Strategy Quarterly
Second Quarter 2013
Executive Summary
Global banks and governments face a market dilemma:
establishing sufficient fiscal austerity to limit deficits and at
the same time not so much as to restrain growth. Historically
low interest rates and high budget deficits constrain the
effectiveness of traditional monetary and fiscal policy
maneuvers.
On the bright side, an upturn in the cyclical component of
the economy, such as housing and business investments,
coupled with very accommodative monetary conditions,
should offset higher taxes and government spending cuts.
A potential 2013 economic path seems to trace this
sequence: limited growth in the first half of the year due to
relatively weak demand and fiscal policy uncertainty;
acceleration of investment activity in the second half of 2013
on an improving housing sector; a resurgence of the U.S.
manufacturing sector; and relief from policy uncertainty that together with strong corporate balance sheets and cash flows
- should free up business investment.
Downside risks include European crises, fiscal and political
friction in the U.S. and abrupt slowdown of global economic
growth.
The risk cycle in the bond market is on a decided upswing
as investor sentiment continues to be ebullient with too many
investors reaching for yield as evidenced by the riskier
portions of the bond market reaching multi-year highs,
fueling continued concerns of overvaluation.
Bond investors would do well to avoid excessive risk taking
that occurs in a low rate environment and maintain a
conservative position in regards to interest rate risk.
Strategies to mitigate bond market risk include 1) shorter
durations, 2) exposure to non-U.S. interest rate based credits,
3) broadening diversification to include sectors that are
uncorrelated to a rise in rates, and 4) seeking out alternative
income-producing assets.
Massimo Santicchia
Chief Investment Officer
Crest Investment Partners
Cypress Trust Company
[email protected]
Ryan Kuyawa, CFA
Vice President, Senior Portfolio Manager
Cypress Trust Company
[email protected]
Global Economic Backdrop
The International Monetary Fund (IMF) expects
global growth to increase during 2013, as the
factors underlying soft global activity are expected
to subside. However, this upturn is projected to
be more gradual than previously projected. Policy
actions have lowered acute crisis risks in the euro
area and the United States. But in the euro area,
the return to recovery after a protracted
contraction is delayed. While Japan has slid into
recession, stimulus is expected to boost growth in
the near term. At the same time, policies have
supported a modest growth pickup in some
emerging market economies, although others
continue to struggle with weak external demand
and domestic bottlenecks. If crisis risks do not
materialize and financial conditions continue to
improve, global growth could be stronger than
projected. However, downside risks remain
significant, including renewed setbacks in the euro
area and risks of excessive near-term fiscal
consolidation in the United States.
Chart 1. Global GDP Growth (% Q/Q annualized)
Source: IMF estimates
Global financial conditions improved further in the
fourth quarter of 2012. However, a broad set of
indicators for global industrial production and
trade suggests that global growth did not
strengthen further. Indeed, the third-quarter
uptick in global growth was partly due to
temporary factors, including increased inventory
accumulation (mainly in the United States). It also
masked old and new areas of weakness. Activity in
the euro area periphery was even softer than
expected, with some signs of stronger spillovers of
that weakness to the euro area core. In Japan,
output contracted further in the third quarter.
Growth in the United States is forecast to average
2 percent in 2013, rising above trend in the
second half of the year (Chart 2). A supportive
financial market environment and the turnaround
in the housing market have helped to improve
household balance sheets and should underpin
firmer consumption growth in 2013. In Europe, a
meaningful recovery is likely to take somewhat
longer. Within the euro area, there is a renewed
divergence between growth in Germany, which is
likely to pick up strongly over the first two
quarters of 2013, and that of other countries,
which will remain slow or negative. Growth
among emerging economies remains higher than
that of advanced countries on average, although
with significant differences across countries.
Given the substantial share of the world economy
now accounted for by emerging economies, they
will again significantly contribute to growth at the
global level this year.
Chart 2. GDP Growth (% Q/Q Annualized)1
Economic conditions improved modestly in the
third quarter of 2012 (Chart 1), with global growth
increasing to about 3 percent. The main sources
of acceleration were emerging market economies,
where activity picked up broadly as expected, and
the United States, where growth surprised on the
upside. Financial conditions stabilized. Bond
spreads in the euro area periphery declined, while
prices for many risky assets, notably equities, rose
globally. Capital flows to emerging markets
remained strong.
Source: OECD
1. Seasonally adjusted
2. Weighted average of three largest countries in euro area
2
Monetary Policy & Financial Conditions
Uncertainty around current forecasts remain high.
Nonetheless, downside tail risks diminished in late
2012 and early 2013 as a result of actions taken to
tackle the fiscal cliff in the United States and the
European Central Bank (ECB) announcing its
Outright Monetary Transactions (OMT) program.
