Calvert Investments Mid-Year Outlook 2014
Looking toward the year’s end in U.S. and Global economic issues, interest rates, stocks, bonds, and more.
Cathy Roy, chief investment officer, fixed income, Natalie Trunow, chief investment officer, equities, and Steve Van Order, fixed-income strategist met to discuss the key investment themes they see shaping the markets in 2014.
CIO, Fixed Income
- The economy has run at a sub-par pace of about 2% this expansion. "Escape velocity" from this pace has been elusive.
- Employment participation rates and stagnant wage growth are stalling larger/faster economic growth.
- Interest rates will likely remain steady or rise very slightly.
- Public/Investor pressure is helping push companies in a positive ESG direction.
- Going up in complexity trade is the trend, but higher complexity doesn't necessarily mean higher risk with the proper skills to evaluate the opportunities.
- Macroeconomic data continue to be positive indicating a pick-up in economic activity, GDP increases, and positive news on the income earnings front.
The U.S. Economy:
On balance, after a large contraction in Q1, the US economy has rebounded somewhat. Can you comment on that?
Natalie: I continue to believe that this cycle of economic recovery will be more protracted than usual given the depth and severity of the financial crisis that preceded it. Consistent with that, and recognizing that this protracted cycle will continue to be characterized by very slow improvement, we think the U.S. economy has largely recovered and is now going into an expansion phase. What this may mean going forward is that economic growth may continue to be slower than usual for this stage in the cycle, but it should still prove robust.
Steve: Yes, the US economy has gotten stronger but it hasn't moved as well as people have hoped; surprised on the downside to what the results are. (This is not a grade but a growth rate.)
Cathy: The Consumer Sentiment Report last week was the best in 6 years. Sentiment was higher due to positive data points such as fewer firings, stabilization in gas prices, and record stock prices.
Steve: The economy would have to grow over 3% for the balance of the year to hit the Fed's forecast pace for a bit over 2%.
Cathy: Despite the improving employment picture, the labor participation rate is the lowest it's been since 1978. That needs to improve. We're also not seeing any noticeable wage growth – wages have grown only 2% in recent years.
Steve: Moving that to the next logical step, if Millennials are going to buy houses—creating the next healthy phase for the housing market which should be a driving economic recovery force – we need better quality jobs not just the increased quantity of jobs. The housing sector is not adding to economic growth as we thought it would.
Natalie: With respect to corporate income, company earnings have been quite robust over the past few quarters and we believe this trend can continue. Specifically, we are encouraged by the fact that U.S. corporations have been able to keep their cost structure contained at post-financial crisis levels while benefiting from improving top-line momentum. This trend in earnings, coupled with investor's renewed appetite for risk, makes for a market environment where further multiple expansions – a process that started only a year ago – is not out of the question. We believe that asset classes that are more leveraged to the recovery, such as small caps and the emerging markets, can outperform in this environment.
Steve: There is corporate cash-on-hand, but what corporations are doing is engaging in dividend buy backs and acquisitionâ€“not investing in organic growth. If corporations were investing that cash, it would help boost the cap ex figure in GDP. The potential is there but companies are still not doing things the old fashion way. Corporations are holding on to the cash instead of investing in growth because they lack confidence, do not see really good payoffs for big capex and the tax code makes repatriating profits expensive.
Natalie: Rather than focusing on events happening abroad, investors fixed their attention on improving U.S. macroeconomic data and strong earnings beings reported by U.S. companies, and put the first quarter's negative gross domestic product (GDP) growth in the rearview mirror, attributing the setback to extreme weather conditions. As part of our ESG integration into investment analysis, we closely monitor such extreme climate events and their impacts on companies' supply chains, which could ultimately translate into growth and performance dynamics of entire regions and countries, as was the case here. In the U.S. alone, extreme weather conditions erased about 1% of GDP in the first quarter. If this is a longer-term trend, markets may be in for a rude awakening.
