Poking An Angry Bear?
2007 Review
"In 2007, we positioned the Calamos portfolios for a decent market and economy. This proved beneficial: For the year, most of our strategies beat their broad market benchmarks."
The Outlook commentary we wrote in early 2007 presented a positive but cautious view for the year ahead. We expected the U.S. economy to grow at a still respectable pace, though likely at a rate below the levels of previous quarters. We believed the chances of a recession were "slim." We wrote:
"The economic landscape sets the stage for another year of good performance in the equity markets. Against the backdrop of a mid-cycle slowdown, we expect growth to outperform value, and large-cap to outperform small-cap."
Within the U.S. markets, we also expected equities to outperform debt. We believed international equity markets would outperform the U.S. markets and emerging markets would underperform developed markets. This view was based on our expectations that commodity prices had reached an interim peak and would decline, which in turn would take some of the froth out of the riskier commodity-based emerging markets.
We reserved our highest degree of concern for the high yield markets, noting that "the current risk/reward trade-off is no longer as attractive as it has been... the economy is slowing and complacency may have set in... The lack of negative surprises and the low volatility in asset classes has manifested itself in more leverage and debt build-up and in tight credit spreads."
Given our views, in 2007, we positioned the Calamos portfolios for a decent market and economy. This proved beneficial: For the year, most of our strategies beat their broad market benchmarks. We emphasized larger-cap, traditional growth companies with quality fundamentals—such as healthy balance sheets, robust free cash flows and high return on invested capital. We sought companies with stable earnings growth potential that was not entirely dependent on recovery-level economic growth or commodity prices. We also emphasized companies with strong footings in non-U.S. markets, in order to participate in the powerful trends associated with global economic expansion. In general, we moved to higher-grade debt and favored equity exposure over credit exposure.
In 2006, we had been early on the call for growth stocks. However, in the early months of 2007, we saw indications of changing market sentiment. Investors began to pay increased attention to the risk in the markets, and the prices they paid for securities with more dubious prospects for long-term earnings growth. Although cyclical sectors (such as energy and materials) continued to perform well through 2007, the turn we had been expecting came in mid-year. Large-cap growth came into favor in July 2007 and has since performed very well.
Our caution on the debt markets and the overall leverage in the financial markets served us well. Even prior to the disruptions in the credit markets, our positions within the financial services sector emphasized brokerages and asset managers, rather than banks and lenders. We were also correct in our view that non-U.S. markets would outperform the United States. Although we were incorrect in our view that emerging markets would lag developed markets, our international and global strategies performed robustly, thanks to an emphasis on larger companies from traditional growth sectors.
2008 Outlook
"The U.S. economy benefits not only from its diversification, but also from the inter-relationships of a strong global economy."
The economy has withstood the credit crisis and turned in two quarters of surprising growth (3.8% in the second quarter and 4.9% in the third quarter). Employment has remained robust and spending has held up remarkably well. But economic growth, employment and spending data are backward-looking measures. The volatility in the markets, the credit crunch, the housing market recession, and rising inflation may signal a more challenging future. We believe the risks of a U.S. recession are as high as they have been since 2000-2001, and some slight shifts in consumer behavior or monetary adjustments could be the tipping point.
We believe the U.S. dollar may be oversold relative to the euro but is overvalued to Asian currencies. The U.S. dollar will probably not weaken much more against the currencies of developed countries, but likely will continue to decline against emerging economies' currencies. We view the dollar's weakness against emerging markets as a function of their economic growth, increased maturity and stability, rather than because of weakness in the U.S. economy.
We can't yet be certain if the noise from 2007 has roused the bear from his cave. He'd have to be sleeping soundly to not have been disturbed by hedge fund antics, the ebullient lending practices that fuelled the subprime meltdown and credit crunch, and rising inflation. Whether or not we'll see a bear market or a recession in 2008 depends on several factors:
- What is the true extent of the credit crisis, and what are the future implications for future credit extensions? Will the Fed's medicine fix the problem again, or have we become immune to the liquidity injections that have provided a cure in the past 25 years?
- How will consumer spending respond to the reduction in net worth resulting from the first nationwide housing correction since the 1930s?
- Are we approaching the end of the credit super-cycle and a beginning of a great asset deflation?
- How strong and sustainable is the global economic expansion?