In Japan, upside risks have increased following
recent policy announcements, notably relating to
a new fiscal stimulus package and the raising of
the inflation target, which have resulted in a
weakening of the yen and a strong rise in equity
prices. This shift in the balance of risks, together
with abundant liquidity, has been an important
factor behind the strength of financial markets in
recent months.
At its meeting at the end of January, the FOMC
kept the federal funds target unchanged at 0.00 to
0.25 percent. The Committee stated that it will
continue purchasing additional agency mortgagebacked securities at a pace of $40 billion per
month and longer-term treasuries at a pace of
$45 billion per month. It is also maintaining its
existing policy of reinvesting principal payments
from its holdings of agency debt and agency
mortgage-backed securities in agency mortgagebacked securities and of rolling over maturing
treasury securities at auction. Taken together,
these actions should maintain downward pressure
on longer-term interest rates, support mortgage
markets, and help to make broader financial
conditions more accommodative.
Chart 3. Economic Policy Uncertainty Index
Chart 4. Corporate Bond Spreads
Source: www.policyuncertainty.com
Source: OECD
Despite a still high level of political uncertainty
(see Chart 3), global equity prices have surged,
corporate bond spreads have narrowed and,
despite a number of negative shocks, sovereign
spreads in the euro area periphery moved down
substantially in the last quarter of 2012 and have
declined further in 2013. Riskier assets have
generally gained the most. However, according to
the OECD, real activity has yet to reflect fully the
improvement in financial market sentiment,
especially in the euro area. This highlights the risk
of asset prices getting out of line with
fundamentals. Loose monetary policy does not
guarantee prosperity – it only buys time.
The European Central Bank (ECB) left its policy
settings unchanged at its meeting in early
February. The key refinancing rate remains at 0.75
percent. ECB President Mario Draghi noted that
“the economic weakness of the euro area is
expected to prevail in the early part of 2013.” He
added that “later in 2013, economic activity
should gradually recover, supported by
accommodative monetary policy stance, the
improvement in financial market confidence and
reduced fragmentation, as well as a strengthening
of global demand.” The ECB is of the view that
“the risks surrounding the economic outlook for
the euro area remain on the downside.”
3
Chart 5. Central Banks Balance Sheets Growth
Source: Strategas
Chart 5 above shows the extraordinary growth of
the balance sheets of the largest central banks in
the world. This growth reflects the quantitative
easing (QE) that has been implemented globally in
the aftermath of the 2008 financial crisis in order
to contain damages and support financial markets
and the economy. The goal of QE is to expand
balance sheets via increasing bank reserves
through purchases of fixed income securities in
order to lower interest rates. This makes fixed
income securities relatively unattractive and
pushes investors towards riskier assets such as
stocks. Theoretically these higher prices should
lead to a wealth effect and increased economic
activity.
Indeed, it was the deep financial crisis in the
United States in 1907 that prompted the U.S.
Congress to finally set in motion the creation of
the Federal Reserve System. The explicit
understanding was that the Fed would use its
balance sheet to promote a currency that would
be “elastic” in meeting the needs of a growing
economy. The idea was also that it would address
the forces behind the periodic financial panics
that had plagued the United States up to that
time. And mistakes have been made over the
years and lessons were learned along the way. In
the 1930s, for example, the deepening of the
Great Depression was due in part to the failure of
the major central banks to fully grasp the
consequences of debt deflation. Central banks in
the 1930s failed to use their balance sheets
sufficiently to lower long-term rates and to
counter a cascading sequence of bankruptcies.
The lessons learned from that crisis have guided
many central banks in dealing with the recent
crisis.
A recent paper looked at the effects of
unconventional monetary policy on inflation
expectations.2 Chart 6 shows how the Fed
responded to the recession that began in
December of 2007 and escalated rapidly in
September of 2008.
Chart 6. The Effects of QE on Inflation Expectations
This phenomenon has received a lot of attention
from the press and some economists have
criticized the central banks’ bloated balance
sheets by arguing that this continued injection of
liquidity does not really help the real economy
and that it will eventually result in high and
volatile inflation.
In reality, the central bank’s deliberate use of its
balance sheet has played a salient role in financial
history – especially during crises. From very early
on, central banks were given the monopoly of
note issue, and the role of lender of last resort
naturally fell to them. During times of financial
distress, only the central bank could be a credible
lender of last resort. Its ability to create monetary
liabilities could be used to provide liquid assets to
a bank in difficulty.1
4
Source: R. Farmer (2012), NBER
1
Why Central Bank Balance Sheets Matter, Jaime Caruana, BIS, 2011
2
The Effect of Conventional and Unconventional Monetary Policy Rules
on Inflation Expectations, R. Farmer, NBER Working Paper, 2012.