I believe that the unemployment rate can continue to fall further and could be well below 6% or even 5.5% within 6-12 months. Other macroeconomic data also pointed to a second quarter rebound – auto sales continued to rise, manufacturing PMI remained firmly in expansion territory, and consumer confidence edged up. The housing market recovery, an important driver of economic growth, also got back on track with second-quarter data indicating a pick-up in housing activity, which had been suppressed by the severe weather conditions and declining activity by institutional buyers. Despite this spate of positive U.S. macroeconomic data, one area of concern was sluggish consumer spending, which is likely being held down by low wage growth. However, we believe that U.S. economic growth will accelerate in the coming quarters, allowing for personal income growth, which should boost both consumer confidence and spending.
Non U.S./Global Economy:
Leadership has rotated between developed-market securities and emerging markets securities. Which segment is better positioned going forward? Are there any geopolitical events that could greatly impact global markets? (e.g., Ukraine, Russia, Middle East, etc.)
Natalie: We added to our emerging market equities allocation following the first quarter sell-off, which has proved to be a timely move so far. We believe that selective and well-timed investments in this asset class can be very attractive over a long investment horizon.
Steve: Exposure to emerging markets (USD EM debt) has been good. I think it's still a good sector in which to invest since it is nicely priced against US high yield. This market has the potential to continue to do well. The main risk is that it correlates strongly with other risky markets. If the global markets turn persistently risk averse it will underperform. That said, we like USD EM debt in partial substitution for US HY exposure.
Cathy: The US is where the greatest opportunities are.
Steve: When comparing Anglophone countries like the US, Canada and Australia to other advanced-economy countries like Japan and Europe, the yields are relatively cheap.
Natalie: Overall, these geo-political events seem to have insignificant impact on developed markets with investors focusing primarily on healthy earnings reports coming out of U.S. corporations and continued accommodative stance from central bankers around the globe.
Unless Israeli-Palestinian and Sunni-Shiite conflicts threaten to escalate and engulf the region, significantly impacting the price of oil, current market reaction to these events is likely to remain benign. Most of the impact is felt in the emerging markets where these geo-political events have more immediate economic impact.
Russia in particular is at risk of become a pariah State should it fail to de-escalate its involvement in Ukraine. Economic and currency impacts could be severe despite the significant leverage Russia maintains over much of Europe via its stronghold on the supply of natural gas and oil to the region.
This is another example of how our ESG analysis translates into a macro-view on a specific country or region, in this case Russia and Eastern Europe, where governance challenges manifest themselves in geo-political risks that impact market performance.
As we have anticipated, European economic recovery will take much longer to materialize than market consensus has indicated. Overall, we believe global economic growth will continue to move ahead slowly, supported by favorable central bank policies, and these conditions will continue to provide a favorable underpinning for the equities markets, with the U.S. markets in the strongest position. With the dollar strengthening and low inflation keeping commodity prices in check, it appears that, to some degree, the U.S. has benefited from weakness in China and other emerging markets. However, a sharper slowdown in China could prove troubling for global markets, especially given the unknown ripple effects on the global economy should the Chinese real estate bubble burst in an unmanageable way.
What is the most likely scenario for interest rates over the next 3-6 months? Will they remain low for another 12 months?
Steve: Rates look to remain range boundâ€“using our internal model: as one guide we have the 10-year note at about – 2.5-3.0% over coming months. The likelihood is that yield levels will remain low – if they rise even a half point, they are still going to be low. As we look ahead 12 months from now, it is going to be right about mid-point of current market bets for the first rate hike. If the Fed moves in the direction of the first rate hike in the middle of next year, the two year treasury (as the front end benchmark) needs to continue to rise to reflect thatâ€“maybe 1% yield.Â Longer-maturity rates may rise moderately perhaps 3% for the ten-year note. Regarding the slope of the curve, it could remain close to where it is today.Â For example, if you have a 2-year bond 1% and a 10-year bond at 3%, then, the yield curve would stay fairly stable.
Natalie: I expect the Fed will continue its focus on maintaining positive U.S. economic growth and to adjust the pace at which it tapers quantitative easing (QE) accordingly. As we have maintained for some time, a key consideration in the Fed's strategy remains the U.S housing market, one of the chief drivers of U.S. economic growth. As a result, we don't expect to see much interest-rate volatility in the near term. Having said that, time will continue to work against low rates as the long-term trajectory has nowhere else to go, but up.
