Strong economy and fundamentals overshadowed by skittish investors, sawtooth markets
During the second quarter of 2006, we saw the market overreact to a small uptick in inflation, which heightened fears that the Fed would continue to raise rates and send the U.S. and global economies into recession. Uncertainty and confusion surrounding recent Fed communications caused the stock market to engage in a nervous sawtooth pattern in the past few months. We see one month up, signaling that the mid-phase cycle has begun, followed by a month down, on fears that continued interest rate increases will precipitate the end of the economic expansion. These concerns accelerated in May, sparking a fear of inflation that spooked the equities markets around the world.
In our view, this is a case where isolated economic statistics trigger speculations that are not warranted by the larger macro picture, which we consider to be quite positive. Many investors have been hypersensitive to the day-to-day release of various economic indicators, trying to interpret what these reports will mean for performance of the markets. Instead of being reactive to short-term economic data during such a volatile period, our strategy is to remain watchful toward the underlying fundamentals—such as productivity, supply-side stimuli and creativity in the marketplace—that truly drive stock prices. We continually assess whether we are positioned properly for what will happen, not today or tomorrow, but in six to 12 months.
And when we take that long view, we see a strong underlying economy that favors long-term growth. Despite many changes—particularly skyrocketing energy prices and the 17 interest rate hikes driven by the Fed—the economic climate has remained positive. First-quarter earnings reports were stronger than forecasted. President Bush signed a tax bill extending lower rates on dividends and capital gains through 2010, a move that favors capital formation and access while lowering capital costs. Corporate cash flows and balance sheets are at the best levels we've seen in a generation. Gross domestic product growth remains above average while unemployment is below average. The S&P 500 Index trades at about 15 times earnings—so is reasonably valued—while interest rates are still relatively low. All these factors are positive for the equity markets. In our opinion, a small uptick in inflation should not derail the economy.
How has the current economic climate influenced your positioning so far this year?
Despite recent market volatility our positioning hasn't changed drastically from the first quarter. Because the long-term trend of the economy is toward expansion, we believe that the market will break to the upside—we just don't know precisely when. Thus we plan to stay fully invested and to keep our portfolios situated for growth.
Although technology was hit hard in the second quarter, we are still fairly heavily weighted in the sector. We believe business capital expenditures will continue—and that includes a lot of spending on technology-related items. Within the sector, we're overweight in semiconductors and communications equipment.
We're also heavy in financials, particularly in the asset management industry, which we think will see more activity as consumers increase their savings. Within health care, we don't have much weighting, but we're looking to increase our exposure, particularly in small- to mid-sized pharmaceutical companies. We're neutral in the energy sector—we're looking for companies that are priced properly, offer a decent risk-reward balance and have the ability to use some of the cash flow that they're throwing off right now to improve balance sheets.
What themes are you watching for in 2006?
We have positioned our portfolios to benefit from the long-term economic and business investment themes that we feel will drive global market opportunities well into the future. The recent market volatility only serves to reduce leverage or shake out the weaker-stomached investors; it has no impact on longer-term investment opportunities. Our portfolio construction continues to focus on opportunities that are aligned with investment themes such as:
- the surging global need to outsource or significantly enhance productivity
- global connectivity
- global media and entertainment
- supply-side business models
- global demographic and wealth shifts
- energy and commodity dislocations
- the global march towards democracy and global trade
What's happening in convertibles?
Convertible bonds did their job in the second quarter, outperforming equities during a down period and demonstrating their ability to moderate risk. As the markets reacted impetuously to suggestions of inflation and fears of continued rising interest rates, convertibles showed the benefits of their hybrid nature, helping to protect on the downside while offering equity-like upside potential. Whereas convertibles exhibited stock-like performance in the strong-performing first quarter of 2006, their bond attributes enabled them to behave more defensively in the second quarter, keeping them ahead of the equity market.
In addition to exhibiting some downside protection for investors during the period, the landscape for convertibles has modestly improved, although it remains somewhat challenging. Issuance levels are better, roughly offsetting redemptions so far in 2006, unlike recent years that have seen net redemptions. Perhaps even more importantly, the issuance that has come has offered better terms and average size to investors, providing more opportunities. Now that interest rates have moved away from historic lows it is also possible that companies seeking access to capital are more likely to consider convertible debt rather than alternatives such as straight high-yield bonds, particularly should the equity market resume its upward pace.