The Credit Crunch and Black Holes
In recent years, investors, the Securities and Exchange Commission and the Federal Reserve have pushed for transparency in accounting and financial markets. Many new regulations have emerged as a result. FASB, which creates accounting standards, instituted new rules to bring "reality" into accounting; Sarbanes-Oxley regulations carried a big stick; and the SEC has dug deep to reveal transparency. Market participants responded by pushing further out into the unregulated dark corners of the financial world. The regulations of recent years have only accelerated the black hole of non-transparency and complexity. Today, the major market makers and risk allocators are the hedge funds. Because of them, the unregulated market for liquidity, risk shuffling and financial engineering has exploded.
We are amazed at the huge sums of money that have been allocated to the new risk takers—especially as many offer questionable track records. The most successful of these risk takers receive compensation that defies reason. Unfortunately, in the past, when the economics of an arrangement encourage one party to take excessive risks for excessive pay, a lottery approach to financial liquidity and risk emerges.
The 2007 credit crisis looks to be in the midst of resolving itself, and this may return some normalcy to the short-term credit markets. Banks are starting to bring back onto their balance sheets the loans that they once cleverly hid, the Federal Reserve and other European central banks moved in an organized effort to provide infusions of capital, and Asian and Middle East pools of sovereign capital have provided relief to some financial institutions that needed to recapitalize their balance sheets.
So, if the banking crisis is on the mend, do other near-term implications exist? We believe that in the next year, the credit creation process will likely slow and available capital will decrease as banks reassess their lending practices. For example, banks may be held responsible for providing reasonable reserves for loans made and sold in securitized debt; this would serve as an incentive to make "better loans." Held to this higher level of accountability, banks' boards of directors and executives may run for cover—and lower risk—as they become more familiar with the collateralized debt, structured investment vehicles, and other creative instruments that fuelled the credit meltdown of 2007.
More limited access to capital will likely result in slowing GDP growth because this U.S. economy is highly dependent on credit expansion for growth. We face higher energy costs, a housing collapse and the potential for a decline in household net worth—factors that may cause consumers to take on less debt and boost their savings rate. Historically, a high inverse correlation has existed between changes in the household savings rate and changes in household net worth (see Figure 1). The increase in savings, coupled with a slowdown in debt accumulation, likely would lead to reduced spending that would cause economic growth to slow and corporate earnings to slow further. In fact, it is possible we see negative earnings growth for the S&P 500 Index in 2008, particularly given the pressure the financial industry is under and its large representation within the index. Declining corporate profits or negative year-over-year earnings growth do not necessarily mean declining equity markets, however.
| Fig. 1: Personal Saving Rate and the Ratio of Net Worth to Disposable Income (1Q 1953 - 3Q 2000) |
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| Source: www.federalreserve.gov. Dean M. Maki and Michael G. Palumbo. "Disentangling the Wealth Effect: A Cohort Analysis of Household Saving in the 1990s," April 2001. Personal saving and disposable personal income are published by the Bureau of Economic Analysis (BEA); household net worth is published by the Federal Reserve Board. |
Moreover, even under this scenario, the corporate spending cycle should continue because many companies are flush with cash and offer highly competitive products to a growing global market place. U.S. consumer trends, meanwhile, are highly dependent upon spending from the wealthiest third of consumers. This group has a high level of discretionary income and should be able to weather a slowdown without significant reductions in spending patterns. (A sharp equity market correction may have a large negative impact on the spending of the wealthiest consumers, since most of their net worth is in financial assets, not housing.)
The Fed: Between a Rock and a Hard Place?
"The trade relationship between the United States and China, the information technology revolution, and the growth of the global economy... are three of the engines for growth which we believe will benefit the United States in 2008."
As the credit crisis unfolded, the Federal Reserve Board moved decisively, making three cuts to the fed funds target rate in 2007 to provide liquidity and keep the U.S. economy on track. Yet, today, the Fed may fear it is sowing the fields for another crisis. Inflation measures have soared in the past few months: the November Consumer Price Index and Producer Price Index registered year-over-year gains of 4.3% and 7.2%, respectively. With the economy showing signs of weakness and rising inflation, the Federal Reserve Board may not be overly aggressive in lowering rates to support the economy. Further easing of interest rates will increase expectations of inflation and a declining U.S. dollar. Conversely, the Fed could threaten economic growth by raising rates to support the dollar and fend off inflation.