Steve: As long as the Fed continues to guide for a mid-2015 lift off; then gradual and limited hikes; doesn't make a mistake in communications; and the macro-economic data doesn't force a big change in their policy path, a modest to moderate rise in yields going into the first hike in a year would make sense. The more interesting angle is going to be that the front end yields should continue to rise but as long as the Fed continues to carefully guide markets, it should not be a big problem for investors in the short duration, i.e. big negative returns.
Cathy: The SEC is talking about the floating NAV (Net Asset Value) for institutional money market funds; there was an inside article saying they were going to make some proclamation on that. If in fact if you do see institutional money market funds move to a floating NAV, there could be some disruption in the short end of the yield curve. We will need to consider where those cash-like investments go and what impact this change will have on near-term volatility and yield curve moves.
We maintain a relatively short duration in our fixed income portfolios and have an allocation to floating rates instruments that benefit as short rates rise. Both these strategies should help relative performance in a rising rate environment. Credit spreads right now are near historic lows; credit default swap indices can help hedge credit exposure down the road if and when we anticipate significant spread widening. We also use treasury futures to adjust our yield curve and duration positioning.
Cathy, how do you see Calvert's Green Bond approach helping global environmental issues?
Cathy: Calvert's innovative approach to Green Corporate Bonds, for example, is designed to help the market place drive corporate behavior to positively impact environmental challenges. A good example of a Green Corporate as defined by the Calvert environmental sustainability experts is SAB Miller. They have committed to reduce water usage in their beer making 25% by 2020. In supporting their bonds, we hope to influence other competitors and companies to reduce their own footprints. In addition to green corporates and existing agency issued Green bonds, we hope to see more issuance in Green bonds across sectors such as real estate (green mortgage backed securities and CMBS). There is also a lot of positive opportunity in homebuilding and office space planning and design – retrofitting homes with higher energy efficient appliances, solar panels, and better insulation as well as equipping office buildings with solar panels and building to meet LEED standards.Â We also expect to see more bonds issued which support various infrastructure projects (green taxable municipal bonds).
Do you see companies increasingly paying attention to ESG considerations? Are there sectors or industries where ESG issues are particularly prominent now, for better or worse?
Cathy: ESG risk consideration is an integral part of our fixed income investment process. We see growing demand from institutional investors for their investment managers to incorporate ESG risk assessment into their investment analysis.
Banking was one of the first to have an ESG lens applied to it when their governance practices were challenged after the financial crisis. As the focus on ESG risk assessment continues to grow, companies will need to improve their own ESG reporting. It seems impossible to understand a company's credit risk without considering the risks around an industry or company's salient ESG metrics. It would be imprudent to look at a mining company, for example, without delving into its labor practices, its level of respect for indigenous peoples' rights, and its environmental footprint.
Natalie: Last year, we predicted that some of the sectors which traditionally score low on ESG-metrics—like energy, commodities, and industrials—may snap back and outperform the rest of the market and that this could hurt SRI investors from a sector allocation point of view. This has played out thus far this year and is a trend that could continue. Higher exposures to IT and financial sectors may provide SRI investors some relief from this likely new trend.
Longer term, however, ESG factors and how they impact company valuations are likely to continue to garner more attention in the markets for a variety of reasons. U.S. consumers are more aware of, and educated about, ESG issues and how they impact lives and the economy. This is positive for both the U.S. economy as a whole, and for companies that are poised to benefit from the push toward improvements in ESG factors – as well as for portfolio managers who can identify those trends and benefit from them. We believe that Calvert's specialization in ESG integration and active portfolio management puts us in a good position to find the companies that manage their ESG impacts sustainably. Calvert's legacy in ESG allows us to have a differentiated view on companies, and it is becoming increasingly clear that ESG factors will continue to play a more meaningful role in companies' fortunes and investors' assessments of related impacts, risks and opportunities. We also believe that ESG integration on an individual stock level is likely to produce increasingly positive results for investors.
Steve: Question to you, Cathy – Do you think private label jumbo area is a place that might consider green MBS as it might get their spread in?
