Economic Outlook

April 2018

During the first quarter, volatility returned to the markets in dramatic fashion. Despite generally positive economic data and healthy corporate fundamentals, markets gyrated as investors confronted the likelihood of more Federal Reserve hikes and rising inflation. The shifting terrain may be jarring for some, but the conditions we are seeing today are more normal than recent years, when investors grew accustomed to record low interest rates, a near-absence of inflation and the subdued volatility. As a more typical environment emerges, our positioning reflects the following beliefs:

  • Coordinated global economic expansion will continue through 2018, although improvements in some economic fundamentals may have peaked. The pace of growth among economies will likely be more varied than in 2017.
  • The near-term risk of a U.S. recession is very low. Inflation and short-term interest rates will rise but are unlikely to soar out of control in 2018.
  • The bull market has more room to run, supported by positive economic conditions and corporate fundamentals. Volatility is unlikely to return to unusually low levels, however.
  • In advancing but choppy markets, opportunities increase for active and risk-aware approaches.
  • Evolving trade policies, uncertainties around North Korea, Russia and Syria, and U.S. mid-term elections will fuel short-term market disruptions over these next months. Fears of a trade war have risen in the markets, but we believe Washington’s recent moves can set the stage for negotiations that lead to freer and fairer trade over the long term.
MARKET REVIEW

Entering the year, we anticipated an increase in volatility and a long overdue equity correction, as well as a continued rise in short-term interest rates. These expectations came to pass in short order, contributing to lackluster quarterly results for equity and fixed income benchmarks. Convertible securities proved more resilient to both volatility and rising rates.

FIGURE 1. GLOBAL ASSET CLASS PERFORMANCE, 1Q 2018
global asset class performance 1q 2018
Past performance is no guarantee of future results. Source: Morningstar and Bloomberg. Data shown in USD unless otherwise noted.

United States

We see very low risk of an imminent U.S. recession. GDP growth has continued at a good clip in the U.S., and tax reform and deregulation can provide further catalysts from here. With tighter labor markets and increased incentives to make capital expenditures, we expect U.S. businesses to re-invest in their businesses at higher rates than recent years. While we are monitoring a falling savings rate as a potential signpost of weakness, the U.S. consumer looks to be in good shape overall, benefiting from job growth, wage gains and rising housing values.

Corporate fundamentals—including earnings, sales and revenue growth—are very strong, and equity valuations look more reasonable due to the tailwinds that tax reform provides corporations. We expect good company earnings announcements to steady the U.S. equity market and push it higher. That said, year-over-year comparisons are likely to become harder as time progresses, given the healthy growth expected over the nearer term.

There is every reason to expect inflation will continue rebounding as slack in the U.S. and global economies decreases. At this point, the trend merits close monitoring, but not consternation. Inflation is coming off historically low levels and remains contained, with realized inflation readings significantly trailing expected inflation (Figure 2). As economic growth continues, the Fed is likely to maintain a gradual course. We anticipate at least two more short-term interest rate hikes in 2018, with the yield curve flattening as global bond markets hold U.S. long-term rates in check.

In an environment of continued economic growth and more normal interest rates, the bond surrogate trade is over. As the search for income becomes easier, it should be less of a dominant focus in the equity market, cyclical growth sectors should enjoy greater market recognition, with utilities and real estate coming under increased pressure. We believe many of the technology growth names that sold off in the wake of negative headlines will stabilize. Through the remainder of the bull market, we could well see a narrowing of leadership across all sectors, which would benefit active managers.

realized inflation
softer but still positive manufacturing data

Global and International Strategies

Major global economies are positioned for growth, although softening data suggests that the improvements in economic fundamentals may well have peaked. PMI data points to a slower rate of manufacturing activity (Figure 3), and positive economic surprises have fallen. Liquidity conditions have tightened at the margin (primarily in the U.S. and China), and geopolitical risks remained heightened. In addition to those risks we already noted, we are vigilant to the potential for an unexpected ECB tightening, and elections in Italy, Brazil and Mexico.

Global equities can still do well in this slower-growth environment, supported by attractive valuations and growth metrics (Figure 4). We have sought to build in greater resilience to downside equity moves, broadly favoring a mix of secular growth and cyclical growth names. We remain constructive on the emerging markets, with Chinese companies among those especially well represented in our portfolios. We expect Chinese economic data to be more mixed than in 2017 as targeted tightening works its way through the economy, but we have found names that offer attractive valuations and strong earnings prospects. These include technology companies that provide exposure to several of our favorite secular growth themes, as well as home-court advantage over U.S. counterparts in understanding how to navigate the domestic market. Further, China continues with initiatives that will enhance the long-term stability of its markets and economy, including reducing its dependence on the U.S. dollar through the expansion of renminbi-denominated securities.

