Calamos Investments - Investment Team Blog


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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China Market Downturn Unlikely to Spread Globally

By Gary Black

July 29, 2015

It’s been said that corrections end with good news as bulls find new reasons to buy and that crashes end with bad news when the last bull throws in the towel.

We view the current U.S. market downturn as a correction. We believe the China market collapse will not derail global growth, with current market volatility providing opportunities to buy growth equities, which remain compelling versus non-growth equities.

In our view, China A shares remain generally overvalued but will find a natural bottom once the Chinese government withdraws its broad market support measures to prevent moral hazard. Over the past five years, the Shanghai Composite Index has traded at an average of 10x–11x forward earnings (equivalent to a 9%–10% earnings yield) versus a yield of 3.5%–4.0% for Chinese 10-year government bonds. This translates to a roughly 600bp equity risk premium needed since 2010 to hold equities versus bonds. At its mid-June peak, the Shanghai Composite traded at 21x forward earnings, which has since dropped to 16x forward earnings (see Figure 1). This translates to just a 300bp earnings yield advantage of equities over bonds, or roughly one-half of what was needed over the past five years.

Figure 1. The P/E of Shanghai Composite Has Retreated from Its Recent High
Shanghai Stock Exchange Index, Best P/E Ratio, July 2010 – July 2015

Source: Bloomberg. Data shown using the “best P/E” function which calculates 2 quarters forward, 2 quarters back.

Source: Bloomberg. Data shown using the “best P/E” function which calculates 2 quarters forward, 2 quarters back.

Put differently, since early 2014, the forward P/E on the Shanghai Composite has doubled from 8x to its current level of 16x. Meanwhile, forward earnings estimates have increased by just 20%, while China consumer and business confidence metrics have fallen (see Figure 2), along with GDP growth estimates. With most of the 75% appreciation in the Shanghai Composite over the past year due to multiple expansion (and not changes in earnings growth or GDP growth), China valuations may have more room to fall.

That said, we have high confidence that the Chinese government can put to work its deep arsenal of fiscal and monetary tools to keep official GDP growth near its target of 7%. From a portfolio standpoint, we remain highly selective, and continue to find attractive China opportunities on the Hong Kong exchange, which trade at lower multiples than the Shanghai or Shenzhen exchanges.

Figure 2. China Consumer and Business Confidence Has Fallen

Figure 2. China Consumer and Business Confidence Has Fallen

Sources: Cornerstone China Enterprise Survey, July 13, 2015 (business confidence), Cornerstone China Enterprise Survey, using data from Westpac MNI, July 13, 2015. (consumer confidence).

What is the potential good news that could pull the U.S. market out of its current downturn? First, the Federal Reserve will meet this week to assess U.S. economic activity. The Fed has already set the table for a lift-off in short-term rates later this year, and we expect it to do little to change this perception. The absence of any additional hawkish tone could be positive for the markets.

Second, the level of M&A volumes and share buybacks continue to increase, given the persistently wide spread between forward earnings yields and corporate borrowing costs. This spread remains the ultimate market put option, with falling stock prices quickly greeted by corporate buyers with cash or excess borrowing capacity eager to snare something cheap. With a normalized 3% yield for the 10-year Treasury, a forward 2015 P/E multiple of 16.0x for the S&P 500 Index ( equivalent to a 6.3% earnings yield) and 2%-2.5% GDP growth for the U.S. during the second half of the year, it is difficult for us to see the market remaining in correction mode much longer.

Lastly, we continue to be struck by the continuing narrow spread between growth and value stocks. The current premium of 20% is about half its historic premium of 37% (Figure 3). With deflationary forces still clearly at work—oil, copper, iron ore are all hitting fresh 52-week lows—secular growth companies trading at fair valuations seem very attractive following the recent pullback.

Figure 3. One-Year Forward P/E: Russell 1000 Growth Index relative to Russell 1000 Value Index
December 31, 1989 to June 30, 2015

Figure 3. One-Year Forward P/E: Russell 1000 Growth Index relative to Russell 1000 Value Index

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

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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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Greek Contagion Fears Likely Overblown

By Gary Black

June 30, 2015

Although the Greek debt drama has veered off script over the past few days, we believe investors have overdiscounted the impact of Greece defaulting on the €1.6 billion loan that was to be repaid to the IMF by midnight tonight. The Greek government has signaled it will not make this payment, a decision which could lead to Greece exiting the euro zone. Equity markets have sold off sharply, as investors worry that the bank runs and general liquidity freeze in Greece could carry across to other European countries with similarly high debt-to-GDP ratios—namely, Portugal, Italy, and Spain.

We expect volatility will stay high in the run up to the Greek austerity referendum scheduled for July 5. A poll by the Greek newspaper Alco suggested that 57% of Greeks are likely to vote in favor of austerity. A yes vote on July 5 would likely pave the way for a new leadership more amenable to demands of creditors. A no vote does not mean an automatic Greek exit from the euro zone, as there is no formal mechanism for such a departure. And a default tonight on the €1.6 billion payment to the IMF does not mean that the ECB will withdraw its €89 billion Emergency Liquidity Assistance (ELA) lifeline.

We believe a deal between Greece and the rest of the EU can be struck, allowing the banks to reopen and the now-frozen financial system to thaw. Even if a deal cannot be reached immediately, history has shown that Greece’s decision to default on its IMF debt may not unleash a Europe contagion, with Argentina’s default on its IMF debt in 2001 serving as the most recent example.

Importantly, the European Central Bank remains committed to “doing whatever it takes,” to stabilize the European financial system, including flooding it with its €1 trillion monetary war chest, using all instruments available, including quantitative easing (QE), outright monetary transactions (OMT), and unconditional long-term refinancing operations (LTROs). Should they occur, bank runs in Portugal, Spain, or Italy are likely to be dealt with forcefully and expeditiously, in a way that makes clear Greece’s issues can be contained. While risk premia on European sovereign paper may rise near term, reflecting the higher uncertainty associated with a Greek default, sovereign rates are likely to head lower longer term once the Greece situation plays out and the ECB and other central banks unleash QE and other monetary tools to calm global investors.

We remain bullish on global equities despite the expected near-term volatility, as we believe the Greek situation will be resolved in a manner that the markets will view constructively. Valuations in the U.S. remain attractive by historic standards, with the S&P 500’s 2016 P/E of 15.8x equating to an earnings yield of 6.3%, or a roughly +400 basis point spread over U.S. 10-year Treasury yields (Figure 1). By this measure, equity valuations rank in their cheapest quartile over the past 60 years.

Figure 1. S&P 500 Differential of Trailing Earnings Yields and 10-Yr Treasury Bond Yields

Figure 1. S&P 500 Differential of Trailing Earnings Yields and 10-Yr Treasury Bond Yields

Source: Standard & Poor’s, Corporate Reports, Empirical Research Partners Analysis. Recessions Indicated by shaded areas.

We continue to anticipate global GDP growth in the 2.0-2.5% range for 2015, led by the U.S. and fueled by global monetary accommodation. In the U.S., we expect 5-6% corporate earnings growth for 2016, with record buybacks and M&A continuing, driven by the persistently huge spreads between earnings yields and borrowing costs, which effectively put a floor on equity valuations. With Treasury yields at even 3%, which would imply a normalized S&P 500 multiple of 17.0-17.5x on 2016 S&P 500 earnings of $130 per share, we may well see the S&P 500 reach a new record of 2250 by this time next year.

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Why Rising Interest Rates Aren’t Necessarily Bad for Stocks

By Gary Black

June 4, 2015

When interest rates rise, it’s not necessarily bad for stocks, since a rising rate environment is usually consistent with better economic growth and in turn, better corporate earnings growth. Simplistically, if the rise in rates is offset by the same increase in corporate earnings growth, multiples on stocks shouldn’t fall:

Theoretical S&P 500 Index Multiple = 1 / (ke - g)


ke = equity return required by the market, equal to the risk-free rate plus the equity risk premium required to hold equities versus bonds

g = the long-term growth rate of S&P 500 earnings

Looking back over the past 60 years, S&P 500 earnings yields (1 / P/E) have typically traded at a +130 basis point premium to 10-year Treasury rates. Looking forward, the current spread between the 2016 S&P 500 earnings yield and the 10-year Treasury rate is roughly +380 basis points (2016 EPS is forecasted at $130, 2016 P/E = 16.2x, 2016 E/P = 6.1% versus 10-year Treasury yields of 2.3% today). So if history repeats, 10-year Treasury yields would have to rise to at least 4.8% before we start worrying that stocks are too expensive relative to Treasury bonds, using 2016 earnings as the relevant earnings metric (see Figure 1).

Figure 1. S&P 500 Differential of Trailing Earnings Yields and 10-Yr Treasury Bond Yields
1950 through March 2015
Figure 1. S&P 500 Differential of Trailing Earnings Yields and 10-Yr Treasury Bond Yields

Source: Standard & Poor’s, Corporate Reports, Empirical Research Partners Analysis Recessions Indicated by shaded areas.

