10 comforting charts

There are plenty of things to worry about these days. The fiscal cliff negotiations and the likelihood of higher taxes on capital and small businesses; the Federal Reserve's massively expansive monetary policy; the recession in the Eurozone; the lingering threat of sovereign defaults; the political deterioration in the Middle East; the prospect of trillion-dollar federal deficits for as far as the eye can see; the gigantic unfunded liabilities of U.S. entitlement programs; the recent decline in industrial production in most developed economies; the slowdown in Chinese growth; the rising regulatory burdens; the onset of ObamaCare; the very weak U.S. dollar; the relatively tepid growth of the U.S. economy; and the huge gap between current and potential growth. 

But all is not lost, and the end of the world is not imminent. Here's a collection of 10 charts that tell a story of an economy that continues to improve on the margin. They don't point to any big growth revival, but neither do they point to an imminent recession. At the very least they are comforting.

Housing starts are up 60% from early last year, and up 22% in the past 12 months. 

Building permits typically lead starts, and they are up 27% in the past year. The future of residential construction looks very bright.

Architecture billings typically lead construction spending by 9-12 months. A majority of the firms surveyed for this index in November reported increased billings activity. The future of nonresidential construction looks better than at any time in the past 5 years.

Industrial metals prices are good indicators of global economic activity. Although they are down from recent highs, they are still orders of magnitude higher than they were 10 years ago, and they are up 113% from their Great Recession lows. At the very least, these prices tells us that global economic activity remains relatively strong.

We all know that the Eurozone is in a recession and that growth prospects are miserable. Yet Eurozone equity prices are up 26% from last year's low. This is not necessarily a sign of strength, but it does suggest at the very least that the situation in Europe is not as bad as many had feared. After all, prices today are about the same as they were in late 1997, 15 years ago! U.S. equity prices have fared better, but still, they have made zero progress in the past 12 years, despite the fact that after-tax corporate profits have more than doubled since then. My take is that equity prices are moving higher because things are not as bad as they market had feared; markets have been priced to a recession, but instead we continue to see that growth is positive albeit disappointingly weak.

Credit Default Swap spreads show no signs of any fundamental deterioration in the economy. Indeed, they are about as low as they have been since the recovery started. They are still elevated by historical standards, but on the margin they are telling us that conditions are improving.

The implied volatility of equity options—the Vix Index—is still somewhat elevated relative to what we would expect to see in "normal" times, but it is far below the levels registered at times of crisis. At the very least, this is telling us that the "fiscal cliff" negotiations are not a do-or-die event for the U.S. economy. Not good, but not bad either.

Swap spreads are very important indicators of financial market health and systemic risk, and have proven to be good leading indicators of economic strength. The very low level of swap spreads today is a reflection of very healthy liquidity conditions and very low systemic risk. It would therefore be very surprising for the economy to dip into a recession.

Inflation is neither too low nor too high. This chart shows the quarterly annualized change in the GDP deflator, the broadest measure of inflation in the U.S. economy. Year over year inflation is running a bit less than 2%, regardless of the measure you wish to use.

The pace of jobs growth is very disappointing, to be sure, but employment around the world, as well as in the U.S., continues to expand. Slow growth is much better than contraction.

Corporate bonds are moderately attractive

Over the past four years, corporate bonds have delivered total returns that rival those of equities. The S&P 500 has generated a total return of 77%; high-yield bonds (using HYG as proxy) have enjoyed a total return of 101%, for an annualized return of 19%; and investment grade bonds (using LQD as a proxy) have delivered a total return of 55%, or 11.6% annualized. The drivers of this spectacular performance were falling yields and lower-than-expected default rates. 

The chart above shows just how much yields on corporate bonds have declined since late 2008. In retrospect, the late 2008 surge in junk bond yields was a once-in-a-lifetime opportunity for investors willing to take the securities off of the hands of the many investors who were forced to sell at super-depressed levels. Towering yields at the time implied a massive wave of corporate defaults which never materialized, thanks to the recovery—however tepid it has been—and to the Federal Reserve's super-accommodative monetary policy stance.

So: is this the end of the greatest corporate bond rally in history? The chart shows that corporate bond yields are as low as they have ever been, so that is a sign that caution is warranted.

Digging deeper, swap spreads and credit default spreads, shown in the two charts above, suggest that there is still some room for improvement. The level of corporate bond yields is at an all-time low, but corporate bond spreads are still relatively wide. Furthermore, the significant decline in swap spreads suggests that corporate yields and spreads can decline further. If the economy keeps growing at a slow pace, short-term rates remain incredibly low, and monetary policy remains super-accommodative, investors will be all but compelled to continue buying corporate bonds for their still-attractive yields. For example, HYG has an indicated yield today of over 6%, while LQD's yield is almost 4%.

The case for corporate bonds would be bolstered fundamentally by continued improvement in the economy and relatively low default rates. A growing economy and easy money are a perfect recipe for improving corporate cash flows, and that is music to corporate bond investors' ears.

Still, with yields this low, investors should realize that there is a very small cushion against downside risk. If another recession hits, default rates would likely rise in that in turn would erode returns even if interest rates remained very low. If the economy were to strengthen unexpectedly, the Fed would be forced to tighten policy, and that could push corporate bond yields higher, which would also erode returns. It's probably time to start taking some—but not all—of your outsized corporate bond risk off the table, beginning with the investment grade sector.

Richard Bernstein: 13 for 2013

Richard Bernstein of former Merrill Lynch fame has a nice note out on his 13 ideas for 2013.  You can read the full note at Richard Bernstein Advisors.

1) US stocks outperform Emerging Markets, yet again.
Rationale: US corporate profits continue to be the healthiest in the world. EM profits are likely to improve, but the profits rebound might be more muted than many investors currently expect.

