Calamos Investments - Investment Team Blog


Global Long/Short Team Perspectives:
Watching Stock Prices Is Not Always the Best Way to Assess the U.S. Economy

By Michael Grant

April 6, 2016

The American economist Paul Samuelson famously noted that the stock market has “predicted nine out of the last five recessions! And its mistakes were beauties.”

With the major equity indices suffering peak-to-trough declines of nearly 20% from last summer through February, how should investors consider the latest bear move in the context of what is known about the economy?

U.S. recession fears have ebbed in recent weeks and this is a critical development. Bear markets have been much shallower and shorter when they have not coincided with recessions. According to Ned Davis Research, since 1968, cyclical U.S. bear markets not associated with recessions have lasted an average of seven months with average declines of 19%—or about the magnitude of the past year’s correction. If my forecast that a U.S. recession is highly unlikely in 2016 proves correct, the near-term prospects for equities should be brighter.

Another reason why this non-recession judgment is critical relates to earnings. The U.S. has witnessed an earnings recession in the past year and this is the gist of the bear argument. After all, how can equities advance if earnings are not growing? Addressing this starts with understanding the cause of the earnings slowdown, which in my view amounts to weakness across global manufacturing including energy and commodities, sluggish economies overseas (such as China, Brazil) and the strong U.S. dollar. Fortuitously and through all of this, the U.S. consumer has performed just fine.

This economic setting of weakness abroad but respectable U.S. activity has happened before.

The chart below highlights the performance of the MSCI ACWI since 1988, with the gray shaded areas representing OECD-defined periods of global economic slowdown. The three circles highlighted in green are periods when the weakness was predominantly overseas and did not notably impact the U.S. economy. In those instances, the “global recession” excluded the U.S. and posed less of a threat to equities. In fact, the magnitude of those three prior declines appears much in line with the decline of the past year.

Figure 1. Performance of MSCI ACWI (Local Currency) During OECD-Defined Global SlowdownsDecember 1987 – March 2016, Daily Data (Log Scale)
Shaded areas represent contractions based on peaks and troughs of OECD Reference

Absent recessions Bear Markets Have been shorter
Source: Ned David Research Group, using data from MSCI, OECD, Main Economic Indicators (MEI),
© Copyright 2016 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at For data vendor disclaimers refer to

Regardless of how our global long/short team slices the latest data, we don’t see it as supporting an apocalyptic view of the U.S. economy. To the contrary, the healing has been substantial and 2016 may ultimately be viewed as another global slowdown, excluding the U.S. And as the economies outside the U.S. eventually recover, this should restart the cycle of earnings growth.

This is why stronger global GDP is the necessary underpinning for equities to break sustainably higher.

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Another Bear Market Rally or the Start of the Next Bull?

By Michael Grant

March 30, 2016

The global equity rally that emerged forcefully in mid-February has been decried by some as the unnatural outcome of short covering and excessive bearishness.

Of course, this may be true. But most major bottoms in equities start in such a fashion that the upturn in corporate fundamentals is rarely visible at turning points. To be fair, there has been progress on many issues that unsettled investors in January including greater clarity regarding euro zone monetary policy, Chinese currency stability and the Fed’s pace of future rate hikes.

But investors remain deeply skeptical, with many convinced that the U.S. economy stands on the precipice of recession. This conclusion starts with the global recession that is evident across many manufacturing industries, of which energy and commodities are the most notable. The U.S. economy has remained resilient through much of this, partly because the U.S. consumer is benefiting from healthy employment markets and the substantial drop in oil prices.

But now, the question on the mind of many is whether the manufacturing sector will pull the U.S. consumer into recession or, having bottomed, will the sector recover along with the major economies into 2017?

Part of the answer may lie in the latest regional PMI releases, which have been striking. The PMIs, or Purchasing Manager Indices, are coincident reflections of what is happening across U.S. manufacturing. And in March, these releases witnessed meaningful upside surprise. In my experience, the biggest surprises for these releases tend to occur at inflection points.

As the charts below highlight, the Empire State Manufacturing Survey, the Philly Fed Business Outlook Survey and the Richmond Fed Survey have all moved back into expansion territory.

Figure 1. Empire State Manufacturing SurveyJanuary 2013 – March 2016 Empire State Manufacturing Survey Source: Bloomberg

Figure 2. Philly Fed Business Outlook SurveyJanuary 2013 – March 2016 Philly Fed Business Outlook Survey Source: Bloomberg

Figure 3. Richmond Fed SurveyJanuary 2013 – March 2016 Richmond Fed Survey Source: Bloomberg

On April 1, we will get more insight into the state of economic activity with the release of the U.S. payroll reports, the ISM Index and the Global PMI reports. If these highlight further upside momentum, I believe investors should give the U.S. equity market the benefit of the doubt. In other words, this bull move could last much longer than anticipated, as global GDP finally improves through the latter half of 2016.

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Field Notes: Japan

By Nick Niziolek

March 9, 2016

The Calamos Global Equity team regularly visits the countries in which we invest. We meet with company management teams, local analysts, industry professionals and government officials and visit facilities. We also seek out ways to understand a country hands-on, including through conversations with people from all walks of life.

We recently returned from a two-week trip to Japan, and while evidence of change is visible, the process is slow. Here are some field notes from our recent meetings, including how our travels are shaping our view of opportunities in Japan.

Military and Defense
Military and defense were central themes in several meetings, including in two meetings we had with Prime Minister Shinzo Abe and members of his political party. The mindset about military and defense is changing in Japan, and there’s great concern about the ambitions of neighbors like China and Russia as well as the instability of regimes like North Korea. Defense and military spending is becoming a larger part of the Japanese budget, which could provide some good opportunities for investors. While it’s difficult today to gain direct exposure to Japanese defense companies, we have invested in global defense companies that are indirectly benefiting from increased defense spending, worldwide.

Japan technology opportunity defense spending
In addition to recreational applications, virtual reality technology is finding growing defense and military applications. Above Paul Ryndak (right), the cyclicals sector head for our global equity team, tries out some technology.

Construction and Real Estate
Construction and real estate are areas where we see more compelling near-term opportunities. The Bank of Japan’s recent decision to enact a negative interest rate policy (NIRP) was a hot topic and came up in most meetings with government and central bank officials. The initial market reaction was negative, especially within the banking sector, and the people we spoke with made great efforts to justify the policy shift and emphasized how a three-tier system should minimize the financial impact on banks while promoting lending and improving asset quality.

We are not yet convinced a NIRP will benefit Japanese banks. However, we did see evidence that an ultra-low interest rate environment is making an impact on the real estate and construction sectors. During our travels, we spoke to consumers who had recently purchased real estate or were in the process of doing so. Many indicated that the “newness” of the units was very important. While several new mega-projects are now underway, the larger opportunity near-term may be tied to the renovation of existing aging buildings. We spoke to several real estate developers who are re-developing existing buildings and they told us they are now able to lock in extremely low interest rates for longer periods (for example, moving from less than 3 years to more than 10 years). We also heard stories about labor shortages in construction, which could be a constraint to growth given Japan’s strict immigration laws and low unemployment (~3%). We expect further wage growth pressures as well as policies that allow for additional foreign labor.

Japan NIPR construction demand opportunity
Here we are in Ibaraki Prefecture, visiting the plant of a Japanese machinery company that primarily manufactures wheel loaders and dump trucks, which are typically used in construction and mining activities.

Chinese Tourism
Chinese tourism remains a strong theme in Japan and many companies are focused on attracting the Chinese consumer. We spoke to a property developer who purchased existing hotels that typically had one bed per room and a maximum capacity of three people per room. By making simple renovations and adding a second bed to rooms, he was able to increase maximum capacity to five, catering to the Chinese consumer preference for four-to-five person occupancy rates. This change required minimal capex but increased his average nightly room revenue from $80 to more than $120, and his occupancy rate has improved due to strong demand from Chinese visitors.

We also had the opportunity to tour a new duty free store in the high-end shopping district of Ginza, in Tokyo. We visited an eight-story mall where the top floor was converted to duty free shopping. Chinese consumers can shop duty free any time during their vacations and have packages delivered to the airport to await their departures. This business model has done very well in Korea and expectations are high that Japan may see similar success.

Japan_traditional_mall Japan_Chinese_tourism_supports_retail

On the left is a traditional Japanese mall; on the right is a cosmetic department that caters to Chinese tourists.

Corporate Governance and Culture
As we have written in past blogs, Japanese corporate culture is slowly changing, with a growing emphasis on increasing shareholder returns via better corporate governance and capital allocation. Compared to past trips, we had more meetings this year where companies discussed dividend payout ratios, share buybacks, and improvements in return on equity.

While this was encouraging, we were reminded that Japanese companies have a long way to go. Many have just begun to reach for the low-hanging fruit, while others have not gone that far. We still aren’t hearing about restructuring—rationalizing underperforming businesses, selling off units, etc. Although Japanese businesses frequently discuss cutting costs and improving efficiencies, we didn’t hear any discussion about consolidation, which would help capital efficiency.

The Japanese culture is rooted in respect and tradition, both very positive attributes, but in some meetings, our sense was that these attributes could be helping sustain the status quo, to the disadvantage of shareholders as well as the country’s growth prospects. There are still companies focused on accumulating cash or building empires that may not reflect the best interest of shareholders. We met with one company that was stockpiling cash in case of another major earthquake, while another company was excited to share news that it had recently purchased an island, to which it would be moving production. Although earthquakes are valid concerns, we hope more of our future meetings will center around growing production to meet future demand and innovation as opposed to moving or replacing production.

In closing, it was a very successful trip for our team. From our many conversations and meetings, we were able to enhance both our top-down and bottom-up views of investable opportunities in Japan. We observed the impact of secular trends first hand, affirmed investment theses and also identified many areas that we’re looking forward to researching further.

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The Convertible Trifecta

By Scott Henderson, CFA, CIMA®, CMFC

March 2, 2016

Convertible securities have not been immune from the volatility that has roiled risk assets in 2016. However, we believe the volatile start to the year has set the stage for longer-term opportunities. A convertible bond can be thought of as a corporate bond (credit) with an embedded call option (equity). (For a primer on convertible valuation, please see our guide.) Because of its stock and bond characteristics, a convertible’s valuation can be influenced by forces in both the credit and equity markets, as well as by dynamics that are specific to the convertible market.

In this post, we’ll take a look at some factors that we believe can support convertibles going forward. More specifically, credit spreads have widened dramatically, equities have declined significantly, and convertible valuations have cheapened. A reversal in any one of these factors could provide a tailwind to convertibles, and if all three reverse, convertibles may be poised for a potentially powerful “trifecta.”

  1. Convertibles can benefit from an eventual narrowing of spreads. Since the Federal Reserve began quantitative easing in 2008, the vast majority of convertibles have been issued by companies with below investment grade credit ratings. Only about 20% of the convertible market carries an investment grade rating and as a result, we’d expect performance in the convertible market to reflect what’s happening in the high yield market.

    This most recent round of risk-off sentiment has taken a toll on the high yield asset class, with spreads topping 800 basis points over comparable U.S. Treasury bonds in February. As we noted in a recent high yield review, spreads have reached the 800 basis-point threshold just three times over the past 20 years: in the months following 9/11, in the midst of the financial crisis, and during the telecom meltdown. After reaching the 800 basis-point level, the one-year forward return from the initial month of crossing over was positive each time (4%, 8%, and 19% respectively).

    Spreads have since narrowed to 782 basis points, and we expect continued narrowing as investors become more confident that a U.S. recession is not imminent. Inflation is low, unemployment is down, wages are rising, and the Fed has given every indication that it will remain patient in raising short-term interest rates. Alongside high-yield nonconvertible debt, we believe convertibles are poised to receive a boost as spreads tighten.

  2. The underlying equities of convertibles could be positioned for a comeback, making the embedded option of convertibles more valuable. At its lowest point year-to-date (February 11), the BofA Merrill Lynch All U.S. Convertibles Index (VXA0) had fallen -10.56%. However, the underlying stocks in the VXA0 fell far more steeply, declining -19.89%. This difference is significant for a number of reasons. First, it indicates that the convertible structure is continuing to provide considerable relative downside resilience.

    Second, this level of decline in the underlying stocks of the VXA0 has also been a precursor to healthy rebounds during the following six-month and 12-month periods. In its February 2016 global convertible research report, BofA Merrill Lynch noted that 71% of the VXA0’s underlying stocks have fallen more than 20% below their trailing 1-year highs. Since 1999, this has only happened three times (the 2002 tech bubble, the 2008 global financial crisis, and the 2011 European sovereign crisis/U.S. credit downgrade). In each of these periods, returns were positive for the subsequent six-month and 12-month periods (up an average of 13.23% and 26.95%, respectively).



    Past performance is no guarantee of future results. * Stock declines based on fall from trailing 1-year highs. Sources: BofA ML Global Research, Bloomberg.

  3. Convertible valuations are attractive. We can look at the theoretical fair value of a convertible bond as the sum of its bond and call option (the right to convert into the underlying stocks) components. In 2016’s risk-off environment of higher volatility, falling stocks and widening spreads, convertibles have been cheapening, according to BofA Merrill Lynch’s “% cheap” statistic, a measure of the relative valuation of the convertible universe. At the February 11 low, the convertible index was trading at 3.55 “% cheap,” a level reached only three times since 1995. And in each case, healthy returns followed. Of course, past performance can’t predict future results, but we believe this historical data is certainly worth noting—especially given our view that a U.S. recession is not imminent and that stocks may be able to stabilize near recent lows.

    BofA Merrill Lynch: Convertible % Cheap (January 31, 1995 through February 11, 2016)


    Past performance is no guarantee of future results. Source: BofA Merrill Lynch. The % cheap measure is based on constituents in the VXA0.

In light of our outlook for slow U.S. economic growth and continued elevated market volatility, we believe convertibles offer attractive potential for long-term investors. The potential for narrowing spreads, a rebound in convertibles’ underlying equities, and improving convertible valuations may be setting the stage for a convertible trifecta. Encouragingly, convertibles and their underlying equities have shown signs of stabilization in the second half of February. From the February 11 lows through the end of month, the underlying stocks of the VXA0 have climbed 8.45%, while the VXA0 has returned 4.47%.

As we have discussed, the structural characteristics of convertibles can provide unique advantages over stocks and traditional fixed income securities. However, these same attributes also add to the complexity of the convertible security. Selectivity and experience will remain essential in identifying the specific convertibles with the most attractive risk and reward characteristics.

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CoCos Are a No-Go for Calamos

By Eli Pars, CFA

February 11, 2016

Contingent convertible bonds (“CoCos”) have been in the news lately. And not in a good way. As several European banks have reported poor earnings recently, investors have become concerned again about banks. Cocos have been ground zero for those fears.

Banks have issued CoCos over the past few years to meet Additional Tier 1 and Tier 2 capital requirements under Basel III. The CoCos of a number of big European banks have been in virtual freefall in recent weeks, with some falling to as low as 70 cents on the dollar after trading above par in 2015. From what we hear, this is all happening with limited liquidity as there are apparently few buyers of these bonds.

Two years ago, in our blog “CoCos: An Overview of the Anti-Convertible Bond,” we explained why we were avoiding CoCos:

  • In many ways, a CoCo is the mirror image of a convertible bond. Instead of the equity upside participation and potential downside protection that can make a convertible bond so attractive, CoCos may have much higher potential downside. … CoCos typically pay higher coupons than a bank's straight bonds. However, if the bank gets in trouble (think 2008), these bonds turn into equities …

  • In our convertible portfolios, we're focused on upside equity participation with potential downside protection over full market cycles. Because the risk/reward profile of these bank CoCos is the opposite of the risk/reward profile we look for in convertible bonds, we are quite willing to pass them by.

Now that a whiff of fear is in the air, apparently many holders of these bonds are beginning to understand our concerns. (You can read the full blog here.)

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Why I Believe Staying in the Market Makes Good Sense

By John P. Calamos, Sr.

January 22, 2016

Earlier this month in our Outlook, we shared our view that markets would experience elevated volatility but that there still were opportunities for investors, including in stocks. We explained why we believed an imminent recession in the U.S. was unlikely and cautioned investors against panicking out of the market.

The past few weeks have borne out our expectations of volatility, and stock markets have posted steep declines. Despite the macro fears dogging the markets, my view remains that the U.S. is positioned for slow growth in 2016—not recession.

In times like these, the best thing that investors can do is to stay level headed. This is a belief I have held more over 40 years—including through the difficult financial markets of the 1970s, the recession of 1990, the bursting of the bubble in the early 2000s, and more recently, the Great Recession.

I recognize that for many investors, it’s hard to avoid the temptation to time the stock market when headlines are so negative. What’s important to remember is that market conditions can also improve quickly and with little notice. As shown in Figure 1, being out of the market for even a few days can have a significant impact on results.

Figure 1. Timing the Market Could Be Costly
S&P 500 Returns and the Growth of $10,000 over 20 Years (1996-2015)
Figure 1. Timing the Market Could Be Costly

Source: Morningstar. Data ranges from 1/1/1996 through 12/31/2015. Past performance is no guarantee of future results.

The sources of market volatility are always changing, which can make some investors feel like “this time is different—this time the market won’t come back.” After all, when markets were worried about the uncharted territory the global economy was in when oil was trading at $145 a barrel in 2008, who would have thought we would see prices in $20s? For me, when I think about the many problems that the markets have surmounted, I’m reminded of the long-term resilience of the global markets and economy.

