At the onset of the Iraqi conflict, we noted that despite the market turmoil during the buildup and initial days of combat, the market was poised for meaningful recovery once it looks past the war news. Like all investors, were pleased that such improvement is now occurring. While the run-ups in the market indexes provide the more obvious signs of recovery, its not sufficient, however, to base ones outlook on this rise. Despite the overall upward trend, if this recovery is like any other, the rally may undergo periods of retrenchment which will prompt hand-wringing among those who look to the daily markets as the compass for their course of action.
At Calamos Investments, we rely on the combination of macro-economics with intense scrutiny of company fundamentals, and let the daily market movements take care of themselves. Because of this well-grounded approach, we've maintained since the markets trough that our economy's problems were cyclical, not secular. As strong believers in Americas history of innovation and its willingness to allow market clearing to occur (whether through mergers, acquisitions, or bankruptcies), we foresaw the right-sizing that had to take place in industries with too much capacity, and prepared for the subsequent realignment of resources as investors found reasons to put capital back to work.
The shift to riskier assets began in late 2002, as some investors recognized that low interest rates, low inflation, and fiscal stimulus would eventually tip the scales to favor growth over market uncertainties that were driven by geopolitics and accounting scandals. As this dynamic has now taken place, two additional factors have given substantial ballast to the long-term recovery: A dramatic reversal in the markets willingness to provide companies with capital, along with a dramatic change in tax law. In their own ways, both demonstrate the power of capital to create wealth, when given the chance.
Access to Capital: From Famine to Feast
Although the consumer has long benefited from the historic lows in interest rates via cheap credit and low mortgage rates, it wasn't too long ago that corporate financing had dried up completely for all but the most gilt-edged of companies. Combined with plummeting valuations, many cash-starved firms concentrated on mere survival for most of 2002, postponing any prospects of growth. The flow of capital to riskier assets, along with the markets rediscovery of income as a desirable component of total return, finally unblocked firms access to capital, as both the high-yield and convertible markets have experienced a flurry of new issuances. In May, for example, the convertible market saw a record number of deals for a one-month period, while the high-yield market has issued an even greater amount in proceeds.
Abundant, cheap debt financing, combined with rising stock prices, makes for a low cost of capital, which typically foretells rises in capital spending. While the majority of new issuance is still being put to work by companies to retire costlier debt rather than go to outright growth financing, lower debt costs raises the prospect for future top line growth, especially as we continue to see improving earnings and improved quality of earnings. Also, now that corporate America has come a long way in improving its balance sheets, lower debt costs will provide additional improvements, which in turn creates even more operating leverage. This translates into better economies of scale, resulting in a higher amount of new revenues moving to the bottom line. With access to capital already providing this array of benefits, the next phase of the recovery will be confirmed when we see more outright growth financing and more IPOs.
Tax Law Changes: Lightening the Load
The macro-economic overlay to our investment decisions finds additional support for the health of the recovery due to another structural shift, this time in economic policy. We believe that the lowering of the tax burden on the public, both as consumers and as investors will have a profound long-term impact on our economy. In its simplest terms, wealth creation depends on those who choose to commit resources to purveyors of goods and services, whether as consumers or as investors. The amount of capital committed depends on both the willingness of investors to supply capital to a venture, and the availability of capital to begin with. The two are of course interrelated, as greater availability of capital boosts the willingness to spend or invest.
A higher after-tax return for working and investing can alter behaviors, as consumers enjoy a rise in disposable income and investors experience a greater return. Thus, lower taxes on work and investments naturally translate into more of both, which in turn results in economic growth. And growth can cure many ills, including concerns such as overcapacity, deficits, and jobless rates, all of which will benefit from growing investor confidence in the benefits of taking risks with capital. That confidence is only increased when individuals perceive that they have greater control over how their capital is allocated: whether spent, saved, or ventured, capital in the hands of individuals, not governments, builds wealth.
Putting It All Together: Portfolio Positioning
Given our outlook, it should be no surprise that we continue to align our portfolios with a bias towards riskier assets, and towards companies that will benefit from more capital expenditures by businesses. Although this positioning takes on different forms in our different strategies, our underlying outlook remains consistent. Overall, our increased emphasis on economically-sensitive securities comes at the expense of our long-held overweighting of consumer-dependent sectors (such as autos) which continues to shrink. Examples of industries that should benefit from increased capital spending include network equipment and education: that's because as companies and workers strive to remain competitive, they will need to advance both their technologies as well as their levels of expertise. Among equities, we anticipate growth stocks re-emerging relative to value stocks following the aforementioned increase in outright growth financing, perhaps by the end of this year.
In the high yield arena, we are adding slightly riskier assets but will not involve ourselves in truly distressed debt. Much of the gains enjoyed by this asset class for the year to date have come from the dramatic narrowing of credit spreads. Going forward, identifying special situations and bottom-up analysis will be essential in order to outperform here, and we remain confident in our research-driven process. In addition to the sheer amount of new issuance, the range of terms and levels of risk vary widely, requiring much research and selectivity. Finally, in the convertible market, although the surge in issuance is favorable to the economy overall, as convertible investors, we find that the terms of most new deals greatly favor the issuers over the buyers, and lack the appropriate risk/reward profiles that our selection process requires. Although we are finding few deals to currently participate in, as the financing cycle continues and equity valuations make further comebacks, its likely that the convertible market will offer more appropriate balances between risk and reward. As each of the above examples illustrate, we continue to focus on the proper balance between risk and reward in all of our strategies, as we do throughout the market cycle. As noted previously, we believe this approach serves as the keystone to our long-term record of performance.