2) Inflation remains benign. Gold and commodities underperform.
Rationale: China has tremendous excess capacity, and continues to build more. Although slack in the global economy may be reduced in 2013, the global economy is unlikely to experience either the credit creation or the bottlenecks that are traditionally necessary to fuel a late-cycle inflationary environment that typically fosters commodity or gold outperformance.
3) The Japanese Yen weakens substantially.
Rationale: Japan just recorded their first current account deficit. ¥100/dollar should not be summarily ruled out if that current account deficit expands.
4) A cash-financed M&A wave begins in the US.
Rationale: By hoarding cash, larger US companies have under-invested for future growth. They may start buying growth in 2013 if the economy continues to improve. Small or Midcap stocks appear undervalued (based on EV/EBITDA) relative to their larger cap counterparts in seven of ten sectors.
5) Consensus warms to European stocks in the second half of the year.
Rationale: Relatively easy profit comparisons lie ahead for European companies, and every new cycle begins with easy comparisons. Unfortunately, despite attractive valuations, European corporate fundamentals still appear to be deteriorating.
6) Long-term treasury rates continue to fall.
Rationale: The long-duration “wall of worry” remains very high. Bond portfolios have been consistently short duration relative to benchmark for seven years despite that the 10-year treasury rate has fallen from above 5% to below 2%. Inflows are incredibly strong to shortduration funds. Such overwhelming negative sentiment toward the long-end of the curve argues that long-duration assets are likely to outperform.
7) Non-dollar debt underperforms.
Rationale: Stronger USD might hurt non-dollar returns, and credit spreads might widen as investors realize they have underestimated the risks associated with investing in emerging markets.
8) Hedge funds continue to experience outflows to traditional asset allocation funds.
Rationale: Hedge funds’ combination of high fees, regulatory headlines, and correlated underperformance make traditional asset allocation funds increasingly tough competition.
9) Volatility begins to increase late in 2013.
Rationale: Perhaps the most important factor influencing the long-term trend in equity market volatility is central bank liquidity. Thus, it has not been surprising to us that the VIX has stayed so low because of the huge amount of liquidity the Fed has provided. Our work is starting to suggest that the VIX might begin to increase toward 2014.
10) The American Industrial Renaissance continues
Rationale: Small and mid-cap US-centric industrial and manufacturing stocks are likely to outperform as the companies continue to gain market share because of the combination of closing wage disparities, lower  energy and transportation costs, and political stability.
11) Small US banks
Rationale: Smaller US bank stocks are likely to outperform because of the combination of improving household cash flow, continued improvement in housing and construction, improving asset values, and virtually no exposure to the deflation of non-US credit bubbles.
12) The opportunity cost of not owning equities becomes too great for investors to not participate.
Rationale: Equities have outperformed most short-duration fixed-income returns, but the opportunity costs have evidently not been high enough to get investors to move into equities. Given our bullish stance on the equity market, we think that opportunity cost will continue to expand, and investors will finally start to chase equity performance.
13) Short-duration is not a panacea
Rationale: Investors have flooded into short-duration bond funds believing that these funds offer both high yield AND safety. The basic tenets of investing say that risk and return go hand-in-hand, which means that high yield typically comes only with added risks. It is our guess that investors are quite unaware of the risks imbedded into short-duration funds. Trouble could lie ahead.

Chart Gazing

Apple
Probably the most talked about death cross in ages.  Apple’s 50-day moved through its 200-day moving average last week leaving the stock technically vulnerable.   This sell-off probably ends in a massive short squeeze sparked by some positive fundamental news, in our opinion.
Mexican Bolsa
Sneaky rally to new all-time high.  Mexico’s stock market has been the tortoise of Aesop’s Fables.  Slow, steady grind higher.

Brazil Bovespa
Mexico’s Bolsa must make Brazil’s Bovespa the hare of Aesop’s Fables.   The index has been weighed down by the China slowdown and the government’s use of some of large cap stocks, such as Petrobras,  as piggy banks.
India’s Sensex
The index has been one of the best performers in local currency terms this year.  It is also closing in on an all-time high.
Hang Seng
It’s no wonder that equity markets are rallying into the close for the year.  The Hang Seng is are favorite indicator species of global risk appetite.  The index has performed remarkably well given the Shanghai Composite if just off a 3-year low.
Shanghai Composite
The Shanghai bounced hard after making a 3-year low on Tuesday.   This index is the odd man out this year the only major stock market index we cover with a negative return.  It could be setting up as the trade of 2013, but still needs more technical work, such as taking out the 200-day moving average.
Japan’s Nikkei
The Nikkei has had a huge snapper rally based on the expectations Shinzo Abe will become Japan’s prime minister next Sunday and will lean heavily on the Bank of Japan to implement massive quantitative easing.  The yen has weakened considerably and taken the Nikkei up.  This policy will not be without big risks, however.
Australia’s All Ords
Not far from a 52-week high.  Australian equities are caught in between the risk on rally and weaker commodity markets, in our opinion.

U.K.’s FTSE
It will be interesting to see if the FTSE can break to new highs by the end of year on the back of the DAX and CAC breakouts.    We think traders, led by Santa Claus, will have the Christmas Spirit in them to move the index over 6000 by the New Year.

Euro
The euro has been in a definitive range over the past three months.  Having difficulty breaking above 1.31625.   Let’s see if Italy’s political problems and economic weakness can take out the downside at 1.2700
Yen
If they don’t sell the Abe news next week, the yen looks ready to break to new lows.   Feels like traders are setting up the Japan trade next year.  Long the Nikkei, short the yen.   Two death crosses this year! Outch!
Crude Oil
Crude oil has led the commodity complex lower.  Resistance levels are declining though crude is trying to hold its recent low of $84.52.  It should be helped by the China story, but the CFTC is working hard to take the spec bid out of the market.  Lower crude has now become equity positive.  Wouldn’t be surprised to see the low at 79ish tested.  Brent may be a different story, however.
Copper
Clearly bouncing with the Shanghai.   Tough one here.
Gold
Gold has been a very difficult trade this year.  If QE∞ can’t move the yellow metal to new highs, something must be wrong.   Though the actual printing of money has lagged greatly QE rhetoric.  The last time we looked the U.S. monetary base is slowly shrinking and the ECB has yet to engage in OMTs.   Maybe the rise of Shizno Abe as Japan’s Prime Minister next Sunday will be the spark.   And, maybe, not.   We have learned the hard way never to fall in love with a position.
Wheat
Cool chart.  Big spike and big, long flag formation.  A breakout to the upside would not be positive for the overall economy and global political stability.
(click here if charts are not observable)

Corporate bonds outstanding exceed MBS for the first time in over 20 years

For the first time in since 1991 the amount of corporate paper outstanding in the US is higher than the amount of mortgage related securities.