In this environment, I believe investors can be well served by reaching out to their financial advisors. Instead of trying to time the market on your own, you and your advisor can discuss the growing array of choices that you may have to diversify and potentially stabilize your portfolio in these volatile markets. Depending on your needs, these may include a market neutral or convertible allocation or a strategy that seeks lower-volatility participation in the U.S. or global equity markets.

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Mexico vs Brazil: A Tale of EM Have and Have-Nots

By Nick Niziolek

January 22, 2016

As our regular readers know, selectivity is an important tenet of our risk-managed approach to emerging markets. Especially in an environment of slower global growth and falling commodity prices, we expect a sustained divergence among the haves and have-nots, a divergence likely to be amplified by different economic reform trajectories.

Last year, we compared India and Brazil and received some feedback that it was too easy a contrast. So this time, we’ll compare Brazil and another Latin American energy producer, Mexico. We’re notably underweight Brazil and overweight Mexico. This positioning is supported by our team’s top-down and bottom-up research, including our discussions with the management teams of companies domiciled in each country.

In the past, I’ve been struck by the optimism of the management and investor relations teams of many Brazilian companies. More recently, conversations have centered on the headwinds Brazil is facing—headwinds that extend far beyond falling commodity prices. In my last set of meetings, for example, executives voiced frustration with economic conditions, government corruption and huge fiscal shortfalls that have led to a suspension of pay for federal and state employees in one Brazilian state, as well as declining access to key public services throughout the country. These conditions are fueling a brain drain as talented younger workers leave Brazil for better opportunities, including to the United States and Portugal. Against this backdrop, it comes as little surprise that consumption and business confidence are falling.

A change in government could be a turning point, and impeachment proceedings are underway against Brazilian President Dilma Rousseff. However, it is unclear how much momentum supports the process or what would happen if new leadership took the reins, especially as impeachment demands in Brazil seemed to accelerate only after President Rousseff began pushing forward more austerity measures, which we believe are needed. Exports could get a boost from Brazil’s weak currency but that’s unlikely to be enough to offset the economic problems and brain drain the country is facing, at least not over the near term.

In contrast, we see a more favorable landscape for companies in Mexico and believe positive momentum can continue through 2016, supported by favorable trends in a variety of economic freedoms. Figure 1 compares Mexico and Brazil based on their scores on several criteria, as measured by the Heritage Foundation.

Figure 1. By Many Measures, Mexico is Moving in the Right Direction, Brazil is Not

Source: Heritage Foundation.

Also, although Mexico also has a twin deficit (current account deficit and fiscal deficit), it is improving, while Brazil’s twin deficit now exceeds more than 10% of its GDP (Figure 2). Falling commodity prices are not a positive for Mexico, but the government has been proactive in hedging its oil revenues, which provides support for fiscal spending. We also saw stronger-than-expected consumer activity during the second half of 2015. Remittances from Mexicans working in the U.S. have been robust, benefitting from a weak peso and the country’s close ties to the improving U.S. economy. The industrial sector is also adding more jobs, with increased “re-shoring” activity in the auto and aerospace industries.

Figure 2. Twin Deficits as a % of GDP

Source: Macrobond

In closing, we believe there are many factors supporting our relatively more bullish case for Mexico, and a cautious stance on Brazil. However, given the volatility in the markets, we are monitoring top-down conditions and bottom-up fundamentals with added scrutiny. We continue to believe that the emerging markets offer attractive long-term growth opportunities … if you know where to look.

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A Low Volatility Portfolio Should Include More Than Low Volatility Stocks

By John McClenahan, CPA, CFA

December 21, 2015

There are several ways to construct a low volatility portfolio. One way is simply to invest in a basket of low volatility stocks and call it a day. There are a growing number of ETFs that offer this approach. While straightforward and potentially useful as a tactical allocation, several potential negative “side effects” accompany the use of this method for long-term investing.

The first is that over time, the lowest volatility stocks are found in different sectors. And when you have a year like 2015, when the lowest volatility stocks were increasingly in two sectors – financials and consumer staples – you end up with a portfolio that is highly concentrated in these areas. For example, one ETF that promotes itself as a low volatility offering has seen its combined weighting in financials and consumer staples soar 18 percentage points in a year to nearly 60% of its portfolio. Clearly, if something were to cause either or both of these sectors to decline, the portfolio could suffer.

Another issue that plagues a portfolio of low volatility stocks is that, by design, the portfolio is overly exposed to one factor – low volatility! Things are great when this factor is doing well. 2015 was a strong year for low volatility stocks. Some people tend to think of momentum and beta as being almost synonymous. But unlike 2014, the momentum that drove the market over the past year was increasingly found in low volatility stocks. According to the MSCI Barra Global Equity Model (GEM)®, the correlation of the momentum and low volatility factors increased from -0.6 in late 2014 to +0.7 in late 2015.

5 Years Ended 12/2015

Past performance is no guarantee of future results. Source for data: MSCI Barra.

Additionally, valuations of these stocks look to be high and the trade seems to be very crowded. According to J.P. Morgan, the forward P/E multiple of low volatility stocks is 19x compared to 15x historically with close to $1 trillion invested in low volatility strategies.

A Better Approach to Low Volatility Investing

Another approach to long-term, low volatility investing is through a portfolio that decreases volatility the “old fashioned way” – via active diversification. As John Calamos, Sr. mentioned in a recent investment commentary, while diversifying between stocks and bonds can provide lower volatility, a potentially better method is to include convertible securities. Carefully managed while taking into account company fundamentals, convertibles provide equity participation with less exposure to the downside given the securities’ stock-bond hybrid nature. This approach is designed with a structural asymmetry that works to mitigate downside risk and potentially benefits from volatility.

Such a portfolio can provide a level of volatility that is roughly the same as that of many leading low volatility products. And it can offer diversification and equity participation in many sectors and areas of the global stock market – not just low volatility stocks. Volatility is controlled at the portfolio level, not the individual stock level.

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Gamma Trading: Why Big Market Swings Can Be Good News

By Jason Hill, SVP and David O’Donohue, VP

November 20, 2015

When it comes to your investment portfolio, volatility can be an unsettling word. For strategies that utilize convertible arbitrage though, market volatility can be a welcomed phenomenon, as we may be able to profit from it through what is referred to as gamma trading. In a convertible arbitrage strategy, we are buying convertible bonds and selling short shares of the underlying stock as a hedge. If the stock rises, we will lose money on the shares we are short but we will make money on the bonds we own as they appreciate in value.

This brings us to our topic, gamma trading. To understand gamma trading, we have to begin with another Greek letter: delta. Keep in mind that from here on out, we’ll be discussing theoretical outcomes, not the performance of any security. If you look at the convertible fair value price track (Figure 1), you can see that as the price of the underlying stock rises, the convertible value rises, and as the stock value falls, the convertible value falls as well. (For more on the convertible fair value price track, see the Calamos guide.) How much the convertible value rises or falls for a given stock move is referred to as delta. The higher the delta, the higher the sensitivity to the stock’s moves.

Figure 1. The Convertible Fair Value Price Track

If we look back at the price track, we can see that sensitivity to stock moves (delta) increases as the stock price advances and the bond becomes more equity-like (higher delta). Price sensitivity falls as the stock price declines and the convertible becomes more bond-like (lower delta). The change in delta as stock price moves is what we refer to as gamma.

Now the big question: how might we profit from this?

As noted earlier, in a convertible arbitrage strategy, if a stock rises, we will lose money on the shares we are short but we will make money on the bonds we own as they will appreciate in value. If we think the stock is undervalued, we can short fewer shares (a bullish hedge). Or, if we think a stock is overvalued, we can short more shares (a bearish hedge). More frequently however, we implement what is called a delta neutral hedge. If we are on a delta neutral hedge, the money we make on the bond and the money we lose on the stock should be equal and offset. Unlike a bullish or bearish hedge where we are seeking to profit from the stock rising or falling, a delta neutral hedge seeks to profit simply from stock volatility.

As we discussed earlier, as the stock moves, our delta changes (gamma) and we need to adjust our position if we wish to maintain a similar hedge. As the stock rises, our delta increases, which means we need to short additional shares to stay on a similar neutral hedge. Conversely, as the stock falls, our delta falls and we need to cover shares to remain on the neutral hedge. From a mechanical standpoint, we continually sell as a stock advances (sell high) and buy as a stock declines (buy low). The more volatility in the market, the more stocks rise and fall—which can give us more opportunities to sell high and buy low.

Let’s look at a hypothetical example. We own an XYZ convertible bond that converts into 100 shares of XYZ stock and has a .50 delta. On Day 1, we would short 50 shares of XYZ stock to be on a neutral hedge. If on Day 2 the stock rises and our delta increases to .60 we would short another 10 shares of stock to remain neutral. Let’s say on Day 3 or Day 4 the stock price declines back down to the original Day 1 level. We would then buy back the extra 10 shares we shorted. We would still be on a neutral hedge with the same bond and stock prices as on Day 1 but we now have real profits booked on shares we sold high and then bought low.

In Figure 2, we show an example of gamma trading over a longer period. The chart shows five sales and five purchases of XYZ, which together produce the desired pattern of buying low and selling high. As the stock price moves, we buy or sell based on the change in delta (gamma). At the end of the period, the stock price is very similar to where it was at the start of the period, and theoretically, the convertible bond price and the delta would be fairly similar to their starting levels, as well. If we had simply held the position, we may have only minimal profits or losses. However, in this hypothetical example, we have locked in realized profits from the five sets of gamma trades.

Figure 2. Gamma Trading Hypothetical

The above example is not meant to represent the performance of any given security. It is a hypothetical illustration of general investment themes.

So while big market swings may not be comfortable for most investors, they can provide a convertible arbitrage strategy with lots of gamma trading opportunities.

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India vs. Brazil: A Contrast in Fundamentals

By Nick Niziolek, CFA; Dennis Cogan, CFA; and Dave Gallagher, CFA

November 2, 2015

A comparison between India and Brazil highlights the importance of a selective approach to emerging markets. In the early 1990s, India and Brazil both rose to prominence alongside China and Russia as members of the “BRIC” group. More recently, the two countries have taken divergent paths. Both countries benefit from favorable demographics, but while India has recently focused on positive economic reforms and prudent fiscal policy, Brazil has lacked the political will to address structural issues in its economy. As commodity prices continue to decline, Brazil’s economy has struggled given the country’s heavy reliance on commodity exports. In contrast, India, a commodity-consumer, has reaped benefits from lower commodity prices due to its increased reliance on imports. These differences have contributed to a divergence in monetary policies as well as equity and currency market returns.

The Reserve Bank of India recently announced a 50 basis point cut in its repo rate (the rate at which the Reserve Bank of India lends money to commercial banks). This larger-than-expected cut illustrates India’s confidence in inflation remaining subdued and the country’s ability to maintain accommodative monetary policy as global growth struggles. While India will not be immune to a global slowdown, the progress it has made in reducing its current account and fiscal deficits as well as in containing its inflation rate has decreased its vulnerability relative to other emerging markets (Figure 1). With economic growth momentum improving over the previous two years, optimism around new leadership, and the potential for positive reforms, India looks better positioned to attract and retain capital despite recent volatility in the emerging markets. Looking forward, subdued inflationary pressure should permit more accommodative monetary policy to continue while an improved fiscal situation can provide additional flexibility to support growth.

Figure 1. India: Benefiting From Tailwinds

Brazil, on the other hand is the poster child for dysfunction within developing economies. During the commodity super-cycle of the previous decade, Brazil enjoyed strong economic growth tied to commodity exports, which resulted in a strong currency that also crowded out non-commodity exporters. The Brazilian government was lax on policy and significantly overspent on welfare programs. Over the past few years, the mistakes of the previous decade have come home to roost, as weak commodity prices have hurt Brazil’s fiscal situation and growth prospects. As a result, capital has moved out of the country. The near-term prospects are not much brighter, as the economy contracts under weaker domestic spending and the banking sector tries to manage through a credit bubble (Figure 2). Brazil is in a slightly better position than it was during the 1980s commodity collapse, as much of the country’s debt is locally denominated, rather than dollar denominated. The depreciation of the Brazilian real, which has fallen nearly 43% versus the U.S. dollar since the beginning of 2014, should ultimately provide a tailwind for non-commodity exporters and improve Brazil’s current account deficits, but this will be a multi-year process that requires structural changes within the Brazilian economy to have a sustainable impact on longer-term growth prospects.

Figure 2. Brazil: Facing Headwinds

For more on our views on international markets, please see “The ‘Fasten Seatbelt’ Sign Has Been Turned On” and “Global Insights,” a compendium of our analysis about global secular growth themes.

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Investing Through Volatility: Finding Opportunities in a Slow-Growth Environment

By John P. Calamos, Sr.

October 5, 2015

We continue to believe the U.S. stock market is in a reset period, as investors contemplate the prospect of slowing global economic growth, mixed messages from the Fed (potential tightening) and the continued easing from other central banks (Japan, China and the ECB). Market participants seem concerned about the central banks’ inability to manufacture inflation after several years of near-zero interest rates. These concerns have resulted in higher volatility, catching many investors off guard.

While recent job growth data has fallen short of expectations, our view is that the U.S. can still continue on its slow growth course through 2015. (For more on our economic outlook, you can view a recent interview I had with Maria Bartiromo last week.) Although corporate earnings estimates have come down and commodity overcapacity will create pockets of weakness, other favorable factors should result in moderate growth. Most notably, positive job growth over the longer term, low interest rates, and low energy prices are contributing to strong U.S. consumer activity. Also, a slowly expanding global economy can further support the U.S.

We expect elevated volatility to persist over the next several quarters, due to both well-entrenched concerns as well as growing uncertainty around fiscal policy and the 2016 election. The recent biotech sell-off provides one example of how the election may influence the markets, as presidential candidates’ comments regarding drug pricing fueled a correction, despite elections being over a year away.

Although markets have been unnerved by the Fed’s recent comments and a policy misstep cannot be ruled out, we do not believe a move to tighten monetary policy will upend the economy or the markets over the longer term. Regardless of the timing of the first Fed rate increase, we expect the path will be slow and shallow. A more normal rate environment should ultimately prove beneficial, so long as the economy continues to improve. For example, banks can earn more from their lending activities, providing a greater incentive to loan money to small businesses, a vital engine of job growth. Also, stocks have tended to perform well after rate hikes.

In an environment of more muted economic growth where earnings growth is more scarce, we believe growth equities remain more attractive than value stocks. Given this economic environment and the market’s risk-on, risk-off dynamic, our overall stance reflects caution. Still, we expect market volatility can provide opportunities for our longer-term approach.

In addition to seeking out reasonable valuations, we are favoring companies with higher quality attributes and the ability to grow earnings even in a slow-growth economic environment. We see opportunities among companies tied to the U.S. consumer, social media and internet security, while remaining concerned about companies that are dependent on commodity prices and emerging market demand.

We maintain a highly constructive outlook for convertible securities. Because they have fixed income characteristics and equity attributes, they are often more resilient during periods of short-term market volatility, while demonstrating reduced sensitivity to interest rate increases. We believe the high volatility we’ve seen—and the probability it will continue—underscore the value of using convertibles to pursue risk-managed equity exposure.

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Green Shoots in China?

By Nick Niziolek

October 5, 2015

Those who follow our posts know that we see considerable secular growth potential in China. This view was again affirmed during my most recent trip to Hong Kong last month, where members of our team had the opportunity to meet with management teams throughout Asia that are benefiting from secular growth trends as they navigate near-term cyclical pressures. The country’s geopolitical aspirations (including its bid to internationalize the renminbi), as well as its commitment to transition its economy from public sector and investment-led growth to private sector and consumption-led growth are likely to provide many opportunities for long-term investors.

In addition to this longer-term lens, we also consider risk/reward from short- and intermediate-term perspectives. In the third quarter, our focus on managing near-term volatility contributed to our decision to underweight China. However, as we enter the fourth quarter, we are starting to see some of signs of stabilization in economic data that is contributing to a more constructive near-term view on China.

First, China’s primary measure of manufacturing PMI activity was 49.8 for September. While still hovering below an expansionary level of 50, the reading showed signs of stabilizing and came in ahead of the consensus of 49.7, which we view as positive. Moreover, we were expecting muted manufacturing data in September, due to the massive manufacturing shutdown mandated by the government to ensure blue skies for China’s commemoration of the 70th anniversary of the end of WWII. Our view has been that once the “Victory Blue” shutdown concluded, we would begin to see signs of recent stimulus working through to economic data. State-owned enterprises are likely to show the benefits of stimulus first, with a trickle down to small and medium enterprises in the coming months.

As we’ve noted in the past, China has many tools at its disposal to support its economy. In recent weeks, we’ve seen several fiscal policy moves that demonstrate the country’s commitment to avoid a hard landing while promoting the transition to a more consumption-driven economy. These include an auto tax cut and a reduction in requirements for property down payments. We’ve also seen a stabilization of the renminbi after a sharp depreciation, with additional capital controls being implemented to manage the flow of capital and reduce the volatility of this exchange rate. Over the medium-term, we should expect further depreciation of the renminbi relative to the dollar, as this currency adjusts to the weakness of other major trading currencies like the euro and yen, but the rate of this depreciation will be important as companies and governments adjust to this new environment.

To be clear, we still believe capital preservation remains paramount in the current environment. Nonetheless, we believe we are seeing encouraging signs that can improve investor perception about China by alleviating concerns about an imminent hard landing, while the correction we’ve seen in the equity markets seems to have more than discounted this risk. As a result, we are using this opportunity to gradually increase our exposure to China, both through equities that we believe have more than priced in this near-term risk and defensive convertibles that appear well positioned to participate in the eventual recovery of the Chinese equity markets.