The figure breaks down the balance sheet of the
Fed into three separate components, short-term
treasury securities, mortgage securities and other
securities. The balance sheet of the Fed increased
from approximately $800b in 2007 to over
$2,000b immediately following the Lehman
Brothers bankruptcy in September of 2008. This
increase did not arise from the purchase of shortterm treasury securities, the method of operating
monetary policy in normal times; it arose instead
from the purchase of risky securities with variable
payouts. Chart 6 also shows a measure of oneyear inflation expectations taken from a derivative
security in the asset markets. This is the value of
expected inflation implied by a swap in which one
party makes a payment to the other at the end of
the contract. On December 2, 2008 expected
inflation from the one-year swap market was 4.5%. Markets were pricing a large expected
deflation. From that date on, inflationary
expectations increased steadily returning to the
range of plus 1% by the fall of 2009. Thus,
according to this analysis, unconventional
monetary policy, implemented through the large
scale purchase of mortgage-backed securities and
long term government bonds, was effective in
preventing deflation. The policy worked by
signaling the intent of future policy actions to
financial markets. Because the policy of asset
market purchases acts as a signal of future intent,
it is complementary to alternative communication
strategies such as the publication of the inflation
expectations of Fed policy makers (Farmer, 2012).
So in conclusion, it’s reasonable to state that the
Fed (and other countries’ central banks) have
been effective in mitigating the financial crisis.
Given the still fragile state of the global economy,
we believe the real risk is still deflation, not
inflation - and that until the economic recovery
strengthens unambiguously, continuous liquidity
injection is helpful to support the economy and
markets.
But what are the risks to the economy and
financial markets ahead, deriving from this central
banks’ increasing “unconventional” intervention?
Chart 7 - a stylized central bank’s balance sheet helps to understand the transmission channels
and the implications of central banks’ growing
balance sheets. Any accumulation of assets
implies an increase in corresponding liabilities. In
addition, the purchase of domestic assets will
directly affect their prices and therefore credit
spreads, term premia and long-term interest
rates. An increase in monetary liabilities (e.g.,
reserve money) will have implications for the
liquidity of the banking sector in the short run,
and this may undermine price stability in the
medium term. But an increase in long-term
liabilities could also crowd out lending to the
private sector. It is quite clear that large
expansions of central bank balance sheets have
implications for both the real and financial sectors
of the economy. Potential risks may develop.
Chart 7. A Central Banks Balance Sheet Model
Source: J. Caruana (2011), BIS
First of all, inflation risk. It will be very important
whether governments in the advanced countries
take decisive action in the years ahead to curb
future fiscal deficits in a durable way. The very
high and growing levels of public debt in many
countries raise uncomfortable questions for
central banks not only about the creditworthiness
of the sovereign but also about fiscal dominance.
At a certain point central banks will have to come
up with an exit strategy; bringing balance sheets
back to more normal levels will require the
intensive and timely use of tools for draining
liquidity. Drain of excess bank reserves on this
scale is going to be unprecedented. It will require
not only judgment about uncertain and evolving
financial conditions, but also skill in managing
market expectations and sensitivity to the political
economy dimensions of restrictive policies
(Caruana, 2011).
5
U.S. Focus
U.S. policymakers face a difficult task: bringing
fiscal austerity to control the deficit without
restraining growth. This task is challenged by the
current historical low levels of interest rates which
does not leave room for further rate cuts. In
addition, the current historical high levels of fiscal
deficit do not allow for fiscal stimulus. However, in
2013 positive trends in cyclical growth and
accommodative monetary policy should offset
higher taxes and reduce government spending.
The positive indirect effects of the ongoing
recovery in the housing market should not be
underestimated. Goldman Sachs estimates that
2012’s 5% gain in national home prices boosted
consumers’ net worth by an estimated $1 trillion,
pushing consumer confidence to a four-year high.
In turn, rising net worth typically decreases
consumers’ desire for precautionary savings,
providing a tailwind to spending.
Moreover, with the majority of bank loans backed
by real estate, higher home prices decrease
banks’ credit losses and augment their willingness
to lend (Chart 10 shows that recent credit growth
has been exceeding GDP growth by 2.5%).
Chart 10. Bank Loans and Leases, Real GDP
20%
15%
10%
5%
2.5%
0%
-5%
Loan Growth minus GDP growth
-10%
GDP Growth
Loan and Leases Growth
-15%
74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Chart 8. Total Construction Spending (Y/Y % Chg)
Source: Federal Reserve Bank of St. Louis
20%
Corporate investment has been a bright spot as
equipment and software investment grew at the
unexpectedly rapid rate of 11.8% in Q4 2012 after
Q3's 2.6% decline. According to the Equipment
Leasing & Finance Foundation, investment in
equipment and software is expected to grow 5.6%
in 2013. The Foundation increased its 2013
equipment and software investment forecast to
5.6%, up from 2.9%.
