Monthly Market and Economic Outlook: May 2015

Amy MagnottaAmy Magnotta, CFASenior Investment Manager, Brinker Capital

In April we saw a reversal of some of what occurred in the first quarter. U.S. large cap equities were positive on the month (S&P 500 Index gained +1.0%); however, U.S. mid and small cap stocks experienced declines of -0.9% and -2.6% respectively. International developed equity markets continued to outperform U.S. markets (MSCI EAFE gained +4.2%), led by strong gains in Europe. The Euro strengthened 4.5% against the dollar during the month. Emerging markets led developed markets (MSCI EM gained +7.7%), helped by double-digit gains in China and Brazil. In the real assets space, crude oil soared +25% in April after an -11% decline in the first quarter, while REITs experienced modest declines.

Global sovereign yields moved higher in April. The yield on the 10-year Treasury climbed 11 basis points and as a result the Barclays Aggregate Index fell -0.4%. While investment-grade credit was negative on the month, high-yield credit gained +1.2% as spreads tightened. Municipal bonds underperformed taxable bonds during the month.

Our outlook remains biased in favor of the positives, but recognizing risks remain. We feel we have entered the second half of the business cycle, but remain optimistic regarding the global macro backdrop and risk assets over the intermediate-term. As a result, our strategic portfolios are positioned with a modest overweight to overall risk. A number of factors should support the economy and markets over the intermediate term.

  • Global monetary policy accommodation: Despite the Federal Reserve heading toward monetary policy normalization, the ECB and the Bank of Japan have both executed bold easing measures in an attempt to support their economies.
  • U.S. growth stable and inflation tame: Despite a soft patch in the first quarter, U.S. economic growth remains solidly in positive territory and the labor market has markedly improved. Reported inflation measures and inflation expectations are moving higher but remain below the Fed’s target.
  • U.S. companies remain in solid shape: U.S. companies are beginning to put cash to work through capex, hiring and M&A. Earnings growth outside of the energy sector is positive, and margins have been resilient.
  • Less uncertainty in Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year; however, Congress will still need to address the debt ceiling before the fall. Government spending has shifted to a contributor to GDP growth in 2015 after years of fiscal drag.

However, risks facing the economy and markets remain, including:

  • Timing/impact of Fed tightening: The Fed has set the stage to commence rate hikes later this year. Both the timing of the first rate increase, and the subsequent path of rates is uncertain, which could lead to increased market volatility.
  • Slower global growth: While growth in the U.S. is solid, growth outside the U.S. is decidedly weaker. It remains to be seen whether central bank policies can spur sustainable growth in Europe and Japan. Growth in emerging economies has slowed as well.
  • Geopolitical risks: Issues in the Middle East, Greece and Russia, could cause short-term volatility.

While valuations have moved above long-term averages and investor sentiment is neutral, the trend is still positive and the macro backdrop leans favorable, so we remain positive on equities. The ECB’s actions, combined with signs of economic improvement, have us more positive in the short-term regarding international developed equities, but we need to see follow-through with structural reforms. We expect U.S. interest rates to normalize, but remain range-bound and the yield curve to flatten. Fed policy will drive short-term rates higher, but long-term yields should be held down by demand for long duration safe assets and relative value versus other developed sovereign bonds.

As we operate without the liquidity provided by the Fed and move through the second half of the business cycle, we expect higher levels of market volatility. This volatility should lead to more opportunity for active management across asset classes. Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Asset Class Outlook Comments
U.S. Equity + Quality bias
Intl Equity + Neutral vs. U.S.
Fixed Income +/- HY favorable after ST dislocation
Absolute Return + Benefit from higher volatility
Real Assets +/- Favor global natural resources
Private Equity + Later in cycle

Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Past performance is not a guarantee of similar future results. An investor cannot invest directly in an index.

Yield in the Time of Cholera

CoyneJohn E. Coyne, III, Vice Chairman, Brinker Capital

I recently reread the Gabriel Garcia Marquez novel from the 80s, Love in the Time of Cholera, and as I found myself being warped back to that decade, it naturally led made me reflect on the current municipal bond market! I’ll explain.

Because romance is nowhere near as risky as this market is today, it is easy to see how we can fall in love with the exciting, attractive yields in the after-tax world (around 8.5% on the long end). Nevertheless, there is something to be said for stability and safety in a time of incredible uncertainty especially with continuing interest-rate increases and, even more unnerving, a frightening credit risk landscape.