Source: SIFMA

There are a couple of reasons for this:

1. Net corporate issuance has continued at a good pace even after the financial crisis (seethis post for example).

2. Consumer deleveraging after the financial crisis has been reducing the amount of mortgages outstanding. At some point however, these balances will begin to stabilize (driven by demographics) and mortgage related securities outstanding will begin to climb again.

Total mortgages outstanding in the US (source: Mortgage News Daily)

Talking Macro, Fixed Income, and the Strategic Alpha Bond Fund with Loomis Sayles’ Matt Eagan

David Schaw

Loomis Sayles is undeniably one of the pre-eminent names in the world of bond funds. The flagship $22 billion Loomis Sayles Bond Fund has returned 10.07% annually over the last 10 years, beating the Barclays Capital U.S. Aggregate Bond Index by a remarkable 4.66% annually. While the big name at Loomis Sayles is the lead managerDan Fuss, CFA, co-manager Matt Eagan, CFA, plays a crucial role in managing the Loomis Sayles Bond Fund and other funds.

I recently had the chance to catch up with Matt to discuss the fixed-income universe, issues facing the global macro economy, and his multi-sector global opportunity Loomis Sayles Strategic Alpha Bond Fund. This fund is a go-anywhere multi-sector bond fund that is managed to relatively low volatility versus core funds. It’s a very interesting fund given the uncertainty in the bond markets from central banks and geopolitical risks (such as in the eurozone).

David Schawel: Tell me a little about your background and your time at Loomis Sayles.

Matt Eagan: I’ve been at Loomis Sayles for 15 years, managing portfolios for 12 years. My background is in the credit side. I previously worked for Liberty Mutual covering investment grade (IG) corporates, high yield (HY), and emerging market (EM) sovereigns. I came to Loomis as a research analyst in the early 1990s, and one of the first sectors they gave me was oil and gas. A lot of risks and opportunities existed in the oil and gas industry, with oil falling to $10 per barrel. They gave me some telecom credits, and I was also able to select corporate debt trading at attractive levels during the Asian crisis, such as Philippine Telecom.

David: In addition to being co-manager on the Loomis Sayles Bond Fund, you manage the Loomis Sayles Strategic Alpha Fund. Take us through the purpose, objectives, and strategy of this fund.

Matt: This multi-sector bond fund style is very eclectic. It’s a multi-sector, global opportunity set, allowing you to go anywhere in the fixed-income space. We don’t look like the benchmark. It’s a long–short fund, and at its heart, it is multi-sector. It has a lot of flexibility to go where there’s value. The objective is to generate LIBOR + 2–4% per year. When LIBOR is very low, like right now, we are looking to generate a return of at least 6% net annually for our clients over a three-year horizon. In this portfolio, we are going to provide investors with an explicit target of where we want to be in terms of standard deviation, which is 4–6% on average. We do this because when you give money to a multi-sector fund manager, you aren’t exactly sure what you’re getting in terms of volatility. We want investors to know what volatility they will be getting. Core fixed-income funds usually run about 4–5%, so it’s a bit of a step out from a core fund. But at the same time, it’s a long ways from long-only multi-sector global credit-oriented strategies, which run volatility of 6% or more, even up to 8%.

David: Can you go into some more detail with respect to your risk management practices?

Matt: We can go long and short. We could go 100% long or 100% short. We use interest rate, currency, and credit space derivatives to move the beta around. I spend a lot of time with risk management to disaggregate different risk factors. I’ve always looked at the three Cs (credit, curve, and currency) in this type of multi-sector portfolio. We can build the portfolio based on our top-down views and broad opportunities, or we can be purely alpha-focused and pick from a bottom-up perspective. When we put the portfolio together, we are measuring the market risk that is embedded in it. For every bond, we cut up the risks into term structure, credit, and currency risks. All of these risk factors can be separated and looked at independently, but they can also be rolled up so we can see how they covariate. For example, in HY and IG, where we see valuations on the stretched side or “fair at best,” we can dial down the beta by shorting some credit derivatives but maintain the long exposure. A long-only fund cannot reduce exposure without selling the bonds at the risk of never seeing them again.

David: How does this type of volatility targeting benefit the average investor, particularly in this low-interest-rate environment?

Matt: The challenge I see is that a lot of people are tied up in funds that are benchmarked to the Barclays Aggregate. Embedded into this is a high degree of interest rate risk because a large percentage of the aggregate index is in U.S. Treasuries (USTs), agency debt, and agency MBS (mortgage-backed securities). So naturally, this has a high degree of sensitivity to interest rates. The Barclays Aggregate correlation with interest rates is somewhere in the neighborhood of 90% or more. The Fed is forcing people to make a decision to move out into term structure or move into credit and take a different type of beta risk, such as high yield.

David: Speaking of that, let’s talk about the high-yield, leveraged loan, and CLO (collateralized loan obligation) space. The HY and loan markets have had a strong year, returning 13% and 9%, respectively, year to date. Issuance has exploded as investors seem to be chasing yield as they are pushed out of government securities, such as agency MBS and USTs, into riskier assets. Issuance of HY and loans of $580 billion through November has already exceeded the previous annual record set in 2007. Meanwhile, defaults in these markets have been below 2% for the past few years. How do you look at these asset classes?