15%
10%
5%
0%
-5%
-10%
-15%
-20%
03
04
05
06
07
08
09
10
11
12
13
Source: U.S. Census Bureau
Chart 9. Investment Equip.& Software (Y/Y % Chg)
20%
15%
10%
5%
0%
-5%
-10%
Thus the potential 2013 economic path seems to
trace this sequence: limited growth in the first half
of the year due to relatively weak demand and
fiscal policy uncertainty; acceleration of
investment activity in the second half of 2013 on
an improving housing sector; a resurgence of the
U.S. manufacturing sector; energy renaissance
and relief from policy uncertainty that – together
with strong corporate balance sheets and cash
flows - should have an unlocking effect on
business investment.
-15%
-20%
-25%
96
97
98
Source: BEA
6
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
Downside risks include European crises, fiscal and
political friction in the U.S. and abrupt slowdown
of global economic growth.
It’s not unusual to see price and earnings moving
in opposite directions: earnings contractions can
be offset by multiple expansions and result in
stock price appreciation. A recent study by
Strategas looked at periods characterized by
earnings declining from peak to trough over the
1950-2009 timeframe.4 It found that since 1950,
S&P 500 companies – on aggregate – have
experienced pronounced contractions in
corporate profitability on 12 occasions, posting an
average peak-to-trough fall of -18%. However, on
8 of these occasions, stocks advanced about 22%
(Chart 13).
Earnings Cycle Analysis
The stock market is up a stunning 130% since the
low of March 2009. The global coordinated
intervention among global central banks restored
market and business confidence which resulted in
earnings rebounding from depressed levels and
stocks rallying despite continuous macro and
political friction (European crisis, U.S. fiscal cliff,
and more recently, Cyprus’ banking crisis).
Liquidity injections from central banks have
supported the economy and favored risky assets
such as stocks and high yield bonds. However, the
economic fundamentals have lagged. For
example, although we have been out of
Chart 13. EPS Peaks to Troughs
Chart 11. Output Gap in Percent of Potential GDP
Quarter
Start
End
Dec-50
Jun-52
Mar-56
Sep-58
Dec-66
Sep-67
Sep-69
Dec-70
Sep-74
Sep-75
Mar-80
Mar-81
Dec-81
Mar-83
Dec-84
Jun-85
Jun-86
Dec-86
Jun-89
Dec-91
Sep-00
1-Dec
7-Jun
9-Sep
Average (All)
Average (Price Up)
Average (Price Down)
Source: IMF
recession for several quarters, the output gap is
still negative and projected to become positive
only by 2017.3 With GDP growth in 2013 projected
at around 2% it’s hard to get excited about
economic growth. Even from a bottom-up
standpoint with profit margins at historical peaks
it’s difficult to see what will drive earnings growth
and stock prices higher in the near future. So
where do we go from here?
Pct. Change
EPS
Price Mult. Exp.
-17.60% 22.30%
48.50%
-21.90% 3.30%
32.20%
-4.50% 20.40%
26.10%
-12.90% -1.00%
13.60%
-16.00% 32.00%
57.20%
-4.60% 33.20%
39.70%
-19.10% 24.80%
54.40%
-3.50% 14.70%
18.90%
-6.70%
-3.50%
3.40%
-24.40% 31.20%
73.50%
-31.60% -20.10%
16.80%
-56.70% -29.70%
62.40%
-18.30% 10.60%
37.20%
-14.00% 22.70%
43.80%
-27.00% -13.60% 24.10%
Source: Strategas
Thus, positive projections of future earnings (2014
and beyond) are fueling multiple expansions even
as 2013 estimates fall (Chart 14).
Chart 14. EPS Consensus Estimates
Chart 12. After-Tax Profit Margin
Source: FactSet
Source: Yardeni
3
The output gap is a measure of the difference between the actual
output of an economy and the output it could achieve when it is
most efficient, or at full capacity.
4
Sector Strategy Report, Strategas Research Partners,
April 4, 2013
7
As long as expectations for future earnings growth
is higher than current growth, multiples may
continue to expand and stocks may continue to
move higher.