That said, if recession risks increase, our 2016 EPS forecast of $130 for S&P 500 earnings would come down, and stocks would look more expensive. We currently believe the odds of a U.S. recession are low, given strong recent job growth, manufacturing activity, consumer confidence, and a still highly accommodative Fed.

Long-Tailed Growth Stocks Could Face Multiple Compression
When the market discounts higher interest rates, what has tended to happen in the short term is that longer-tailed, higher P/E growth stocks tend to face multiple compression versus non-growth stocks. This makes sense intuitively, since for a given long-term earnings growth differential between two companies, one a high-growth name and the other a slower-growth name, the relative multiple between the two will compress for a given rise in interest rates, assuming no change in the underlying growth rates of the two companies as interest rates rise. As long-term interest rates increase, this growth differential is worth less (the relative P/E compresses); when interest rates fall, the growth differential is worth more (the relative P/E expands).

As the market starts to discount higher long-term interest rates and as global interest rates start to move higher driven by the long-awaited rebound in economic activity in Europe and Japan, we would expect relative multiples of long-tailed growth stocks selling at high multiples to come in a bit. Even so, we continue to believe we are in a growth regime similar to 1995–1999 and 2004–2007 where growth stocks should significantly outperform value stocks, given valuation spreads between growth and value stocks remain very narrow by historical standards (see Figure 2).

Figure 2. The Case for Growth: Attractive Valuations
1-Year Forward P/E: Russell 1000 Growth Index Relative to Russell 1000 Value Index
December 31, 1989 to March 31, 2015 Figure 2. The Case for Growth: Attractive Valuations

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

Our point: one must be careful about what one pays for high-growth, longer-tail names that may be revalued on a relative basis if we get a sustained rise in long-term rates that is not accompanied by a commensurate acceleration in earnings growth.

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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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Forget Interest Rates Rising Anytime Soon

By Gary Black

April 6, 2015

With only 126,000 new jobs added to the U.S. economy in March (Figure 1), the most recent jobs report was much softer than most had expected. Companies tempered hiring as harsh winter weather and a slowdown in energy-related capital investment combined to curtail economic growth. The more cautious U.S. economic outlook we shared in our post last week looks accurate, and although the jobs report increases the potential that the economy is stalling here, GDP growth is unlikely to turn negative.

Figure 1. Lackluster Job Growth Should Delay Fed Action on Short-Term Interest Rates
Change in total U.S. nonfarm payroll employment
Figure 1. Lackluster Job Growth Should Delay Fed Action on Short-Term Interest Rates

Source: Bureau of Labor Statistics

Given our view that the first U.S. short-term interest rate hike will be pushed out, we expect the euro to stabilize versus the dollar. Similarly, energy and commodity prices could drift higher from here, following the inverse relationship between the dollar and commodities we’ve seen over the past year (Figure 2). That said, we think it’s premature to move back into energy, as global demand remains weak relative to a still-increasing level of supply.

Figure 2. U.S. Dollar and Commodities Remain Inversely Correlated
April 2010 – March 2015
Figure 2. U.S. Dollar and Commodities Remain Inversely Correlated

Sources: Federal Reserve Bank of St. Louis and Bloomberg

We remain bullish on equities and particularly growth equities. With the Fed likely to hold off on raising short-term rates until later this year, a stabilizing dollar and bottoming energy prices, the decline in earnings estimates we’ve seen over the past few weeks should end soon. Against that backdrop, we still anticipate 2.0–2.5% GDP growth in the U.S. (but only 1% in 1Q), and a resumption of 6–8% S&P 500 earnings growth in 2016. With earnings yields still far in excess of long term borrowing costs, record M&A and buyback activity will likely continue, putting a floor on the stock market.

In this environment, we are favoring a balance of secular and cyclical growth, with overweights in technology, health care and consumer discretionary, and underweights in energy, materials and commodities.

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Why Fed Patience on Rate Hikes Is Likely to Continue

By John P. Calamos, Sr. and Gary Black

April 1, 2015

As the first quarter comes to a close, we believe:

  1. Lackluster economic data, low inflation, and a strong dollar could prompt the Federal Reserve to delay increasing short-term interest rates until late 2015, providing a tailwind for equities over the next few months. Bad economic news (provided it’s not too bad) will continue to be good news for stocks.
  2. That said, investors should be prepared for increased market volatility in the wake of this Friday’s jobs report and first quarter earnings reports, which kick off next week.
  3. As the ECB’s quantitative easing takes hold, long-term U.S. yields will follow euro zone rates downward.
  4. Growth equities and convertibles remain attractive. Growth equities have performed well when long-term rates have been low, and convertible securities can benefit in an environment of slow growth and slowly rising interest rates.

While we don’t believe we are in any danger of a recession, we’ve seen mounting indications that U.S. economic expansion is slowing, including weakness in durable goods orders, personal spending, housing starts, and exports. Although unemployment dropped to 5.5% in February and we’ve seen 12 consecutive months of job growth in excess of 200,000 (a record last achieved in the mid-1990s), these gains have not been accompanied by commensurate improvements in productivity or wage growth. As global energy supply continues to outpace demand, we would not be surprised if oil prices slide further (potentially to $40 a barrel). Although we believe prices can stabilize over the next few months as drilling contracts expire and capital spending cuts are implemented, certain industries and regions tied to the energy sector will still feel near-term economic pain. And more broadly across sectors, we expect corporate earnings growth will slow as a strong dollar makes overseas sales less profitable for U.S. multinationals.

We believe this backdrop will compel the Fed to take a cautious approach. The Fed can also bide its time because inflation is not a problem. At 1.7%, the core Consumer Price Index is below the Fed’s target of 2.0%, while Chair Yellen’s preferred inflation measure, the core Personal Consumption Expenditures Deflator, is even lower at 1.4%.

Low Inflation and Sluggish Economic Growth Suggest Fed Will Remain Patient About Raising Short-Term Rates
Low Inflation and Sluggish Economic Growth Suggest Fed Will Remain Patient About Raising Short-Term Rates

Sources: Bureau of Labor Statistics and Federal Reserve Bank of St. Louis. Recessions indicated by shaded areas.

Despite our increased caution about the economy, we see continued opportunities for investors. Although a strong dollar may clip corporate profit growth, we see continued opportunities in equities, where earnings yields remain highly attractive relative to both U.S. Treasury bonds and inflation. Companies are continuing to take advantage of low corporate borrowing costs and high earnings yields, and merger-and-acquisition and share buyback activity remains robust. As we have noted in past posts, this activity can provide a floor to the equity markets during periods of volatility. Growth stocks remain attractively priced relative to value stocks, and we believe that growth stocks should continue to benefit as earnings growth slows but remains solidly positive, corporate earnings continue to expand, and long-term interest rates remain low.

We also maintain a constructive outlook on convertible securities. Because convertibles offer equity participation with potential downside protection, they can be particularly advantageous during volatile but rising stock markets. They can also provide a hedge against an eventual rise in interest rates, due to their equity characteristics.

For years, investors have been preoccupied about when the Fed will end its accommodative policy. While we cannot rule out the possibility of a policy misstep, we believe it is far more likely that when the Fed raises rates, it will be because the U.S. economy no longer needs the highly accommodative policy of the past several years. And that would be good news. In the meantime, we’ll be watching for Friday’s jobs report and the first batch of 1Q corporate earnings announcements, as well as preliminary first quarter GDP data in late April.

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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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Stocks Likely to Tread Water Through Year End Before Moving Higher in 2015

By Gary Black

December 10, 2014

We see continued upside for U.S. stocks in 2015 but believe the market will struggle through year end, with several factors contributing to near-term volatility:

    1. A decline in oil prices portending global economic weakness, as in 2000 and 2009 (Figure 1)
    2. Anticipation that the Fed will remove its “considerable time” language from its statements about how long it will forestall interest rate increases
    3. The absence of consensus between the European Central Bank (ECB) and German finance ministers about whether the ECB can move forward with true quantitative easing (that is, buying unsecured debt of EU member nations)
    4. Growing concerns about the bubble-like valuations of some U.S. “momentum” stocks

Although we view the recent fall in oil prices as indicative of global slowdown, the worst of the decline is likely behind us. We don’t believe another recession is looming. Rather, we still believe we are in the fifth or sixth inning of this economic cycle, where global GDP growth of 2%–3% for 2015 is balanced with low inflationary pressures. We expect U.S. corporate earnings growth in the 5%–6% range for 2015.

As investors grow accustomed to the idea of U.S. short-term rates rising slowly against a backdrop of improving economic growth, we believe the stock market will move to new highs in 2015. Our 12-month price target for the S&P 500 Index is 2250, which would translate into a 13% equity return, including dividends.