Within the developed markets, Japan offers attractive valuations and favorable liquidity conditions. Although economic fundamentals remain challenged, many companies have put capital to good use and have seen profits soar (Figure 5). We have sourced a number of growth opportunities in Japan, including worldwide leaders in robotics and automation. By favoring multinational companies benefitting from improving global growth, we have also reduced exposure to the domestic economy. In contrast, in Europe we have favored small and mid cap companies over large-cap multinationals with more vulnerability to rising rates and a stronger euro.

global valuations
japanese corporate profits push upward

Convertible Securities

During a difficult quarter, the U.S. and global convertible markets posted positive returns, diverging from the losses in the equity and bond markets. We expect convertible securities to perform well in this environment. With attributes of stocks and fixed income securities, convertibles tend to benefit from upward moving but volatile equity markets. (Since the March 2009 low, there have been 20 corrections of 5% or more in the U.S. stock market, and convertibles have outperformed equities through 19 of those periods.) Moreover, convertibles’ equity characteristics may make them less vulnerable than investment-grade bonds to rising interest rates.

However, in a period of rising rates and elevated equity market volatility, active management is especially important for maximizing the potential benefits of the convertible structure. Convertibles vary in their degree of equity and fixed-income sensitivity. Securities with the highest levels of equity sensitivity may fail to provide adequate downside protection, while those with the lowest levels may be sidelined during upswings. In our positioning, we seek to capture the majority of equity upside, with better potential downside protection than both the overall equity and convertible markets. Reflecting these considerations, we continue to favor balanced structures, emphasizing the technology and consumer discretionary issues. We are more cautious regarding defensive sectors, where convertible structures tend to be more bond-like and therefore, less likely to participate in the rising equity market we expect.

The global new issuance market got off to a brisk start during the first quarter as $27.8 billion came to market. The U.S. set the pace ($13.7 billion), with cloud computing companies especially well represented. We expect a strong stream of issuance for the remainder of 2018, as companies seek new growth capital and refinancing for maturing securities. As we noted earlier this year, U.S. issuance could ramp up in the wake of tax reform. Interest deductibility caps provide additional incentive for companies to issue convertibles rather than straight bonds. Further, if repatriated funds catalyze M&A activity, acquiring companies may choose to shore up their balance sheets by issuing convertibles.

Fixed Income

After years of unprecedented conditions, Fed rate hikes have begun to work their way through the economy, inflation is trending upward and financial conditions have begun to tighten from extraordinarily loose levels. While many market participants expect Chair Powell will take a more hawkish tone than his predecessor, we believe a gradual path remains most likely: two additional Fed hikes this year and a “Chairman’s choice” in December, dependent on the economic environment.

In high yield, we anticipate gradual, further softening in credit spreads, but view some out-of-favor areas as a source of idiosyncratic opportunities, while fundamentals are strong. The high yield market may face challenging technicals, such as decreased demand from foreign investors. We expect the default environment to continue to trend below the long-term historical average of 3%. Although several large, well-telegraphed distressed situations are expected to default in 2018, these have been anticipated for some time and are not expected to dramatically change an otherwise positive fundamental environment.

Following the Financial Crisis, historically low interest rates and extraordinarily accommodative liquidity drove investors to seek out bonds for appreciation and stocks for income. In a more normalized interest rate environment, we would expect a return to the traditional relationship, with fixed income allocations still providing valuable benefits: diversification from equity market volatility and a source for income. However, given the crosscurrents associated with this shift back to normal, an experienced and active approach remains essential to ensure appropriate compensation for potential risks.

Conclusion

We may not have yet seen the bottom of this current correction, but we believe the duration of the downturn will be relatively short lived. Our teams are using short-term volatility to our advantage—rebalancing our positions, locking in gains, and striking the risk/reward profile we believe is appropriate for this climate. We encourage investors to maintain a long-term approach and resist the urge to make short-term moves. More often than not, trying to time the ups and downs results in being whipsawed—capturing the downside and missing the upside. Instead, managing volatility will be key to succeeding in this environment. Having invested through more than 40 years, we believe we are well equipped to navigate the course ahead. We welcome the return of more normal levels of volatility and the opportunities it will bring for our active approach.

This material is distributed for informational purposes only. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the information mentioned and, while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable.

CALAMOS INVESTMENT COMMITTEE

John P. Calamos, Sr.

John P. Calamos, Sr.

Founder, Chairman and Global Chief Investment Officer

John P. Calamos, Sr. is Chairman and Global CIO of Calamos Investments, a firm he founded in 1977. With origins as an institutional convertible bond manager, the firm has grown into a global asset management firm. Mr. Calamos is often quoted as an authority on risk-managed investment strategies, markets and the economy. He received his B.A. in Economics and an M.B.A. in Finance from the Illinois Institute of Technology. He joined the United States Air Force after graduation and served as a combat pilot during the Vietnam War.