Chart 15. EPS Expectations and P/E Multiples
Using Shiller’s cyclically-adjusted P/E ratio, market
valuation does not appear particularly attractive
(Chart 16). Valuation metrics that adjust for
leverage such as Enterprise Value-to-Free Cash
Flow (EV/FCF) offer a complementary view of
equity markets. This approach emphasizes free
cash flow versus earnings. Free cash flow is a
more comprehensive measure of profitability as it
includes working capital and capital expenditures
needed for growth. It also offers insight into
capital allocation decisions that reward
shareholders directly, such as dividends and share
buybacks. This metric also adjusts market
capitalization to include net debt (total debt
minus cash) so that a high debt level results in a
higher (more expensive) valuation.
Chart 17. Enterprise Value-to-FCF – S&P500 Ex Fin.
70
60
50
40
30
Source: Strategas
We believe that global central banks’ easing has
been supporting a fragile economy and has put a
floor under asset prices. This “distorting” effect
has driven overall multiple expansion, particularly
favoring more speculative issues and even high
yield and deep value stocks over high-quality
stocks. This trend may continue for a while.
However, we caution investors not to chase hot
themes such as high yield or momentum stocks.
8
20
10
0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Source: FactSet
On a relative basis to the bond market, equities
offer great value as the equity risk premium is at
an historical high of over 4%. The risk premium
has averaged 29 basis points since 1960.
Chart 16. Cyclically Adjusted P/E Ratio
Chart 18. Equity Risk Premium
Source: http://www.multpl.com/shiller-pe/
Source: Strategas
Generation and Uses of Cash Analysis
In this section we’ll take a close look at how the
S&P 500 companies in aggregate are generating
and deploying their cash flows. Corporate
earnings trends are relevant in analyzing the
business cycle and its connection to the equity
markets. We focus on the analysis of companies’
cash flow generation and their capital allocation
policy. The magnitude and consistency of cash
flows from operations and their deployment are
major criteria in our stock selection process and
are major determinants of long-term portfolio
returns, in our view.
Chart 19. Cash & Short-Term Investments
Chart 20. Growth of OCF and FCF (Y/Y)
Source: FactSet
Cash flows from operations amounted to $354.6
billion in Q4, which marked an increase of 9.9%
year-over-year. Due to a 10.5% increase in yearover-year capital expenditures, Free Cash Flow-toEquity increased at a slower rate (+8.5%). The
Consumer Staples and Materials sectors led
the index with Free Cash Flow-to-Equity growth of
28.6% and 21.3%, respectively.
Chart 21. Selected Dividend Trends
Source: FactSet
Chart 19 indicates that, in aggregate, S&P 500 (exFinancials) cash and marketable securities
balances grew 6.1% year-over-year to a balance of
$1.27 trillion at year end 2012. The sequential
growth rate for aggregate cash balances was
3.4%, the sixth consecutive quarter of single-digit
growth following ten quarters of double-digit
growth. The continued growth in cash came
despite a large uptick in cash outflows from
acquisitions (+15.5%), capital distributions
(+10.9%), and capital expenditures (+10.5%) yearover-year. These outflows were offset by 9.9%
growth in cash flow from operations. Cash inflows
from debt issuance added $39.6 billion and cash
flows from asset sales added an additional $37.5
billion in the fourth quarter. Finally, other
financing and investing cash flows had a net
positive impact on cash.
Source: FactSet
Aggregate dividend payments amounted to $92.0
billion for Q4 2012 (January 2013). Over the year
ended 2012, $310.5 billion was paid out in
dividends, which is a ten-year high for trailing
twelve-month periods. On a per-share basis, the
aggregate dividend payment was $31.40 per
share, reflecting year-over-year growth of 15.9%.
The Information Technology, Financials, and
Consumer Discretionary sectors led all sectors in
year-over-year growth on a per-share basis at
46.1%, 25.6%, and 20.6%, respectively.
9
Despite strong dividend growth, with the current
payout well below the historical average, and
given ample liquidity, there appears to be more
room for further increases (Chart 22).
Chart 22. S&P 500 Dividend Payout Ratio
Analogous to a dividend yield, we can calculate a
“buyback yield” by dividing the trailing twelve
month share repurchases by the company’s
average shares outstanding over the year. Chart
24 shows that the buyback yield for the S&P 500
on aggregate is currently around 3%. This results
in “total yield” (dividend plus buyback) of about
5%. Consumer Discretionary, Health Care and
Technology sectors lead in buyback activity with
yields above 4%.
Chart 24. Buyback Yield
Source: Strategas
Companies have been returning cash to
shareholders via share buybacks as well. Dollarvalue share repurchases amounted to $93.8
billion over the fourth quarter and $384.3 billion
for 2012, representing year-over-year growth of
9.6%. Dollar-value buybacks amounted to 79.1%
of free cash flow on a trailing twelve month basis,
which is the largest value since Q3 2008. The
Consumer Discretionary and Consumer Staples
sectors both spent more than 100% of their free
cash flow (116.7% and 114.2%, respectively) on
buybacks. The Energy and Utilities sectors spent
$35.8 billion and $1.4 billion, respectively, on
buybacks, despite generating negative free cash
flow (-$25.7 billion and -$23.5 billion).