We maintain the view that we are entering a growth regime similar to 1996–1999. As we have discussed in the past, there are several factors that have historically been indicative of a growth regime, most of which have fallen into place. They include a flattening yield curve, narrow but widening valuation spreads, and a declining percent of companies showing margin improvements. The yield of the 10-year Treasury bond is likely to stay in the 2.0%–2.5% range for 2015, given economic weakness outside the U.S., a strong U.S. dollar and weak oil prices.

While there are some companies with bubble-like valuations, equity valuations appear reasonable overall, and accretive M&A transactions and highly accretive share buybacks can provide ongoing support to the equity market. In this environment, we continue to identify what we believe are great franchises at attractive valuations. We remain overweight technology, consumer discretionary, health care, and financials, and underweight consumer staples, utilities, energy, and materials.

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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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October’s Correction: Likely a Pause that Refreshes

By Gary Black

October 22, 2014

Last week, we showed that the S&P 500 Index had fallen through its 200-day moving average just five times since the bull market began in March of 2009:

  Decline from peak Key factors
July 2010 -16.0% Flash Crash (May 6), euro zone debt crisis
October 2011 -19.4% Downgrade of U.S. government debt, euro zone debt crisis
May 2012 -9.9% Anxiety about Spain and Greece, slowing U.S. economy
November 2012 -7.7% Fiscal cliff looms
October 2014 -7.4% Europe deflation concerns, Ebola

Past performance is no guarantee of future results. Source: Bloomberg.

Past performance is no guarantee of future results. Source: Bloomberg.

We posed the question as to whether the current pullback is more like the July 2010 and October 2011 corrections, or more similar to what we saw during the two corrections of 2012. In 2010 and 2011, the pullbacks led to 15%-20% declines that lasted three to four months before reversing. In 2012, the pullbacks lasted just weeks, acting as pauses that ultimately refreshed the bull market.

We continue to believe that this is more like the 2012 pauses, and consistent with those brief pullbacks, the market has already pushed back through its 200-day moving average amid indications that:

    1. The ECB, having already embarked on “QE light” (covered bond buying), will move on to true QE to stimulate growth, German objections notwithstanding.
    2. Ebola concerns should ease as the 21-day incubation periods for individuals in the U.S. roll off, without significant additional cases outside West Africa.
    3. Fed officials have signaled they are open to pushing back expected interest rate increases to 2016 and even to providing additional QE if the global economy weakens.
    4. September quarterly earnings have been generally positive to date, and with quiet periods now ending, share buybacks can resume in earnest, with earnings yields (E/P ratios) significantly above corporate borrowing costs, which makes buybacks very accretive.

Against this backdrop and given that U.S. stock valuations are at highly attractive levels versus the 10-year U.S. Treasury yield as well as inflation, we continue to believe that this bull market has more room to run, led by technology, health care, financials and consumer discretionary.

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Technicals Bearish, But Fundamentals Haven’t Changed

By Gary Black

October 14, 2014

Much has been made about the S&P 500 Index breaking through its 200-day moving average yesterday. This appears to have happened five times now (including yesterday) since this bull market began in March 2009. The first two times, in May 2010 and August 2011, the S&P 500 corrected -16.0% and -19.4%, respectively, before reversing and going to new highs. The last two times, May 2012 and November 2012, the S&P 500 dropped by more moderate amounts of -9.9% and -7.7%, respectively. Through yesterday’s close, the S&P 500 is now down -6.8% from its peak.

What worries me more than the magnitude of the current correction is its similarities to the August 2011 decline. Since 2011, we’ve had a series of higher lows—until last Friday, when the S&P 500 finished at 1906, slightly below its previous higher low of 1910 from August. With yesterday’s S&P 500 close of 1875, the three-year string of higher lows has been broken, as the chart below shows.

S&P 500 Breaks Technical Barrier in the Face of EU Growth Concerns and Ebola Fears
October 14, 2009-October 13, 2014

Past performance is no guarantee of future results. Source: Bloomberg.

I continue to believe the very public fight between ECB President Mario Draghi and Deutsche Bundesbank President Jens Weidmann about the ECB’s proposed €1 trillion quantitative easing program leaves the ECB hamstrung, creating huge uncertainty about whether Europe can avoid recession. This uncertainty and news of the first two Ebola cases transmitted outside of Africa have given investors a real case of the jitters. Both concerns need to be overcome for the bull market to resume its five-year run. I believe this week’s earnings announcements from key bellwethers can relieve some pressure, but it sure would be nice to see Draghi and Weidmann holding hands and singing “Kumbaya.”

While we are concerned by the breakdown in technicals, we believe not much has changed on the fundamental side. We believe the equity markets will shrug off these renewed growth concerns and move to new highs. We are still looking for 3%+ GDP growth in the second half of 2014 and 2015, inflation remains virtually non-existent, and the plunge in oil prices gives central banks more room to maneuver. Corporate profits are likely to be 6% to 7% in 2015, although the strong dollar could clip that by a point or two. As I’ve discussed in past posts, M&A and buybacks continue to put a floor on this market. Any sharp drop in stock prices is likely to precipitate more deals and more buybacks. U.S. equity valuations remain in their cheapest quartile over the past 65 years, with the S&P multiple now at 15.1x (6.6% earnings yield) and the 10-year Treasury yielding 2.2%.

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5% Corrections Have Been Normal in this Bull Market

By Gary Black

October 10, 2014

Yesterday’s S&P 500 close of 1928 marked a 4% correction since the index peaked at 2011 on September 18, 2014.

Let’s keep this in perspective: If the market falls another 1% to 1910, it would mark the fifteenth correction of 5% or more since this bull market began in March of 2009. On average, there have been two 5%+ corrections per year since the bull market began in 2009. The most recent was the 5.6% correction in January, which also resulted from concerns about slowing global economic growth.

Past performance is no guarantee of future results. Source: Bloomberg.

This correction feels no different than others: We’ve had a spike in volatility to around 19 off of July’s record low of 11 (as measured by the VIX) as the market has gyrated from worrying about too much growth leading to an early Fed rate hike to worrying about too little growth as European Central Bank President Mario Draghi and German finance officials disagree about the efficacy of quantitative easing.

In the end, we believe this correction and spike in volatility will end when investors conclude the upward trajectory of corporate earnings will continue. With expected S&P 500 2015 earnings growth of 6%, the S&P 500 could earn $124 in 2015, which implies a 15.5x P/E multiple, or a 6.4% earnings yield. Relative to today’s 2.3% 10-year Treasury yield, equities remain in the cheapest quartile of valuation relative to bonds over the past 60 years. Furthermore, corporate buybacks and M&A—which remain at their highest levels since 2007—put a floor on the equity market. If stocks fall further, we believe corporations awash in cash and able to borrow at some of the lowest rates in decades will continue to buy either their own or someone else’s stock. For most companies, both actions are highly accretive and will likely continue as long as borrowing costs remain low and/or earnings yields stay high.

We believe the 3Q earnings season, which moves into full swing next week, combined with greater unity by European officials on how to jump start economic growth, and additional soothing comments from our own Fed about keeping short-term rates low for a considerable time, should allow this correction to dissipate without incident, propelling the five-and-a-half year bull market to new highs.

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Why We Believe the Market Will Go to New Highs

By Gary Black

October 3, 2014

Today’s +248K jobs growth number and the August revision to +181K suggest recent worries that the U.S. economy was falling backward were misplaced. Over the past two weeks, the 10-year Treasury yield had fallen from 2.6% to 2.4% and the S&P 500 Index lost roughly 3% on fears about slowing global growth. But the combination of today’s strong U.S. employment data, indications of dissipating Hong Kong unrest, and no new Ebola cases put many of those no-growth fears to rest.

We can’t help but be bullish: In our view, U.S. GDP growth for the second half of 2014 continues to run at 3%+; 2015 corporate profit growth is likely to be 6% to 7% with S&P 500 earnings expected to reach $125; global monetary conditions remain extremely accommodative; inflation remains almost non-existent; and U.S. equity valuations remain in the cheapest (least expensive) quartile over the past 65 years. As Figure 1 shows, with today’s 10-Treasury yield of 2.5% and an E/P ratio of 6.3% (inverse of 2015 P/E ratio of 15.9x), the spread is 3.8%. For stocks to be viewed as fairly valued relative to historical levels over the past 65 years, the 10-year Treasury yield would have to rise to 4.3%, or the S&P 500 P/E would have to rise to 22x.

Meanwhile, for the first half of 2014, M&A and buyback activity were the strongest since 2007, providing an effective floor on valuations, since any weakness in stocks would encourage companies to buy back their own or someone else’s stock. With the Fed unlikely to raise short-term rates until mid-2015 and European investors pushing down U.S. long-term yields in a quest for income, we expect M&A and buyback activity to remain robust, with the spread between S&P 500 earnings yields and corporate debt costs near levels not seen since the late 1970s.


