Island Light Quarterly Commentary (March 2013)
Shouts of, “USA! USA! USA!” echoed down Wall Street this quarter. US equity market performance demolished every other asset category as the combustible recipe of expansionary monetary policy, temporary relief from political stalemate and near-record corporate profits combined to drive most major US equities to all-time highs. Fear was dwarfed by greed and investors on the sidelines lament their lost opportunity. On the other side of the Pacific, cheers of “banzai! banzai! banzai!” reverberated in Tokyo as the Japanese monetary authority doubled down on their bet to grow the economy through debt creation and currency devaluation. Nothing was heard from China and Spain, nor from fixed income investors, except for a few groans of dismay.
We are struck by the rate of change in investor sentiment and consumer behavior in the last few months. At least in our corner of the world, restaurants are full on Saturday nights, roads are congested, and new home construction is recovering briskly. Hope abounds and spring is in the air. On the surface, for those with income, steady jobs and stable homes, New England is a pretty nice place to be. And there is plenty of reason for optimism in this highest income region of the US. Interest rates are low, equity markets, jobs and housing starts are up, and wealth is back to levels last approached seven years ago. These Americans have reason to be optimistic as they reaffirm their abilities to better themselves through hard work and good luck.
However, we sense another sentiment in the celebration. Below the surface lies a sense of anxiety that this might be a false spring and that things are not quite as they appear. This feeling is the world of the other American citizen; he who lives alone or with too many dependents, perhaps without a job, or who has left the workforce with little wealth and savings. This undercurrent of fear and sense of lost opportunity is the yin to the yang of the muted celebration of the gainfully employed. In addition, headwinds to growth include political uncertainty in North Korea and high levels of national debt. The uneasiness is heightened by pundits and noisemakers in the televised press, whose gloom contributes to investor uncertainty.
We expect hopeful trends while we fear a descent to an unpleasant equilibrium. We are optimistic about the direction of equity markets, principally due to corporate profits that have not yet been reduced by wage appreciation. In addition, the extraordinary monetary expansion now promulgated by Japan, following the lead of the US, Bank of England and the European Central Bank, should keep global interest rates low and support current equity levels. We will try to take advantage of this unique opportunity. But we balance this hope with the knowledge that free money policies will not solve our long term issues, and thus fear that when the party ends, the consequences may be severe. We’ll therefore cheer on the US and Japan but keep an eye on the other parts of the global economy so we may secure lasting victories over the long term through broad diversification.
First Quarter Results
US equity markets reached new highs, restoring the US equity market to levels not seen since the latter half of 2007, as the S&P 500 was up 10.6% for the quarter ended March 31. The increase in equity markets appears to be fueled by a drop in investor uncertainty. Clearer signals on European commitment to the stabilization of the Euro, compromise on the fiscal cliff and sequester (or was that a non-sequester?) were all deemed to be positive events by equity investors.
US corporations now enjoy the second highest profit to GDP ratio ever, fueling expectations for a rejuvenation of growth. Coupled with strong balance sheets, large cash levels, continued Fed stimulus, and improvement in the housing sector, equity markets reacted very strongly. Larger value stocks and small growth stocks led the market rally, returning 12.3% (Russell 1000 Value) and 13.2% (Russell 2000 Growth).
Overseas markets were also strongly positive, but well below the outsized growth in the US as the MSCI EAFE index returned 5.1% for the quarter. The commitment to devalue the yen by the Japanese government of Prime Minister Shinzo Abe provided hope to an ill economy hoping to export its way to economic growth. Japanese equities returned 11.7% in dollar terms and the entire Asia-Pacific region returned 9.7% (MSCI Pacific). European markets were weak performers, returning 2.7% (MSCI Europe) as hoped-for economic growth did not materialize. One surprise was the significant underperformance of emerging markets, losing 1.8% for the quarter (MSCI Emerging). Overall, the world equity market, as measured by the MSCI All Country World Index (MSCI ACWI) returned 6.1%. The United States comprises somewhat less than half of this index.
On the fixed income front, US Bonds lost 0.1% for the quarter as measured by the BarCap US Aggregate Bond Index. Shorter duration bonds and credit bonds modestly outperformed longer duration and Treasury securities. Gold lost 4.5% for the quarter. All returns are through March 31, 2013.
The Island Light portfolios, as globally diversified asset allocation portfolios, were all positive for the quarter and, by and large, performed in line with expectations.