10
Source: FactSet
The blue bar of Chart 25 represents the net debt
issued. The yellow line is the 10 year treasury
yield – a proxy for cost of debt capital. Companies
are taking advantage of low interest rates to issue
cheap debt to be used – at least partly – to
repurchase shares. This is equivalent to a transfer
of value from debt holders to equity shareholders.
This activity also has the effect of leveraging up
the balance sheet, which could potentially lower
the credit ratings and therefore increase the
investment risk.
Chart 23. Dollar Value of Buybacks ($M)
Chart 25. Net Cash Flows from Borrowing
Source: FactSet
Source: FactSet
Credit Markets: The Ascent of Risk
Markets sway back and forth like a pendulum with
greed at one end and fear at the other.
Throughout history those two emotions have
driven the upward climb and downward descent
of markets. Let us set aside for a moment
business and economic cycles to look at the risk
cycle to see where the pendulum is swinging in
the greed/fear continuum. The risk cycle is just
as useful, if not more so, than the economic cycle
although the two often are correlated albeit not
perfectly. To explain further, let us take a look at
investor behavior in times of excessive risk taking,
when greed overpowers fear, and in times when
fear overpowers prudent risk taking. Some
characteristics of investor behavior at these two
extremes include:
Fear
▪ Return Of Capital
▪ Don’t lose my money!
▪ This pain will never end!
▪ Worry about being in the
market.
▪ Risk dominates risk/return
objective.
▪ Depressed asset prices.
Greed
▪ Return On Capital
▪ Make me money!
▪ The good times will never end!
▪ Worry about not being in the
market.
▪ Return dominates risk/return
objective.
▪ Peaking asset prices.
Risk is actually the highest in a market
characterized by greed as excessive risk taking
becomes the norm (think real estate market of
the early/mid 00’s) and asset valuations are bid up
to nose-bleed levels. At the time this is occurring a
general euphoria permeates the market as risk
management is seen as an antiquated concept.
Conversely, risk is the lowest in a market
characterized by fear (stock market of ’08/’09) as
risk taking is almost completely abandoned and
asset prices reflect this lack of demand and offer
compelling valuations. At this moment, few have
the emotional strength to take advantage of such
opportunities. Back to the original question,
“Where is the credit market on the greed/fear
continuum?” The pendulum’s momentum is
swinging towards greed. A few charts help to
confirm our suspicions. The VIX Index which
measures the volatility implied in equity option
prices is also know as the “Fear Index” as it spikes
in times of stress when volatility is high and
flattens when volatility is low and investors feel
blissful about the markets. The VIX spiked to an
all-time high of 81 in late 2008 during the height
of the credit crisis. The VIX just recently reached a
5-year low of 11 on March 14, 2013.
Chart 26. VIX Index
90
80
70
60
50
40
30
20
10
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
Mar-13
Source: Bloomberg
We already mentioned that peaking asset prices
are a characteristic of investor behavior when
investors are feeling particularly optimistic about
future prospects. It is important to look at the
riskiest portions of an asset class to see how they
are performing. If there is strong demand for
high-risk assets, that can provide a great insight
into investor psychology.
Chart 27. S&P/LTSA Leveraged Loan 100 Index
110
100
90
80
70
60
50
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
Mar-13
Source: Bloomberg
The chart above reflects the historical return of
the S&P/LTSA Leveraged Loan 100 index. As the
name suggests, leveraged loans are loans given by
banks to companies that already carry a significant
amount of debt. Leveraged loans occupy the
riskiest portions of the credit market. This index
bottomed out in late ’08 at $59 as risk taking was
shunned during the height of the credit crisis.
However, the index has rebounded and is now is
at a 5-year high of $98.
11
After leveraged loans, the next riskiest portion of
the credit market is junk bonds which carry the
euphemism “high yield” bonds. These bonds are
issued by higher risk companies that are more
challenged to repay their debt, thus investors
must be compensated for taking on this additional
risk in the form of a higher yield. How much yield
are investors receiving? Close to all-time lows of
roughly 5.6%. But that is more a function of the
low rate environment. The credit spread - the
difference between the yield on a corporate bond
that carries credit risk and the yield on the
theoretically “risk-free” treasury bond which does
not carry credit risk - provides insight into risk
perception.