Past performance is no guarantee of future results. Source: Empirical Research Partners using Standard & Poor’s, Corporate Reports, Empirical Research Partners Analysis. Estimates are indicated by “E.”

After five years of what has largely been a value regime and the considerable defensiveness during the first half of this year (when large-cap growth stocks lagged value stocks by some 200 basis points), we believe indications are that we have moved into a growth regime. As Figure 2 shows, this generally happens as we enter the latter and most robust part of the business cycle. The last such growth regime occurred from 2005 to 2007 and before that, we had a growth regime from 1996 to early 2000.


Past performance is no guarantee of future results. Source: Empirical Research Partners Analysis. Equally weighted data used for the lowest two quintiles of price-to-book ratios compared to growth stocks.

Growth regimes are characterized by several conditions, according to Empirical Research Partners, which has done considerable work on the topic. Those conditions include:

  • A flattening in the yield curve (off already low rates)
  • Narrowing in the percent of companies generating margin improvement
  • The market rewards companies with high capital spending and cash reinvestment
  • The market rewards higher-volatility names
  • The valuation spreads between growth and value is narrow (for more on this, see John P. Calamos’ recent blog).

On this last point, large-cap growth stocks now trade at 1.2x large-cap value stocks, versus a long-term average multiple of 1.4x and vs. the peak reached at the height of the 1999 tech bubble of 3.0x.


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

Our view remains that technology, health care, financials, and consumer discretionary stocks will continue to lead the market higher in an environment of low-inflation and 3%+ GDP growth. We believe the Fed will keep short-term rates low for an extended period to make sure the geopolitical risks and weak economies around the world do not cause the U.S. to fall backward. Our 12-month price target on the S&P 500 remains in the 2150 to 2200 range, based on S&P 500 earnings of $125, and the normal multiple of 17.5x that has been associated with 3-4% long-term interest rates.

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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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Yellen and Putin: New Odd Couple Driving the Markets

By Gary Black

August 22, 2014

I am surprised the market is not selling off more, given Russia’s latest provocative convoy incursion into Ukraine. But Chair Yellen didn't exactly exude confidence at Jackson Hole and yet wasn't dovish enough to delay expectations of a first rate hike past next summer. In my view, the simple decision matrix for getting stocks right this summer continues to be:

Yellen Putin Market Results
Dove Good Positive
Hawk Bad Negative
Dove Bad Flat
Hawk Good Flat

So, the market looks like it may tread water and digest its recent gains near term before becoming more volatile in September given a rich economic calendar culminating in another Fed meeting on September 16 and 17.

In the meantime, Chair Yellen can't possibly get more dovish as the August employment report nears, and Putin can't be up to any good sending a 280-truck convoy into Ukraine for purely humanitarian reasons.

Longer term, we remain bullish. We believe 3% GDP growth and sub 2% inflation, 6-8% S&P 500 earnings growth, and strong buyback and M&A activity driven by attractive valuations and cheap financing set the market up for further gains.

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Putin and the Fed Keep Giving Us Buying Opportunities

By Gary Black

August 15, 2014

In my opinion, there is little Vladimir Putin can do to retaliate against Ukraine for partially destroying the Russian military convoy that crossed into Ukraine last night. However, Ukraine has not blown up Russia’s slow-moving humanitarian convoy—as many had previously feared. So Putin seems to be back in the no-win situation of simultaneously expressing his commitment to finding a diplomatic solution to the Ukraine situation, while being caught sending military equipment into Ukraine, presumably for the separatist rebels. Because Europe still doesn't have the political or economic will to bring additional broad sanctions against Russia, we believe matters are likely to wind up where they have been, with verbal sparring but no real escalation in tensions.

Meanwhile, 10-year Treasury yields continue to fall (to 2.33% as of today). European investors are still chasing U.S. yields downward as European economies, including Germany, contracted in the second quarter and Ukraine sanctions exacerbate business and consumer uncertainty. Given that Japan, South America, and Russia have also recently shown economic contraction and that U.S. housing and retail are still both weak, it's hard to see the Fed raising short-term interest rates any sooner than it has to in 2015. And the debate at next week’s annual Jackson Hole Economic Policy Symposium will likely shift from when the Fed will raise rates to how Europe can get out of its economic malaise.

In sum, we view today's geopolitical volatility as another buying opportunity in what still seems to be the middle innings of a secular bull market.

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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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Why Buybacks Matter

By Gary Black

August 4, 2014

We believe finding stocks that deliver sustainable growth in their core businesses (via volume growth, pricing, or margin expansion that exceeds investor expectations) is the surest way to deliver outperformance, and it’s where we at Calamos spend the bulk of our research efforts. That said, we believe we also often add value by correctly anticipating change in a company’s cash reinvestment strategy—specifically, by identifying companies that will use their excess cash flow to buy back stock when there is a significant difference between a stock’s earnings yield (E/P) and the company’s after-tax cost of debt or cash. As research by Jefferies shows (Figure 1), this can create substantial value for shareholders as well.

Figure 1. Buybacks Have Given Stocks a Significant Boost

Source: Jefferies, “Global Equity Strategy, US: The Big Squeeze, III,” August 4, 2014, using data from Bloomberg, Jefferies. The S&P 500 Buyback Index measures the performance of the top 100 stocks with the highest buyback ratios in the S&P 500 Index, a measure of the U.S. stock market.

Theory says a company should buy back stock if the internal rate of return on equity free cash flows exceeds the company's marginal cost of capital, assuming no better uses of the cash and no financial duress.

From an accretion standpoint, buybacks are accretive if the forward earnings yield (E/P) exceeds the marginal after-tax cost of debt or cash. If the marginal cost of debt is 3.9%, the P/E on next year's earnings is 15.6x, and the tax rate is 35%, then the return on buybacks is E/P = 1/15.6x = 6.4% versus a 2.5% after tax-cost of debt. This particular buyback would be very accretive to equity holders.

Mathematically, the actual year 1 accretion formula can be spelled out as follows:
% accretion = {$ repurchased/market cap} x {1 – [(cost of debt x (1-tax rate))/(E/P)]}*

If the year 1 buyback is 8% of market capitalization, the 2015 P/E is 15.6x, and the after-tax cost of debt is 2.5%, then accretion would be: 8% x [1 - (2.5%/6.4%)] = 4.8%.

All other things being equal, if the buyback is unanticipated, EPS and the stock price should rise by about 4.8% on such an announcement. However, if the market already expects a year 1 buyback of 5% and the company announced a year 1 buyback of 8%, EPS estimates and the stock price would increase by a still-not-shabby 1.8%, based on: {(8% - 5%) x [1 - (2.5%/6.4%)]} = 1.8%. As the P/E goes up or the cost of debt increases if the firm is perceived as riskier, the efficacy of buybacks obviously diminishes.

In dollars, share buybacks are now at their highest level since 2007 (see Figure 2). As a percentage of market capitalization, buybacks are at their highest level since the third quarter of 2011. We expect the heightened buyback activity to continue in the quarters ahead, given yields of 3.4% for A-rated 10-year corporate paper and 3.9% for BBB-rated 10-year paper (2.5% after-tax with a tax rate of 35%), and a 6.4% S&P 500 earnings yield (based on the S&P 500 Index selling at 1930/$124 EPS for a 15.6x P/E on 2015 estimates).

Figure 2. Share Buybacks in Dollars and as a Percentage of Market Cap

Source: Goldman Sachs Equity Division

In short, we believe that share repurchase activity by CEOs and CFOs, who are closer to the fundamentals of their businesses than anyone, is a good indicator of a stock's future direction.

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Too Much of a Good Thing Is Not Such a Good Thing for Markets

By Gary Black

August 1, 2014

Wednesday’s one-two punch of 4.0% second quarter GDP growth, plus the Fed’s language that inflation had moved closer to its longer-term target, gave the equity markets a severe case of agita. The S&P 500 Index fell -2.7% for the week, its worst percentage decline in the past two years. We expect the recent surge in volatility to continue near-term as the consensus shifts about how quickly the Fed will raise short-term rates in 2015. The worry, of course, is that the Fed will suddenly wake up and realize it has fallen behind the proverbial eight ball in controlling inflation and be forced to ratchet up short-term rates in a messy rather than predictable fashion.

Everyone seems to agree the Fed will be forced to raise rates at some point during the next two years with inflation nearing the Fed’s 2% target. Does it really matter whether these rate increases begin in November 2015 or May 2015? With 209,000 jobs created in July and now six continuous months of 200,000-plus job growth, bond vigilantes have called the Fed’s zero-rate monetary policy “inappropriate” at best and “irresponsible” at worst, with the U.S. economy expected to grow by 2.0% to 2.5% this year. Put differently, the vigilantes say an average growing economy deserves an average monetary policy, not the one adopted in 2008 to get the country out of the worst financial crisis since the 1930s.

