Monthly Market and Economic Outlook: September 2013

Magnotta@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital

The U.S. equity markets experienced a modest pullback in August, with a -2.9% decline in the S&P 500 Index, fueled by concern over the anticipated Fed tapering of asset purchases as well as a U.S.-led military strike on Syria. However, the index is still up +16.2% through August, the best start since 2003.

International equity markets fared better than U.S. markets in August despite the headwind of a stronger U.S. dollar.  So far this year, the return of developed international equities has been about half of the S&P 500 return while emerging market equities have declined -8.8%.  Both Brazil and India have experienced declines of more than -20.0%, suffering from significantly weaker currencies and slowing growth.

Fixed income outperformed equities in August on a relative basis, but the Barclays Aggregate Index still fell -0.5%.  Interest rates continued their move higher, and the yield curve steepened further. The yield on the 10-year U.S. Treasury note has increased 140 basis points from a low of 1.6% in early May, to 3% on September 5, fueled by the Fed’s talk of tapering asset purchases.  The technicals in the fixed income market have deteriorated markedly.  The rise in rates has not yet lost momentum, and investor sentiment has turned, causing large redemptions in fixed income strategies. Our portfolios remain positioned in defense of rising interest rates, with a shorter duration, emphasis on spread product and a healthy allocation to low volatility absolute return strategies.

Interest rates are normalizing from artificially low levels, but still remain low on a historical basis.  Despite slowing or ending asset purchases, the Fed has signaled short-term rates will be on hold for some time. Rising longer-term interest rates in the context of stronger economic growth and low inflation is a satisfactory outcome. In addition, the fundamentals in certain areas of fixed income strategies, including non-Agency MBS, high-yield credit and emerging-market credit, look attractive.

However, we continue to view a continued rapid rise in interest rates as one of the biggest threats to the U.S. economic recovery.  The recovery in the housing market, in both activity and prices, has been a positive contributor to growth this year.  Stable, and potentially rising, home prices help to boost consumer confidence and net worth, which impacts consumer spending in other areas of the economy.  Should mortgage rates to move high enough to stall the housing market recovery, it would be a negative for economic growth.

Outside of the housing market, the U.S. economy continues to grow at a modest pace.  Initial jobless claims, a leading indicator, have continued to decline.  Both the manufacturing and service PMIs have moved further into expansion territory. U.S. companies remain in solid shape and valuations do not appear stretched. M&A activity has picked up. Global economic growth is also showing signs of improvement, in Europe, Japan and even China.

However, risks do remain.  In addition to the major risk of interest rates that move too high too fast, the markets are anticipating the end of the Fed’s quantitative easing program.  Should the Fed follow through in reducing monetary policy accommodation, it will do so in the context of an improving economy.  Washington will again provide volatility generating headlines as we approach deadlines for the budget and debt ceiling negotiations.  However, unlike in previous years, there is no significant fiscal drag to be addressed.  In addition, the nomination of a new Fed Chairman and geopolitical risks (Syria) are of concern.  The market may have already priced in some of these risks.

Risk assets should do well if real growth continues to recover despite the higher interest rate environment; however, we expect continued volatility in the near term. As a result, in our strategic portfolios we remain slightly overweight to risk.  We continue to seek high conviction opportunities and strategies within asset classes.

Some areas of opportunity currently include:

  • Domestic Equity: favor U.S. over international, financial healing (housing, autos), dividend growers
  • International Equity: frontier markets, Japan, micro-cap
  • Fixed Income: non-Agency mortgage backed securities, short duration, emerging market corporates, global high yield and distressed
  • Real Assets: REIT Preferreds
  • Absolute Return: relative value, long/short credit, closed-end funds
  • Private Equity: company specific opportunities

 Asset Class Returns9.6.13_Magnotta_MarketOutlook

The Name is Bond, Muncipal Bond

Magnotta@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital

As interest rates have moved higher over the last six weeks, municipal bonds have sold off along with other fixed income sectors, but to a slightly greater degree. From May 1 through June 17, the Barclays Municipal Bond Index declined -2.25%, compared to -1.98% for the Barclays Aggregate Index and -1.72% for the Barclays Treasury Index. While municipals are still in negative territory year to date, they are slightly ahead of taxable bonds.