Matt: I agree, and I think it’s very fair to view HY and leveraged loans together. It all starts out with the business cycle. Where are we in the default cycle? We think we are past the best part of the default cycle. Defaults troughed last year well below 3%. It doesn’t get much better than this. The capital appreciation has run its course in HY. If you were just looking at dollar prices, you would argue that yields are fully priced. With HY, you never really trade higher than par plus half your coupon. We’ll assume the typical coupon is roughly 8% right now. Because of the call option embedded in these HY credits, you cap out at about par plus half your coupon (104–105).

David: So you’re saying the bonds are negatively convex here?

Matt: Yes, they act negatively convex. You aren’t able to generate high capital gains as yields start to come down further because the companies will begin to refinance the debt out of 8, 9, 10% bonds into 5, 6, 7% bonds. We are at the point where the return profile is very negatively skewed. The upside is basically your yield; however, that’s not something to sneeze at. A lot of people say “spreads are still cheap at over 500 bps.”

David: I hear that a lot, too. I’d probably argue that, given how low UST yields are, the spreads are less meaningful here.

Matt: They are less meaningful to an extent. Compared with USTs, the data indicate that HY is a very good income generator. I don’t think the credit cycle will turn hard here though. We are at a point in the credit cycle that I’d call a “benign point,” where defaults just kind of bump along. Underwriting since 2008 has been relatively decent, and the use of corporate proceeds hasn’t been egregious. There’s been some silliness, but by and large, it’s been okay and it takes time for problems to surface.

David: We’ve started to see more and more PIK (payment in kind) deals surface, but at what point do you start to say things have gotten too frothy? The technicals in spread markets are very bullish here. Net supply for spread products in 2013 is projected to be negative, even before accounting for the impact of the Fed’s purchases continually pushing people out the risk spectrum. What stage of the game are we at here?

Matt: We’re at a stage where you want to be very picky about the credits you’re in. It’s become a bond pickers market here. There are plenty of one-off opportunities. From a complete top-down perspective, the most you’ll likely get in HY is your yield. With silly season in underwriting just starting, it takes time as the seeds are being sown. The minefield is being laid for the next credit cycle to get worse down the road. You don’t know what PIK deals will blow up on you, but they will come. The seasoning period takes 2–3 years before the defaults escalate. Getting back to your comment about the benchmark being broken, another way of looking at the spread is to compare the HY absolute yield with CPI. If you back out CPI and look at what your real yield is, you get a CPI-adjusted yield. This gives you a result of 300–400 over, which is well within the normal range in real terms.

David: Is there any specific names you’ve been long or short that you would elaborate on?

Matt: In the credit space, we have been playing the convergence trade in Europe. We started buying these credits late last year, focusing on IG corporates — large names like Telefonica, Finmeccanica, Telecom Italia S.p.A., and others (that is, IG names that are in the wrong zip code by being in peripheral countries). What appeals to us is that they have a lot of financial flexibility. Look at a name like Telefonica: It’s one of the largest telecom companies in the world, it has holdings in Latin America, and you have a 70 billion euro market cap below your debt as a cushion. Debt was trading at cents on the euro, with yields up to 8%, that is, trading as cheap as high yield. We kind of loaded up on those late last year and into this year. We had to take a longer term view that the eurozone would not fall apart. We ran a sensitivity analysis on each country, and projected that, even if they left the eurozone, these credits would go to non-IG. But guess what? They’re trading cheaper than non-IG.

David: So, are you guys looking at what these companies would look like if their respective countries exited the eurozone?

Matt: I’m old enough to remember the Brady bond crisis, and I’ve approached the eurozone crisis the same way. You have too much debt, so you’ll see some restructurings. I’m always thinking about what my margin of safety is. If I can at least have a roadmap in the worst case scenario of what it can trade down to, then I can make an intelligent decision about at what price it looks compelling. I don’t avoid situations. There’s always a price at which it makes sense. We took each country and put them into restructuring, and we said, what would it take to fix each country’s debt structure by knocking off a certain amount of debt? I’m always thinking, at what price?

David: The ECB (European Central Bank) has seemingly thrown the kitchen sink at the problems it has encountered. Do you think the “fat tail” risk has largely been taken off the table?

Matt: There were two key announcements in Europe that have taken the fat tail risk out of play. The first was the LTRO (Long Term Refinancing Operation), which took the systemic banking crisis off the table. The second was the ECB saying that it would not tolerate too high of a convertibility premium in the peripheral. It didn’t want the monetary transmission to be blocked to the peripherals. That’s how the ECB came up with the OMT (Outright Monetary Transactions). It has removed, to a certain degree, the risk of convertibility, such as Portugal and others leaving. Now, you look at Portugal-type names, and let’s say maybe the embedded convertibility risk gets taken out and they start trading more in terms of a spread to core names—then Spain, Italy, and Portugal start to look attractive, and that’s what has happened from where we were in July. Spreads have ratcheted in enormously. We’ve been long Spain and Portugal plus the IG corporates. So, we captured all of that, and I think there’s more to come. The next thing that could come is a triggering of the OMT, but our underlying premise is that the eurozone will stick together. It’s more of a range trade. We think the convergence trade theme will continue with peripheral yields coming down and the core names selling off as the flight to quality bid fades.

David: Michael Pettis’ commentaries are among my favorite to read. He recently remarked that, “For now, Spain has implicitly chosen the option of unemployment, in the hopes that it will be able to adjust in one or two years and eventually resume normalcy. No country, after all, can bear the pain that Spain is bearing today without a serious deterioration in the social and political fabric. If Spain wants to continue along its current path, it must be prepared to suffer at least another five years of extraordinarily high unemployment, an erosion of the productive capabilities of its economy, and rising political chaos. Or it can leave the euro. Given how rapidly the political environment is deteriorating, I have little doubt it will leave the euro. Unfortunately we will have to wait a few more years for Madrid to drive the economy into the ground and to rip apart the country’s social fabric before they choose to devalue. But I fully expect they eventually will.” Do you agree with his assessment of the options?