Matt Freund

Matt Freund, CFA

Co-CIO and Senior Co-Portfolio Manager

As a Co-Chief Investment Officer, Matt Freund is responsible for oversight of investment team resources, investment processes, performance and risk. As Head of Fixed Income Strategies, he manages investment team members and has portfolio management responsibilities. He is also a member of the Calamos Investment Committee, which is charged with providing a top-down framework, maintaining oversight of risk and performance metrics, and evaluating investment process. Matt joined Calamos in 2016 and has 28 years of industry experience. Prior to joining Calamos, he was Chief Investment Officer of USAA Investments, leading the teams responsible for the portfolio management of USAA’s mutual funds and affiliated portfolios, including P&C and life insurance products, and overseeing more than $140 billion in assets. During this time, he also served as lead portfolio manager for several highly regarded fixed income mutual funds. Earlier in his career, Matt served as a senior investment analyst for MetLife in the Capital Markets Group. He received a B.A. in Accounting from Franklin & Marshall College and an M.B.A. from Indiana University.

Michael Grant

Michael Grant

Co-CIO, Sr. Co-Portfolio Manager, Global Long/Short and US Growth Strategies

Michael Grant manages investment team members and leads the portfolio management teams responsible for our Global Long/Short and US growth strategies. He is also a member of the Calamos Investment Committee, which is charged with providing a top-down framework, maintaining oversight of risk and performance metrics, and evaluating investment process. He joined Calamos in 2015 and has 30 years of investment industry experience. Prior to joining Calamos, Michael founded Phineus Partners in 2002, where he launched a successful long/short strategy. Previously, he was a Managing Director of Schroder Investment Management with responsibilities over US equity mandates. During his tenure at Schroders, he also served as Head of the Global Technology Team and Head of the U.S. Equity Team in London. Prior to that, Michael was a portfolio manager for the National Investment Trust Co. in Taipei, Taiwan and a US equity analyst for the Principal Group in Canada. Michael earned a master’s degree from the London School of Economics, where he specialized in International History. He has Bachelor of Commerce from the University of Alberta, Canada.

John Hillenbrand

John Hillenbrand, CPA

Co-CIO, Head of Multi-Asset Strategies and Co-Head of Convertible Strategies, Senior Co-Portfolio Manager

As a Co-Chief Investment Officer, John Hillenbrand is responsible for oversight of investment team resources, investment processes, performance and risk. As Head of Multi-Asset Strategies and Co-Head of Convertible Strategies, he manages investment team members and has portfolio management responsibilities for those investment verticals. He is also a member of the Calamos Investment Committee, which is charged with providing a top-down framework, maintaining oversight of risk and performance metrics, and evaluating investment process. John joined Calamos in 2002 and has 24 years of industry experience. Prior to joining Calamos, he served as an equity research analyst at Credit Suisse First Boston and ABN AMRO and as an Account Manager - Business Credit Group at Continental Bank. John received a B.B.A. in Public Accounting from Loyola University and an M.B.A. in Analytic Finance from the University of Chicago Graduate School of Business. He is also a member of the American Institute of Certified Public Accountants.

Nick Niziolek

Nick Niziolek, CFA

Co-CIO, Head of International and Global Strategies, Senior Co-Portfolio Manager

As a Co-Chief Investment Officer, Nick Niziolek is responsible for oversight of investment team resources, investment processes, performance and risk. As Head of International and Global Strategies, he manages investment team members and has portfolio management responsibilities for international, global and emerging market strategies. He is also a member of the Calamos Investment Committee, which is charged with providing a top-down framework, maintaining oversight of risk and performance metrics, and evaluating investment process. Nick joined the firm in 2005 and has 14 years of industry experience, including tenures at ABN AMRO and Bank One. He received a B.S. in Finance and an M.B.A. from DePaul University.

Eli Pars

Eli Pars, CFA

Co-CIO, Head of Alternative Strategies and Co-Head of Convertible Strategies, Senior Co-Portfolio Manager

As a Co-Chief Investment Officer, Eli Pars is responsible for oversight of investment team resources, investment processes, performance and risk. As Head of Alternative Strategies and Co-Head of Convertible Strategies, he manages investment team members and has portfolio management responsibilities for those investment verticals. He is a member of the Calamos Investment Committee, which is charged with providing a top-down framework, maintaining oversight of risk and performance metrics, and evaluating investment process. He also is a member of the Calamos Office of the CEO, responsible for comprehensive oversight of business execution and strategic growth initiatives. Eli has 28 years of industry experience, including nine at Calamos. Prior to returning to Calamos in 2013, he was a Portfolio Manager at Chicago Fundamental Investment Partners, where he co-managed a convertible arbitrage portfolio. Previously, he held senior roles at Mulligan Partners LLC, Ritchie Capital and SAM Investments/The Hampshire Company. Earlier in his career, Eli was a Vice President and Assistant Portfolio Manager at Calamos. He received a B.A. in English Literature from the University of Illinois and an M.B.A. with a specialization in Finance from the University of Chicago Graduate School of Business.