Over the next weeks, there will be a great deal more data for us to evaluate, including foreign reserves data on October 6. Signs of stabilization in foreign reserves and savings deposits would point to a reduced risk of capital flight, which would give us more confidence in a gradual depreciation of the renminbi. We’ll also be watching for mid-month data on imports. As with many other data points coming out of China over the near term, we expect imports to be lower year-over-year, but here too we are looking for signs of stabilization in these next months.

If these green shoots begin to take hold and the markets can become comfortable that a hard landing is off the table for the near term, we wouldn’t rule out a fourth quarter rally in Chinese and global equity markets.

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Staying Level-Headed in the Face of Fed Uncertainty

By John P. Calamos, Sr.

September 23, 2015

As we know, uncertainty about the Fed’s plans for raising short-term rates remains a key driver of market volatility. It’s understandable that investors are afraid to be in the markets and at the same time, afraid to be out. Whenever rates do rise (probably before the end of the year), there’s every reason to expect continued heightened equity market volatility. Even so, I view a more normal interest-rate environment as long-term positive—for the economy and for the equity market.

Here are some points to keep in mind.

  1. Higher short-term rates should be viewed as an affirmation of U.S. economic health. The Fed has consistently expressed its commitment to a patient, globally informed, data-driven approach. It will raise rates when it believes the U.S. economy is strong enough to continue growing without artificially low rates.
  2. The “path” of short-term rate increases is likely to be slow and shallow. In other words, I don’t believe we’ll see the Fed move to raise rates significantly and many times, provided that the overall economic landscape remains consistent with what we’ve seen over recent years—slow growth, low inflation.
  3. A more normal interest rate environment can support continued economic growth, particularly among smaller businesses. When interest rates are higher, lenders can earn more from borrowing activities. This should provide an increased incentive to lend to small businesses, especially against the supportive backdrop of continued economic growth. With increased access to capital, small businesses can grow and hire more people, contributing to better overall economic growth.
  4. Higher short-term rates don’t signal that we’ve entered a bear market. Earlier, I noted that markets are likely to remain volatile when rates rise, but that doesn’t mean there won’t be opportunities, especially for long-term investors who take an active approach. Historically, stocks tend to perform well during periods of economic growth (see point #1). Stocks have continued to advance after the onset of an interest rate increase, as Figure 1 shows. Moreover, as our Co-CIO David Kalis explained in his recent video interview, the prospects for U.S. growth stocks look especially attractive.

    Figure 1. S&P 500 Returns After Rate Hikes

    Past performance is no guarantee of future results. Source: Cornerstone Macro. “Positioning For A Fed Tightening Cycle,” September 16, 2015.

  5. Convertible allocations may be particularly effective in this sort of environment. Because they have fixed income characteristics, convertibles may be able to mitigate the impact of short-term equity downside. And because they have equity characteristics, convertible securities generally demonstrate less vulnerability to interest rate increases than investment grade bonds. That means that when rates do rise, allocations to convertibles may prove more resilient. (Co-CIO Eli Pars outlines more of these potential benefits in this video interview.)

It’s been observed time and again that markets hate uncertainty. That’s not likely to change. More importantly, what’s also not likely to change is this: volatility creates opportunity for those who can tune out the short-term noise and take a long-term view.

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Treasure in the Junkyard?

By Jeremy Hughes

August 27, 2015

For more than a year, the high yield asset class has struggled against its share of headwinds. We’re seeing signs that the tide may be turning, with the selloff providing expanding opportunities for more risk-tolerant investors.

Since mid-2014, the high yield asset class has been battered by a range of uncertainties, including Grexit, China’s economic health, the apparent collapse of OPEC as the driver of global oil prices, deteriorating issuer fundamentals, and the Fed’s plan for a liftoff in short-term rates.

Against these headwinds, the U.S. high yield market (as represented by the BofA Merrill Lynch U.S. High Yield Index) returned -4.1% from June 30, 2014 through August 24, 2015, with greater underperformance from the CCC segment of the market (-13.1%) and the energy sector (-21.6%). This selloff occurred despite falling Treasury yields and a high yield default level that has been well below the long-term average (2.2% over the 12 months ended June 30, 2014 versus an average of 4.5% over 30 years).

Where Are We Now?
We’re seeing signs we believe point to increasing opportunities within the high yield asset class.

  • Yields have risen. The high yield market’s “yield to worst” has increased from 5.0% as of June 30, 2014 to 7.6% at August 24, 2015. Yield to worst captures the yield for a bond that incorporates its call structure.

  • We’ve experienced a widening of spreads. The “spread” is the difference in return an investor can expect without defaults versus a U.S. Treasury bond with a comparable maturity. The spread to worst has widened from +372 basis points (bps) on June 30, 2014 to +625 bps as of August 24, 2015 (Figure 1). A +625 bps spread implies a total return for high yield that’s 6.3% greater than that of comparable Treasury bonds, holding everything else constant (we’ll return to this important point soon).

    We’ve also seen excess spreads widen. Excess spread represents the premium that an investor requires to own a riskier high yield bond instead of a comparable Treasury bond. This is because high yield bonds entail greater risks (they’re called “junk” for reason). In addition to interest rate risk, high yield bonds have increased default and liquidity risks versus Treasury bonds.

    With Moody’s Investors Service projecting a 3.0% default rate over the next 12 months, the excess spread was 464 basis points on August 24, well over the long-term average of 366 bps (Figure 1). While past performance cannot predict future results, in months when the excess spread was greater than 466 bps, the high yield asset class has earned a positive 1-year return 100% of the time since June 2002 (43 instances) with a median return of 19.3% (16.2% excluding the financial crisis of 2008–2009).

Figure 1. Historical High Yield Spreads and Defaults.

Past performance is no guarantee of future results. Source: BofA ML and Moody’s. Data as of 12/31/1996 to 6/30/2014. Spread to worst data through 8/24/15.

Let’s return to the idea of “holding everything else constant.” As I noted, high yield securities have additional risks, and there can be considerable variations among bonds. This is where rigorous research and experience can make a big difference. In our approach, we seek to manage risk on many levels, including through proprietary credit analysis and by underweighting bonds with the highest likelihood of default. We won’t buy a bond if we don’t believe we’re being appropriately compensated for its risks. We want to see companies with reliable records of servicing their debt and respectable balance sheets. We also put our portfolios through ongoing risk monitoring and hypothetical stress tests to ward against unintended risk.

High yield bonds may not be appropriate for all portfolios, but for more risk-tolerant investors, now may provide a time to “dip a toe” into the high yield pool. Every piece of junk can be another’s treasure.

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Why Rising Interest Rates Aren’t Necessarily a Harbinger of Trouble for EMs

By Nick Niziolek and Todd Speed

August 18, 2015

In our July outlook, we noted that many emerging markets have improved their balance sheets, which we believe may make them less vulnerable to an eventual rise in U.S. short-term interest rates. Below, Portfolio Specialist Todd Speed presents some analysis that supports this view.
--Nick Niziolek, CFA, Senior Co-Portfolio Manager and Head of International Research

Todd Speed, CFA, Portfolio Specialist
Many investors are worried about the impact rising U.S. interest rates and a stronger dollar will have on emerging markets, as a rate hike may constrain the availability of credit and further strengthen the dollar. Fueling the fire, recent market headlines that EMs will suffer when the Fed hikes rates and the spillover effect the “taper tantrum” of 2013 created are understandably causes for concern. However, we believe EMs are generally less fragile and better positioned ahead of future rate hikes. Compared to just a few years ago, many EMs have reduced their deficits, and by extension their vulnerability to foreign capital flows, and EM currencies have depreciated versus the dollar. Moreover, in the past 25 years when the 10-year Treasury yield rose more than 100 basis points, EMs have generally outperformed the S&P 500 Index and delivered strong absolute gains. The “taper tantrum” may be more of an outlier than a prediction of things to come. For more on our perspectives on emerging markets, read our recent commentary.

EMs Have Been More Resilient to Rising Rates
Past performance is no guarantee of future results. Current performance may be lower or higher than the performance quoted. Indexes are unmanaged, do not reflect fees or expenses and are not available for direct investment. Rising rate environment periods are from troughs to peak from October 1993 to December 2013. Source: Morningstar and Bloomberg.

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Why the Yuan Devaluation Does Not Erode China’s Long-Term Investment Potential

By Nick Niziolek

August 14, 2015

The devaluation of the yuan this week has roiled markets, but our overall long-term thesis about China remains intact. Our team continues to identify a range of long-term opportunities in China, including potential beneficiaries of:

    1. Secular growth trends, such as the rise of the emerging market consumer
    2. An eventual inclusion of the yuan into the International Monetary Fund’s special drawing rights reserve pool, a goal which China is determinedly pursuing
    3. The country’s “One Road, One Belt” development initiative, a massive infrastructure build-out that should extend China’s geopolitical influence throughout Asia

We believe recent actions by the People’s Bank of China (PBOC) are in line with our view of China’s long-term geopolitical strategy of strengthening its status as a global superpower. More specifically, the devaluation should advance China’s bid to internationalize the renminbi. As we noted in our May 29 blog, we expect these geopolitical aspirations to provide long-term economic growth tailwinds and produce an expanding opportunity set for investors.

While we are less likely to see a Mario Draghi “whatever-it-takes” or Hank Paulson “bazooka” moment designed to allay market fears, we believe the Chinese government will continue to work around the margins to stabilize growth. As we look to the weeks and months ahead, we expect policy to remain accommodative and additional targeted stimulus measures, further stabilizing the gradual deceleration in growth and economic transition. We also expect the central bank to intervene to reduce market volatility, if required.

While some investors may view the lack of more aggressive stimulus as a concern, weighing on global economic growth, we view this measured approach as longer-term positives for China, particularly when viewed in combination with the country’s commitment to internationalize its currency and solidify its place on the global stage. We maintain our belief that a hard landing for China’s economy is still not the most likely outcome.

In our July 10 post we discussed our view of China’s market downturn, highlighting that while there were segments of overvaluation—particularly in the A share market dominated by local investors—there were other areas of the market that were less richly valued, including many companies with attractive growth fundamentals.

Our approach has been and will continue to be to maintain a disciplined valuation approach guided by fundamental research. As long-term investors, we expect to use short-term market pullbacks to capitalize on the bottom-up growth potential we see, consistent with our identification of long-term top-down tailwinds.

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Resolving the Greek Crisis Requires a Pro-Business Focus

By John P. Calamos, Sr.

July 22, 2015

Key points:

  • Austerity and debt restructuring cannot overshadow pro-growth policies
  • Increased privatization, a flat tax, and fewer hurdles for small businesses will sow the seeds of growth and reverse the brain drain
  • Greece can achieve economic growth by drawing on its heritage of entrepreneurial spirit, perseverance and competitiveness

When people think of Greece, they typically focus on the events of recent years: government debts, failed austerity measures, and dissent with EU leadership. For many, the July 5 vote to reject the EU’s austerity measures and the fractious negotiations that ensued between Greece and its creditors support a narrative of intractable economic problems.

There is a road to recovery and growth, however. Greece can achieve prosperity through a rekindled focus on private sector development, entrepreneurship, and job gains. Austerity has been the dominant focus, but it cannot be the only one. The way forward requires pro-growth policies and new thinking.

A Commitment to Europe
From thousands of miles away, it is easy to view austerity measures dismissively and abstractly. Although many outside of Greece have advanced the view that a vote against austerity was a vote against EU membership, I believe that assumption is far from correct. The Greek people have weathered painful and unexpected changes in life circumstances. They would not have done so if they were not committed to the euro zone and to helping Greece achieve a larger role on the global stage. The Greek Parliament’s mid-July approval of the austerity measures required for a new bailout package is further evidence of the country’s commitment.

Moreover, while the magnitude of the problems facing Greece is certainly more severe than elsewhere in the euro zone, Greece is not alone among EU countries in regard to its struggles with protection programs, high unemployment, and a brain drain, particularly among younger workers. Greece is also not the only country in the EU where contentious internal debate rages about the pros and cons of EU membership.

Similarly, the prescription that I offer for growth is not unique for Greece. Greece has devoted considerable energy to refinancing government debt. However, history has shown that the road to prosperity is paved by a strong private sector, rewards for risk taking, freer capital markets, an appropriate level of government oversight, and tax policies that are reasonable.

  1. A Strong Private Sector Can Be the Foundation of National Prosperity

    Greece’s public sector dominates its economy, but the absence of a strong private sector has limited its growth. During the past years, Greece took some encouraging steps toward privatizing businesses—steps that were rewarded by increased interest from foreign investors—but which regrettably have stalled more recently. Over these next years, I believe the country will be well served by re-focusing its policies on increasing the contributions of its private sector and creating an environment that is hospitable to foreign investment.

    Many in Greece are wary of privatization, viewing it as a mechanism by which something will be taken from Greece. However, I would encourage the Greek people to embrace privatization and lay claim to the economic prosperity that a strong private sector can offer them, not only in their lifetimes but over future generations. Privatization should not be thought of as a loss for Greece, but rather as a mutually beneficial and profitable relationship.

    The private sector provides an environment where entrepreneurship thrives, where hard work is rewarded, and sustainable jobs are created. In contrast, a public-sector led economy is unlikely to reward risk taking and innovation, and as a result there is little incentive to be competitive or improve. There is little inspiration for the entrepreneur. Capital goes to where it is treated best, including human capital, so growing the private sector could help reduce the brain drain.

  2. Policies Must Foster the Growth of Small Businesses

    I believe the Greek people will achieve economic success and individual prosperity by coming together to champion regulations that support rather than hinder small businesses. Around the world, small businesses face added challenges in navigating bureaucracy and regulation. However, the hurdles have been particularly onerous for small businesses in Greece over recent years, with banks hesitant to provide credit and cumbersome documentation requirements.

    The ramifications of these headwinds are especially consequential for Greece: Nearly all businesses in Greece are small enterprises—more than 99%, according to data from the Hellenic Confederation of Professionals, Craftsmen and Merchants, as cited by the OECD.1 Additionally, more than 35% of civilian employees in Greece are self-employed, far higher than the euro area as a whole.2 This data underscores the far-reaching impact that small-business-friendly policies could have on the country. For example, if policies become more supportive of entrepreneurship and the private sector, small Greek business are more likely to grow into larger ones over time. Eventually, this should allow more Greek businesses to extend their reach across the competitive global economy.

    In countries all over the world, many members of the Greek diaspora have successfully created wealth through entrepreneurship. To me, this proves that businesses can thrive in Greece if the environment becomes more hospitable.

  3. Sensible Tax Policies

    Simplifying, rather than raising taxes, can encourage further business development and may attract more foreign capital. I believe that a straightforward and fair “flat tax” would be welcomed by the Greek people and result in more robust government coffers. Poland, for example, followed the lead of other Eastern European countries and replaced a complex tax code with a flat tax and catalyzed economic growth by privatizing government enterprises.

  4. The Brain Drain Must Be Reversed

    As I have noted in past writings, I know firsthand that Greece is a country rich in human capital and entrepreneurial spirit. My frequent travels to Greece consistently affirm my view of the economic potential that exists there. Last month, I participated in a conference in Athens hosted by Capital Link, and I was impressed by the young entrepreneurs that I met and the many creative and viable business ideas they brought forth. Indeed, one of the country’s greatest resources is its highly educated, multi-lingual younger generation that is equipped with the knowledge and drive the global economy requires. Greece’s economic future hinges on finding ways to leverage this talent.

Success Stories: Pro-Growth Policies Open the Door to Prosperity
No matter how Greece and the EU decide to address balance sheet issues, history has shown that countries can sow the seeds of economic growth in relatively short order. Poland, as discussed, serves as an example, as do Chile and Mexico. Chile has benefited from policies that reduced government spending and money supply, privatized businesses, and reduced impediments to free enterprise and foreign investment. Mexico, meanwhile, is on an encouraging trajectory of growth after political parties came together to forge the Pact for Mexico, a sweeping agenda of economic reforms. Among developed markets, Canada has benefited from its moves in the 1990s to reign in profligate spending, implement free market reforms, and reduce taxes.

There are many variables relating to the course that Greece will take from here, over both the near and longer term. No matter which route is chosen, I believe the road out of the Greek crisis will be paved by policies that encourage the expansion of the private sector, as well as entrepreneurship, risk taking, and business growth. To be successful, Greece needs to pivot and focus foremost on economic growth, and this pivot needs to be supported not only within Greece—by its citizens and leaders—but also more broadly by EU leaders.

Achieving economic stability will not be easy, but the Greek people have demonstrated their ability to persevere—through history, over recent years, and around the world. Private sector growth is built on competition and individual liberty, and I am confident that the Greek people can rise to the challenge of a highly competitive global economy. After all, the national identity of Greece is anchored in the honorable competition of the Olympics—a tradition that extends not through decades or centuries, but through millennia.

About the Author
The son of Greek immigrants, John P. Calamos, Sr. is the chairman, chief executive officer and global co-chief investment officer of Calamos Investments (NASDAQ: CLMS), the company he founded in 1977. Calamos Investments is a global asset manager that serves institutions, families and individual investors, through strategies that include equity, fixed income, convertible and alternative investments. Mr. Calamos is actively involved in a variety of philanthropic endeavors in the Hellenic American community. He serves as the Chairman of the Board of Directors of the National Hellenic Museum in Chicago.