Matt: I agree with what he’s saying. The policy decision of austerity is the wrong one for Spain, or anyone else in the periphery for that matter. Spain is facing a balance sheet crisis, and the last thing you need when the private sector is deleveraging is for the public sector to deleverage too. That is a policy mistake, and I think that’s becoming more well-understood now. The complexity comes from the political situation where the core doesn’t want to throw good money at bad. Germany has kept the pressure on these countries, not austerity for austerity’s sake but, rather, to make big structural changes and fiscal reform, moving toward fiscal centralization. They are trying to get countries to give up their sovereignty over their fiscal policy, which is a big leap for them to make, and also broad labor market reforms. That’s what Germany is really after; they are keeping pressure on these countries so they are forced to make the hard decisions.

David: It feels like some progress is being made, but in my opinion, it will get worse politically and socially before it gets better.

Matt: Slowly but surely these policies are being enacted. They are playing a delicate game, and they need to be careful what they say politically. Pettis is right that it’s a dangerous game to play, as there’s a certain amount of hubris to say you can do this without causing a crisis, but the lynchpin is the ECB. The ECB, through its OMT, can keep the threat over the market from getting too unhinged from the downside that you’d fall into a crisis. The funny thing about the OMT program is that it has worked well. Looking at Spain’s yields, they’ve come down without ever having to trigger it, and it has reduced borrowing costs. It has allowed Spain to not ask for the OMT. It’s a bizarre situation, but if push comes to shove, Spain will come back to the ECB and agree to the core government requirements. There may be some tests along the way, and it’ll go on for years, but eventually, the north will have some control over the budgets of the south.

David: Eventually, the current account deficit situation will need to be repaired for true healing to occur.

Matt: We are already starting to see big changes in current account deficits. I think Portugal is in a positive current account surplus at this point. That’s not because it is becoming competitive on the exports, like Ireland is, which is the poster child for positive reform. Portugal has a current account surplus, a knowledgeable workforce, and low tax rates. The other countries don’t have that; the way its surplus happened is a collapse in the imports, and that’s not necessarily a good thing. But that does build the adjustment in. It will be painful, and the risk is that it can lead to social unrest.

David: You’ve said that your base case is for the eurozone to stick together, but how, if at all, should they go about hedging tail risk?

Matt: A lot of it is trying to figure out how much of these macro risks are priced into the market. You don’t want to be hedged paying for insurance when the risk is already out there in the market. This time last year, the risks seemed high, but you were already being paid for it. We are in a transition market right now. The global economies are deleveraging. The private sector debt has ended up on the balance sheets of the public sector. The public sector’s fiscal budgets are tapped out and are being forced in the best case to be non-stimulative and in the worst case to undergo some austerity. A weak private sector and a public sector with handcuffs on it mean that the underpinning impulse of the economy is very disinflationary. In Europe, you have the possibility of deflation in some places. The only reflation game in town is through the central banks, and they are doing their best to keep it going. We think the way out is through reflation and debt monetization. Historically, they get solved through inflation down the road, as debt as a percentage of nominal GDP gets eroded or monetized away.

David: I’m glad you bring up the central banks. As a portfolio manager myself, I have seen first hand how much the Fed has impacted asset prices through its QE (quantitative easing) programs.

Matt: We are in the late stages of a “risk on” rally, and you really want to fade it, as we know the underlying picture really hasn’t changed. There’s been a shelf life for central bank activity. They’ve flooded the economy with money, and as risky asset valuations have gone up, we have started to layer in hedges. We’ll go toward neutral in credit and take our beta down to zero. We won’t go short due to risks of getting hit by the Fed.

David: I’ll present a counterargument to that. Although many areas of the credit markets have rallied substantially, as measured by inflows, investors have not been pushed substantially into stocks yet, which is arguably one of Bernanke’s main goals through QE.

Matt: I think that’s a fair statement. I think the risk premium can come down in equities and multiples can go up. The thing that people may be misunderstanding is that QE-infinity does not have a shelf life with a date. I wouldn’t be surprised to see at the next Fed meeting, that the Fed would buy more U.S. Treasuries as Operation Twist ends. You’ll probably see $40 billion of USTs in addition to the $40 billion of MBS from QE3.

David: What’s interesting about another UST buying program is that it would be balance sheet expansion. Operation Twist was “sterilized,” as they were selling one maturity and buying another. They were adding duration, but it was still sterilized.

Matt: Exactly. It’s pure balance sheet expansion.

David: Real yields have continued to go lower, and I’m waiting for the 30-year real yield to turn negative as well. What is the catalyst for them to become less negative and eventually positive? And does the fact that they are negative here (except for the 30 year) imply that the Fed is working?

Matt: The Fed will move toward a targeting mechanism. They might currently use inflation and employment dual mandates, but really what they are targeting is nominal GDP. They are distorting the yield curve very successfully. The idea is that they will keep them low until they hit their targets — closing the trillion-dollar nominal GDP output gap, which we think could take a few years. The first impact would be that the yield curve will start to rise and steepen. It will steepen initially as the numbers get better. People won’t be looking for a certain date; they’ll be looking for economic forecasts. I think rates will rise on a secular basis from here. The first cycle will be relatively benign from an inflation basis. It will be more painful from a real rate basis as real rates move from negative to positive, and inflation will pick up more steadily after that.

David: In my view, there’s a large percentage of market participants who confuse base money supply and broad money supply. Bank loan demand has picked up, but it’s still extremely challenging here. Consumer and real estate loans are largely flat. C&I (Commercial and Industrial) has picked up.

Matt: This is a key point. The money multiplier is not working right now. The money that is pumped into the banking system from QE is being stuck as excess reserves at the fed and not lent out.

David: Lacy Hunt likes to say that the money multiplier is negative at the margin here. Would you agree?

Matt: Yes, I would. If they pump a trillion dollars into the monetary base, even if the money multiplier is negative, it will still expand nominal GDP at some level. Eventually, the deleveraging will turn around, and the private sector will start to borrow. You need to watch when lending starts to pick up again. That will be when those excess reserves start to leak out. The Fed is saying it will be able to rein that in through draining the reserves or raising IOER (interest on excess reserves).

David: I am not a big believer that IOER will be a very effective tool if things started to overheat. For instance, at the margin, I don’t believe lending decisions are being made over whether IOER is at 25 bps or 225 bps.