Our economic themes have not changed substantially in this quarter from our outlook as expressed at the beginning of the year. We anticipated more economic certainty would be an important driver of investor sentiment, amidst a continuing low global interest rate environment. We also anticipated a slowly recovering Europe and slowdown in US GDP growth in the first half of the year due to payroll tax increases. What has changed in the last quarter that might affect our economic outlook? Europe remains in recession with its fifth quarter of economic decline. The major markets of Germany, France and the UK all experienced negative growth in the fourth quarter of 2012. Anticipated growth due to a weakening Euro, exports to the US and China and internal demand has not yet materialized, although political sentiment appears to be moving away from austerity policies. We remain cautiously optimistic that economic growth will return to Europe in the second half of 2013. The Japanese bet on growth through quantitative easing is a welcome but possibly desperate act to revive a moribund economy. This is a major development that could have material outcome on bond yields globally and the balance of trade. While unconvinced this alone will bring the Japanese economy out of a 20 year decline, the new stimulus merits attention. Looking forward, we expect modest economic growth globally, led by the US economy, a rising interest rate environment in the latter half of 2013, monetary easing globally, with reversal of US quantitative easing beginning late in 2013. Emerging markets economies will continue to expand at a lower rate than historically, as they adjust to a new world of rising labor costs, inflation pressure and over-capacity.
The importance of shale oil production and hydro-fracking technology should not be underestimated. New US oil and gas production will have a long term positive effect on US economic growth both in employment and the stimulative benefit of lower energy costs, assuming of course that environmental consequences can be minimized. Higher housing prices and equity markets, super low interest rates, and the natural cycle of growth in a later-stage economic recovery all point toward a modest growth outlook for the rest of 2013. We do not expect unemployment to drop significantly, however, as inventories remain somewhat high and profits are substantial. To be sure, there are still economic headwinds to come, including resurgent consumer confidence, which dropped in March from an escalated February level, political stalemate and fears of interest rate and inflation increases due to higher growth and expansive monetary policy.
In March, it was reported that GDP grew at a rate of 0.4% in the fourth quarter of 2012. Earlier, the Federal Reserve further weakened its economic forecast, expecting the US economy to grow between 2.3% and 2.8% for 2013 and from between 2.9% to 3.4% for 2014. The Congressional Budget Office updated its economic projection for 2013 to 2.9% nominal GDP growth (February 2013). All things considered, we still expect nominal GDP growth in 2013 to tally between 2.0% and 2.5%.
Estimates for 2013 operating earnings for the S&P 500 are expected to be from 12 – 15% higher than 2012 earnings (bottom up). In addition, equities are yielding 2.2%, about 0.2% above the 10 year Treasury, which according to the Fed Model, makes equities relatively more attractive than bonds. This ratio may be more about the fact that bond yields are at very low levels (1.87% for the ten year treasury) than the sense that equities are fairly priced. Finally, the current PE ratio for the S&P 500 is approximately 14.1 versus a 20 year historic average of 16.2. All of these factors lead us to believe that US equity returns should remain positive in 2013, continuing their first quarter growth. The rally in stocks cannot progress at the same rate as the first quarter, so there will be pauses and setbacks for the year. Nevertheless, the long-term trend continues to look encouraging, particularly in comparison to the fixed income alternative.
Inflation increased modestly to an annualized 2.0% in the first quarter, due in part to increasing economic growth. Large amounts of global debt and expansionary US monetary and fiscal policy will contribute to inflationary expectations while continued weakness in non-US demand, stubborn unemployment in the US and severe unemployment in Europe will combine for low demand for goods and services and a stagnant real wage environment. With the Fed proposing a target rate of 6.5% for unemployment and 2.5% for inflation, expect continued monetary stimulation and quantitative easing at least through the upcoming quarter. Longer term, we think that inflation will increase modestly primarily because of monetary expansion and a recovery in housing (representing 40% of CPI weight). Offsetting this increase could be the impact of lower energy prices (especially natural gas) on energy and transportation.
Interest Rates and Fixed Income
Investment strategists remain spooked by today’s bond market and any news that could lead to monetary tightening is met with a rush away from longer duration instruments. Historically low yields amid an enormous supply of US Treasuries have created expectations that the 30 year fixed income rally will come to an end and that bonds of all stripes will suffer. We continue to hope for a soft landing. The benchmark 10-year Treasury yield finished the quarter essentially unchanged at 1.87%. Signals from a minority of Fed governors of their desire to end quantitative easing will eventually hurt bond prices in 2013. The 30-year bond yielded 3.1% at the end of the quarter, up from 2.9% at year end. AAA Corporate bond spreads above the Treasury Spot rate are 0.6%, while AA Corporate Bond spreads are 0.9%, 0.2% below average. These credit spreads are lower than their historic averages, but still well above historic lows. In Europe, the Eurozone benchmark interest rate remains pegged at 0.75% and the British rate is 0.50%. Japan retains its 0.0% interest rate and Australia remains steady at 3.0%. The major Emerging Market interest rates range from 4.0% (Mexico) to 8.25% (Russia).