6.19.13_Magnotta_InterestRatesBoth the technicals and the fundamentals in the municipal bond market remain on solid footing. From a technical perspective, supply and demand dynamics are favorable. New issuance isn’t keeping up with maturing debt, resulting in a reduction in total outstanding supply. With 10-year municipal bonds now yielding 2.4% and 30-year maturities yielding above 4%, we will likely see buyers step back into the market. The muni/Treasury ratio is north of 100%. In addition, June and July are typically large months for reinvestments, potentially creating more demand for municipals.

On the fundamental side, state and local government finances have improved. State revenues are back to pre-2008 levels across the board and are expected to increase. Local governments, which source their revenues primarily from property tax receipts, have received a boost from stabilizing home prices. Most states have taken steps to address their longer-term entitlement program and pension issues in some form. While credit is improving generally, there are still areas of concern. Headlines surrounding Detroit, MI, Stockton, CA and Puerto Rico could negatively impact the municipal bond market, but we do not see a concern regarding widespread municipal defaults.

The backup in interest rates has resulted in significant outflows from both taxable and municipal bond mutual funds over the last two weeks. ICI reports that municipal bond funds experienced $2.2 billion in outflows the week ending June 5 and $3.2 billion in outflows the week ending June 12. The recent sell-off could provide an opportunity for municipal bond investors, especially those focused on higher quality intermediate and longer-term bonds where valuations are attractive.

One For The Muni

Magnotta@AmyLMagnotta, CFA, Brinker Capital

Municipal bonds have delivered very strong positive returns since Meredith Whitney famously predicted hundreds of billions in municipal defaults during a 60 Minutes interview in December 2010. Municipal bonds outperformed taxable bonds (Barclays Aggregate Index) by meaningful margins in both 2011 and 2012.

iShares S&P National AM T-Free Muni Bond Fund

Source: FactSet

Municipal bonds have benefited from a favorable technical environment. New supply over the last few years has been light, and net new supply has been even lower as municipalities have taken advantage of low interest rates to refinance existing debt. While supply has been tight, investor demand for tax-free income has been extremely strong. Investors poured over $50 billion into municipal bond funds in 2012 and added $2.5 billion in the first week of 2013 (Source: ICI). This dynamic has been driving yields lower. The interest rate on 10-year munis fell to 1.73%, the equivalent to a 2.86% taxable yield for earners in the top tax bracket. Similar maturity Treasuries yield 1.83% (Source: Bloomberg, as of 1/15). We expect new supply to be met with continued strong demand from investors.

*Excludes maturities of 13 months or less and private placements.  Source: SIFMA, JPMorgan Asset Management, as of November 2012

*Excludes maturities of 13 months or less and private placements. Source: SIFMA, JPMorgan Asset Management, as of November 2012

While technical factors have helped municipal bonds move higher, the underlying fundamentals of municipalities have also improved.  States, unlike the federal government, must by law balance their budget each fiscal year (except for Vermont).  They have had to make the tough choices and cut spending and programs.  Tax revenues have rebounded, especially in high tax states like California.  Last week California Governor Jerry Brown proposed a budget plan that would leave his state with a surplus in the next fiscal year, even after an increase in education and healthcare spending.  Stable housing prices will also help local municipalities who rely primarily on property tax revenues to operate.

While we think municipal bonds are attractive for investors with taxable assets to invest, the sector is still not without issues.  The tax-exempt status of municipal bonds survived the fiscal cliff deal unscathed, but the government could still see the sector as a potential source of revenue in the future which could weigh on the market.  Underfunded pensions – like Illinois – remain a long-term issue for state and local governments.  Puerto Rico, whose bonds are widely owned by municipal bond managers because of their triple tax exempt status, faces massive debt and significant underfunded pension liabilities and remains a credit risk that could spook the overall muni market.  As a result, in our portfolios we continue to favor active municipal bond strategies that emphasize high quality issues.

The S&P 500 in 2012

2012 was definitely a better year than it felt, with the S&P gaining over +13.0% on a price basis and +15.9% on a total return basis.

It was a great year to be invested in the global equity markets despite investors pulling out over $139 billion from equity mutual funds. Investors continued to pour into fixed income funds, adding over $300 billion during the year. (Source: ICI) The Barclays Aggregate gained +4.2% in 2012.

Below is a great snapshot of S&P 500 performance in 2012 from Bespoke Investment Group:

1.2.13_Magnotta_S&P_2012Perfromance