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Perspectives on China’s Market Meltdown: Long-Term Opportunity Remains

By Nick Niziolek

July 10, 2015

We believe:

  • There are considerable opportunities in China for disciplined, fundamentally driven investors.
  • Because the rally in China’s A-share market (shares that are primarily owned by mainland investors) was too quick and too strong, a pull-back in the market was not unexpected.
  • The magnitude of the correction, coupled with the inability of policy to restore investor confidence, has been a surprise.
  • Investor behavior is reminiscent of U.S. markets in 2008 and 2009, when liquidity dried up and many investors were forced to sell liquid blue chip companies over less-liquid smaller-cap securities. This created a significant opportunity for us then, and we believe this could set up a similar opportunity now.
  • China’s medium- and longer-term secular tailwinds remain intact. Global geopolitical aspirations will drive China’s government to transition the Chinese economy from investment-led growth to consumption-led growth, and from the public sector to the private sector. The Chinese government is committed to expanding its economic and military influence in Asia and globally. Over the medium term, we’ve seen an opening of capital markets and a bid to internationalize the renminbi. (For more on our perspectives of China, read our recent blog “A Long-Term View for China”.)

Margin financing fueled much of the rally in Chinese stocks, particularly in less-liquid smaller-cap Chinese A-shares. As the market began to correct and many of these securities were locked down for multiple days, the sell-off spread to more liquid holdings. This week, the panic has spread to the China H-share, Taiwan, and ADR markets, as forced sellers with illiquid assets have sold anything liquid to meet margin requirements, including many high-quality H-share blue chip companies. As in the U.S. sell-off in 2008, many of the Chinese blue chips that have been caught up in the selling frenzy had not rallied to dizzying valuations nor have their fundamentals deteriorated, in our view.

A Closer Look at Valuations
During recent months, news coverage has focused on high valuations in Chinese equities. Less well known is that many of the most pronounced valuation dislocations were in the Chinese A-share market, with the media often quoting backward-looking P/E ratios or focusing on specific segments of the market. In our view, the valuations of many other Chinese stocks have remained at much more reasonable levels.

For example, as of July 8, 2015 the CSI 300 Index, a benchmark of the top 300 A-share stocks by market cap, traded at 13.6x forward earnings, which is 5-10% below historical averages. In contrast, the MSCI China Index (H-shares) trades at 7.4x forward earnings, more than 20% below its 10-year average, nearly 20% below the MSCI Emerging Markets Index and nearly 40% below the S&P 500 Index.

Our Approach in the Current Environment
Over recent months, we had been monitoring valuations and fundamentals, leading us to reduce exposure to several positions that became more fully valued. In some cases, we reallocated capital into more defensive convertible securities (see our recent post, “Investing in China’s Expanding Universe of Opportunity While Maintaining a Risk-Managed Approach” for more) as well as into more attractively valued equities. With the pullback we’ve seen in the H-Share listed market, we continue to focus on individual company fundamentals, valuations and secular trends where we can selectively allocate capital.

Our team continues to encourage investors to look past the short-term noise and remain focused on the longer-term potential. The economic transition that China is attempting is incredibly challenging. Right now, Chinese regulators have taken a kitchen-sink approach. While it hasn’t achieved the desired effect, it affirms the depth of China’s commitment to stabilize its markets. As always, our process and approach to investing in China focuses on understanding downside risks, and despite the market dislocations we’ve seen, we believe our approach positions us well for the eventual recovery.

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Investing in China’s Expanding Universe of Opportunity While Maintaining a Risk-Managed Approach

By Nick Niziolek

May 29, 2015

Followers of our posts and commentaries know that we have long held a positive view on China, specifically as it relates to the growth of the country’s middle class. In recent years, many investors have become increasingly focused on the decelerating growth and significant leverage in the Chinese economy. While not losing sight of these factors, we are also focusing on the transitions that are underway in China’s economy—from investment to consumption and from public sector to private sector. These shifts have created powerful tailwinds for many consumer, information technology, and health care companies, both those domiciled in China as well as multinational corporations selling into China’s growth story.

We have always monitored China’s policy actions and reform initiatives through the lens of whether these activities support the medium-term goal of a more consumption-based economy with a greater contribution from the private sector. Overall, we believe China is making good progress in this regard, and we have remained more constructive on China than a number of other investment managers. We believe our stance has been affirmed by China’s strong market performance over recent years, including within the investment technology and health care sectors we favor.

Since the middle of last year, we have expanded our view of investable opportunities in China. While we believe China remains committed to the medium-term goal of growing consumption and the private sector, the country is equally if not more focused on its longer-term goals of solidifying its position as the dominant power in Asia and establishing itself as equal to the U.S. on the global stage. China’s push to have the renminbi to IMF’s special drawing rights, its opening of local markets, its founding of the Asian Infrastructure Investment Bank, and the “One Road, One Belt” infrastructure program all support its bid for greater influence in Asia and globally, including the internationalization of the renminbi. As one measure of China’s progress, we see China is converging ever closer with U.S., when measured by market cap to GDP (Figure 1).

Figure 1. U.S. versus China: Market Cap to GDP trend
U.S. versus China: Market Cap to GDP trend

Source: CLSA

As China pursues its longer-term goals, we see tailwinds for many more industries within the country. This has led us to increase our weighting to China, including through investments in several state-owned-enterprises (SOEs) and infrastructure-related companies that we may have found less compelling in the past.

Convertible Structures Afford Risk-Managed Exposure
Of course, we recognize that these companies are not without their own risks. They may be more influenced by policy and regulation changes; historically, many have been less focused on efficiencies than businesses in the private sector; and in some instances, they may also entail more balance-sheet risk than their private sector counterparts. However, we see significant opportunities, particularly for investors who are willing to do their homework. We believe some of the risks we previously saw in SOEs and investment related companies are mitigated by the course government policy is likely to take over the next six months.

For those of our strategies that have the flexibility to utilize convertible securities, we have additional tools for tapping into the expanding opportunities we see in China, consistent with a risk-managed posture. Within emerging markets, Chinese and Hong Kong companies have been active issuers of convertible securities. Convertible securities have been key in bolstering our overall exposure to China, including in SOEs and companies tied more closely to investment rather than consumption.

As interest rates have declined in China, the bond floors of our convertible positions have moved up, improving downside protection, while the increased volatility we have seen in the market recently increased the values of the embedded call options. The breadth of the convertible market has allowed us to participate in the strong rally we have seen within cyclical sectors, with our delta to the underlying equities increasing as the rally in China’s equity market has progressed.

We typically pare convertible positions when their deltas become equity like, rolling into more balanced structures on an ongoing basis. This active management has permitted us to keep up with the equity markets during strong rallies, while providing better downside protection during recent pullbacks we’ve seen and expect to continue throughout the remainder of the year.

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Big Data, Nefarious Actors, and the Tech Investment Opportunity

By Michael Roesler, CFA

April 24, 2015

It is now 50 years since Gordon Moore first traced out the curve that forecasts semiconductor performance doubling every 24 months. Combined with the binary code that allows computers to interpret the world in zeros and ones, the ever-increasing power of hardware and software has led to an explosion in the amount of digital data that is created, consumed, and stored every second of every day.

Figure 1. A Digital Data Explosion Is Underway
Figure 1. A Digital Data Explosion Is Underway

Source: Hitachi Data Systems, Hu, Yoshida, December 9, 2007, citing data and forecasts of Rick Villars of IDC

At Calamos, we believe technology stocks provide some of the best opportunities to invest in the emerging trends and themes that we view as long-term drivers of alpha. Similar to software developers creating their apps on an underlying platform, we see the digital data explosion as a platform to identify potential investments.

Over these next months, I’ll be writing posts on how the explosion of data has influenced different areas of the technology industry and where we’re finding investment opportunities. This post focuses on how data is a target for nefarious actors, how the security industry is evolving to protect that data, and how that influences our investments.

As interconnected data networks initially proliferated, security was generally limited to a firewall provided by the switch or router maker. Over time, more specialized vendors sprang up, established themselves as best-of-breed, and carved out significant market share providing firewalls, intrusion protection systems (IPS), URL filtering and web application firewalls (WAF).

As data growth went parabolic, there was an equally explosive growth in the number and types of attacks to which networks were exposed. This led to a new generation of security approaches that sought to block the different vectors of attack the hackers were using from both outside and inside the network. Next generation firewall (NGFW) vendors have focused platforms that address the threats that come from outside an organization, while advance persistent threat (APT) companies focus on identifying hackers that are already inside a network and are broadcasting sensitive information to criminals and rogue states.

Key to this new breed of security technology is the ability to harness the power of data to identify the behavior patterns that are within the “normal” range for a particular user. This behavioral identification approach allows the security analyst to then focus on “abnormal” behavior. For example, if you are a financial advisor who frequently accesses client account information, that activity could fall into your “normal” bucket. If suddenly your computer started accessing the firm’s database of trading activity and sending it to an outside server, that activity could be identified as “abnormal” and flagged for investigation.

The challenge of this approach is that when multiplied across the millions of phones, tablets, laptops, desktops, applications, servers, routers, and switches that exist in a large organization that are being utilized by tens of thousands of people, the amount of data to be analyzed for outside-the-ordinary actions is astronomical. However, the power of the hardware and software tools that security analysts have today allows them to sift through that data and dramatically reduce the time it takes to identify, investigate, and remediate a security threat.

As growth investors, we focus on those companies that are providing these sophisticated tools and taking market share from incumbents. Within our framework, we seek to identify companies with sustainable competitive advantage, accelerating fundamentals, growth potential uncaptured by current street estimates, and identifiable catalysts for unlocking the value potential. This week, members of our research and investment team are attending the annual RSA Conference, a leading IT security conference, where we are focused on identifying potential competitive threats and market opportunities for our existing holdings as well as looking for the next crop of companies for future investments.

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Convertibles Address Multiple Investor Needs

By John P. Calamos, Sr.

March 30, 2015

I began investing in convertible securities during the 1970s, and since then, I’ve seen an exciting evolution of the asset class—from little-known securities to a global asset class totaling approximately $342 billion USD today, including issues from household-name companies worldwide. Clearly, what began as an “alternative investment” has become much more mainstream.

Despite this growth and broader acceptance, the different ways that convertibles can be used in asset allocation are less well understood. What’s important to remember is that convertibles can support multiple asset allocation goals because of their hybrid characteristics. Convertibles combine equity and fixed income attributes, but the balance changes over time—both for the convertible universe as a whole as well as for individual securities. That makes active management essential. You can’t reap the potential benefits of convertibles simply by including them in a portfolio. Instead, you need to find the right blend of convertibles and manage them to achieve a particular objective.

Because convertibles offer the opportunity for equity participation with potential protection from downside volatility, I’ve long advocated including them within a strategic (or core) allocation, held through full market cycles. (My paper, “The Case for Strategic Convertible Allocations.” explores this at greater length.) In my view, the benefits of using convertibles to pursue lower-volatility equity participation are particularly pronounced in the current market environment. As our team has discussed in other posts, this bull market has been volatile but we see continued upside. Because fixed income attributes may lessen the impact of equity market downside, convertibles can mitigate anxiety about short-term market fluctuations.

In addition to holding convertibles strategically through market cycles, I believe there’s good reason overweighting convertibles more tactically in the current environment, within what I like to call an “enhanced fixed income” allocation. An enhanced fixed income allocation seeks to further portfolio diversification—with less vulnerability to interest rates changes than traditional fixed income investments (government bonds and investment-grade corporate bonds). Increasingly, we’re speaking with institutional investors who are concerned about how an eventual rise in interest rates could hurt their fixed income investments. Convertibles have historically been less sensitive to interest rate risk because of their equity characteristics. This can make convertibles a compelling alternative to traditional fixed income securities—for institutional and individual investors alike.

Convertibles Delivered Compelling Performance in Rising Interest Rate Environments
Convertibles Delivered Compelling Performance in Rising Interest Rate Environments

Past performance is no guarantee of future results. Source: Morningstar Direct and Bloomberg; most recent data as of 12/31/2014. Yield is represented by the 10-year Treasury yield, showing periods where yields rose more than 100 basis points. Performance shown is cumulative.

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Japan at an Inflection Point

By Nick Niziolek

March 17, 2015

Regular readers of our blog know we turned bullish on Japanese equities this past fall, as we believed the Bank of Japan was ready to embark on a second round of quantitative easing and equity valuations were attractive. And perhaps most importantly, we saw a potential inflection point in corporate governance as the tone and actions of company managements were becoming more investor friendly. Since that November 4, 2014 post through March 13, the Nikkei 225 Index has rallied more than 7%, outperforming the S&P 500 Index (+2.9%) and the Euro Stoxx 50 Index (+1.4%).

While this advance has already been impressive, we believe Japanese equities may still only be in the early stages of a longer-term rally. As we wrote in November, Prime Minister Shinzo Abe’s government has highlighted the Nikkei 400 Index as a key part of its structural reforms. Unlike indexes that focus on market capitalization or sector, this index includes Japanese equities issued by companies that efficiently utilize capital and have investor-focused management. A strict financial screening criteria and quantitative and qualitative scoring are used to determine the index’s 400 constituents. Many Japanese companies aspire to be included in this index, which we believe has contributed to recent increases in stock buyback activity and capital expenditure announcements.

Among the recent examples that have anecdotally affirmed our optimism about Japanese equities, a large Japanese robotics company historically known for its lack of transparency made headlines when its chief executive officer indicated publicly that the company would set up a shareholder relations department, and was also considering both increases its to dividend payout ratio and a stock buyback program. This may not sound like an earth-shattering announcement, given that even many small-cap companies in the U.S. have dedicated investor relations departments. But for those of us who follow the Japanese equity market, dividend increases and stock buyback programs have not been a focus for many Japanese companies, specifically this company; and discussing these topics via the media was surprising. Moreover, this same company also recently announced plans to increase its manufacturing capacity via two new factories in Japan, requiring a capital investment of nearly $1 billion. This is yet another positive signal that Japanese corporations are becoming more comfortable with investing in growth and building these facilities within Japan.

Structural Reforms in Japan: A Catalyst for Stock Buybacks

Source: J.P. Morgan, “Japan Equity Strategy,” February 3, 2015, using data from Bloomberg and J.P. Morgan.

Within our economic profit valuation framework, many Japanese companies that historically exhibited very low returns on invested capital (ROIC) and allocated capital to under-producing assets are now beginning to exhibit ramp-ups in ROIC as they refine their capital allocation strategies. The combination of capital growth, improving returns, and a low cost of capital is accelerating intrinsic value creation for many of these Japanese companies, in turn supporting the strong returns we have seen in the equity markets.

Our investment process seeks to identify these inflection points from both the top down and the bottom up. Japan provides a recent example of how we believe this process can create significant value for investors.

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Advice for Investing in Today’s Volatile Markets: 5 Points

By John P. Calamos, Sr.

January 21, 2015

Yesterday, I appeared as a guest on CNBC’s “Closing Bell.” One of the topics we discussed was market volatility and the role of lower-volatility equity strategies, which seek to avoid downside without foregoing the opportunity to participate in stocks’ upside. The interview was similar to many of the recent conversations that I’ve had with investors. Here are some of the key points I’ve been making in these conversations.

In my view:

  1. Volatility will likely continue at an elevated level. Falling commodity prices, global growth fears and political uncertainties in the euro zone are among the factors that will add to volatility in the markets over these next months.
  2. The U.S. stock market can continue to advance for 2015. The U.S. economy looks set to continue its expansion, supported by accommodative Fed policy, healthy job growth, and good corporate profit growth. Valuations are attractive by a number of our favored measures, and especially for growth companies.
  3. Investors need to look through the short-term volatility and position their portfolios proactively and strategically. Downside protection is important. Investors need to settle into an allocation that won’t tempt them to market time or sell into weakness.
  4. Diversification is important—but bonds aren’t necessarily the right answer, or the only answer. We believe there are risks in the bond market. Short-term rates may stay low through much of 2015, as the Fed takes a “patient” approach. Even so, it’s important to remember when rates move, they can move quickly and take investors by surprise. Also, many factors can influence long-term rates, beyond what the Fed does.
  5. Lower-volatility equity approaches are especially well suited to this environment. What can investors do if they are concerned about market downside but don’t want to abandon their long-term goals? I believe strategies that include both stocks and convertibles can be especially advantageous for investors who are struggling with the “afraid to be in the market, afraid to be out of the market” dynamic.

    Convertible securities combine stock and bond attributes, providing the opportunity for upside participation and downside protection. More specifically, convertibles can benefit from upwardly rising stock markets because they are equity sensitive, while their fixed income attributes may provide a floor of sorts when the stock market is volatile. Compared to traditional fixed income securities, they are less sensitive to interest rates, so investors may not have to scramble when rates do begin to rise. However, because all convertibles do not have the same upside and downside attributes, they must be actively managed to provide the right risk/reward balance between upside participation and potential downside protection.

For a closer look at how we pursue lower-volatility equity participation, please see my paper, “Asset Allocation Strategies for Volatile Markets.”

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A Long-Term View for China

By Nick Niziolek

November 25, 2014

When I meet with clients, one of the most frequent questions I’m asked is, “What do you think about China?” With China’s rate cut this past Friday helping to fuel a global equity rally, we were reminded of how relevant the China question is to the overall health of the global markets and economy. In this post, I’ll discuss the lens through which we view China and how we interpret the daily flood of policy-related headlines coming out of the country to determine what is “noise” and what is actionable.