We believe global deflationary pressures and excess global capacity will continue to offset short-term U.S. inflation concerns. (In other words, U.S. inflation can be held in check by the abundance of cheap goods and inexpensive labor from other parts of the world.) The Fed is also not in a hurry to reverse or halt the falling dollar since the trade deficit has begun to shrink and export growth has provided a boost to the economy in the past few quarters.
Ultimately, we expect the Fed to continue its policy of monetary easing. We believe the Fed views a weak economy with the possible deflationary asset implications as a much higher risk than inflation. The leverage in the economy and the complexity of the financial markets has grown, while most asset classes in the world have appreciated significantly in the past 25 years. A great asset deflation and de-leveraging would have devastating implications that the Fed and other central banks would do everything in their power to avoid. Accordingly, we expect further injections of liquidity and a lowering of short-term rates to 3% or even lower, if needed. (This may be hopeful thinking on our part. A clear risk to the economy would be an acceleration in inflation that would prompt the Fed to raise rates.)
Will the Fed's response to a slowing economy be enough this time around? One risk the U.S. economy faces is similar to that faced by Japan in the 1990s. Once deflation took hold, the Bank of Japan could not stem the tide with liquidity injections. Each time a U.S. crisis has occurred, the Fed has come to the rescue with stimulative monetary injections that supported the U.S. economy and markets. The liquidity injections resulted in lower interest rates and more leverage, so the solution has helped cause, or at least enhance, the longer-term underlying problems.
The U.S. auto and financial industries, the residential real estate market and housing-related markets are all in recession, and the prospects for a nationwide recession have increased. Yet, while the economy is under stress, it is not broken. The U.S. economy has weathered many rolling, industry-level recessions without falling into a recession as a whole.
Additionally, as we have discussed in past commentaries, the U.S. economy benefits not only from its diversification, but also from the inter-relationships of a strong global economy. Powerful secular global trends should continue to support the growth of both the global and domestic economies. The trade relationship between the United States and China, the information technology revolution, and the growth of the global economy (particularly emerging markets) are three of the engines for growth which we believe will benefit the United States in 2008.
Growth Engine #1: The U.S.-China Relationship
"We are in the midst of the greatest global economic expansion in history."
The early part of the current global economic expansion has been supported by U.S. consumption and Chinese infrastructure build-out. The U.S.-China trade relationship has been an especially important driver of global growth since China entered the World Trade Organization in 2001. Underpinning this trade relationship is a currency peg that allows China to keep labor costs low and product prices artificially low also. China benefits from increased labor participation and a move from an agriculture economy to an industrial- and service-based economy.
China is in the midst of building a competitive capital base, much as Japan and Europe did after World War II. To help rebuild War-devastated economic infrastructure, the Bretton Woods Agreement pegged Japanese and European currencies to the U.S. dollar at a low rate as these nations re-built exports and economic strength.
The artificially low Chinese currency peg is advantageous for the United States as well. Chinese imports are cheaper than they would be otherwise, thus helping cap inflation for many consumer goods. The United States also benefits from trade-deficit financing, as China funnels its growing reserves into low-risk U.S. Treasury securities. These Chinese investments support healthy demand and allow U.S. Treasury yields to remain artificially low, which helps cap interest rates and encourages U.S. economic growth.
We expect China will slowly allow its currency to appreciate as it increases production capacity and transitions a significant percentage of its rural agricultural workers into the new economy. And although the global economy has grown to the point that the U.S.- China trade relationship is less important for growth, the relationship remains beneficial to both countries, as we expect it will be for the foreseeable future.
Growth Engine #2: The Technology Revolution
The technology revolution is another significant engine of global growth. We see no evidence that the secular trends in communications, entertainment and business technology are slowing. In fact, they may be accelerating as emerging market consumers and businesses deploy their growing wealth to upgrade and improve their IT infrastructure. Although leading technology companies are located all over the world, the United States continues to be at the forefront, and should continue to benefit from the world's continued demand for technological innovations.
Growth Engine #3: Continued Global Economic Expansion
We are in the midst of the greatest global economic expansion in history. The expansion has reached virtually all corners of the world and asset prices have surged as millions of people are moving out of poverty and despair. This continued global growth and prosperity should provide support to the U.S. economy in 2008.