Higher credit spreads mean that investors require
more yield to be compensated for bearing credit
risk. When spreads are high, risk tolerance is low,
and when spreads are low, risk taking is high as
investors require less additional yield to take on
the additional credit risk. Currently, high yield
spreads are around 480 basis points (additional
yield required to bear credit risk). The long-term
average (since 1987) has been around 600 basis
points with the high, a whopping 1,800 basis
points during, you guessed it, the credit crisis in
late 2008. During the euphoria of the late ’90’s
spreads compressed to all-time lows of 270 basis
points. We are far from that level, but spreads
have been compressing, revealing that risk taking
has been on a steady rise.
Chart 28. Barclays High Yield Corporate Bond Index
Credit Spread (in basis points)
2,200
2,000
1,800
1,600
1,400
1,200
1,000
800
600
400
Mar-08
Mar-09
Mar-10
Source: Bloomberg, Barclays Capital
12
Mar-11
Mar-12
Mar-13
Consider a few more stats on risk taking:
The best performing investment grade credits
over the past year have been Bank of America,
Citigroup, Morgan Stanley, & Goldman Sachs far and away the riskiest credits in prior years.
High yield bond prices reached a 23 year high of
$105.1 in late January 2013 (BofA/Merrill Lynch
U.S. High Yield Master II Index).
M&A activity remains elevated. Through year
end 2012 the highest volumes of M&A activity
were recorded since 2008.
Investment grade credit default swap prices are
5 points off of their 5 year lows of 75 basis
points and 25 points below their long-term
average.
The Impact of Monetary Policy on the Bond
Market: Is the Fed sowing the seeds of a bond
market bubble? We have postulated that risk
tolerance increases in low interest rate periods
and this is a sentiment shared by the Federal
Reserve. Chairman Bernanke in a March 1, 2013
speech to the Federal Reserve Bank of San
Francisco said the following, “On the other hand,
we must be mindful of the possibility that
sustained periods of low interest rates and highly
accommodative policy could lead to excessive
risk-taking in some financial markets.” In the
same speech he referenced a speech by Fed
Governor Jeremy Stein to the Federal Reserve
Bank of St. Louis. On February 7, 2013 Governor
Stein had this to say, “For example, a prolonged
period of low interest rates, of the sort we are
experiencing today, can create incentives for
agents to take on greater duration or credit risks,
or to employ additional financial leverage, in an
effort to ‘reach for yield.’ ” As previously
demonstrated, in the credit markets we believe
investors have begun to increase their risk
tolerance noticeably in an effort to, as Governor
Stein said, “reach for yield.” Perversely, the
monetary policy being employed to stimulate the
economy out of the ruin created by the credit
crisis may in fact be planting the seeds for another
crisis of sorts, brought on by rising rates and
excessive risk taking in the form of paying too
much for overvalued fixed income securities.
Investors who point to corporate deleveraging
and improving credit profiles of corporations are
missing the risk in the bond market. Unlike in the
mid-’00’s when credit risk was the cause of the
credit crisis, the risk in the bond market now lies
in interest rate levels. From these rock-bottom
levels, interest rates have little room to decline.
The return profile for much of the bond market is
asymmetric. To illustrate, let us look at the
following scenarios (assume the 10 year treasury
at its current 1.90%):
Rates Stay Flat- investors can reasonably expect to
earn their coupon rate which is likely to be around
2-4% based on the low level of bond coupons.
Rates Fall- a low probability scenario although not
unrealistic should macro concerns resurface
(economic slowdown, Europe, etc.), but rates
have little room to fall from the already rockbottom base of 1.90%. If they were to drop to
1.50% then returns could reasonably be expected
to be in the high single-digit to low double-digit
area, say 7-12%.
Rates Rise- if rates were to rise 300 basis points
(the average rise in rates over the last 90 years) to
bring the 10 year to 4.90%, investors could expect
a double-digit loss in their bond portfolios.
This being known, it makes Chart 29 all the more
puzzling:
Chart 29. Cumulative Net Flows- Equity vs. Bond
Mutual Funds (in billions, 1/1/08-3/6/13)
Implications for Bond Portfolio Management:
Strategies for Mitigating Bond Market Risk
Here are a few of the strategies we are employing
to mitigate the risks we have outlined:
Keep a short duration portfolio. Accept the
negative real yields offered by the market
until rates rise.
Diversify into non-U.S. interest rate based
credit products.
Invest in high premium priced “cushion”
bonds as their high coupons will soften the
blow of rate increases.
Diversify. Simple and straightforward, but
increase exposure to other areas of the bond
market to smooth out volatility.
Find alternative income-producing asset
classes (equities, real estate, etc.).
Consider greater use of exchange-traded
funds (ETF’s) as their structure of broadly
diversified holdings and continuously
maturing bonds will allow for improved
diversification and reinvestment at higher
rates.
We highlight two fixed income strategies that we
manage at Cypress that share many of the
characteristics noted above.