Cathy: According to one study, controlled for neighborhood income levels, house size, age of house, and local unemployment rates among other factors, energy efficient homes are less likely to go into default. Logically, the savings from energy efficiency provides some debt service cushion. Seems a good pool of collateral could be aggregated for a private label Green MBS.
Is the high-yield sector still attractive, given recent gains?
Steve: In previous communications, including a number of issues of our Focus On Fixed Income publication, we laid out the methods in which investors may seek to add yield such as extending maturities, going down in credit, etc. We also believe that going up in complexity, in the structured markets, is a good place to be at this point in the interest rate cycle. It's important to note that a rise in complexity does not necessarily equate to a rise in rate or credit risk. All kinds of creative investments can be done in the securitized sector.Â The key is to be able to pick out good novel structures that offer good return for risk tradeoffs.
Cathy: Moving from a high yield bond to a leveraged loan is an example of going up in complexity, but coming down in risk. Loans are higher in the capital structure but have more complex covenants and cumbersome settlement processes than do high yield bonds. We are still supportive of the high yield sector but do not expect any significant spread tightening from current levels.
Steve: The Barclays HY index has a YTW back above 5%.Â This seems a reasonable return projection too for the sector. (YTW, or Yield-To-Worst, measures the return on an investment if all market factors perform in the most negative manner possible.)
Cathy: The high yield market is much more sensitive to interest rates than 3 years ago given the narrow spread premiums.
In our review of Q2, we discuss some of these trends which are unfolding under (and because of) fairly harmonious forward guidance from the major central banks. In ways, it seems more like 1996 than 1998 or 2005 than 2007. If so, then perhaps we are in the 7th inning of this cycle. As we have written before, investors can mindfully stretch for yield but it does get challenging as the cycle plays out.
Security structure matters a lot at this point in the cycle as investment complexity rises; covenants, optionality, collateralization, and even novelty. Over many cycles, we've seen quite a few new structures tested, and some did well and some did not. Picking through the new offering for ones with staying power and that are cheap today is most important. In the last year we have liked, for example, mortgage agency risk-sharing deals and repackaged legacy multifamily-backed securities. Doing that work requires a nexus of the macro view (the housing appreciation trend is good) with credit (evaluating the pool collateral quality and the security payment structure) and quantitative (prepayment and default risk analysis) expertise. Is the issuer committed to additional deals to improve liquidity in the structure? What will the security class most correlate with? For what can it be substituted? The yield reward for price risk taken is there if you can do the work and move quickly enough. But a shop has to click on all cylinders to take advantage. The low hanging fruit has been long picked in Bondland.
Stock Market Direction:
Where do you see the stock market going given data showing the economy is moving slowly in a positive direction?
Natalie: I agree that macroeconomic data continue to be positive, indicating that the next couple of quarters could show a pick-up in economic activity, increases in GDP growth, and further positive news on the earnings front.
Unfortunately, equity markets seem to have priced some of these positives in and may be overly reliant on continued stimulative support from the central banks. In the U.S., this sentiment is likely to change in the next 6-9 months with the end of quantitative easing by the U.S. Federal Reserve. Additional risk premium is likely to be priced into the market with the potential for increased market volatility which could present attractive buying opportunities. I believe this negative impact can be offset by acceleration in corporate earnings and economic growth which will provide further support to the equity markets. However, the net impact is likely to be mild, so I don't expect significant further appreciation in the U.S. equity market in that time frame.
Large Cap vs Small Cap Changes:
Are the large caps and their stocks getting stronger as the small caps weaken?
Natalie: With increases in rates looming in the next 9-18 months, it is understandable that performance out of Small Caps has been less than stellar recently. However, as investors get more clarity on timing, magnitude and the clip of interest rate increases and the end of quantitative easing by the Fed we believe that Small Caps can outperform Large Caps as their earnings have been showing better growth and their business models are more leveraged to U.S. economic growth. We believe that GDP growth can accelerate in the next 9-18 months which should benefit Small Caps, and if the interest rate picture becomes clearer, Small Caps should do better.
This commentary represents the opinions of the author as of 8/1/14 and may change based on market and other conditions. These opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information. Calvert may have acted upon this research prior to or immediately following publication. In addition, accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.
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