Our view is that the market isn’t worried that short-term rates are headed higher. Instead, we believe the market’s concern is that the Fed will be forced to ratchet short-term rates higher—three, four, five times over a short period—to control inflation that may accelerate well beyond the Fed’s 2% target as economic growth shifts into high gear.

Like a stock that misses earnings and falls to a new equilibrium that reflects the lower earnings and then moves higher, once the market discounts the change in consensus thinking about Fed policy and accepts that rates will rise earlier rather than later, stocks can take off again as investors get comfortable with 3% long-term GDP growth, 2% inflation, a 1% fed funds rate, and 3% to 4% 10-year Treasury yields.

We continue to believe we are in the fifth or sixth inning of a secular bull market, with a recovery cycle prolonged by the severity of the 2008-2009 financial crisis, the recession, and 55% market correction, combined with Washington’s impotency in crafting new fiscal policy to stimulate economic growth through tax incentives rather than government spending.

In our view, valuations remain very attractive relative to both inflation and long-term interest rates. Assuming global GDP growth of 3% in 2015 and beyond with little inflationary pressures, we believe corporate profits can continue to grow by 6% - 8% over the next several years. That is good for stocks, and particularly for growth stocks, which remain depressed with forward P/E multiples at just 1.2x the forward P/Es of value stocks but offer twice the forward revenue growth and 50% more earnings growth.

In sum, for now, too much good news is bad news, but once the markets adjust to the emerging consensus that 1% short-term rates and 3% to 4% long-term rates are indeed just fine, we believe equity markets can move to new highs, supported by 3% long-term GDP growth, low inflation, and M&A and buyback activity that remains highly accretive, given compelling valuations and cheap financing.

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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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The Case For Growth Now

By Gary Black

June 18, 2014

Chair Yellen’s comments in March that short-term rates could move higher early next year, combined with weak economic data, caused a sharp rotation away from growth stocks, especially the longer-duration names we tend to favor (see our post "When Stocks Behave Like Bonds"). There’s been ongoing debate about where we are in the market and economic cycles. Growth has recovered some following stronger economic data, but still trails value year-to-date.

In our view, the economy looks to be positioned for steady growth: not too hot and not too cold. Chair Yellen vowed at her press conference today to keep interest rates low for a “considerable time” after current quantitative easing ended, given continued slack in the economy and inflation that remains below the Fed’s 2% target. Against this economic backdrop, we’ve had a balanced positioning of secular and cyclical growth names. Valuations of growth stocks relative to non-growth stocks remain compelling by historic standards, and we see more room for P/E expansion in growth stocks as the economic recovery strengthens.

The Business Cycle and Equity Market Performance The Business Cycle and Equity Market Performance

Valuations Support the Case For Growth
Large-Cap Growth Stocks Relative to Non-Growth Stocks, Ratio of Forward P/E Ratios
1976 Through Late May 2014 Valuations Support the Case For Growth

Past performance is no guarantee of future results. Source: Corporate Reports, Empirical Research Partners Analysis. Capitalization-weighted data.

This view of growth’s potential is gaining currency: Late yesterday, Empirical Research Partners shifted its forecast from a neutral regime (3 out of 5) to growth-tilt regime (4 out of 5). This is the first time since 2008 Empirical has felt that growth would outperform value. Empirical has long made the case that getting the regime correct (“knowing what game you are playing”) is critical to knowing what quantitative tools will work, and when.

In every business cycle going back to 1970, growth has outperformed value in the last 12 to 36 months of the cycle. This has usually coincided with the following conditions:

  • Flattening yield curve
  • Narrow but widening valuation spreads
  • Breadth of companies showing margin expansion narrows
  • Market rewards high capital spending ratios
  • Market rewards high price volatility (on a risk-adjusted basis)
  • Market rewards earnings and price momentum (also on a risk-adjusted basis)

Growth Stocks Have Typically Outperformed During Late Cycle
Large-Capitalization Growth and Value Stocks
1953 – Mid April 2014; Recessions indicated by shaded areas Large-Capitalization Growth and Value Stocks

Past performance is no guarantee of future results. Source: Empirical Research Partners Analysis. Equally weighted data used for the lowest two quintiles of price-to-book ratios compared to growth stocks.

We expect the merits of growth equities will garner increased recognition as economic growth accelerates in the months ahead. Still, we believe that there will be disparities among companies’ performances. In this environment, we expect our high-conviction, fundamentally driven approach will allow us to pick the winners from the losers within this more attractive growth universe.

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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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When Stocks Behave Like Bonds

By Gary Black

March 25, 2014

The market's sell-off in high-momentum stocks—biotechnology, internet, and cloud names, specifically—can be summarized in one word: duration.

As every bond investor knows, when interest rates rise, long-duration bonds get hit the hardest because they are most sensitive to changes in interest rates.

Equities are no different. When Federal Reserve Chair Yellen raised the specter of tighter monetary policy happening earlier than investors expected, the market’s reaction was swift and unambiguous: sell long-duration equities.

Long-duration equities are those where the vast majority of earnings and cash flows are many years out, and current-year earnings and cash flows are non-existent or negative. (Think of a technology company that reinvests all its cash back into its business to fund its rapid growth—where the anticipated payoff could be significant but many years out.) The stocks hit hardest in yesterday’s sell-off were those where substantially all the intrinsic value is in the future "terminal" value (i.e., value based on cash flows that are 10, 15, or 20 years out). The prospect of higher interest rates cuts down the terminal values that drive growth stock valuations in the internet, cloud, and biotech sectors. These sectors were among the hardest hit yesterday and again today.

I believe that as Fed governors speak out over the next few days and try to throw cold water on the market's foregone conclusion that short rates will start rising as early as the spring of 2015—as implied by Yellen’s comments—the shift out of long-duration equities should reverse. We are likely to see a return of "bad news is good news"—that is, weak economic data reduces the odds of tightened monetary policy—which would cause long-duration equities to get bid up again.

Our research shows that over the past 35 years, the combination of negative real but low absolute interest rates at the short end of the yield curve and rising but moderate rates at the long end of the curve indicates an expanding economy without inflation. In such an environment, the technology, consumer discretionary, financials, and industrials sectors have tended to do best. We remain committed to the secular growth names our analysts have identified and believe they can benefit from secular tailwinds such as mobility, 24/7 access to information and entertainment, the emerging middle class, a global marketplace, aging demographics, productivity enhancements, and global infrastructure. At the same time, we remain disciplined about what we pay for companies that can benefit from these secular tailwinds, while being cognizant of the impact of rising rates on these longer-duration equities.

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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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U.S. Equities: Cheap Relative to Bonds and Inflation

By Gary Black

February 12, 2014

Our regular followers are likely familiar with some of our favored equity valuation measures. Below, we show updated valuation charts comparing S&P 500 Index trailing earnings yields versus 10-year Treasurys and versus inflation. This analysis, which spans 60 years, offers a measure of the current "cheapness" of U.S. equities versus both bonds and inflation relative to the past.

Based on trailing earnings, the return advantage offered by equities versus 10-year Treasurys was about 300 basis points at the end of January; the equity advantage versus inflation was about 400 basis points. Looking back over the past 60 years, the current return advantage offered by equities over bonds would rank at the 24th percentile of cheapness (1st = least expensive, 100th = most expensive) of all observations. Versus inflation (which some investors prefer given their views that the long bond has been engineered lower by rounds of QE) equities today would rank among the cheapest 29th percentile of all observations over the past 60 years.

At yesterday's S&P 500 Index close of 1820, the current S&P earnings yield on 2014 earnings was 6.3% (2014 EPS = $115, P/E = 15.8x). Roughly, that gives equities a 330 basis point advantage versus an expected 10-year Treasury yield of 3.0% at year-end 2014, and a 460 basis point advantage versus expected 2014 inflation of 1.7%. So, equity valuations on 2014 earnings and rates look even cheaper.

U.S. Equities: Attractive Versus Bonds
Differential of S&P 500 Trailing Earnings Yields and 10-Year Treasury Bond Yields
1950 Through Late January 2014

U.S. Equities: Attractive Versus Bonds

Past performance is no guarantee of future results
Source: Standard & Poor's, Corporate Reports, Empirical Research Partners Analysis.

U.S. Equity Advantage Over Inflation
Differential of Trailing S&P 500 Earnings Yields and Inflation
1950 Through Late January 2014

U.S. Equity Advantage Over Inflation

Past performance is no guarantee of future results
Source: Standard & Poor's, Corporate Reports, Empirical Research Partners Analysis.
Trailing earnings yields less the core CPI. Prior to 1958 the overall CPI is used.

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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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Sherman’s Rant: Passion and The Quest for Investment Excellence

By Gary Black

January 21, 2014

By now, probably everyone has heard about Seattle Seahawks’ cornerback Richard Sherman’s explosive, adrenaline-induced rant following the Seahawks’ victory over the San Francisco 49ers on Sunday. While many viewed Sherman’s rant as rude, disrespectful, and offensive, you have to give him credit for his intense passion, focus, and obsession with being the best cornerback in the National Football League.