Our outlook on China remains generally positive. All recent policy actions and reform initiatives suggest the government’s continued commitment to transitioning China to a more balanced and market-driven economy.

However, this transition is a long-term endeavor. Its complexity and magnitude call for slow and coordinated execution, which likely will result in periods of near-term volatility and at times frustrate investors.

During this process, we expect growth will continue to decelerate. Although the official growth rate has been reported as 7.3% for the third quarter of 2014, a number of the key indicators we monitor are tracking well below this level. For example, electricity consumption grew at a reported 1.5% for the third quarter, while rail freight contracted by -2.3%. Among key primary measures, only bank loan growth of 13.3% trended above the official economic growth rate.

Thus far, China has utilized targeted policy actions and stimulus to moderate the slowdown. While recent policy action was more broad based, we do not expect a significant reacceleration in growth as the government’s focus remains on unwinding credit and investment bubbles while promoting consumption and private sector growth. Last week’s rate cut is consistent with the reality that the system is too fragile to risk a hard landing.

While the Chinese economy faces challenges, our positive outlook is predicated on our view that China will avoid a near-term credit crisis and that significant opportunities exist for companies and industries exposed to the country’s positive reform initiatives. As we analyze news out of China, there are broad trends that we monitor for consistency with policy actions. We then identify investable companies and industries that we believe can benefit from these actions. Below, I’ll highlight three of the most important trends.

  1. Internationalization of the renminbi (RMB): In April, the Bank of International Settlements published a paper entitled “One currency, two markets: the renminbi’s growing influence in Asia-Pacific.” The authors suggest that China’s influence throughout ASEAN countries has expanded beyond the real economy, with movements in the currency markets creating faster and more volatile impacts on these economies. This becomes intuitive given the increased use of the RMB for settlement in China’s trade, up from 3% in 2010 to 18% today. To put it in perspective, Japan’s current use of the yen for settlement is less than 15%.

    As we review policy actions, China has consistently promoted the RMB as a trading currency, which supports the longer-term goal of making the RMB a reserve currency for the Asian region. For the RMB to become a reserve currency, we believe China will need to create open, well-regulated, and deep capital markets. The first signs of this include the creation of the “dim sum” offshore RMB bond market in 2007, which has allowed investors, including Calamos, to invest in CNH-denominated debt of global multinationals and Chinese companies. The development of this market represents an important step in promoting trade in the RMB, as it provides China’s trade partners with higher-yielding options for the RMB they were receiving from trade with China. Since then, we have seen an acceleration in RMB bilateral swap agreements, the introduction of the Shanghai-Hong Kong stock market interconnect, and removal of RMB conversion caps for Hong Kong residents. We have sought to participate in this longer-term positive trend via exposure to brokers, exchanges, asset managers, and other potential beneficiaries of the increased flow of capital into and out of China.

  2. Transition from an investment-focused economy to one that is more consumer-driven: Many have raised concerns that as China’s GDP-per-capita has increased, the country is no longer the world’s preferred low-cost labor market, as countries including Cambodia and Vietnam take share from China. While this is true, China continues to introduce policies and reforms to move the country’s manufacturing up the value chain, resulting in higher productivity. Higher productivity leads to higher per-capita GDP, which ultimately results in higher consumption.

    One such recent policy initiative is the “Guidelines to Promote National IC Industry Development,” which provides central government targets and long-term support for domestic developers, designers, and manufacturers of integrated circuits. Over time, this should promote more high-tech design and manufacturing locally, but for local consumption and exports. And to further promote consumption, China is implementing affordable housing, deposit liberalization, and land reform policies.

    We have positioned global and international portfolios to benefit from this transition via increased exposure to consumer, technology, and health care—all sectors markedly under-represented in popular Chinese indices.

  3. Transition from a government-driven to a market-driven economy: In our opinion, this trend provides the most potential benefits, both from an individual-company investment perspective as well as from a broader economic perspective. We believe that capital flows to where it is treated best, which is why our investment process focuses on return-on-invested capital and the marginal return of capital. China is in the process of implementing broad reforms to state-owned enterprises (SOEs) that should promote SOEs’ marginal cost of capital to be above their cost of capital. This creates value as opposed to destroying value, as many SOEs have done historically. Some of these policy actions include the removal of implicit government guarantees, anti-corruption campaigns to enhance supervision and governance, improved ownership structures and management compensation schemes, and provisions that allow the government to re-deploy SOE capital into more appropriate areas, like public welfare. We have identified investments both in SOE companies that are undergoing this transition as well as in private sector companies that we believe are benefiting from the “SOE retreat” as monopolies are removed and new opportunities emerge.

    In conclusion, these three broader trends provide a valuable lens through which we can view the myriad policy changes and announcements coming out of China daily. Guided by this perspective, we continue to identify investments in China that we believe can harness these trends as long-term growth tailwinds.

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The Best Offense is a Good Defense?

By John McClenahan, CPA, CFA

November 21, 2014

While I still believe that economic conditions favor early cycle and secular growth stocks (see The More Things Change, the More They Stay the Same), what I find most interesting right now is the recent outperformance of defensive names over late cycle stocks, two areas of the market that normally travel together. The value of defensive stocks relative to late cycle stocks recently reached its highest level of the past five years.

5 Years Ended November 20, 2014

Past performance is no guarantee of future results. Sources: Morgan Stanley, Bloomberg LP.

As noted in my previous posts, the definitions of these two groups are:

Defensive stocks: Stocks that perform well when investors become especially concerned about the economy. Defensive stocks tend to be in the consumer staples, health care, telecommunications, and utilities sectors.

Late stage cyclical stocks: Stocks that perform well after the economy has been growing strongly for several years and is now decelerating. These tend to be in the consumer staples, energy, materials, telecommunications, and utilities sectors.

But what is the key difference between defensives and late stage cyclicals?

Roughly 60% of each group consists of consumer staples, utilities, and telecommunications. What’s different is that the defensive group includes 40% health care and the late cycle group includes 40% in energy and materials. So now it should be a little clearer what’s driving the divergence in returns. Since the recent market bottom on October 15, health care has rallied nearly 14%. Meanwhile, energy and materials have returned only 4%, with oil down -27% from its recent peak.

Will the divergence between defensives and late cyclicals grow larger or revert to the mean? It’s tough to say. I tend to think that neither of these areas will lead the market into early 2015. As I wrote in September, while we’re five years into a bull market, we haven’t seen a lasting decelerating trend in GDP or rising inflation—two signs of the late stage of the economic cycle. Until we see that happening, I don’t expect a sustained shift away from early cyclicals and secular growth. And defensives have rallied on fears over the spread of Ebola and the situation in Ukraine. While neither of these has gone away, the level of concern has diminished.

Regardless of what one thinks about these segments of the market, maintaining a balanced approach to portfolio construction—where relative exposures to secular growers, early cyclicals, late cyclicals, and defensives are not extreme—is a prudent path to successful risk-adjusted performance.

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Japanese Equities Look Better and Better

By Nick Niziolek

November 4, 2014

As we’ve discussed in recent posts, our investment process marries fundamental research with the identification of long-term secular growth themes, such as those related to demographics and consumption. Based on an intersection of bottom-up and top-down criteria, we’ve become increasingly constructive on Japan’s equity market over recent months. We anticipated that the Bank of Japan (BOJ) would provide additional accommodative monetary policy and that Japan’s Government Pension Investment Fund (GPIF) would continue to increase allocations to local equities.

So, we’re well positioned in light of recent announcements from the BOJ and GPIF. Last week, the BOJ made a surprise announcement that it would increase its monetary target by ¥80 trillion and also purchase stock assets. Previously, the central bank said it planned to increase Japan’s monetary base by ¥60-70 trillion yen annually.

Also significant was the BOJ’s statement that it would consider buying exchange traded funds that track the Nikkei 400 Index. Introduced in January, the index includes companies that meet certain standards of profitability, including higher return on equity (ROE), as well as shareholder-friendly corporate governance policies.

Prime Minister Shinzo Abe’s government has spotlighted the index as a key part of its structural reforms. And by putting its own stamp of endorsement on the index, the BOJ is tacitly moving into economic areas well beyond traditional monetary policy, while also demonstrating its alignment with Prime Minister Abe’s initiatives. A company that generates strong free cash flow but decides to sit on its cash will see a negative impact to ROE and risk not being incorporated in this now-important index. This should promote higher dividends, buybacks, and/or capex spending—all positive for equity markets and potentially for Japan’s economy as well.

Additionally, last week, Japan’s Government Pension Investment Fund (GPIF) announced a new target asset mix last week. GPIF manages the pension assets for Japanese public sector employees. As one of the largest pension funds in the world, shifts in its allocation can have a meaningful impact on the markets. There were several positives in the announcement, including:

  • The allocation to Japanese stocks has risen to 25% from 12% (with a permissible range of deviation of nine percentage points). To accommodate this increase to local equities, the allocation to bonds has dropped from 60% to 35% (permissible deviation of 10 percentage points).
  • The allocation to non-Japanese equities has also doubled, which we believe can provide a boost to the global equity markets.
  • The benchmark for the international (non-Japan) stock portion of the GPIF has changed from the MSCI World ex-Japan Index to the MSCI All Country World Index ex-Japan. As a result, the benefits of the increased international allocation target may be especially pronounced for emerging market assets because the new index incorporates emerging markets, while the previous one did not.

Current valuations are reasonable, and we see additional room for P/E expansion. The one-year forward P/E of the Japanese equity market, as measured by the Topix 400 Index, is currently at 15x. While this is higher than the 12x level of October 2012, it is far less than the 20x multiple reached in April of 2013. As GPIF implements these new targets (which may take a period of years), we expect that it will take advantage of price weakness, providing added support to the global equity markets.

We’ve been building our allocations through new purchases and by increasing allocations to existing holdings. We’re favoring export-oriented companies and companies that are positioned to benefit from asset reflation. We’re still relatively more cautious on companies tied to the Japanese consumer, given the headwinds of a weaker yen and increasing taxes. The prospects of these stocks would be more compelling if the government postpones the next value-added-tax increase or if valuations come down some more, but last week’s announcements by the BOJ and GPIF likely increases the chance the VAT proceeds as previously expected.

As we have added to our Japanese equity allocations, we have maintained our focus on risk management. For example, we’re closely monitoring our yen exposure to ensure it does not exceed the levels with which we are comfortable.

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Is Your EM Allocation Vulnerable to Index Vagaries?

By John P. Calamos Sr.

September 29, 2014

Recently, global index provider FTSE announced it has reclassified Morocco from “emerging market” to “frontier market” and Argentina from “frontier market” to “unclassified.”* These changes will impact the composition of FTSE’s emerging market and frontier market indexes in mid-2015.

Such constituent shuffling happens more often than many investors might realize. What’s more, I believe shifts between categories will occur with greater frequency as emerging markets follow divergent growth/contraction trajectories, due to different economic policies, political systems and geopolitics.

There is no single definition for “emerging market” and therefore for “emerging market investing.” Indexes use different criteria to classify countries. As a result, one index’s emerging market is another index’s developed market. South Korea is a case in point. While Standard & Poor’s and FTSE classify South Korea as a developed market, MSCI places South Korea in its emerging market index, where it represents more than 15% of the benchmark.

Similarly, FTSE and Standard and Poor’s consider Greece to be a developed market, but MSCI counts it among the emerging economies—for now, at least. Greece has hopped between MSCI’s categories, moving from emerging markets to developed markets in 2001 and then back to emerging in 2013.

Figure 1. Even Experts Don’t Agree on What Constitutes an Emerging Market

Source: MSCI Inc., S&P Dow Jones Indices LLC, FTSE Group as of June 30, 2014

In my view, the fluid nature of EM indexes illustrates the need for an active approach to EM investing. Passively managed strategies are subject to the vagaries of index reshuffling. What’s more, speculation about what’s in or out of a particular index could lead to volatility within emerging markets as passive strategies must sell or buy en masse to accommodate constituent changes.

We continue to believe fundamentals and top-down views provide the best criteria for deciding whether or not to invest in a company or market. When portfolio construction is dictated by the vagaries of a third-party index provider, I believe the potential for unnecessary downside risk increases significantly.

In a passive ETF strategy, investors end up with a static approach punctuated by abrupt and wholesale changes driven by index shifts rather than company fundamentals. In contrast, an active approach can adapt and capitalize on market opportunity.

As our international team has discussed in posts, our team emphasizes countries moving toward increased economic freedoms and companies with attractive growth fundamentals that are participating in long-term secular growth themes, such as the megatrend of global middle class expansion. As a result of our active management, our EM strategies may look quite different from an EM index—in our view, that’s good for investors.

*For more, see “FTSE Drops Argentina, Demotes Morocco: Mind Your ETF Index,” by Dimitra DeFotis,, September 25, 2014

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The information in this report should not be considered a recommendation to purchase or sell any particular security. The views and strategies described may not be suitable for all investors. As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility and difficulty obtaining information. In addition, emerging markets may present additional risk due to potential for greater economic and political instability in less developed countries.

Indexes are unmanaged, do not entail fees or expenses and are not available for direct investment. The S&P Emerging BMI captures all companies domiciled in the emerging markets within the S&P Global BMI with a float-adjusted market capitalization of at least US$ 100 million and a minimum annual trading liquidity of US$ 50 million. The S&P Developed BMI is a comprehensive benchmark including stocks from 26 developed markets. Source: Standard and Poor’s, as of 7/11/14. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The FTSE Emerging Index includes large and mid cap securities from advanced and secondary emerging markets, classified in accordance with FTSE’s Country Classification Review Process.

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Why Growth Stocks Now?

By John P. Calamos Sr.

September 9, 2014

After five years of a strong bull market, I believe there’s still room for stocks to advance. Growth stocks look especially attractive. At 1.23, the premium for growth over value remains lower than the historical average of 1.44. Even when we omit the tech bubble from the long-term average, the 1.23 premium for growth is lower than that 1.37 average.


Source: FactSet (1989-6/2012) and CapIQ (7/2012-present). Past performance is no guarantee of future results.

While growth stocks’ prices are low relative to value, their earnings prospects are significantly better. The 5-year forward EPS growth rate for the Russell 1000 Growth Index is 14.76%, versus 8.77% for the Russell 1000 Value Index (Figure 2). As investors move from the "bad news is good news" mindset to "good news is good news," we believe that growth stands to benefit.


Past performance is no guarantee of future results.Data as of July 31, 2014.

As we’ve discussed in our previous commentaries (including our most recent outlook), we believe that the market has entered a growth regime, and that this current economic expansion cycle will likely be longer than typical—providing a favorable backdrop for growth stocks. Accommodative monetary policy seems set to continue: Last week, the European Central Bank surprised the markets with a rate cut and Friday’s anemic job numbers suggest that the Fed is unlikely to accelerate the pace for a rate increase. But when a rate increase does eventually occur, P/Es are likely to go up as well. History has shown that P/Es go up when interest rates are moving up from abnormally low levels.

No doubt, there will be volatility from economic reports and geopolitics, with Ukraine and the Middle East looming largest today. Active management and a long-term perspective will make the difference in taking advantage of the short-term choppiness that is likely to occur.

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¡Viva La Reforma! Part II

By Nick Niziolek

September 3, 2014

In my December post "¡Viva La Reforma!," I discussed how economic reforms were contributing to an increasingly favorable top-down view of Mexico. Fast forward eight months, and we remain bullish on Mexico for several reasons. Most importantly, President Enrique Peña Nieto has continued to advance the "Pact for Mexico," with a broad reform agenda that has touched the energy, financials, public, and educational sectors. Additionally, we believe Mexico’s strong ties to an improving U.S. economy can also provide economic tailwinds to companies in a range of sectors.

As I recently discussed in Barron's (August 23, 2014), we're seeing better property-right protection for creditors and improved transparency. Other promising reforms are focused on reduced judicial process and a closing of loopholes that discouraged foreign investment. Energy sector reforms also continue to progress. Expectations are that Mexico’s state-owned petroleum company proceeds with its first farm-out agreements early next year and that round one, which will permit private company bidding, begins in mid-2015. Meanwhile, regulations in the financials sector should improve competition—for example, by fostering increased mobility of deposits and loan choices, improving access to credit information, as well as by eliminating bundled financial products and services. In a further demonstration of the government’s commitment to transparency, nominations or dismissals for the boards of state-owned enterprises must now receive approval from two-thirds of the country’s senate.

We believe reform policies have the potential to add more than 200 basis points annually to GDP growth by 2018. Energy and financial reforms should have the most immediate impact, likely felt beginning in 2015 and more fully in 2016, while telecom and fiscal reforms are also expected to provide a tailwind to economic growth. Education sector reforms designed to root out corruption and improve accountability have proven more challenging to implement, but should provide longer-term economic benefits to the Mexican economy.

The most difficult aspect of investing in Mexico today is balancing the optimism about future growth prospects with the subdued growth environment that currently exists. Reflecting these crosscurrents, we have focused on identifying companies that are not only tied to the long-term potential of the Mexican reform story but that also benefit from near-term catalysts and reasonable valuations.

For example, this dual focus has led us to a materials company positioned to capitalize on domestic infrastructure investments (the long-term potential) that is reaping balance sheet improvements from strong ties to the U.S. economy and housing market (the near-term catalysts). Similarly, there are a number of financial companies that we believe can leverage reforms, including one that can benefit from an expected ramp-up in investment spending in the years to come but in the interim has expanded its domestic consumer base and implemented efficiency programs (near-term growth catalysts). Within financials, we also have identified opportunities in real estate, an industry benefiting from a stable and improving economy, low rates, and attractive affordability levels compared to other global and regional markets.

