgage market—has imploded. We believe it unlikely that the subprime mortgage market's downturn will be the catalyst that causes a recession. The Fed has engineered a slowdown to pop the asset inflation in a section of the market. It has bet on the economy's ability to contain the isolated losses and avoid a full-fledged financial debacle reaching beyond the mortgage markets. The Fed also has significant flexibility to come to the rescue with lower rates if necessary to stem the slide.
Also, through its rate increases, the Fed has likely been targeting other sections of the financial market—for example, the yield curve carry trade and leverage in the hedge fund industry. (Broadly, the "carry trade" refers to arbitrage strategies that seek to take advantage of differences in interest rates.) In recent years, the yield curve in the United States allowed investors to borrow at interest rates near 1% and invest in assets with longer maturities and yields of 4% to 12%. This created significant leverage—and risk—to the financial markets. In decades past, such asset/ liability mismatches have often led to the demise of the banking and financial industry.
Although the sub-prime mortgage market has suffered a blow, the yield curve carry trade has played out with very little pain overall, as hedge funds seemed to have heeded the stern warnings of then-Chairman Greenspan. Today, the yield curve carry trade has most likely migrated and added to the yen carry trade. The weak yen and low interest rates in Japan have encouraged hedge funds to borrow in yen at near 1% interest rates and then purchase higher-yielding assets, including U.S. government bonds, Euro bonds and possibly even high yield debt.
"Rolling Recessions" and the Housing Sector
The housing sector is in a recession which could continue for many years. Housing prices are likely to decline or at least remain flat for a significant period, with home values dropping on a real basis. However, history has shown that a diversified economy can absorb rolling recessions. For example, since the 1980s, the economy has experienced rolling recessions in various sectors while avoiding a significant overall decline. During the expansions of the 1980s and 1990s, there were recessions in the agriculture, commodities and manufacturing sectors. The 1990s economic boom also saw declines in the banking, auto and transportation sectors. The expansion since 2002 has been accompanied by recessions in the automotive and information technology (IT) capital spending sectors, as well as in service industry groups such as advertising, newspapers, grocery stores and IT consulting.
The strength of the economy is due to its diversification, global reach, productivity gains and inflation containment. Indeed, during the past few years, the global markets have experienced the highest growth in over 30 years, even as Japan—the world's second largest economy—has failed to contribute. Overall, the avoidance of a significant systematic financial shock and only minor policy mistakes have allowed the economy to expand with only minor setbacks for the last 25 years.
Inflation Remains Largely in Check
Inflation in the United States is 30 basis points above the Fed's target range; but with energy prices removed, inflation is at target. The Fed is on hold but, with rates at 5.25%, has flexibility to move higher or lower. Globally, inflation is well contained and economic growth appears in good shape.
The inflation "wild card" is the global U.S. dollar surplus. As we've discussed in previous commentaries, this surplus is the result of the trade deficit, the dollar's status as the dominant reserve currency to the world, and the fact that the dollar is the currency on which most commodity and all energy transactions are based. The game is changing, however. The world economy is no longer as "dollar-centric" as it once was. Other currencies are more broadly held as reserve currencies and the U.S. trade deficit is starting to get re-circulated out of dollar-based investments and into other alternatives. A significant weakness in the U.S. dollar could usher in higher inflation; this, in turn, could raise interest rates and slow consumption. We are carefully watching the Treasury secretary's actions regarding China's and Japan's desire to strengthen their currencies against the dollar. The United States will not prosper off the back of a weak currency any more than companies with weak stock prices prosper.
Strategy and Positioning
Broadly, we continue to favor large equity and quality growth equity, growth over value, equity over debt, and convertibles over high yield. Among sectors, we generally favor non-cyclical over cyclical.
U.S. Equity
We are optimistic about the equity markets. Corporate earnings growth remains respectable and balance sheets are solid. Valuations appear reasonable—in fact, the market is as cheap now as it was in 1994. Private equity activity should also further the appreciation in the stock market.
We believe our strategies are well-positioned for a period of mid-cycle slowdown. We strive to invest ahead of market turns, and this led us to be early in some positioning decisions in 2006. But because shifts are often sudden, we believe that being early is a more prudent course than trying to chase events.
In an environment of mid-cycle slowdown, we continue to favor traditional growth companies—that is, companies with high-quality balance sheets and prospects that are not entirely dependent on the economy and volatile commodity prices. We have not avoided energy companies entirely, however, viewing our exposure as a hedge against potential geopolitical turmoil and event risk. We have also found compelling opportunities to invest in industrial companies with global reach.
Convertibles
We have a positive outlook on convertibles. We would expect convertibles to benefit from increased volatility and an upward moving equity market. We continue to favor more equitysensitive issues, reflecting our positive outlook on the equity markets. From a sector perspective, our emphasis is on less economically sensitive issues. Traditional growth-oriented sectors such as financials, health care, consumer discretionary and information technology are well represented among our convertible holdings. In contrast, we remain very selective within cyclical sectors such as energy, industrials and materials.
We maintain a bias toward higher-quality issues. While this hindered relative performance during the quarter, we believe a highly selective approach to lower-rated credits is appropriate during a period of mid-cycle slowdown.
High Yield
We remain selective on the high-yield market, but continue to find opportunities through rigorous bottom-up research. As we noted earlier in this commentary, our view is that highyield debt may be more vulnerable to markdowns as the market slows and volatility increases. The economic slowdown could impact the investment burden of companies, particularly those with less solid balance sheets.
During the first quarter, the lower tiers of the high-yield universe continued to outperform. This placed us at somewhat of a disadvantage, given our preference for issues in the higherrated tiers of the high-yield universe (credits rated BB or B+). We believe our quality bias is appropriate, however. In the past, we've shared our view that a higher coupon or income stream can't make up for a default. As long-term investors who pursue yield as a component of total return, we are emphasizing companies which we believe offer factors such as quality balance sheets, sustainable growth prospects, reliable debt servicing and potential for credit upgrades.
Global and International
We see abundant opportunities in the global market. Companies—and countries—all over the world are contributing to the prosperity of a synchronized global economy.
In Europe, we have invested in multi-national growth companies, balancing economic and non-economic sensitivity. Our positioning in Southeast Asia includes yen exposure, investments in Japanese mid- and large-caps, and companies with a higher degree of economic sensitivity (relative to our domestic positioning). We continue to invest in emerging markets on a highly selective basis, favoring companies in the commodity and consumer staples sectors.
We remain considerably more cautious about Latin America; this reflects our concerns about the lack of economic freedoms through much of the region.
While the correction in China's market may be troubling to some, it is important to maintain perspective: China's total market cap is only 3% of that of the United States, the correction occurred after huge-run ups, and the market has since rebounded to an all-time high. Overall, the country's economy remains strong and we expect China to continue to serve as a growth engine for the region.
Conclusion
We're moving into the second quarter with confidence in the global economy and conviction in the positioning of our strategies. We are encouraged by the emerging indications in March that investors have begun to place a greater premium on quality fundamentals. There may be more bumps in the night, but we believe our long-term perspective, time-tested discipline and rigorous research will help us turn uncertainty and short-term volatility into long-term opportunity.