I certainly don't condone Sherman's behavior, which inspired hours of social media tweets, criticism, and hate mail. But like him or not, his teammates love him, the NFL brass loves him, and most importantly, the fans who buy Super Bowl tickets love him because of his determination to do whatever it takes to win football games. After being drafted in the fifth round by the Seahawks in 2010—behind many players that in his opinion weren’t in the same league as him—Sherman famously recounted what was going through his mind to a reporter, "When I get to the NFL, I am gonna destroy the league, as soon as they give me a chance." And destroy it he has.

Great investors, like great football players, are also obsessed with winning. While nerdy by comparison, winning in investing is also characterized by intense passion, focus and sheer determination to beat the competition. With about 10,000 hedge funds and 7,400 long-only funds all trying to outperform each other in an environment where everyone is smart and correlations have risen, the investment game has clearly changed in the past 10 years, with Reg FD, company guidance, and the internet leveling the playing field. Being close to the company is now a necessary but insufficient condition to generating strong performance. So is being able to build a 10-year discounted cash flow model with every assumption under the sun about total addressable market, market share, pricing, and margins built in as sensitivities.

In my 25 years in the business, the men and women who get it right most are those obsessed with figuring out the one or two most important drivers of a business, and then researching those factors relentlessly until they are totally sure they have figured it out. Those most obsessed about winning, and most relentless in their research efforts, tend to be the most confident in their conclusions, and thus tend to make the most money for their investors.

At Calamos, we hire passionate, driven analysts who pride themselves on knowing their sectors better than anyone else. They don’t depend on company managements to tell them the answers; they do their own research, and speak with the companies, competitors, suppliers, and customers to find out what is actually happening. Our analysts don’t blindly depend on reversion to the mean when looking at market share, margins or returns. They think about how the company’s investments, positioning versus peers and execution will play out over time in generating cash flows that beat consensus expectations. Our analysts think like owners, and do whatever it takes to understand the company’s strategy, brand positioning, and distinctive competencies.

When looking at potential investments, our analysts identify the one or two most important drivers of the business, do exhaustive research to forecast those drivers, and come up with valuations using different approaches to determine a security’s risk/reward. Finally, they think about timing: A company may have a great business and be attractively priced, but it may not be a good time to invest, or there may allow for a cheaper entry point down the road.

Like great athletes, great analysts and portfolio managers are obsessed with winning—that is, generating higher investment returns than their competitors. It’s what drives the truly great investment athletes in our business. And when we get it right, the adrenaline rush can be exhilarating.

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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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Markets Will Likely Weather Jobs Report

By Gary Black

January 10, 2014

Today's job growth report fell short of economists' expectations, with the Labor Department reporting a gain of 74,000 jobs in December. We believe the market will overlook the weak December employment numbers. The calendar was compressed with Thanksgiving coming late; the weather was bad; and if one considers both November (which was revised up) and December data, the average monthly job growth has been a respectable 160,000.

At the margin, the employment numbers could allow the Fed to take a more gradual approach to tapering or adopt a "wait and see" approach. The December numbers are also inconsistent with the other stronger economic data we’ve seen over the past few weeks (such as ISM manufacturing data, new unemployment claims, ADP’s private sector job growth report, and the trade balance), which has caused consensus estimates for fourth quarter GDP growth to double to around 2.5%.

In our view, stocks remain cheap by many measures. Equity earnings yields of 6.3% (inverse of a forward P/E estimate of 16x for the S&P 500 for 2014 and earnings per share of $115) provide a 340-basis points advantage relative to 10-year Treasury yields at about 2.9%. At this level, the equity return premium still ranks among the most attractive over the past 60 years, and inflation pressures remain subdued.

Globally, Europe and Japan continue to rebound economically, and emerging markets remain stable. Quarterly earnings will move to center stage starting next week. Other than retail and restaurants—which like the employment numbers were similarly affected by the compressed calendar and weather—we believe most sectors are likely to do better versus reduced expectations.

We continue to like equities, and growth equities remain cheap relative to value equities, in our view. We would use the recent market pullback to add to higher growth names with strong franchises in sectors that benefit from secular shifts to mobile, the cloud, and internet/social media; consumer discretionary names tied to housing and autos; and financials that may benefit from the upward slope in the yield curve, increased lending, and stronger equity markets.

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Let the Taper Begin

By John P. Calamos Sr.

December 18, 2013

The Fed's announcement today that it would begin to slow its quantitative easing was met with a roar of approval from the stock markets. While there's no reason to anticipate a string of daily 250-point rises in the Dow, I'm optimistic about the longer-term benefits of the taper for the markets and economy.

We can be confident that the Fed is undertaking a deliberate and well-thought out plan. There's nothing reactionary about what's happening. Chairman Bernanke and his colleagues have latitude to work with, and they've stated their intention to keep the spigot on, maintaining a level of stimulus until a healthy degree of inflation kicks in.

In my view, there can be no doubt that the Fed's unprecedented easing did help move the U.S. economy through an extremely challenging time, but it also caused dislocations in asset valuations and discouraged banks from lending to small businesses and individuals. And even Chairman Bernanke noted that the taper has fallen short of what it set out to do. Inflation has been nearly flat, the velocity of money hasn’t picked up commensurately, and job growth has been measured.

Ultimately, the best fix for the problems that remain are pro-growth policies. A more normal interest rate environment should serve as a catalyst for increased credit access for small businesses, the engine of job growth. Over the past few years, people have increasingly thought of the Fed as the guiding hand of the markets and the economy, but this isn’t really the case. Of course, monetary policy has an impact, but it's only one piece in the puzzle; we also need sound fiscal policy. We can’t tax our way to economic growth.

The Fed's decision from taper talk to taper action affirms the slow—but more importantly, steady—economic recovery in the U.S. The good news seems to be getting better. The U.S. has been driving the global recovery, but we're starting to see a positive global synchronization among major economies. The emerging markets are regaining their traction. China does not look to be in a bubble; and the Chinese government is taking steps that support the economic freedoms that both support growth as well as investment opportunities. Europe is coming back, especially the northern economies. Economic conditions in Greece are also improving, with growth forecasted in 2014. This global synchronization is a positive for U.S. investors and markets, because the strengthening in international markets is not coming at the expense of a U.S. recovery. Instead, it can support it.

While my expectation is that U.S. and global equities will continue to move higher in this environment, I don’t believe that a rising tide will lift all boats. Successful investors have to do more than look at the market, you also have to look in the market. As tapering eases, I believe company fundamentals will play a greater role in stock prices. We're positioned (and have been) for this shift from yield to growth and growth cyclicals. This is an environment where we see considerable opportunities for long-term investors.

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¡Viva La Reforma!

By Nick Niziolek

December 17, 2013

2013 may go down as a monumental year in Mexico's history. Soon after taking office, President Enrique Peña Nieto announced the "Pact for Mexico," bringing opposition parties together with his Institutional Revolutionary Party (PRI) to move forward with far-reaching structural reforms. This was a significant positive development for a country whose political system had been deadlocked for more than a decade. More importantly, President Nieto focused on reforms in education, labor, the financial system and the energy sector—all critical areas for businesses deciding where to allocate capital. The pact's broad scope includes privatization of the energy sector and improvements to lending rights and labor relations.

Also, President Nieto has taken a different approach to domestic security issues, with local headlines increasingly dominated by economic optimism, as opposed to ongoing updates on the drug war. While more progress needs to be made on security issues, an improving economy could ultimately provide a headwind to organized crime in the region.

Given our positive view on Mexico and the impact reforms will likely have on multiple industries within its economy, one might infer a case for broad-based exposure to the Mexican equity market via a passive strategy or ETF. However, we believe that active management remains crucial for capitalizing on Mexico's investment opportunities; bottom-up selection provides us with an important advantage in adding value.

Often, the emerging market investment story focuses on the consumer, but many of the larger consumer companies in the Bolsa (the Mexican Stock Exchange) trade at rich valuations. So, although our bottom-up research has uncovered opportunities tied to the consumer, it's not our greatest area of emphasis in Mexico. Instead, our bottom-up work in Mexico is focused primarily on industries and companies we believe are most likely to benefit from pending reforms and the re-acceleration of the Mexican economy. We've found opportunities within the Mexican banking sector, where companies are positioned to benefit from strong loan demand and improving credit and asset quality. Through select materials positions, we've sought to benefit from increased demand from the energy sector for a range of infrastructure needs, such as new plants.

Mexico's reforms and economic progress provide opportunities for companies outside of Mexico as well. Our team's bottom-up process focuses on where a company's assets are domiciled and where its revenues are generated. These are important drivers in understanding a company's growth potential and broadens our ability to access the growth story we see unfolding in Mexico.