Although we believe reforms in the energy sector are further along than those in other sectors, there are fewer direct investment opportunities, given the sector’s high level of nationalization. As a result, we have instead sought global companies that stand to profit from increased demand from Mexico for their products and services, such as large oil and service providers.

Year to date, the emerging market rally has been led by optimism for change via election cycles and/or reforms in several countries (India, Indonesia, Brazil, China) and has been less dependent on near-term fundamentals and growth. As we look forward, we believe the market will shift its focus to countries that have successfully implemented reforms and to companies that are directly benefiting from the improvement in economic growth and sustainability. While Mexico has lagged the broader emerging markets year to date, we’d expect investor interest to return as economic growth accelerates during the second half of 2014 and more significantly in 2015 and beyond, as the impact of these reforms is felt more fully.

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The More Things Change, the More They Stay the Same

By John McClenahan, CPA, CFA

September 2, 2014

Back in the beginning of April, I wrote a post about how the stock market can be divided into four areas of economic sensitivity:

  1. Defensive stocks: Stocks that perform well when investors become especially concerned about the economy. These tend to be in the consumer staples, health care, telecommunications, and utilities sectors.
  2. Late-stage cyclical stocks: Stocks that perform well after the economy has been growing strongly for several years and decelerating. These tend to be in the consumer staples, energy, materials, telecommunications, and utilities sectors.
  3. Early-stage cyclical stocks: Stocks that perform well when the economy is starting to accelerate. These tend to be in the consumer discretionary, financials, industrials, and technology sectors.
  4. Secular growth stocks: Stocks that perform the best when the economy is growing at a steady pace but neither accelerating nor decelerating. These tend to be in the consumer discretionary and technology sectors.

At the time of this earlier post, defensive had taken the lead as investors responded to Janet Yellen’s interest rate comments. What happened to these four areas since then? Well, first there was more backtracking on Yellen’s “six months after QE” line, and then there was bad 1Q economic data, with GDP growth coming in at -2.9%, versus an estimate of -1.8%.

People started thinking: When will this end? Could all of this economic decline be due to weather? As you would expect, late-stage cyclicals and defensives led the market.

Then in July, 2Q advance GDP growth was released at 4.0%, versus an estimate of 3.0%, and 1Q GDP contraction was revised upward to -2.1% from -2.9%. The market initially declined as these revisions raised fears that the Fed would raise rates sooner than expected. But once Yellen showed she was still dovish at Jackson Hole, secular growth returned to the forefront with early cyclicals close behind.

More recently, early cyclicals outperformed even secular growth (4.9% versus 3.6% for the month of August) as investors became more acclimated to the Fed’s improved outlook. Given that 2Q GDP was revised higher to 4.2% on August 28, the trend of early cyclicals leading the market may continue for a while—especially if the August monthly payroll number (due September 5) comes in north of the 228,000 expected. And while we’re five years into a bull market, we haven’t seen a lasting decelerating trend in GDP or rising inflation—two signs of the late stage of the economic cycle. Until we see that happening, I don’t expect a sustained shift away from early cyclicals and secular growth. Plus, there’s room for these areas to play “catch up,” given that defensives still lead year to date, thanks to their strength in the first half of the year and spikes of geopolitical uncertainty tied to Ukraine and the Middle East.

Figure 1. Defensives Still Lead YTD, Secular Growth and Early Cyclicals Make Back Significant Ground
Historical Stock Performance and Economic Sensitivity

Past performance is no guarantee of future results.
Sources: Morgan Stanley, Bloomberg LP.

Figure 2. Historical Stock Performance and Economic Sensitivity
Historical Stock Performance and Economic Sensitivity

Past performance is no guarantee of future results.Sources: Morgan Stanley, Bloomberg LP. Data through 8/31/14.

There’s growing consensus that the Fed may raise rates sooner, but it’ll be because the economy is doing well. Obviously, this is all predicated on the situation in Ukraine not continuing to escalate (which would likely lead to defensives holding up better than the other three areas).

Next up: Payrolls on September 5 and the FOMC announcement on September 17. Stay tuned. Expected GDP growth for 2015 hasn’t moved from 3.0% since mid-June.

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EM Growth Provides Tailwind for Automation Companies

By Nick Niziolek and Paul Ryndak

August 15, 2014

Many of our emerging market posts focus on global top-down developments and macroeconomic shifts, as these provide tailwinds or headwinds to companies around the world. Equally important to our research process is our identification of long-term secular themes that may help sustain a company’s prospects, in spite of more challenging economic conditions. One growth theme we have focused on for many years is the growth of automation. Below, our Non-U.S. Industrial Sector Head Paul Ryndak shares his thoughts on future opportunities in automation, drawing on insights from his recent travels to Japan and China.
–Nick Niziolek, SVP and Co-Portfolio Manager

Paul Ryndak, Non-U.S. Industrial Sector Head

One of the investment themes we are most excited about is automation. The days of Henry Ford’s assembly line are long gone, replaced by automated conveyor systems and robots that do much of the heavy lifting, including welding, painting, lifting and gluing windshields onto the car. We believe a number of factors will support the future growth prospects for automation companies, including the rapid expansion of automation within emerging economies, specifically China.

Recently, I met with the management teams of several automation companies in Japan and one consistent theme they discussed was the opportunity for growth in China. Later that week, I visited three automotive production facilities in China with outstanding degrees of automation.

We believe that China will continue to seek out automation solutions as a way to enhance profitability and global competiveness. The tremendous growth of the Chinese auto industry has led many auto manufacturers to build new production facilities with teams of robots and other highly advanced automation features.

There are many other reasons that companies in China are seeking opportunities to automate. Labor costs are rising quickly, providing incentive for manufacturers to be more productive and contain costs. Also, the technical and quality requirements for manufacturing cars, phones and other electronics is increasing, requiring more precision. This precision can be more readily accomplished with automated processes and equipment.

When people think of automation, robotics typically comes to mind. This isn’t surprising, given the increasingly important role that robotics play, not only in auto manufacturing but also in a range of other industries, such as component manufacturers. We believe the expanded use of robots provides significant investment opportunity for automation companies, especially those with business strategies focused on China. At only 213 robots per 10,000 employees, the robot density in China’s automotive manufacturing sector is low, compared to 1091 in the U.S. and 1562 in Japan.

Robotics: China’s Growth Provides Opportunities for Increased Adoption

Source: Barclays Capital, using data from IFR World Robotics 2013.

In both China and the developed markets, we believe the expansion of collaborative robots is one of the most promising areas of growth within robotics. Unlike industrial robots (such as those that are typically used in auto plants) that need to be contained and separated from humans for worker safety, collaborative robots have features such as sensor-based systems that allow them to work safely next to humans. The continued development of collaborative robots provides exciting applications in light manufacturing and assembly processes, and further expands the market opportunity for robot manufacturers.

In addition to robot manufacturers, we have also identified opportunities in automation companies that manufacture sensors and motion controls, automated machine tools and the computer programming that controls the machine tools, and software programs that control the automation workflow. As manufacturing capacity increases in places like China, we expect the trend of automation to accelerate, providing more opportunities for automation companies and investors alike.

Our investment approach marries our identification of secular growth themes with comprehensive fundamental research. In the case of automation companies, the pullback in Japanese equities earlier this year brought the valuations of select companies to attractive levels that do not fully reflect the long-term growth potential we see.

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Why Higher Quality May Mean Higher Risk

By Eli Pars, CFA

August 12, 2014

When I speak with clients about convertibles, one topic that often crops up is how credit quality considerations play into portfolio construction. Some believe that a portfolio built exclusively from investment grade convertibles is inherently safer than a portfolio that also includes below investment grade and non-rated securities. Our view is that in the current environment, the opposite may be true. Here’s why we believe that having the flexibility to invest across credit qualities makes sense:

  • An investment grade portfolio may be subject to a shrinking opportunity set, as investment grade convertibles currently make up a small and decreasing segment of the overall universe. As of July 15, 2014, the 300 securities of the BofA Merrill Lynch Global 300 Index had a total market value of more than $170 billion dollars (USD). However, the index includes just 44 investment grade issues out of the 300, with a total market value of $37.6 billion.

    There’s a similar issue in the U.S. market. The BofA Merrill Lynch All U.S. Convertibles Index included 484 issues as of July 15, with a total market value of $209 billion. The investment grade subset, the BofA Merrill Lynch VXA1 Index, included just 61 names, valued at $47.7 billion.

  • Non-investment grade securities have dominated recent issuance. Recently, global convertible issuance has been very promising, a trend which we expect will continue, supported by global economic recovery. Recent issues have exhibited attractive characteristics and terms, as well as good breadth by sector, geography and market cap. However, this issuance has been largely dominated by non-investment grade issuers, as investment grade issuers have continued to find inexpensive financing in traditional debt.

    Within the global market, 148 issues have been brought to market through the first half of 2014, with a value of $52.3 billion. Only $4.3 billion of this issuance has been rated investment grade, in six issues. Similarly, within the U.S. market, 61 new issues were brought to market during the first half of the year, with a value of $23.5 billion. Just four issues ($3.0 billion) of these were rated investment grade.

  • Investment grade convertibles have typically underperformed the broad convertible universe when interest rates rise. During the past 20 years, there have been nine periods when the 10-year Treasury yield rose more than 100 basis points. During eight of these periods, the BofA Merrill Lynch All Investment Grade U.S. Convertibles Index lagged the BofA Merrill Lynch All U.S. Convertibles Index. While rates are still low, investors should be positioned proactively for an eventual rate increase.

In Rising Rate Environments, Investment Grade Convertibles Typically Lagged the Convertible Universe

Performance data quoted represents past performance, which is no guarantee of future results. Source: Morningstar Direct and Bloomberg. Rising rate environment periods from troughs to peak from October 1993 to December 2013. Data as of 6/30/14.

  • An investment grade portfolio may also be subject to a higher level of equity sensitivity, and therefore, downside equity capture—precisely the risk that most convertible investors seek to avoid. In the current environment, we believe a portfolio composed exclusively of investment grade issues would be subject to a level of equity risk that is higher than most convertible investors would anticipate or intend. While this equity sensitivity may in fact mitigate some of the interest rate risk we discussed above, we believe the profile of much of the investment grade market is not what investors have come to expect

  • Quality restrictions can increase valuation risk at points of the market cycle. Our team continues to identify a range of attractively valued securities in the convertible market. Even so, there are pockets of the market where we believe convertibles are generally fully valued—including a number of investment grade issues. We do expect that equity markets will continue to rise, but believe the global rotation that ran from mid-March to June illustrates that the highest priced securities may be vulnerable to the increased downward pressure when market sentiment wavers. Historically, overpriced bonds often underperform when the market moves in either direction.

  • At Calamos, we believe that the unique advantages of convertibles are best harnessed through actively managed strategies that seek an asymmetrical risk/return profile—that is, one with more equity upside than downside. A flexible approach that can include convertibles across the quality spectrum provides us with the best way to achieve this goal over full and multiple market cycles.

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The Philippine Growth Story Looks Set to Continue

By Nick Niziolek

July 9, 2014

As the Philippine equity market has appreciated more than 20% in the first half of 2014, our team has continually analyzed valuations and the degree to which we include Philippine equities within our portfolios. While the recent appreciation in equity prices makes valuations less compelling than last year, we are still finding attractive opportunities.

In fact, we are optimistic that the Philippine growth story has several long chapters ahead, a view supported by the country’s progress in infrastructure investments and reform initiatives. While maintaining exposures to the Philippine consumer via opportunities in the retail, banking and gaming industries, we have also identified new opportunities in property development as we believe infrastructure investments are creating significant value for the premium operators in this market.

Within the Philippines, the banking industry is one which we have favored historically, due both to the consolidated nature of competition (three dominant competitors hold 40% market share and lead consolidation within the industry) and positive economic tailwinds. Over the previous 10 years, individual wealth within the Philippines has grown by 12% per annum, but 80% of Filipinos are “unbanked.” Overall credit penetration remains below 40% of GDP, one of the lowest levels in the world, and credit card penetration is still below 10%.

Following a slow recovery from the Asian Financial Crisis, the Philippine financial sector is in a much better economic position for sustainable growth than many other emerging markets. We’re identifying companies with strong capital positions, ample liquidity (loan-to-deposit ratios of less than 70%), and strong asset quality and coverage ratios. Foreign competition has been held in check by regulations that limit foreign ownership of local institutions to 40% and cap foreign banks’ branch networks at 20 banks. As a result, foreign banks are essentially unable to compete with larger local institutions that operate 800+ branches each. In our view, the high growth in branch networks from local players over recent years should provide future margin upside as these locations become more fully utilized and operational efficiencies are realized.

Additionally, the Philippine bank regulator has been proactive, implementing the voluntary global banking standards of Basel III at the beginning of this year, at a far more rapid pace than many other emerging markets. We have been closely monitoring recent developments by the regulator, including recent discussions pointing to a new law being enacted in late July that will likely further liberalize the banking sector and permit additional foreign investment. Although this may create near-term competition for the largest local banks, we believe these developments can have positive longer-term implications for the banking industry and the Philippine economy as a whole, as we expect more foreign capital investment and an acceleration of consolidation within the banking industry.

Finally, the overall economic backdrop in the Philippines remains favorable. As we have discussed in past posts (see "Perspectives on the Philippines"), we believe that as economic freedoms continue to increase so too will the flow of foreign capital, fuelling for the economic investments necessary to further develop this economy.

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Emerging Markets: PR is on the Upswing

By Nick Niziolek

May 28, 2014

In early March, I wrote a post titled "Emerging Markets Should Fire Their PR Firms," which focused on some of the positive trends that seemed to be getting lost in the emerging market (EM) sell-off. The tide has since turned, and there has been a strong reversal in both news flows from and equity flows into EMs. Headlines have transitioned from "Currency Crisis" to "Modi Wins," and Russian equities have moved above the levels seen since before the Ukraine crisis began.

After falling more than 8% from the beginning of the year through early February, the MSCI Emerging Markets Index has staged a strong comeback. From March 20 through May 23, the index has risen more than 11%, outperforming the S&P 500 Index by nearly 1000 basis points and the MSCI World Index by more than 800 basis points. Year to date, the MSCI Emerging Markets Index has returned nearly 5%, outperforming both indexes by more than 100 basis points.

Moreover, we’ve identified several near-term catalysts that could further support the equity breakout that is underway. Prime Minister Modi’s victory in India has dominated recent headlines, but the Indonesian Presidential election scheduled for early July could serve as a similarly significant positive catalyst for the world’s sixteenth largest economy. Frontrunner Joko Widodo has campaigned on a platform of education, energy, infrastructure, and bureaucratic reforms. His ability to rapidly implement changes as mayor of Surakarta has fueled optimism that he can successfully move forward reforms on a national scale in short order.

Only in EM investing could a military coup be viewed as a potentially beneficial catalyst, but recent developments in Thailand are shining a new light on the risks and opportunities within that country. While Thailand is unlikely to grab favorable headlines in upcoming weeks, the resolution of regional political conflicts could provide a catalyst for Thailand. We have very little exposure to Thailand currently, but there may be an opportunity later this year to increase our exposure, given our view that the new government will look to rapidly roll out stimulus measures to support the political transition.

Although the breakout in EM equities has had good breadth, there have been laggards, including China and Mexico, both of which outperformed during 2013. We have a constructive top-down view of both countries, and are taking advantage of recent weakness by adding to our favorite positions. While the world focuses on reform prospects in India and Indonesia, Mexico is further along, with promising signs of continued momentum. Mexico recently increased its infrastructure spending target to $587 billion by 2018, more than twice the target President Pena Nieto announced in July of 2013 and the equivalent of nearly 50% of Mexico’s annual GDP. This new figure includes $362 billion in public spending and is 71% higher than what the previous administration achieved. Project awards are only now beginning to ramp up, with many construction projects expected to begin later this year, which should provide additional tailwinds for this economy. Meanwhile, we still see significant opportunity within China as it navigates a soft-landing and advances reforms that should further open the economy and encourage private investment.

Despite the good news coming from many countries, investors should remain prepared for pockets of negative news and the volatility inherent in EM investing. For example, we remain cautious on Russia. Even if tensions de-escalate in Ukraine, recent events highlight the ongoing power struggles between Russia and the West that are playing out in many former Soviet states. Our research team was in Moscow several weeks ago and noted that there were no signs of stress within Moscow due to Ukrainian developments, with public approval ratings and nationalism at all-time highs. While we cannot predict Putin’s next move, we must factor in downside risks when evaluating investments in this region relative to the opportunities we are seeing in more stable emerging markets.

While the market has looked past the near-term fiscal and economic challenges within Brazil, due in part to optimism about upcoming elections, we remain cautious as we have not seen a candidate put forth the slate of reforms we believe are needed to foster a stronger recovery. In this environment, we’re continuing to seek out bottom-up growth opportunities that can do well with a less favorable economic backdrop.

We have been pleased to see more positive headlines coming out of the EMs over these past weeks, with equity flows and returns fueling near-term optimism. We expect additional bouts of volatility, but we believe this will create opportunities given the long-term growth potential of emerging markets and several near-term catalysts that can provide additional positive news flows. We have used the market upswing to realize gains in countries and companies that we believe may have risen too far of late, reallocating capital in some of our more favored countries that have lagged during the initial stages of this rally. As always, we are taking advantage of the inefficiencies that we believe are created by passively managed exchange-traded EM funds. We encourage our clients to not try to time these rallies and corrections, but instead remain invested for the long-term potential that EM equities provide.