Matt: I think it’s some hubris that the Fed thinks it can do that. I agree; I think those reserves will leak into the economy at some point, although I can’t tell you when.

Conclusion 
Going forward, fixed-income investors should be cognizant of the risks they are taking in their bond funds. Coming off of the heels of substantial gains in both government and credit bonds, investors need to understand the risk/reward nature that various fixed-income classes have going forward. Investors who are willing to look at alternative bond funds should consider the Loomis Sayles Strategic Alpha Fund (LABAX). I like that in addition to having a great grasp of the macroeconomic issues, Mr. Eagan has a strong credit background, which shouldn’t be underestimated in a time when yields are at all-time lows and competition for spread assets is so high. While this type of fund is not for everyone, it could be a suitable part of a portfolio for a fixed-income investor seeking attractive absolute total returns with low volatility.

Funds of Hedge Funds May Be Down, But Don’t Count Them Out

When was the last time you read some good news about the funds of hedge funds industry?  Judging by the tenor of most articles in the trade press and general business news outlets, funds of hedge funds (FoHFs) are losing assets, losing interest and losing relevance.  As trumpeted by a recent headline in The Economist, “Going, going, gone?” seems to be the prevailing view of their status. 
It’s certainly true that the industry’s numbers trace a downward trajectory.  In contrast to the strong rebound in assets under management (AUM) by single-manager hedge funds after the financial crisis, total assets managed by FoHFs fell from their 2007 peak of $798 billion to less than $644 billion as of year-end 2011, according to Hedge Fund Research.  Those counting casualties will find no shortage of FoHFs that have shuttered or are on the ropes and revenue-starved. Many fund managers are still working to recoup the steep losses they suffered in 2008, and those that have failed to hit their high water marks have not earned performance fees for three years.  
Most troubling of all is the widespread questioning of FoHFs’ fundamental value proposition. For some 40 years now, FoHFs have existed to provide greater expertise in hedge fund selection, due diligence, and risk management than many investors could muster or afford on their own.  Particularly for smaller and mid-sized institutions with limited experience, FoHFs have served as a gateway and training ground for hedge fund investing.  
Unfortunately, several years of lackluster overall returns, combined with FoHFs’ added layer of fees, have produced a growing trail of disgruntled investors.  News reports, and indeed data, indicate that institutions of varying size are increasingly choosing to go direct, managing their own hedge fund investments despite the learning curve and staffing costs involved.  Needless to say, consultants and single-manager hedge funds are quickly stepping up to offer FoHF-type expertise, in some cases even assembling portfolios of hedge funds themselves. Meanwhile, FoHF managers have been whittling down fees, sometimes going so far as to eliminate management fees altogether for their larger clients.

On the face of it, it’s not an encouraging picture. And yet, when you look beyond the headlines and broad-brush statistics, there are rays of hope. To paraphrase Mark Twain, it appears that reports of the FoHF industry’s demise have been largely exaggerated.

For one thing, some FoHF firms, particularly the larger shops, are not only retaining assets but attracting new allocations even as others are buckling under business pressures.  Indeed, as reported in Hedge Fund Intelligence, 47% of the FoHFs with more than $1 billion in assets saw positive asset growth in 2011, and the total AUM in this group increased by some 10% in the course of the year.

Industry dynamics also suggest some enduring role for FoHFs.  The universe of hedge fund managers and strategies has continued to grow in size and complexity.  Even among large institutional investors, few have all the internal capabilities needed to deal with the full spectrum of investment issues and possibilities. And even the most sophisticated investors still need advice in areas from manager selection and due diligence to risk management, performance attribution, and monitoring.  Seasoned FoHF managers remain a repository of specialized expertise few others can match.

The most compelling notes of encouragement come from FoHF investors themselves.  In a recent SEI survey, 72% of institutional investors and consultants agreed that “FoHFs still play a valuable role in institutional investment portfolios.”  Four out of five investors we surveyed said they see FoHFs as an ongoing portfolio component, not just a way station on the road to direct hedge fund investments. Moreover, 84% predicted that FoHFs will still exist in 20 years.

But that doesn’t mean a continuation of the status quo. Consistent with reports of industry-wide outflows, nearly 44% of investors we surveyed reported lowering their allocations to FoHFs over the past three years.  When the topic of FoHFs’ future is broached directly, two-thirds of investors and consultants we surveyed agree with the statement that “Funds of hedge funds must reinvent their business model if they want to survive.”

So how can FoHFs change their stripes and elevate their competitiveness?  Some trends are already taking shape.  More than a few FoHF managers are already shifting away from well known, name-brand hedge fund managers, positioning themselves as talent scouts who specialize in up-and-coming managers and interesting, little-known strategies.  Some go even further by seeding new funds for talented managers. 
Customization is another promising direction.  FoHF solutions have many elements—from manager selection and strategic advice to portfolio construction and risk management—all of which can be mixed and matched to clients’ specific objectives. Moving up the customization scale, FoHFs could work closely with clients to provide complete, fully customized hedge fund investing solutions, helping to answer investors’ growing concern with matching assets to their liabilities. To be sure, that level of customization is resource-intensive, but it may be a requisite for survival.    
In all, SEI’s exploration identified seven broad ideas for making hedge funds more competitive, augmented by investor, consultant and manager ratings of those concepts.  The report, Seven Ways to Reinvention: Evolving and Enhancing the Funds of Hedge Funds Model, can be requested by visiting www.seic.com/ReinventingFOHF.
Our study made two important things clear.  First, while institutional investors and FoHF managers see eye to eye on a number of issues, on some there is a marked disconnect.  For example, while 63% of responding managers said that “FoHFs have provided the level of transparency investors need,” only one-third of investors and consultants agreed with that statement.  These areas of divergence not only point to a need for more meaningful dialogue among managers and their clients, but also highlight opportunities for managers to differentiate themselves. 
The better news – point #2 –- is that institutional investors, the lifeblood of the FoHF industry, already have some clear visions of what a competitive FoHF looks like.  Moreover, they appear to be receptive to—and even looking for—–a radically reinvented business model that casts FoHFs as versatile solution providers, and trusted advisors. 
As one respondent put it, “The competitive FoHF of the future will be more of an alternative assets platform with different investment structures and an ability to invest across the spectrum of alternative assets.” Other respondents go even further, seeing the competitive FoHF as a partner equipped to offer a comprehensive array of hedge fund investment offerings, strategies and services.   
The FoHF industry’s story is still being written, with the potential for many more twists and turns along the way.  But the upshot is that FoHFs find themselves in a rare window of opportunity, an inflection point in the global hedge fund industry where innovation is welcomed. This is a time when key decision-makers and influencers are not only looking for meaningful and, potentially, even radical change, but are keenly interested in what develops next. That openness to possibility may be the best news the FoHF industry has heard for some time.