For example, we believe the railroad industry will be critical to Mexico over the medium-term, with energy reforms and a North American manufacturing resurgence supporting significant growth potential. Yet there are limited Mexico-domiciled companies from which to choose, leading us to also seek out developed market opportunities with significant links—such as revenues and assets—to the Mexican rail industry.

We believe our revenue-based approach also has been advantageous in the energy equipment and services industry. We expect significant growth within the Mexican oil industry on the back of reforms, but there are limited choices for investing in local companies positioned to benefit from these improvements. To address this, we have also identified several global energy and equipment companies that we believe can capitalize on the increased demand we expect over the next few years.

Moreover, while the tapering of quantitative easing in the U.S. and a stronger dollar may create headwinds for many emerging markets and emerging market currencies, we believe Mexico is not as vulnerable as countries struggling with weakening currencies and current account deficits, such as India and Brazil. Given its close ties to the U.S., the Mexican economy could benefit notably from U.S. economic recovery. Reflecting this view, as U.S. taper talk unsettled the global market in May and June, we used the sell-off to opportunistically buy Mexican equities.

We believe the growth story in Mexico underscores the benefits of an investment process that is both top-down and bottom-up. One might argue that a top-down view is the most critical element in emerging market investing; incremental improvements in economic freedoms may have significant long-term impacts on capital flows into these countries and the growth potential of the companies competing in these markets. Yet, in our opinion, a correct top-down view is only half of the solution. Strong fundamental research remains essential, as not all companies will benefit in equal measure from our top-down outlook. Moreover, many beneficiaries may be located outside of a particular emerging market.

Heading into 2014, we remain optimistic about the Mexican economy and believe we have identified a number of strong bottom-up opportunities that will continue to benefit from these positive developments. ¡Viva La Reforma!

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Washington: Light At the End of the Tunnel?

By Gary Black

October 3, 2013

The Republicans continue to lose ground in the public opinion polls as the federal government shutdown drags on. As the President scores almost daily body blows against the GOP (laying the foundation for blame in next year’s mid-term elections if the economy slows with tapering), Republicans surely are trying to extricate themselves from what looks increasingly like a losing fight. In the latest CBS news poll released this morning, Americans overwhelmingly disapprove (72% to 25%) of shutting down the government. Even among those who disapprove of Obamacare, 59% disapprove of shutting down the government over the issue, versus 38% who don’t. Additionally, 44% of Americans blame Republicans for the shutdown, versus 35% who blame the President and Congressional Democrats. In the latest Quinnipiac poll released on October 1, 17% of voters approve of the job Republicans are doing versus 74% who disapprove—a record-low favorability rating.

The President offered a clear opening for the Republicans in his speech yesterday afternoon. According to Obama, the way out for Republicans is to give up fighting the Affordable Care Act, which already has been passed by both chambers and upheld by the U.S. Supreme Court (not to mention, the Affordable Care Act was a key issue in the Presidential re-election last year, which Republicans lost).

Instead, Obama said he is open to a good budget deal without tax increases, and what is being referred to as a “grand bargain” by legislators. This would include entitlement reform, corporate tax reform, chained CPI (that is, cost of living adjustments for Social Security and veteran’s payments tied to CPI), and most importantly, reduced defense spending cuts as phase II of the sequester kicks in on January 1, 2014. In return, Republicans would have to pass a clean continuing resolution and increase the debt ceiling before the October 17 deadline.

How likely is such a deal over the next two weeks? Representative Paul Ryan is leading this charge with the blessings of Senate Minority Leader Mitch McConnell and House Majority Leader John Boehner. It would allow tea party Republicans to tell their constituents they got something from the President, not a repeal of Obamacare but something potentially much bigger.

Many of the legislative elements of the grand bargain have long been discussed in Washington, and the structural elements could be attached to legislation that contains a clean continuing resolution and an increase in the debt ceiling. Given the Republican’s weakened position after three days of shutdown, and Boehner’s comments this morning that he would suspend the Hastert Rule (the practice of passing legislation with majority of the majority party), he clearly is sending a message that if push comes to shove, he would cobble together enough moderate Republican votes with the vast majority of House Democrats to avoid a debt-ceiling debacle. That increases the odds of a grand bargain, which would be very good for equities.

We remain bullish and view the recent market weakness as an opportunity to buy equities.

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Markets Climb the Wall of Worry

By Gary Black

September 10, 2013

The short-term worries that troubled U.S. equity investors in August have continued to melt away—that is, they seem to have been resolved or discounted by market participants in September. Here’s what we’re seeing:

Syria: A military conflict between the U.S. and Syria is likely to be avoided. The White House has seized upon the Putin-led proposal to allow Syria to surrender its chemical weapons, although the details are still undetermined. President Obama has a fraction of the votes needed in the Republican-led House to launch even a limited attack on Syria, echoing the sentiment of 60% of the American public who opposing a military strike. I expect Obama’s televised speech tonight will likely open the diplomacy door wider.

Tapering: The market appears to have baked in the expectation of an announcement next week that the Fed will gradually reduce its bond buying from $85 billion per month to $75 billion per month, accompanied by language that gives the Fed lots of room to reverse course if economic conditions worsen.

Fed chair: The market also looks to have discounted that Larry Summers will become the next Fed chair, rather than Janet Yellen. The announcement is likely two to six weeks out, depending on the outcome of near-term events in Syria. Former Treasury Secretary Tim Geithner has apparently thrown his support behind Summers, which has led to speculation that Yellen will withdraw her candidacy quietly.

Debt ceiling and continuing resolution: We expect Congress to pass a continuing resolution this week, kicking the can to December 13 (one week before Congress’ winter recess) and avoiding the spectacle of a Republican-led government shutdown set to go into effect on September 30. This could be accompanied by language raising the debt ceiling.

German elections: Polls indicate that Angela Merkel’s Christian Democratic party will handily win the September 22 election over Peer Steinbruck’s Social Democratic party, paving the way for Merkel to remain Chancellor for a third term. Once her party wins, we expect further softening in her European austerity language.

Other positives: Global automotive sales continue to soar; China’s industrial production, exports and retail sales are all stronger than expected; Japan’s GDP growth was even stronger than expected in the second quarter (3.8% versus an estimate of 2.6%), and a new government stimulus package to counter a doubling of sales tax is likely this month.

The S&P 500 Index is already up 3.0% this month, having retraced almost all of August’s 3.1% decline. We believe we are in the mid-cycle of a secular bull market, with equity earnings yields of 6.8% (1/2014 forward P/E estimate of 14.6x), providing a 380 basis point advantage relative to 10-Year Treasurys now pushing 3.0%. This 380 basis point equity premium would still rank among the cheapest 20% equity yields (relative to bonds) over the past 60 years. Putting this differently, if S&P 500 earnings grow from $110 in 2013 by 5% per year (equal to estimated nominal U.S. GDP growth over the next few years) to $125 in 2016, and long-term interest rates move up to 4%, we would expect a normal P/E multiple of 18x to 20x, based on what multiples have been over the past 50 years when long-term interest rates were in the 4% to 6% range. This would equate to an S&P level of 2250 to 2500 by 2016, and a compound growth rate of 12%, plus a current dividend yield of 2.1%, for an annualized total return on equities of 14% to 15%.

U.S. Equities: Attractive vs. Bonds

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Perspectives on India

By Nick Niziolek

August 12, 2013

Financial headlines are focusing on deceleration in emerging markets and near-term revenue and earnings pressures for companies that derive revenues from EMs. There’s been considerable press attention given to India, as structural issues are being complicated by pending elections, investment-led slowdown, and sputtering foreign direct investment policies. These in turn are contributing to a weaker rupee, which is especially unwelcomed in  a consumption-driven economy.

In our emerging market portfolios, we have been reducing exposure to India throughout the year as inflation continues to tick higher, growth remains subdued, and current account deficits remain high.  However, it doesn’t mean there aren’t still reasons for investors to have exposure to Indian companies.

The EM story isn’t one dimensional . The growth is about more than big U.S. and European companies selling soda and chocolate to EMs, or even providing luxury goods to a new crop of  billionaires.  EMs are suppliers to worldwide markets, in ways that extend beyond commodities.

We have pared exposure to India but are not jettisoning Indian companies wholesale. We are positioning portfolios to capitalize on companies that are tied to developed markets and which are less vulnerable to a weakening rupee. India is home to global outsourcing companies, staffed by highly educated professionals, as well as companies which are supporting the worldwide demand for health care by producing affordable generics.  These are the areas that we are presently most interested in, along with some defensive staples, like tobacco companies, which tend to hold up well even when other domestic-demand-driven companies slow.

Our research efforts are focused on identifying these bottom-up growth stories, within our top-down framework.  Simply put, if the developed markets get stronger relative to EMs, it doesn’t mean that EM growth opportunities aren’t still out there.

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EMs: Still More Good News than Bad

By John P. Calamos, Sr.

August 12, 2013

The good news is that we are in a global market that provides opportunities around the world. The bad news is that we are in a global market, so whatever happens anywhere affects us all.