1. Cypress Conservative Income
2. Cypress Total Return
Chart 30. Cypress Conservative Income ETF Portfolio
$1,400
$1,200
Bond
$1,132.8
$1,000
$800
$600
$400
$200
$0
-$200
-$400
-$477.4
Equity
-$600
1-3 Year Short Duration Bonds
Core U.S. Bond Market
Mortgage Backed Securities
Investment Grade Corporate Bonds
-$800
'08
'09
Source: Strategas
'10
'11
'12
'13
Source: Cypress Trust Company
13
A few points about the Conservative Income
portfolio: it maintains a short-duration bias so it
carries much lower interest rate risk than the
typical bond portfolio and includes broader
diversification to supplement the weighting to the
“core” of the bond market (government debt) by
including mortgage backed debt and investment
grade corporate bonds thereby smoothing
volatility and making capital preservation the
primary emphasis.
The Total Return strategy also maintains a strong
weighting to short-term credit, with a short
duration and thus lower than normal interest rate
risk while at the same time offering modest
exposure to non-U.S. rate based credit in the form
of emerging market sovereign debt, and an
allocation to high yield debt. The risks to high
yield debt were previously highlighted but a
modest allocation to the asset class can be
appropriate for some investors. High yield debt
offers correlation benefits to traditional fixed
income as high yield carries equity-like
characteristics that often see it perform well in a
rising rate environment.
Both portfolios are constructed with exchangetraded funds that frequently offer liquidity, cost,
and diversification advantages over individual
bonds.
Chart 31. Cypress Total Return ETF Portfolio
Portfolio Positioning
As we noted in the last edition of Strategy
Quarterly, 2012 was dominated by two main fiscal
crises (one in Europe and the other in the U.S.).
Investors moved out of equities and into bond
funds or even cash as their emotions could not
deal with market volatility. Yet the S&P 500 was
up 17%. We believe that volatility creates
investment opportunities and that investors’
worries are a contrarian indicator: when investors
reach consensus on market direction, it’s likely
time to take an opposite position.
While absolute equity valuations are not
particularly attractive, relative to bonds, stocks
seem to offer a better risk-reward ratio for
investors with an intermediate to long term
horizon. With historically low dividend payout
ratios and with nearly 60% of S&P 500 companies
displaying a dividend yield higher than the 10-year
treasury yield, a significant rebalancing from
bonds to equities is a very possible scenario over
the next few years.
We advise investors not to chase trends or styles
but to stick to a disciplined portfolio management
approach that selects stocks based on persistent
fundamental characteristics that drive
performance over the long-term, such as return
on capital and free cash flow-based metrics.
Income-seeking investors should emphasize
financially strong companies with steady earnings
and dividend growth rather than high yield stocks
with high, unsustainable dividend payouts.
Within fixed income, valuations remain rich but
fixed income should remain part of proper asset
allocation. Investors should avoid reaching for
yield and taking on excess risk. We would
reiterate our refrain of the past few quarters,
which is that return expectations should be
lowered as catalysts for further upside potential
(lower rates and credit spreads) are limited.
1-3 Year Short Duration Bonds
Core U.S. Bond Market
High Yield Debt
Emerging Market Debt
Source: Cypress Trust Company
14
Mortgage Backed Securities
Portfolio Management Massimo Santicchia is the Chief Investment Officer for Cypress Capital Group,
Cypress Trust Company and Crest Investment Partners. He directs all aspects of the investment strategy as
well as develops and manages his own custom equity portfolios. Santicchia has 16 years of investment
experience including: S&P Investment Advisory Services LLC, as portfolio manager of JNL/S&P 4 funds and
co-managed JNL/S&P Managed and Disciplined funds.
Portfolio Management Ryan Kuyawa, CFA is a Portfolio Manager & Fixed Income Trader for Cypress Capital
Group & Cypress Trust Company. He is responsible for security selection, yield curve positioning and overall
fixed income strategy. In addition, he performs equity research and is a member of the Investment Policy
Committee which directs the firm’s overall investment outlook.
Important Notes
This does not constitute an offer or solicitation in any jurisdiction where to any person to whom it would be unauthorized or unlawful to do so. Opinions
expressed are current opinions as of the date appearing in this material only. This information should not be considered investment advice or a
recommendation to buy or sell any particular security. While every effort has been made to verify the information contained herein, we make no
representations as to its accuracy. The information in this material and specific securities mentioned are not representative of all securities purchased,
sold or recommended for advisory clients. Actual portfolio holdings will vary for each client and there is no guarantee that a particular client's account
will hold any, or all, of the securities identified. It should not be assumed that any of the securities or recommendations made in the future will be
profitable or will equal the performance of the listed securities. Past performance does not predict future results.
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