The rising-rate environment of the late 70s and early 80s played havoc on both the value and purchasing power of bonds held by individual investors. So whether for income or safety of principal, the holder was punished. And the credit markets were not nearly as challenged as today. Rates topped out in 1983, and we began the 30-year bond rally that has recently unraveled. I would imagine that during that extended period, an argument can be made that a passive-laddered approach might have been acceptable as opposed to active management—particularly in the bygone days of credit insurers like MBIA and AMBAC.

8.28.13_Coyne_Yield in the time of CholeraWell, not today. If investors want to navigate the treacherous credit markets while capturing these currently attractive yields they need a steady, experienced guide to help manage their portfolio. Advisors should be working with their municipal managers to craft strategies that can balance out their needs for income, safety and maintaining purchasing power.  Now that can make for a wonderful romance.

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 State of Municipal Bonds

 Amy Magnotta, Brinker Capital

In December 2010, analyst Meredith Whitney made a prediction of hundreds of billions of defaults in the municipal bond market. While we have experienced defaults, we have not yet seen anything close to the magnitude of that statement. Prior to that statement, in October of that same year, Brinker Capital released a paper that discussed our positive view on the municipal bond market due to technical factors and improving municipal credit. Because we invest in municipal bond managers with strong, deep credit research teams and a focus on high quality issues and structures, we encouraged our investors to remain invested in municipal bonds. Investors have been handsomely rewarded with close to 20% cumulative returns in municipal bonds since they bottomed in January 2011.

The financial health of municipalities is again hitting the headlines. Moody’s has warned of more problems for California cities after San Bernardino, Mammoth Lakes and Stockton have each sought bankruptcy protection. Scranton, Pennsylvania, which made the news after the mayor cut the pay of all city employees to minimum wage this July, is now seeking help from hedge funds in an effort to delay a bankruptcy. Even Puerto Rico municipal bonds, widely held by municipal bond strategies because of their attractive yields, are being seen as a greater credit risk.

We don’t believe the headlines are representative of the broader municipal bond market. There are more than 50,000 municipalities across the country, each with their individual issues. This makes municipal credit research in this environment extremely important, especially without the fallback of bond insurance. A positive corollary of these types of headlines is that it forces change. Many state and local governments have made the necessary changes to their budgets to set them on a sustainable path, but many still have more to go. Often, the largest owners of a municipality’s bonds are their own constituents – they need to maintain a good relationship with these investors in order to access financing in the future.

We feel the technical factors in the municipal bond market remain positive. Demand is very strong. While supply has been higher in recent years, most of it is refinancing, so net new supply remains at low levels. The budgets of state governments continue to improve while local governments remain under pressure. Rates are low, offering the opportunity for refinancing. The fights over pension and healthcare benefits for public workers will continue, but these issues do not present an immediate cash flow problem. However, this is a broad characterization of the municipal bond market. We will continue to invest with managers that have deep credit research teams and focus on high quality issues, seeking to avoid the problem issues as a result.

Municipal Market Update by Dan Genter, RNC Genter Capital Management

The city of Stockton, CA has decided that it will file for bankruptcy protection under Chapter 9 of the Federal Bankruptcy Code. This announcement is likely to be a national news item that may catch the eye of many investors.

This call to bankruptcy was anticipated considering that Stockton had already defaulted on its debt and, for the last 90 days, had been in a mandatory mediation period in an attempt to negotiate concessions in labor costs and benefits, which are currently almost 70% of the city’s general fund. We do not believe this headline will be considered unexpected or that it will have a negative impact on the municipal bond market.

We also do not consider that this is the start of an epidemic among municipal entities to use default or bankruptcy strategies. Though there may be more smaller entities that will use this option going forward, we view this as more of a politically expedient approach versus a viable solution, which will generally be adopted by municipalities under financial stress.

Frankly, it is hard to understand after the Vallejo, CA experience that a municipal entity nearby would even consider the bankruptcy route. Vallejo spent many months initially having the bankruptcy proceeding approved (it is not as automatic as with corporations), spent three years in bankruptcy proceedings, spent $10 million in legal fees, and almost a year, after emerging from bankruptcy, is still struggling to meet the mandates that were dictated by the bankruptcy court. Considering that their tainted reputation has now effectively barred them from the capital markets, and that the ultimate concessions that they received in bankruptcy mirrored what likely would have been accomplished through diligent negotiations, they clearly have not established an attractive road map for others to follow.

It does reaffirm, however, that smaller municipal entities continue to be under stress and that clients should be very cautious in stretching for yield.