Today, the Wall Street Journal pronounced on the front page, “Emerging World Loses Growth Lead,” citing declines in global trade and improved conditions in the developed economies.  The WSJ cited data from Bridgewater Associates L.P. that “for the first time since mid-2007, the advanced economies, including Japan, the U.S. and Europe, together are contributing more to growth than the emerging nations.” And in July, the IMF announced revisions to its growth estimate for emerging and developing economies to a “more moderate pace” of 5% in 2013 and 5.4% in 2014, with China’s GDP growth estimated downward to 7.8% for 2013-2014.

Less robust growth in the emerging markets (EMs) isn’t welcomed, especially when we don’t know where the bottom will be, but investors shouldn’t get ahead of themselves. Expansion levels remain entirely respectable, both in absolute and relative terms.  After all, the U.S. is staging a recovery with a growth level well under half of that of the IMF’s estimates for the EMs.  Most of us are quite happy about it.  Even the WSJ notes, far further down in its article, “The latest rebalancing of global growth is nascent and could reverse, should emerging economies bounce back even a little.”

As EMs mature and expand, it’s to be expected that growth rates would decelerate from torrid levels. It should also come as no surprise that their economic expansion is not proceeding along a straight-line upward trajectory.  That’s not how economies work. And we should be happy that the developed markets are regaining their footing—to my way of thinking, that’s good for the global economy as a whole.

EMs: Still Doing Their Fair Share for Global Growth

If 5% growth in the EMs cause for extreme consternation, that points to a bigger problem. When global economy needs the EMs to deliver rapid growth, year over year to stay afloat, that’s bad news for the global economy.  EMs can’t be expected to go it alone, dragging the developed markets forward indefinitely. Developed markets must do their share, striking the right balance between capitalizing on EM opportunities without becoming overly dependent on them, whether that’s for loans or export markets.  

Although GDP is decelerating, EMs still look well positioned to be an important driver of economic growth, thanks in large measure to the rise of a middle class. Of course, consumers do adjust their spending habits in tougher economic times, but the exponential prosperity of the EM consumer class provides sustainable opportunities for companies worldwide, even if GDP growth dips to more modest levels—assuming that growth is sustainable.

Moreover, many of the EMs have healthy debt-to-GDP levels and as the EM consumer class grows, we would expect to see an increasing focus on services within EM economies. Over time, this diversification should help smooth some of the bumps in the road that have resulted from having economies dominated by manufacturing and commodities.  And although conditions are different in every country, there have been some noteworthy bright spots, such as China’s recent decision to allow banks greater flexibility in setting interest rates for borrowers.

While economic conditions matter, ultimately it is secular growth themes, not short-term GDP data, that underpin the EM investment story.  So, the deceleration we have seen thus far shouldn’t fundamentally negate our view of the opportunities. The recent volatility does however remind investors to do their homework.  This choppiness will continue as EMs seek to manage their own growth against the backdrop of expanding importance in the global economy. The potential end of QE in the U.S. won’t make things any easier, either. As investors, the key is to be aware of the risks of each country and company. We are continuing to find many exciting companies in EMs that are doing the things that we believe can lead to sustainable growth potential for investments. Alternatively, we are accessing the secular opportunities through developed market companies. By doing both, we believe we’re especially well positioned.

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When Analysts Get Mad at the Companies They Follow

By Gary Black

July 17, 2013

I always find it hilarious when I read a research report where an analyst gets mad because a company didn’t communicate to them that it was going to blow a quarter.

The company isn’t supposed to do the analyst's job. The company's role is direct analysts and investors to publicly available (hint: past) information that allows us to make our own forecast of earnings, cash flows, and ultimately intrinsic value. Under Reg FD, companies can't feed analysts anything material and non-public, or they would have to tell everyone together.

I recently read a report where an analyst bemoaned the fact that a company provided downward guidance without warning him first. I thought, "what planet is this analyst from in thinking that the company should tell investors that the company’s guidance was off?" That's surely the job of the analyst, not company management.

Great analysts get into the weeds of a company's business to figure out what is going on in the underlying market, predicting share trends, assessing product innovation, pricing, competitive plans, spending, etc. so they can be in front of a company missing or beating guidance. It’s not the job of company management to spoon feed analysts information. When analysts start getting mad that a company didn’t tell them it was going to miss, they should look in the mirror and ask themselves, what value are we adding here?

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On Hogs and Opportunity

By Gary Black

June 24, 2013

“Big money does organize itself somewhat like feral hogs. If they detect a weakness or a bad scent, they'll go after it.”
-- Richard Fisher, Dallas Federal Reserve President

It should come as little surprise that market volatility has surged in the wake of Chairman Bernanke's comments about tapering quantitative easing (QE). Fast money chasing the latest move may open up a big opportunity to buy great growth names at 5% to 10% off. In my view, the Fed has presented us with two outcomes: Either (1) the economy improves sufficiently for the Fed to throttle down QE and let long rates rise to 3 to 4% (which I see as a long-term positive) or (2) the economy stays sluggish and QE continues.

I'll choose either option.

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Less Fed Intervention Would Be Good for the Economy

By John P. Calamos Sr.

June 16, 2013

With 15 consecutive quarters of economic growth, a strengthening housing market and other improving data, investors are now increasingly focused on what happens when the QE (quantitative easing) party begins to wind down. I think markets are—as they often do—looking at things from a "glass half empty" perspective. The Fed will be most likely to back away from QE because the economy is showing sustained signs of improvement. It would be time for the crutches to come off the patient.

Yes, when the time comes, tightening the spigot will be complex given the magnitude of the easing. But that same magnitude also provides the Fed with considerable flexibility. QE isn't an "on-off" switch. Decision makers at the Fed are well aware of the task at hand and I believe that they will act deliberately.

If history is any guide, a reduction in QE will likely cause choppiness in the markets, but I believe that ultimately, less Fed intervention will benefit the economy, longer term. While decisive action in response to the Great Recession was understandable, the ongoing role of QE3 in the recovery is debatable.

As the chart below shows, the Fed's actions have contributed to a dramatic increase in money supply. The problem is that money hasn't moved through the economy at anything close to a commensurate rate, as illustrated by a decline in the velocity of money.

The amount of money in the U.S. economy has increased, but the money hasn't moved.

The amount of money in the U.S. economy has increased, but the money hasn't moved

Too much of the money from QE is sitting in the banks. Smaller businesses still struggle to get capital because there’s little incentive for the banks to lend to them. So, how do we speed up that velocity? Moderately higher rates would provide the much-needed carrot. More normal rates (say, a yield of 4% rather than 2% for the 10-year Treasury) have historically been associated with higher P/Es. (For more on this, read the recent post from my Global Co-CIO, Gary Black.)

Of course, inflation is a concern. The worse-case scenario associated with an end to QE would be a repeat of the 1970s, when inflation came roaring back. But inflation seem seems well contained within the U.S. economy at this point. As we noted, the Fed doesn't have to take an all-or-nothing approach, and instead can moderate its course as it goes.

Inflation remains below 2% target

Inflation remains below 2% target

To look at it another way, think of the economy as a train. The Fed may think it's driving the train—and many investors may think so as well. But small business is the engine of job creation, and in turn, lasting economic health. Stoking the engine of small business is overdue.

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P/Es have Risen in the Wake of Rate Increases

By Gary Black

June 13, 2013

For those concerned about the potential negative impact of rising rates, here's some encouraging research on the relationship between P/E ratios and U.S. Treasury yields during the past 60 years. P/Es were actually higher when long-term Treasury yields were in the 4% to 6% range than when they were in the 2% to 4% range, given that long-term Treasury yields under 3% are usually associated with high tail risk uncertainty. So, while an increase in long rates from 2% to 3% or even 4% may unsettle the markets near term, it may portend better economic growth and less tail risk ahead, which historically has been good for both earnings and multiples after the initial shock.

SP 500 Trailing P/E Ratios and 10YR Treasury Bond
Past performance is no guarantee of future results.
Source: Empirical Research Partners Analysis via Federal Reserve Board Click Here to Send Feedback to the Investment Team

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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Dr. Fed

By Gary Black

May 23, 2013

When a doctor takes a patient off his meds, he does so usually only after the patient has shown sure signs of recovery. Generally, the patient himself realizes when he no longer needs the meds.

What the market seems to be implying in today’s sell off is that Dr. Bernanke and his colleagues at Hospital Fed will begin tapering before the patient (the U.S. economy) is sufficiently healthy. And that is where the market has got it wrong– Bernanke made it clear in his testimony yesterday that the Fed won’t begin tapering until there is clear evidence that the economy is strong enough to sustain itself. Tapering by itself is not the issue. If the patient has recovered, he won’t need the meds. Based on his record over the past several years, we can trust that Dr. Bernanke and his colleagues will know when to withdraw the meds.

We should use today’s weakness to buy names we like.

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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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