Investor Newsline
April 2008
Strategy comments pertain to Capital Management Group investment strategies and reflect the authors' personal views about the subject.
Market Review & Outlook
Equity Market Blues: Equity markets around the world suffered through a dismal quarter amid the global fallout from a stagnant U.S. economy teetering on the verge of recession and continuing risk-aversion and market-wide deleveraging. Major domestic equity indices have generated negative returns for five consecutive months, which is the longest negative streak since 1990, but as difficult as the first quarter was for domestic equities, it was even more challenging for foreign markets. Asian markets had their worst Q1 since 1994 and of the 90 primary world stock markets, only 21 posted a gain for the quarter - and most of these were smaller, largely uninvestable markets such as Morocco and Peru. Among the major developed markets, the single-digit decline of the U.S. market stood out positively - the UK, France, Germany, and Japan all saw declines of 12-19% while major emerging markets China and India each lost over 20%. High-quality bonds (both domestic and international) proved to be safe havens amid the global flight-to-quality and delivered strong returns as spreads continued widening for nearly all non-Treasury fixed income investments. Commodities rallied strongly, with the CRB Index gaining 7.9% (after having been up nearly 18% in early March) to deliver its strongest quarterly gain in three years. The commodity pits also saw several high profile price levels breached as oil exceeded $100 and gold pierced through $1000; oil maintained this level while gold receded by the end of the quarter. The commodity strength can be largely attributed to U.S. dollar weakness (U.S. Dollar Index -6.3% for the quarter) as economic growth slowed and the Federal Reserve aggressively lowered interest rates to combat frozen credit markets and financial market turmoil. The Fed also engaged in a handful of atypical transactions to inject temporary and permanent liquidity and to stabilize the financial system, culminating with the 11th hour Fed-brokered buyout of Bear Stearns by JP Morgan.
A Look At Correlations: The disconnect in returns between equity and fixed income investments during the quarter is not surprising to us; in fact, we wrote about our research into the correlation benefits of bonds d cash last spring and we decided that it is a timely topic that bears reviewing. In the graph (right) are the rolling correlations between large cap stocks and five asset classes that are widely utilized in the investment industry. The solid blue line at the bottom of the chart represents high-quality bonds and stands out - far and away - as the asset class with the greatest diversification benefits when combined with large cap stocks. All of the others do offer some risk-reduction and diversification benefits but they are modest, and for the most part, correlations between most asset classes have been increasing over the past decade. This is particularly true for hedge funds, which garnered a good deal of attention in the early part of the decade for having a low correlation to many traditional asset classes; however, since 2004, hedge fund correlations to other asset classes have been on the rise, and as shown in the graph, there have been no significant differences in correlation between large cap stocks and hedge funds, small cap stocks, and international stocks. In fact, as we updated our work, we continued to find that the only asset classes that have delivered consistent diversification benefits (through weakly positive or negative correlations) are high-quality domestic and international bonds, cash, and commodities. Because the correlations of most other asset classes are strongly correlated to each other - and have become stronger over the past decade - the individual risk and return of each asset class becomes more important in constructing diversified portfolios.
Looking Ahead: As we consider the state of the markets and any longer-term opportunities that present themselves in the context of our asset allocation work, we are mindful of the greater level of risk in global equity and fixed income markets as well as the increased correlation of many asset classes that limits the risk-reduction benefits of diversification. As such, we will maintain our focus on higher quality assets while seeking opportunities to broaden our asset class exposure into investments with attractive risk-return profiles over an intermediate time horizon.
Equity Review & Outlook
The FED Comes to the Rescue: Since January the FED has reduced the Fed Fund rate to 2.25%, a drop of 200 basis points, and lowered the Discount Rate 225 basis points to 2.5%. The FED also provided targeted relief for both banks and primary dealers through extended term financing, acting as the lender of last resort. Coupled with the Congressional $170B stimulus package, these efforts should help to calm the markets, allowing orderly restructuring of troubled financial assets in the quarters ahead. The rapid collapse in credit markets has forced leveraged investors, notably hedge funds, to reduce positions in order to remain solvent, often placing liquidity over fundamental valuation. The rise in leveraged assets has increased the demand for "short" ideas, swelling short interest volume by 70% over the last year, to levels approaching $600B. This rapid and significant increase in short interest becomes self reinforcing, as short positions are covered to reduce leverage, driving prices higher and repeating the cycle until all the leverage is neutralized. For traditional investors, especially those employing quantitative strategies, the performance impact has been highly perverse, with lower quality and lower priced stocks outperforming higher quality counterparts by margins that are near record levels. We anticipate that leverage reduction is nearing equilibrium, but high volatility will likely remain. Economic growth remains positive, but slowing will likely become visible in the months ahead. Continued dollar weakness supports export demand, which has grown to 12% of GDP, up nearly 25% since 2005. Commodity prices remain strong but the pace has moderated as worldwide growth slows. Most visible is oil, which rose above $100, fueling inflation fears. For the quarter all indices were lower, the S&P fell 9.5%, the S&P 400 8.9%, and the S&P 600 7.5%.
The Glass is Half Full: Despite continued and severe financial stress, rising unemployment, inflation threats, falling economic activity and sagging consumer confidence, the market has held above the lows posted in January, a healthy sign. Recognition that the FED has become proactive instead of reactive is gradually changing the tone of the market, and we expect investor confidence to slowly return to a more positive stance. The economy should begin to respond to fiscal stimulus by year end, and we look for opportunities to add exposure to early cyclical stocks in anticipation of more robust economic conditions. Until these trends are evident we remain cautious and true to our investment disciplines despite increased volatility.
Fixed Income Review & Outlook
Re-pricing of Risk: Bond markets for the first quarter continued on the path established in late 2007. Treasury interest rates dropped as much as 2% in yield on the shorter maturities, reflecting a weakening economy, and the desire by investors to own Treasury bonds in favor of sub-prime backed bonds, mortgages, and lower rated corporate issues. The Federal Reserve fueled the rally in prices by lowering the Federal Funds rate from 4.25% to 2.25%, reflecting the quickly weakening economic outlook. The strong rally in Treasury bonds and falling prices for weaker credit issues caused a wide variance in return among various bond groups. All-Treasury portfolios returned around 4.43% during the quarter, investment grade corporates 0.43%, and TIPS 5.18%, reflecting concerns about higher inflation. High yield bond spreads widened out from 5.69% to 7.81%, resulting in a -3.02% total return during the quarter.
The late March stock market recovery perhaps suggests that the worst is over for the economic slowdown. However, talk of additional cuts in the Federal Funds rate, continuing real estate price declines and increasing delinquencies suggest caution is still warranted. Inflation risks seem to be building despite the weakening economy. These points bode poorly for bonds in general, and credit related issues more so. We remain underweight corporate bonds, although rising yields on corporate and high yield bonds are starting to paint the outlook for a strong rally in the future. With rates on Treasuries suggesting the Federal Reserve needs to cut rates to near 1%, we believe most of the rally in Treasuries has been priced into the market. Municipal bonds were knocked around in February, and while they have recovered some, offer outstanding value, especially relative to Treasury bonds. TIPS bonds weakened late in March, giving us the opportunity to add them to our funds for additional inflation protection.