Blackstone Readies Mutual Fund Of Hedge Funds

The Blackstone Group will launch a mutual fund of hedge funds, becoming the latest industry player to embrace the retail vehicle.

The New York-based firm this week filed to register the Blackstone Alternative Investment Funds. Blackstone's move follows Kohlberg Kravis Roberts' July registration of two mutual funds.
The Securities and Exchange Commission filing was short on details; Blackstone did not specify when it hopes to launch the fund, a minimum investment requirement or its fee structure. But it did say that it would invest in global macro, opportunistic, quantitative and managed futures hedge funds.

Blackstone also said it would offer the fund through investment advisors, consultants, broker-dealers and others.

Danger Lurks Inside the Bond Boom

Amid Corporate-Borrowing Bonanza, Some Money Managers Warn of Little Room Left for Gains

Investors have been flocking to buy bonds issued by top-rated companies, putting them on pace for a record year of debt raising in the U.S. But some of the biggest fund managers warn that dangers are lurking in what were once seen as the safest investments.
Amid the rush of bond deals, which already have topped $1 trillion in value, these managers—from BlackRock Inc. to Federated Investment Management Co.—are pointing to unusual wrinkles suggesting that now could be one of the most dangerous times in decades to lend to investment-grade companies.

Interest rates are so low and bond prices so high, they warn, that there is little room left for gains. Some worry that even a small increase in interest rates—a traditional enemy of bond returns—could eat away at bond prices.
For the first time in decades, some companies are offering a dividend yield—the value of annual dividend payments divided by the share price—that is higher than the interest rate they pay on their bonds, meaning that investors could get a better stream of income from stocks.
As a result, some of the largest investing houses—including BlackRock, the world's largest asset manager, and Federated—are looking for ways to reduce their exposure to U.S. corporate bonds. At Loomis Sayles & Co., a large bond manager, some money managers are moving into stocks and convertible bonds.
"Fixed-income is becoming an asset class with more risk to it, and I think people underestimate that," said Rick Rieder, who oversees more than $600 billion in assets as BlackRock 's chief investment officer of fundamental fixed income. He is making changes to minimize his exposure to potential losses from rising interest rates, including buying higher-yielding junk bonds and European debt. "It would take very little in the way of a rate increase for investors to lose their total returns across many traditional fixed income sectors."
For now, investors and companies are still rushing into the market.

Companies from General Electric Co. to Intel Corp. sold bonds this week, putting sales on pace to break the 2009 record of $1.024 trillion, according to data provider Dealogic.
The average double-A rated bond, the second-best grade given by credit-rating firms, yields 1.96%, compared with the average dividend of 2.33% for companies in the Standard & Poor's 500-stock index, according to Goldman Sachs Group Inc. Wal-Mart Stores, for instance, now pays a 2.22% dividend on its stock, up from 2.17% two years ago. Its bond maturing in 2020 yields 1.875%, from 4% two years ago.
Investors have been piling into bonds sold by investment-grade rated companies for the past few years, pouring a total of $976 billion into corporate-bond mutual funds since the end of 2008, according to Thomson Reuters unit Lipper.
These bonds were viewed as a sweet spot for many investors because they were considered less risky than stocks but also offered higher yields than U.S. Treasury bonds.
That drove prices up and yields down. High-grade corporate bonds have returned 10.13% so far this year, up from 8.15% last year, according to a Barclays PLC index. The demand prompted global companies to sell $3.65 trillion of debt in the past four years.
But the massive rally, which saw the average yield of an investment-grade corporate bond fall to 2.66% from 4.04%, means there is now little cushion should interest rates rise. As rates rise, the value of existing bonds with lower yields declines.
Yields are so low companies often borrow below the 2.2% inflation rate, meaning bondholders are losing money in real terms.
"This seems mathematically crazy," said Joe Balestrino, senior vice president for fixed-income at Federated in Pittsburgh. He owns fewer investment-grade corporate bonds than the benchmark index his fund tracks.
Bond math dictates that losses will be magnified when interest rates are low, and when bond maturities are long, as they are now. The average corporate bond sold in 2012 matured in more than 11 years, up from less than eight years in 2009, according to Dealogic.
According to Barclays data, if interest rates rose by just one percentage point, the average bond issued in 2012 would lose 5.12% of its value.
By contrast, the same scenario in 2007, when rates were higher and maturities shorter, would have caused a 1.82% decline.
And even if rates don't rise, the chances of a continued rally are slim, some skeptics say.
To generate capital appreciation, prices have to keep climbing, pushing yields lower. With average yields so low, another 10% annual return—the median average over the past three decades—would be "mathematically impossible" unless medium-term Treasury yields—the benchmark for corporate debt—fall to zero, according to Bank of America Merrill Lynch credit strategist Hans Mikkelson.
Some analysts and investors argue that interest rates are likely to remain low for some time. The Fed is still buying Treasury and mortgage bonds, keeping rates low, and has said it will keep overnight interest rates near zero through at least 2014.
"With Fed support, the demand for high-grade bonds will remain strong," said Eric Beinstein, credit strategist at J.P. Morgan Chase & Co. He projects a 5.4% total return in high-grade bonds next year.
Matt Eagan, co-portfolio manager at Loomis Sayles & Co., is looking for ways to avoid what he sees as a wall in bond prices. He increased the portion of stock holdings in his $14.6 billion Strategic Income Fund to 18%, the highest since its inception in 1995. Another 10% is in convertible bonds that can convert into stock.
"We haven't seen this situation where corporate bonds are out-yielded by their equities since the early 1970s," Mr. Eagan said. "As long as your time horizon is long enough and you can absorb some of the volatility, we think you have a better chance of preserving principal on the equity side."