We thus see positive changes taking place in the convertible space. First, the valuation gap, which reached historic lows in the middle of 2005, is narrowing. Convertibles continue to grow toward fair value and while they remain undervalued, we see unique buying opportunities. Furthermore, volatility, which can make convertibles' underlying stock option more valuable, is showing signs of life. We're taking advantage of that volatility, increasing our exposure to equity sensitivity within the convertible strategies. We're also using synthetic convertible positions—pairings of stock and bond positions that mimic convertibles—to offset the redemptions in the market and provide our portfolios with what we consider to be attractive balances between risk and reward.
The risk/reward balance of convertible bonds is still strong and we believe we are positioned to benefit from the unique characteristics of these securities.
Are there still good opportunities in the global marketplace?
International markets fell during the second quarter as the U.S. Fed drove interest rates higher and investors' fears of long-term inflation were magnified by the short-term numbers. Investors fled to securities with more defensive characteristics: value over growth, large-cap over small- and mid-cap, and, in the international realm, developed markets over emerging markets.
Within developed markets, Japan and the United States underperformed, while European countries, on average, held up much better. The United Kingdom, Switzerland and Spain were among the best performers in Europe for the quarter. Within emerging markets, emerging Europe and the Middle East underperformed, while emerging Asia and Latin America performed better. In the international markets, a weaker dollar during the quarter actually helped performance.
Nonetheless, we're still finding good companies in the international markets and in this mid-phase of the economic cycle, we're focusing on secular themes and we're leaning toward mid-cap issues. Among equities, we're looking for companies with low debt, high Return on Investment Capital and sustainable growth. As for convertibles, we're taking advantage of the current undervalue of the asset class.
Despite the difficulties of the second quarter, we still believe the international markets are an important component of a long-term plan for wealth creation. Although we're watching world events and the financial markets closely for indications of any drastic changes in the near term, we're still targeting our investments six to twelve months out. As it has in the past, we believe this long-term stance will continue to benefit us in the future.
What are the prospects for enhanced fixed income in 2006?
Our current economic outlook suggests that an enhanced fixed income strategy will prove particularly valuable for the foreseeable future. During the mid-cycle growth period, the growth orientation of our high yield and enhanced fixed income portfolios can benefit from the equity market's upside potential, and, in our opinion, should outperform traditional, higher quality bonds. With that said, it's important to note that the portfolio still retains the potential downside protection that bonds can provide, even though it offers some equity participation.
Looking ahead, we remain positioned for a growth economy, where we believe larger, growth-oriented companies and those with stronger balance sheets will outperform. Our enhanced fixed income positions reflects this bias, as we tend to hold bonds among the higher-quality tiers of the below-investment-grade realm, and avoid the lowest-quality, more speculative securities. To date, these lower-quality (CCC-rated) bonds have actually outperformed their higher-quality counterparts, but we do not believe that this rally is sustainable, nor are current investors adequately compensated for the risks associated with such lower-rated companies. We are instead focusing on issuers that should benefit from the mid-phase of the growth cycle, and favoring convertible securities over straight corporate bonds. As we have stated in the past, we continue to focus on companies with bonds that may benefit from M&A activity, equity issuance or other corporate events that may improve the company's standing.
How are your portfolios positioned going forward?
We believe the economy is in its mid-phase, where stable, slow growth can last for years. Valuations of growth-oriented companies are compelling as earnings continue to be strong and global economies are on a solid footing. In our opinion, this phase has the potential to produce a double positive: increasing earnings can lead to higher stock prices and some PE expansion, which could increase stock prices even further.
While our growth-oriented stance was beneficial to performance during the first quarter, our weighting in growth securities did hurt us in the second quarter as a flight to quality drove investors to securities with more defensive characteristics. As a result, in the broad market, large-cap outperformed small- and mid-cap, value beat growth and developed markets came out ahead of emerging markets.
We believe a halt to the Fed's interest rate hikes will serve as a catalyst for positive stock market action. Our strategy has always been to position the portfolio before an event rather than to wait for an event and chase after it. Since we know it is impossible to time the upside breakout, we will maintain our positioning, letting the current volatility run its course. Our outlook remains positive and we believe our patience during this difficult period will benefit us in the long term.
This is a time to review longer-term factors instead of focusing on the short-term market fears that can whipsaw investors. We feel that these fears are unwarranted and we encourage investors to focus on the longer-term positives while this short-term volatility runs its course. We strongly believe that the flip side of volatility is opportunity, and that the current market action presents an opportunity.