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Field Notes: India

By Nick Niziolek

May 6, 2014

I recently spent a week in Delhi and Mumbai meeting with corporate management teams and local investors to gain insights into the Indian economy and the outlook for upcoming elections. Meetings like these enhance our team’s understanding of how company management teams are thinking about their businesses and the potential impact they believe future macro events (e.g., elections) may have on how they deploy capital and pursue growth initiatives.

When I meet with company management teams, my primary focus is deepening my knowledge about key business drivers, industry dynamics and near-term growth prospects. However, I always set aside time to discuss the macro environment and what issues are top of mind for management. Often, the conversations take interesting and unexpected turns. During my most recent trip, CEOs shared ranging views, including concerns about the lack of progress on a nearby massive construction project, the perspectives of Japanese investors versus their U.S. counterparts and the policies being implemented under Central Bank Governor Rajan.

In isolation, these exchanges could be viewed as side conversations. However, over the course of a week, my conversations with business leaders in a diverse set of industries helped me gain a fuller picture of what the near-term outlook could be for India and the companies in the region.

One consistent message I heard across industries, regions and political parties was that change was needed and Narendra Modi, the favored candidate for prime minister, was best equipped to bring change to India. Many believe Modi can provide the political and regulatory stability to allow the pent-up demand for infrastructure investments to be unleashed. Many people commented on how the current leadership has rewritten contracts and introduced retroactive policy that makes the business environment difficult to navigate. This approach has hindered economic freedom in the Indian economy, and by extension, the flow of capital into infrastructure projects—hence, cranes that sit dormant for months on end. This concern about the near-term prospects for infrastructure build-out influenced the aforementioned CEO’s admiration for Japanese investors, who are more likely to accept potentially lower returns on invested capital (ROIC) on investments in the region.

Another consistent message of management teams was the concern about the equity valuations of their companies. Specifically, they were worried that investors would become impatient, given that increased economic activity is likely at least several quarters away. This was not just a timing/valuation issue, but they were also concerned that investors’ views have become overly optimistic.

The prevailing view is not that a Modi-Rajan partnership will spark significant economic activity, or that Rajan will have any impact on the economy at all, but instead the view is that a Modi-led government will get out of the way, which will lead to a reacceleration in growth.

In summary, the results of my recent travels were mixed. On the positive side, I had the opportunity to better know several management teams and based on this, I have additional conviction in several of our holdings. Also, we have identified a queue of opportunities that merit additional fundamental research by our investment team. On the negative side, the economic impact of a Modi victory is likely at least 12 to 18 months away and many of the equities we’ve held during this recent rally have appreciated to a degree that we are taking profits in our more cyclically-exposed positions. We have invested these proceeds into information technology and health care exposures that we believe have more reasonable valuations and may benefit, even if there is a lull in economic activity between the elections and enactment of reform initiatives. Longer term, we believe new leadership will be more pro-urbanization than the previous party and we are looking for opportunities that will benefit from this trend.

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The Game is Changing

By John McClenahan

April 1, 2014

I recently wrote a post on monitoring whether we're in a stock picker's market and the importance of volatility and correlation to tracking error. Monitoring the market's economic sensitivity is also important. Generally speaking, the stock market can be broken down into four areas of economic sensitivity:

  1. Defensive stocks: Stocks that perform well when investors become especially concerned about the economy. These tend to be in the consumer staples, health care, telecommunications, and utilities sectors.
  2. Late-stage cyclical stocks: Stocks that perform well after the economy has been growing strongly for several years and decelerating. These tend to be in the consumer staples, energy, materials, telecommunications, and utilities sectors.
  3. Early-stage cyclical stocks: Stocks that perform well when the economy is starting to accelerate. These tend to be in the consumer discretionary, financials, industrials, and technology sectors.
  4. Secular growth stocks: Stocks that perform the best when the economy is growing at a steady pace but neither accelerating nor decelerating. These tend to be in the consumer discretionary and technology sectors.

With all of the economic data coming into the market every day, it should be easy to identify the winners and losers, right? However, it's actually more complicated than it seems because these groups of stocks tend to react more to investors' perceptions of what the economy will do than they do to the actual statistics that are reported. So day-to-day, investor sentiment can have a significant impact on the relative performance of these groups. And sometimes, one group can dominate or lag for several months or longer.

For example, from 2009 through the first quarter of 2010, early-stage cyclical stocks led the market with secular growth stocks a close second. However, as economic expectations began to decline in mid-2010, secular growth took the lead. This lasted through third quarter of 2012, when economic expectations began to stabilize and early cyclicals started to show renewed vigor. As 2013 unfolded and investors began to realize that expectations had stabilized but weren't rapidly accelerating, defensives led the market with early cyclicals remaining close behind.

This past summer everything changed! The Fed announced the possibility (yes, just a possibility!) of tapering asset purchases in upcoming months. Investors paused because not only did they have to consider the market's economic expectations but also the Fed's reactions to changing economic data. When would tapering start? How much each month? What about the discount rate? Would the Fed change that also? And just how dovish is Janet Yellen? For years, investors didn't need to think about these types of issues as the Fed was on auto-pilot, flooding the market with liquidity.

Secular growth stocks and early cyclicals jumped. But then economic expectations declined and the Fed decided to hold off on tapering … secular growth took the lead. As 2013 closed, economic expectations increased somewhat amid the start of Fed tapering and the beginning of the Yellen era. Secular growth and early cyclicals have been back and forth ever since.

First, growth led and more recently, it was early cyclical—despite no significant change in economic expectations. And while dispersion did recently decline due to the situation in Ukraine, it is still greater than it was for much of 2013. The waters are tough to navigate.

Historical Stock Performance and Economic Sensitivity
Historical Stock Performance and Economic Sensitivity

Past performance is no guarantee of future results.
Sources: Morgan Stanley, Bloomberg LP

So now what? Well, in her first FOMC meeting as chair, Janet Yellen was as clear as could be. The Fed could start raising rates in as soon as six months. What? Huh? Sometimes someone makes a statement that is literally so clear, but still unexpected, that it is completely unclear. Both growth AND early cyclicals declined as defensives came to the forefront and investors also took shelter in long-maturity U.S. Treasury bonds.

So now investors are confused and Fed officials are trying to backtrack. And as always, we at Calamos are watching economic expectations and listening closely to Fed speak. We're entering a period where bad economic news may be perceived as good since it could mean that the Fed will hold off on raising rates. (For more on this, see Gary Black's recent post.)That's likely to be good for early cyclicals. If economic expectations don't change much and the Fed is successful at calming rate hike fears, it is likely to be good for secular growth.

How do we use this information? Not only do we monitor which of the above types of stocks are performing the best, but we also monitor our exposure to these types. We seek to ensure that the exposures are aligned with our top-down views and the specific mandates of various portfolios. For example, our growth strategies are managed to be more heavily weighted in secular growth and early cyclicals over defensives whereas our value strategies favor early and late cyclicals over growth. Our growth and income and market neutral strategies tend to have exposure to all of these types of stocks.

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Emerging Markets Should Fire Their PR Firms

By Nick Niziolek

March 10, 2014

As I scroll through Bloomberg headlines on emerging market (EM) crises and analyze recent events with my colleagues, it has dawned on me that if the EMs had public relations firms, it would be time to fire them. Focusing only on the headlines, you'd believe there is nothing great happening in EMs today, but our team has identified many EM companies with attractive growth theses.

While it may be wishful thinking that articles reporting "Macau gross gaming revenues up 40% year over year" or "leading Chinese mobile platform exceeds 300 million users" would appear ahead of headlines like "Crisis in Ukraine" or "Chinese Trust Default," we are looking through the headline risks to identify the bottom-up growth opportunities that we believe will continue to work in this volatile environment.

Of course, we are concerned about Ukraine. Our team is monitoring developments closely, and we have many discussions about the direct and indirect impacts of events in Eastern Europe. Fortunately for our clients, we have maintained very limited exposure to Russia and no direct exposure to Ukraine. In our investment approach, we favor countries with increasing levels of economic freedom, as economic freedom historically has been correlated with economic prosperity. Although Russia has shown some improvements in economic freedoms, we believe Moscow must do much more. Whereas the 2008 summer Olympics provided a catalyst for increased economic freedoms in China, we have not seen a similar impact from the Sochi Olympics.

Regardless of the outcome in Ukraine, Russia appears to be taking a considerable step back in terms of market sentiment, which we expect to be reflected in higher risk premiums and lower GDP growth forecasts as 2014progresses. While Russian equities continue to look "cheap," and are "cheaper" today than they were last week, we have yet to identify the near-term positive catalyst that will accelerate growth, create a re-rating, or increase market interest in them.

So, what are we positive on within emerging markets? We've previously discussed our optimism about developments in Mexico, the Philippines, China, Taiwan, and South Korea, where we've been focused on consumer and technology sectors. This optimism remains, with many strong growth companies in these countries and sectors adding value for our clients in recent months.

We're also becoming more positive about the potential for India and Indonesia. I have a trip scheduled to India later this month, which is excellent timing as elections begin on April 7. Optimism among market watchers is building about a potential partnership between Narendra Modi, a frontrunner for prime minister and Reserve Bank of India Governor Raghuram Rajan. The hope is that Modi and Rajan can push forward the reforms necessary to fuel the next leg of the Indian growth story. Already we've seen comparisons to the 1980s' Reagan–Volker partnership. Following the taper fears of last May, Rajan's aggressive rate hikes have been credited with recent declines in inflation and current account deficits. I'm looking forward to meeting business leaders in various industries as well as economic officials to get better sense of their view of the country's prospects.

In practical terms, the media is the PR firm of the EMs and firing the media is out of the question. We fully expect Chinese trust defaults and concerns about weaker EM economies to remain headline fodder. Still, we are optimistic that the news flow may transition to more positive developments (elections in India and Indonesia, for example) as we move through the year. In the meantime, we continue to identify strong growth opportunities within the EMs and believe our longer-term focus will serve our clients well.

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How Do You Know It’s a Stock Picker’s Market?

By John McClenahan

March 6, 2014

In our most recent Global Economic Review and Outlook, we described 2014 as the year of the fundamental investor with macro factors becoming a less significant driver of investment performance. But how do we monitor this? And what does this mean for portfolio risks and returns?

Generally, when macroeconomic or sociopolitical factors are driving the market, stocks will tend to move together either increasing or decreasing in value. Traders and market pundits will say breadth is strong. If this continues, the average correlation between stocks will increase. When there are fewer significant macro topics driving the markets, stocks will tend to move independently based on company- and industry-specific fundamental factors, such as revenue and earnings growth, return-on-invested capital, valuation, and innovation, among others. When this occurs to a great extent, dispersion—the opposite of correlation—is said to be high. If this lasts over several months or years, it is described as a “stock picker’s market” because gains are to be had by selecting individual stocks as opposed to just buying the overall market.

For example, as we emerged from the 2008 financial crisis and investors regained confidence in the markets, breadth was strong and the average correlation among stocks was high, just as it was when stocks were tumbling the year before. Correlations continued to increase through the third quarter of 2010. But, with the notable exception of the sovereign debt panic of late 2011, average correlation has been declining ever since. In other words, as markets have rallied in the years since the crisis, investors have become more selective in purchasing stocks. Despite the increase in dispersion, I wouldn’t have called this a “stock-picker’s market” until recently, as correlations were still above their long-term averages.

However, the average correlation among stocks is back to its long-term average (as the chart below from our most recent outlook shows) after the best year for stocks in over 16 years. And as many investors believe stocks will post more modest returns than in 2013, stock selection is again front and center.

U.S. Equity Correlations Have Fallen


Past performance is no guarantee of future results. Source: GaveKal Research, January 7, 2014

Why does this matter? If dispersion is high, managers who exhibit a high degree of difference from their benchmarks (“active share”) may be more likely to outperform. Since all securities won’t be moving in tandem, fundamental research should be rewarded. Moreover, alternative strategies such as market neutral and long/short equity (which can extract alpha from both rising and falling stocks) may be better positioned to post strong returns.

But what about risk? Decreased correlations typically lead to lower market and portfolio volatilities as diversification increases. But tracking error (the volatility of portfolio returns relative to a benchmark) can increase. However, lower overall market volatility works to counter the adverse effect of decreased correlations on tracking error.

Hypothetical Effect on Tracking Error


While not overly complicated in theory, knowing where a portfolio stands in terms of expected volatility and tracking error isn’t something that can be easily done via intuition. Even if you believe high active share is vital to investment success (as we do at Calamos), it is important to monitor these risk levels. That’s why we track these risks over time using a variety of measures, which allows us to select stocks and industries we believe will differ significantly from a portfolio’s benchmark.

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CoCos: An Overview of the Anti-Convertible Bond

By Eli Pars

February 27, 2014

Contingent convertible bonds, or CoCos, have been getting more global press recently, including in this past Friday's Financial Times. As one of the world's oldest and largest managers of convertible strategies, we are asked about CoCos frequently. In many ways, a CoCo is the mirror image of a convertible bond. Instead of the equity upside participation and potential downside protection that can make a convertible bond so attractive, CoCos may have much higher potential downside.

A convertible bond is a corporate bond that allows the holder to convert into a fixed quantity of shares in that company's common stock. If things go well and the stock rises, the convertible bond holder participates in the rising stock price, capturing equity upside. If the stock falls, the convertible is still a bond and the holder receives a fixed coupon and par at maturity. Think of a convertible bond as a security that looks like a stock if things go well and like a bond if things go poorly.

CoCos are also hybrid securities, but the similarities to traditional convertibles pretty much end there. Banks issue CoCos to meet regulators' requirements for capital reserves, and to provide a cushion should they find themselves in a serious predicament. CoCos typically pay higher coupons than a bank's straight bonds. However, if the bank gets in trouble (think 2008), these bonds turn into equities. Think of them as anti-convertibles. I also like the term "Bizarro" convertibles, to borrow from Superman comics and a Seinfeld episode. If things go well, you just get your fixed coupon and par back at maturity. But if things go poorly, you quite likely will get little to nothing in return. After all, if a bank is in bad enough shape that its CoCos convert into equities, that bank stock you are getting may not be worth much. In many cases, it won't be worth anything at all. CoCos have become quite popular with banks in Europe; we believe they will probably end up being used in other markets as well.

These securities are not your father's (okay, older brother's) CoCos. Originally, "contingent convertible" described convertible bonds that were convertible into the equity only after the stock had risen to where the bond was well into the money. These contingent convertibles became popular in the U.S. around 2001 and had some accounting benefits for the bond issuers. The term wasn't applied to bank hybrids until several years later.

In our convertible portfolios, we're focused on upside equity participation with potential downside protection over full market cycles. Because the risk/reward profile of these bank CoCos is the opposite of the risk/reward profile we look for in convertible bonds, we are quite willing to pass them by.

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Indonesia: First In Line to Break Away from the Fragile Five?

By Nick Niziolek

February 13, 2014

As one of the emerging markets' Fragile Five, Indonesia finds itself saddled with a current account deficit, a fiscal deficit, and negative market sentiment. While it's far too early to sound the "all-clear," we're seeing indications that Indonesia is making progress toward graduating from the Fragile Five.

Year-to-date, the market has been positively surprised by economic data that Indonesia has reported. Real GDP growth for the fourth quarter came in at 5.7%, with full-year GDP reported at 5.8%. While year-over-year investment growth declined from nearly 10% in 2012 to 4.2% in 2013, consumption was more resilient than expected at 5.3% and exports grew at 7.4% year over year. Indonesia also moved from a trade deficit in the third quarter of 2013 to a surplus in the fourth quarter. Today, we saw additional data pointing to stabilization, with the current account deficit now below 2%.

IHS forecasts a slight decline of GDP growth to 5.0% in 2014, but against the backdrop of an improving current account deficit, flattish inflation, abating currency depreciation, and increasing foreign reserves, discussions about interest rate cuts have begun, albeit still not likely until the second half of 2014. Consensus expectations are that GDP growth bottoms out in 2014 before returning to more normalized 6% year-over-year levels, which would be a positive backdrop for Indonesian rupiah appreciation. Year-to-date, the rupiah is one of a select few EM currencies that have appreciated.

While the other Fragile Five countries continued to tighten in January, Indonesia has been on pause since November. Currency depreciation helped achieve a trade surplus, and the government has used other measures to support the rupiah, such as lower loan-to-deposit ratios, higher reserves, and swaps. A transition from tightening to easing without significant adverse impacts on growth and inflation would certainly be a positive for the Indonesia economy. More broadly, it could boost EM sentiment.

Indonesia holds legislative elections in April and presidential ones in July, with the presidential installation in October. Stalled reform initiatives probably won't pick up prior to October, although we believe increased discussion and optimism around these topics are likely. Indonesia recently announced a delay in its raw mineral export ban and an increase in allowed foreign direct investment in ports and airports. Both are positive steps toward much-needed larger reforms.

Indonesia is not out of the woods yet, but we are encouraged by its recent progress. Upcoming elections and potential monetary easing could provide key near-term catalysts. Indonesia represents 2.4% of the MSCI Emerging Markets Index, and we have been underweight in our portfolios. However, if we identify bottom-up opportunities, we are increasingly comfortable about moving closer to an equal weight in Indonesia.