Emerging markets figure prominently in these trends. Since the end of the Cold War, emerging markets all over the world are prospering from global trade and democracy. They represent a significant percentage of global gross domestic product and an even larger part of global GDP growth (see Figure 2). Emerging markets have made considerable strides in strengthening their balance sheets as they have profited from high commodity prices and avoided financing debt in other countries' currencies, a policy that has been the demise for many nations. In fact, most of the emerging market economies in Asia have become net lenders, not debtors, on the global financial markets. Who would have dreamed that when the U.S. and European banking systems needed to recapitalize that they would find financial support in emerging markets!
| Fig. 2: Emerging Markets' Share of Global GDP 1992-2008 |
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| Source: IMF. Data for 2007 and 2008 are estimates. |
The U.S. Benefi ts from Global Prosperity
The main engines of the global economies and markets appear sound. We expect the global economy will grow at a reasonable pace in 2008, and that this will benefit the United States. During the past five years, the U.S. consumer was commonly singled out as the driver of global growth. This appears to be changing as non-U.S. participants— particularly those in emerging economies—assume an expanded role. The weak U.S. dollar has allowed exports to surge, helping offset the weak housing market.
Strategic Positioning
Life would be a whole lot easier if generating return were a function of selecting an asset off of a shelf based on the past three-, five- or 10-year returns! We believe that it is impossible to manage returns; we can only seek to control the risks we take to achieve returns. Because risk levels have increased in the past year, our positioning has become more defensive. However, we are starting to see large valuation opportunities that we believe could offer excellent returns in the near future.
We believe the growth cycle should continue for a number of years, with growth outperforming value stocks by a decent margin. We have positioned the equity portfolios to favor growth, especially larger-cap growth stocks with stable growth prospects and quality fundamentals. More importantly, we are positioned in growth companies that have significant revenue exposure to non-U.S. markets. (Within our growth equity and growth-and-income strategies, for example, we seek companies with more than 50% of their revenues coming from non-U.S. economies—roughly double the amount of non-U.S. revenues for the stocks of the S&P 500 Index.) Our emphasis on growth has led us to technology and communications companies; we also favor health care and industrials positioned to benefit from global infrastructure build-out. We remain very selective in the financial and consumer sectors.
Our international and global portfolios reflect the same sector and thematic preferences as our domestic portfolios, again emphasizing global growth exposure. This has led us to technology, global industrials and select consumer stocks. Within our global strategies, we expect to be overweight non-U.S. markets, and overweight Asia and select emerging markets.
The credit markets are much more difficult to read as U.S. government bonds and high-grade corporate bonds seem to offer no capital gains potential. Although we continue to find opportunities on a bottom-up basis, we remain extremely cautious about the high-yield market as a whole. The high-yield market is a domestically driven business that may come under added pressure in a slowing economy, and yields have not returned to levels that we believe provide appropriate compensation for risk. That said, sometime in the next six to 12 months, we would expect to see high yield as a buying opportunity as prices drop.
Conclusion
"We are hopeful that the angry bear will not take continued swipes at the market in 2008. But, even if it does, we believe opportunity remains."
We recognize the prospect of a bear market or a recession is unsettling for most investors. However, periods of contraction are expected parts of the economic cycle. In fact, they also may present opportunities for investors who maintain a risk conscious, long-term perspective.
At Calamos Investments, we often remark that "we're long-term bullish, short-term concerned." By "long-term bullish," we mean that we believe the forces of capitalism and globalization will, over the long-term, move the markets upward and provide abundant opportunities for wealth creation. By "short-term concerned," we mean that we always focus diligently on the potential risk in the markets—and more specifically, how we can position portfolios for performance through full market cycles.
Today we remain concerned about the potential for financial market surprises from complex derivatives and opaque markets. Sustained advances in inflation in the United States, China or Europe would threaten global expansion, as would antitrade or strong protectionist legislation. While the U.S. economy is becoming less influential on global growth, a U.S. recession would have a strong negative impact on the global markets. Nonetheless, the secular global expansion is a powerful force that offers incredible opportunities for investors.
We are hopeful that the angry bear will not take continued swipes at the market in 2008. But, even if it does, we believe opportunity remains. Each Calamos investor can be confident that our investment team is actively managing each portfolio, and that risk management is at the core of our investment process. We have focused on quality companies that we believe are well positioned to capitalize on global secular themes— companies which we believe can grow even if economic conditions in the United States become less hospitable. Having invested through many market cycles and periods of uncertainty, we have high conviction in this positioning. Above all, we remain dedicated to improving the financial well-being of the investors who have entrusted us with their assets.