How Top Heavy is the S&P 500?

With the strong rally in shares of Apple (AAPL) this year and its solid lead in terms of its position as the most valuable company in the world (in terms of market cap), there may be some concern on the part of investors that the S&P 500 is becoming increasingly top heavy.  As an index becomes too top-heavy, it no longer becomes an accurate representation of its components.  During the tech bubble of the late 1990s, the rally in a handful of highly valued companies propelled the S&P 500 to record highs even as the majority of stocks in the index were in nasty downtrends. 

We recently came across an interesting table from Standard & Poor's which summarized the number of companies in the S&P 500 that it took to account for half of the index's market capitalization from 1980-2011.  The chart below is adapted from that list, and in it we have added the number of stocks that currently account for half of the index's market cap.  As shown in the chart, 49 stocks in the S&P 500 now account for half of the index's market cap.  While this may sound high at face value, from a historical perspective, it is actually not far from its long-term average.  

To find the period when the S&P 500 was the least top-heavy, you have to go all the way back to 1984 when it took 64 stocks to make up half of the index's market cap.  In 1999, when the S&P 500 was more top-heavy than it has ever been, it only took 33 stocks to account for more than half of the index's market cap.  For all years since 1980, it has taken an average of 51 stocks to account for half of the index's market cap, which is just two more than now.  From a historical perspective, the S&P 500 is hardly at an extreme level of top-heaviness.  That being said, there has been a clear trend of lower highs in the chart, and as the number of stocks accounting for half of the index's market value decreases, the index does become more top heavy.

Pondering Fixed Income in 2013

• I recently had a chance to speak with Loomis Sayles’ Matthew Eagan who is co-manager of the famous Loomis Sayles Bond Fund led by Dan Fuss. We covered a number of topics ranging from the Fed, Europe, High Yield, Hedging Tail Risk, and many others.  You won’t want to miss it as he’s a very bright PM.  It should be posted Wednesday or Thursday on the CFA’s Inside Investor blog found here.
• I was honored to participate in Reuters 2013 Investment Summit last week in New York.  In Katya Wachtel’s article titled “Chasing yield, investors favor credit again in 2013” I join in the conversation.  Chasing yield is no doubt a continuing theme heading into 2013 as institutional investors far and wide are finding a diminishing set of opportunities available.  You are starting to see non-agency MBS become almost “too popular” as every HF is suddenly an expert!  Everyone thinks its a great play on a housing recover and an “easy way” to earn 4-6% returns.  The low hanging fruit has been picked!  Funds such as DoubleLine, Ellington, and Elliot have apparently moved more towards CMBS & CLOs versus incremental non-agency investments.
• Heading into next year, I’d have to think that the majority of the run in high yield is over.  HY spreads and yields are down 111bps and 131bps respectively.  Defaults, which have run under 2% (and likely will next year too) really have no room to improve.  At the same time you have very positive factors supporting the market.  The boom has caused a flood of refinancings, thus debt maturing in the next few years has been dramatically reduced.  HY becomes negatively convex as prices rise, so I anticipate little price appreciation, but rather just the “clipping of coupons” for investors which isn’t a terrible thing.
• I’d prefer leveraged loans to HY:  According to JPM, high yield absolute yields less leveraged loan yields are at only 57bps as of mid-November.  Traditionally this spread is a fair degree higher given that loans are higher in the capital structure.  As concern about interest rate risk grows, I think the retail sponsorship of leveraged loans will continue to grow as investors seek floating rate alternatives; and LL’s provide that.  This along with growing CLO demand could boost LL’s next year.  The average investor can gain exposure to LL’s through various mutual funds or a closed end fund such as $VTA.
• UST Rate Explosion Unlikely:  Sure UST rates could rise. Or they could fall. My prediction for 2013 is that it’s unlikely we see a dramatic rise in UST yields.  Overall, there is still a dramatic lack of risk in the financial system.  Everyone’s waiting for the next crisis, and in my opinion, that’s not what bubbles look like.  While base money continues to explode through the Fed’s QE programs, broad money supply has been kept in check through a lack of bank lending.  More or less, the money multiplier is negative at the margin.  I find it unlikely we see a large rise in yields without a strong lending led recovery.
• Agency Derivatives:   Yes, this sounds like somewhat of an obscure asset class but that’s a good thing.  The natural pool of buyers for securities such as IO’s, Inverse IO’s, etc is small and as a result option adjusted spreads are extremely attractive.  You really can’t buy these on your own, but you can get exposure through closed end funds such as $DBL and $PDI.  
• Mortgage REITs:   No way I was getting through this post without mentioning mortgage REITs.  I mentioned at the Reuters summit that I thought mREITs (particularly pure GSE mREITs) would be poor investments going forward.  Leveraging a bond that yields 1.5%-2% (same bonds the Fed is buying via QE) over 8x is not a great business proposition.  As the Fed keeps their foot down via QE-infinity, prepayments will continue to accelerate causing margin pressures at the mREITs.  At the same time prepayments accelerate, they will be forced to redeploy this cash back into lower yielding bonds.  This is a bad formula and dividends will be cut more than investors realize.  I can’t tell you when, but you’ll see names like AGNC, NLY and others trade a lot lower next year.  If you remember, I was actually a HUGE mREIT bull last year into the first half of 2012.  Here was my post on Two Harbors written last July.  The massive price appreciation in Agency MBS fueled large gains in mREITs, but I think this party is largely over.  MBS prices may tread water, but margins are in trouble and that equals lower dividends and subsequently lower share prices.