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Field Notes: Latin America

By Nick Niziolek

February 3, 2014

Members of the Calamos Research Team recently traveled to Latin America to meet with company management teams from Brazil, Mexico, Chile, Colombia, and Peru. We came away with valuable first-hand insights about the regional macro environment and how companies are capitalizing on this landscape.

The feedback was fairly uniform, with most company management teams expecting a challenged consumer in 2014. The optimists expect a pick-up in consumer activity during the second half of 2014, and most are more positive on 2015. Despite this headwind, there are other regional secular trends and company-specific catalysts that may result in growth opportunities for select companies, and the Calamos portfolios.

Mexico. Uncertainty around the recent "sugar tax"* and the increase in the maximum tax rate to 35% make it more difficult to forecast consumer activity, but most management teams expect weakness at least through 2014. The tone is more optimistic about recent reforms, but managements are realistic that these policies will take time to implement and their benefits will likely be a 2H2014 or 2015 story. Read my earlier post on Mexico.

Our consumer exposure within Mexico continues to be around bottom-up growth opportunities with company-specific near-term catalysts. As Mexico has become a consensus overweight among global investment managers, attractive valuations have become more scarce. We are taking an opportunistic approach, and when Mexico has sold off alongside the broader emerging markets region, we have bought selectively.

We have exposure to Mexican financials, which we believe will realize more near-term benefits from reform initiatives. Select companies offer attractive bottom-up growth potential, as credit penetration increases in this country. We have also identified industrial and materials companies that feed into the energy supply chain, while further benefiting from Mexico's close ties to the improving U.S. economy.

Brazil. The consumer remains highly levered. Actual debt-service costs are likely 1000 basis points higher than what the central bank reports because popular installment loans are excluded from its calculation. While debt-service costs began to fall in the second half of 2013, the central bank has been forced to increase interest rates as inflation remains above target levels. This in turn should negatively impact debt-service costs. Economic growth has now become the Brazilian government's third most important policy outcome, behind inflation targeting and maintenance of the country's credit rating, although the government understands the need to keep growth a very close third.

Despite this dreary economic outlook, there are still opportunities. Most of the macro concerns are already priced into valuations. The Brazilian index is off nearly 50% from its 2011 peak, with currency depreciation playing a significant role.

Within the Brazilian financial sector, we believe there are many underappreciated growth companies that can benefit both from recent changes in government policies and from incremental economic improvements. Where else can you invest in emerging market banks that consistently return more than 20% on equity with loan-book growth in the low-double digits—for less than two times book value?

In recent years, private banks have faced challenges, including a crowding out by public banks that were providing credit more indiscriminately in an attempt to spur economic growth. This resulted in lost market share and slower growth for the private banks. As government has adjusted its policies in 2014 to focus more on inflation and the country's credit rating, private banks can remain selective in their underwriting policies and potentially see an improvement in growth as the lending environment becomes more rational. Despite these positive developments, valuations for the private banks remain attractive. Many global portfolio managers utilize these liquid institutions as proxies for country exposure and are significantly underweight Brazil, given its negative near-term economic outlook. We are also underweight, and while we are monitoring macro developments for a potential inflection point, we maintain some exposure through companies that also have significant near-term bottom-up catalysts that we believe could result in outperformance regardless of exactly when the economic backdrop improves.

We continue to see a strong secular growth opportunity within the Brazilian education industry. With college graduation rates nearing 20%, Brazil remains far behind other Latin American countries, such as Mexico (about 40%) and Chile (about 60%). This is due in part to Brazil's less-developed education system, with some state-run universities reporting lower acceptance rates than Ivy League institutions. Given the limited supply of college-educated workers, the unemployment rate for these grads is effectively 0%, and wage inflation is above average. This has provided a powerful tailwind for private education companies, a tailwind that strengthened when the government began providing subsidized student loans at negative real rates two years ago. Although enrollment has increased, many students are not yet aware of the program's benefits. We expect the program to provide a longer-term catalyst for companies in the education industry, with improving utilization rates in the next two years as initial classes work through their four-year degrees, as well as longer term as a higher graduation rate brings Brazil more in-line with many Latin American peers.

Colombia. We heard universal optimism about Colombia's economic potential, including predictions that Colombia will become the second "rich" Latin American country, joining Chile. Colombia continues to move up in the Heritage Foundation's Economic Freedom Index—the result of recent improvements in trade, business, and fiscal policies. Colombia has moved into the "mostly free" category, ranking behind only Chile within the region.

The opening of peace negotiations with the FARC insurgency has contributed to optimism about further improvements in national security, although only two of five agenda points have been agreed to thus far. Colombia also has strong ties to the U.S., the destination for nearly 35% of its total exports. Better U.S. economic growth prospects could have a positive knock-on effect for Colombia.

To date, our exposure to Colombia has been primarily indirect, as many of our Brazilian, Mexican, and Peruvian holdings generate revenues from this country. However, we are researching several new growth opportunities that may warrant an allocation of capital later this year.

While economic policies and inflationary headwinds create near-term headwinds for Latin American companies, we believe we are getting closer to an inflection point for the region. Meanwhile, our team has identified growth companies we believe can outperform regardless of the economic environment. Drawing upon the insights we've taken from our recent meetings with strong Latin American corporate management teams, we are comfortable allocating capital to select bottom-up growth opportunities. As the economic situation improves, we believe these companies are positioned to benefit from those tailwinds as well.

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Casting Light on China's Shadow Banking System

By Nick Niziolek

January 29, 2014

"China's shadow banking system," the name alone sounds mysterious and uncertain. In recent weeks, this complex system of wealth management and trust products has struck fear into investors, due to apprehension about a potential default. As we follow the ongoing developments in shadow banking, we ourselves are concerned. However, over the long-term we are optimistic for China's plans to further liberalize interest rates and promote financial disintermediation.

During our trip to Asia last fall, we met with the major players within the Chinese banking system, including those with expert understanding of how the banks' off-balance-sheet products work, the magnitude of the market, and the fallout that changes to industry dynamics could have on the larger financial system. Our discussions confirmed the complexity of this financial system. There are varied estimates on size and potential impact, but there’s general agreement that the system has grown rapidly. J.P. Morgan estimates that the shadow banking system doubled in size between 2010 and 2012, equivalent to nearly 70% of GDP, and that it may have grown an additional 30% in 2013.

The shadow banking system broadly refers to an estimated $7.5T* in credit intermediation outside the regular banking system. This Chinese shadow banking system's products differ from those offered by banks in the United States and United Kingdom in that many of the products are directly controlled by the banks and are merely an alternative means to extend credit to their other customers. Few are market traded and the counterparties are non-financial corporate borrowers and investors, as well as retail investors. Trust loans at an estimated $1.5T* represents a non-bank extension of credit (that is, off the banks' balance sheets) in the Chinese shadow banking system and have received increased attention over the past couple years given their outsized growth and increased reports of defaults.

In response to customer demands for higher yields, $1.5T of trust products have been created. The banks have benefited significantly as these products allow them to extend credit outside of the banking system, and thus above the government's stated targets for credit growth. The largest borrowers of the loans underpinning the trusts are local governments, property developers, and corporations looking to fund long-term investments.

The loans in the trusts typically have terms from 18 to 36 months and yields in the 9% to 13% range. Despite these high yields, Chinese investors largely perceive these trusts to be "risk-free" given their implied backing from the banks and government. This system works as long as investors are willing to reinvest every 18 to 36 months or new investors come into the market.

China's government is committed to slowing credit growth and allowing markets to price credit risk through the removal of implied bank and government guarantees. However, the government also clearly recognizes that these longer-term objectives must be balanced with more immediate concerns—including the potential that defaults could spiral out of control and lead to a liquidity crisis and a seizing up of the financial system. This would not be unlike what happened when U.S. banks stepped away from the auction-rate preferred market, leaving investors with illiquid securities. This was the first indication that the financial system was starting to seize up.

Shadow banking is a by-product of innovation within a heavily regulated, traditional banking system that is struggling to satisfy the country's credit and liquidity demands, while providing attractive real interest rates to households and business depositors. The healthy direction for the shadow-banking system would be to improve transparency, appropriately price risks and increase monitoring and control of the market, in parallel to the interest-rate liberalization of the banking system. Unwinding this without fueling systemic risk will be complex because credit is not being priced accurately and nonperforming loans are shuffled around the financial system.

While we have seen more than 50 trust defaults over the past few years, they have been relatively small and easily contained. However, the most recent threat of default was a different matter, given its size ($500M) and initial indications from the Chinese Central Bank that it would not support this product in default. Global markets participants feared that if Chinese investors began to view these trust products as entailed high risk, this changed perception could spiral quickly, causing China's trust and wealth management industries to seize up, with ensuing fallout that could roil the global financial system to the extreme. However, after Asian markets closed on Monday, an unknown "investor" stepped in to purchase the defaulted trust from its current holders. It is widely hypothesized that the unnamed investor is connected in some way to the central bank.

Emerging markets have received a reprieve and a systemic risk has been temporarily taken off the table. Still, this should serve as a wake-up call for those investors who are focusing on the returns in emerging markets without giving equal—or greater—consideration to the risks. We have always been diligent in our monitoring of events and potential consequences within the Chinese banking system, and this certainly won't change.

China is clearly in a period of transition. The government wants the market to set prices and allocate capital, which would help prevent excess leverage in unproductive products. What is important to us as investors is how China navigates this transition. It is our hope that the government sends the right signals, while not disrupting the flow of liquidity within its financial system. The unknown investor that came to the rescue illustrates how the government is trying to balance their nearer-term and longer-term priorities, in this case—communicating the risks of these products without allowing a default to happen.

We expect we will discuss Chinese trusts again this year, as other high-profile trust products will likely default. But, we also expect that our team will be identifying companies positioned to benefit from the longer-term financial disintermediation trends. While we remain underweight to Chinese banks, we are finding new opportunities within the private banking system as e-commerce companies begin offering online banking services and the brokerage and insurance industries benefit from the opening of the world's second largest economy.

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The EM Sell-Off Creates Opportunities for the Active Manager

By John P. Calamos Sr.

January 28, 2014

Currency fears in Turkey, India, South Africa and Argentina, and escalating political uncertainty in the Ukraine are roiling the emerging markets. Investors are responding fearfully, and that fear is causing volatility, leading to more fear, and so on. This downturn may still have some distance to go.

Fear is an increase in systemic risk. It is something that needs to be monitored. At this point, we are of course concerned about the EMs' slide, but we still believe there are many reasons to invest in EMs. It's about being selective.

Although the real problems are confined to just a few countries, the sell-off has cascaded across the EMs. This isn't surprising: market participants often (over)react broadly and emotionally in response to bad news.

As we stated in our most recent economic outlook, "2014: Year of the Fundamental Investor," we expect the nearer-term prospects of emerging markets to be uneven. This creates opportunities for longer-term investors. As the dust settles (which might take a while yet), we expect investors to be more discriminating. This calmer mindset will likely rekindle interest in countries with stronger fundamentals—that is, those that aren't struggling with weak currencies, high current account deficits and fiscal deficits, or elevated levels of political uncertainty.

In fact, in the midst of this acute volatility, we continue to be select buyers of fundamentally strong companies in countries that are currently in a better position for growth. Investors who lump countries like Mexico and the Philippines in with the more troubled ones (India, Brazil) could very well be missing out. As our co-PM Nick Niziolek wrote in his recent posts , these are both countries where positive government reforms are providing an improving backdrop for private sector growth, foreign direct investment and continued economic growth. We also continue to like opportunities in more-export driven economies like Taiwan, which we believe can benefit from the developed markets' recovery.

And what about China? Overall, we're still constructive. The country is in the midst of a far-reaching shift from a manufacturing-based economy dominated by state-owned enterprises to a consumption-driven economy with greater private sector participation. This is a transition that will take time and there will be volatility (inherent in emerging markets), but the Chinese government has many resources at its disposal. The expansion of free markets in China could provide a monumental tailwind to global growth.

Finally, the secular growth themes in the emerging markets are as powerful today as they were before the sell-off. The rise of the global middle class consumer is a mega trend, and for investors who are wary of increasing direct emerging market exposure, developed market companies that provide goods and services to the emerging market consumer continue to be a compelling alternative, in my view.

As always, it pays to be selective. Emerging markets will continue to be volatile, but therein lies the opportunity for the long-term active investor.

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Perspectives on the Philippines

By Nick Niziolek

January 14, 2014

Those familiar with Calamos know that our approach to emerging markets (EM)is active and focused on countries that are moving in a favorable direction in regard to economic freedoms. In my last post, I wrote about our team's constructive outlook on Mexico, where investor optimism about a broad package of reforms has helped drive an equity rally. Our longer-term outlook on the Philippines is also positive. Among the favorable trends, President Aquino has reduced corruption during the first four years of his term, which has benefited infrastructure improvement efforts by reducing funding leakage and fostering a more attractive investment environment. This is especially important for the Philippines as foreign direct investment is presently the lowest in the region.

The Philippines market finished 2013 with a positive return, but it was a volatile year as the index traded off nearly 20% as EMs sold off in May and June on taper concerns. After recovering more than half of these losses during the outset of the second half of 2013, the market experienced another downward leg following Typhoon Haiyan in early November. The humanitarian impact has been severe, and we expect food inflation likely to remain elevated for several quarters and GDP growth to be temporarily impaired.

However, we expect the economic impact to be short-lived. Also, many Philippine-listed equities tied more closely to Manila and Cebu, which escaped the brunt of the typhoon's impact. October remittances were reported at a record $2.06 billion, with the Central Bank expecting surging November and December remittances as friends and family providing support following the typhoon. This is positive for both consumption and recovery following this disaster. Moreover, demographics provide a tailwind to the country's economic growth prospects. With a well-educated population that includes many English speakers, the business process outsourcing industry in the Philippines has grown rapidly, and is now larger than that of India's.

Overseas Filipino Workers Send Record Amounts Home

Overseas Filipino Workers Send Record Amounts Home

Source: CLSA, Philippine Market, December 30, 2013, Alfred Dy.

When we visited Manila in the third quarter of 2013, business leaders voiced consistent concerns about the need for infrastructure improvements to sustain the country's economic growth; among them, they felt that the momentum that President Aquino had realized early in his six-year term was waning. In recent weeks, we've seen developments that point to an increased commitment to infrastructure spending. In particular, there's been a ramp-up in public-private partnership (PPP) grant award activity. PPPs are business ventures between a public sector and private sector entity. PPPs represent one of the ways that a government can give a larger role to private businesses, to mutual benefit. In the case of the Philippines, the PPP projects in the pipeline run the gamut from building better roads and schools, modernizing of health care facilities and improving airports and power supply. These projects bring both short-term benefits (jobs) as well as longer-term ones (promoting education, commerce and longevity).

The Philippines government has set its sights on awarding 15 PPP projects before President Aquino's term ends in 2016, versus five awarded through 2013. From a dollar-perspective, these projects could amount to more than $4B in infrastructure investments, or four times the $1B already awarded. All these shovels in the ground could provide significant stimulus for the economy as well as provide the infrastructure necessary for sustainable growth.

Significant Ramp-up: Infrastructure as a % of GDP

Significant Ramp-up:  Infrastructure as a % of GDP

Source: CLSA, Philippine Market, December 30, 2013, Alfred Dy.

We maintain our positive view on the Philippines relative to other EM opportunities, but acknowledge it is not without risks. While we are optimistic that we will see progress from PPP infrastructure projects in 2014, we will continue to closely monitor these developments as execution is critical. In particular, we are watching developments related to a water tariff issue, where the government has sought to change terms mid-stream. The positive news is that similar cases have held up in third-party arbitration.

We have used the market pullback to add to consumer opportunities that may benefit from a short-term increase in inflation as well as financials that may benefit from increased investment related to PPP projects and recovery efforts. We're also following opportunities where valuations are becoming more reasonable, both in companies that we believe can directly benefit from increased infrastructure investments as well as those that are positioned to receive ancillary benefits.

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Welcome to the Calamos Blog

By John P. Calamos Sr.

May 31, 2013

On behalf of the Calamos Investments, I would like to welcome you to our new blog. The goal of this blog is to enhance our ongoing dialog with you, and we look forward to sharing our perspectives on investing, the economy and the global financial markets. Reflecting the depth of our organization, in the months to come, you’ll find posts from a number of our investment professionals, as well as from me and Global Co-Chief Investment Officer Gary Black. Please feel free to submit your comments or questions, which we will seek to address in future posts.

We hope that you enjoy the blog and visit often.

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Past performance is no guarantee of future results.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Materials contained on this page are historical and as such Calamos Advisors LLC undertakes no obligation to update.

Investing involves risk, including potential loss of principal. Diversification does not insure against market loss. As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities.

In addition to market risk, there are certain other risks associated with an investment in a convertible bond, such as default risk, the risk that the company issuing debt securities will be unable to repay principal and interest, and interest rate risk, the risk that the security may decrease in value if interest rates increase.

Investments in lower-rated(high yield) securities present greater risks than investments in higher-rated securities. This is because there is a greater likelihood that the company issuing the lower-rated securities may default on income and principal payments.

As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility, and difficulty obtaining information. Investments in emerging markets may present additional risk due to the potential for greater economic and political instability in less developed countries.

Important Information

S&P 500 Index—Is generally considered representative of the U.S. stock market.

Merrill Lynch All US Convertible Index (VXA0)-Is comprised of approximately 700 issues of only convertible bonds and preferreds of all qualities.

Unmanaged index returns assume reinvestment of any and all distributions and, unlike fund returns, do not reflect fees, expenses or sales charges. Investors cannot invest directly in an index.


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