The low interest rate environment for sovereign debt makes US corporate and emerging bond debt appear somewhat attractive, despite the low corporate spreads to Treasuries. We remain invested in fixed income. We believe that fixed income has a place in a well-diversified portfolio to protect from downside loss. But we have tried to be more defensively positioned within the fixed income class by reducing overall exposure to Treasuries, while maintaining some exposure to corporate and emerging bonds, international sovereign debt, short-term floating rate notes and short-term corporate bonds. Thus we seek to minimize the effect of a rise in interest rates.
Eurostat reported this week that the economies of the European Union declined by 0.5% in the fourth quarter of this year, which means that the Union has been in recession for more than a year. In February, the European Commission forecast 0.1% economic growth for Europe in 2013 and 1.5% growth in 2014, citing external demand net exports as the driving growth factor. Dollar strength and Japanese currency weakening may forestall this expected export-driven growth. Unemployment remains an enormous problem in Europe with Euro Zone joblessness at 12.0%, led by Spain (26%). Inflation is reported to be 1.7% and the OECD projects weak nominal growth (1.2%) and negative real growth (-0.1%) this year, possibly recovering in 2014. In the first quarter, European markets were up in dollar terms, but performed behind the US equity markets, growing 2.7%, after very strong returns in the latter half of 2012. Nordic countries performed better than their Mediterranean counterparts. The fragility of European confidence may be best demonstrated by the strong negative market reaction to Cyprus bank woes and the Italian election. Any hint of a threat to the stability of the Euro has led to increased market volatility. Consumer confidence remains distressingly negative in the region and business confidence is not much better. We maintain a relative underweight to Europe in the portfolios.
The Asia and Pacific regions
With the appointment of Prime Minister Shinzo Abe in December 2012, the Japanese signaled their desire to break from recent austerity practices and to rapidly expand their money supply, hoping that a significant drop in the yen will lead to export-driven growth and long overdue revival of internal sentiment. Markets responded very positively, with the Nikkei up 19.3% while the yen declined 7.9% and Japan in dollar terms up 11.7% (MSCI Japan). With this extraordinary augmentation of the money supply, the Japanese monetary authorities are doubling down on their “expansion through debt creation” credo. This quantitative easing policy will further increase the debt on the Japanese balance sheet from already record levels of more than 210% of GDP. While equity markets have responded very positively, Japanese bond investors appear to be moving some investments into the Euro to protect from currency devaluation. The situation bears monitoring and the impact on other export-led Asian markets, notably China and South Korea, could be negative. The impact on Japanese equity markets should continue to be positive in the short term. In the rest of the region, the Asia-Pacific index returned 7.0%, continuing torrid performance from 2012.
Emerging markets in the first quarter of 2013 lost 1.8% with performance ranging from minus 14% (Czech Republic) to a high of 19% (Philippines). The largest emerging markets in terms of market capitalization in the index achieved these returns: China, -4.6%; Korea, -3.4%; Brazil, -0.8%; Taiwan, -0.2%; South Africa, -9.0%; Russia, -3.2%; India, -2.6%. The disappointing performance in the emerging equities may be indicative of a longer term trend of decelerating economic growth as the multi-year period of export-driven dynamism runs its course in emerging economies. This is due to currency strength relative to the developing countries, as well as faster rising wages and higher inflation than in the developed world. This relative economic slowdown is particularly apparent in China.
However, we reiterate that emerging markets economies by and large are in better shape than the developed world’s economies with regard to growth rates, level of sovereign debt, unemployment and other economic factors. Manufacturing advantages due to lower labor rate and pro-growth policies remain systemic advantages in productive capacity. Russia, South Africa and Brazil enjoy natural resource abundance and China and India’s enormous populations provide demand for goods and services and low labor rates to the benefit of local companies. Mexico enjoys proximity to the largest consumer market in the world. These advantages and rapid growth rate are the primary reasons to invest in emerging markets long term, despite the higher volatility, political and environmental risk present in these areas. We remain modestly overweight in this sector at this writing.
Alternative assets exposure, and in particular our investment in gold, hurt portfolio performance in the first quarter. Our multi-alternative exposure returned a positive return (2.7%) in the quarter, but less than domestic equities, to be sure. Portfolio diversifiers, including commodities, with their low correlation to traditional asset classes, often perform in the opposite direction from equities, reducing long-term volatility, but occasionally disappointing investors when equity markets are increasing.
As we have said before, our investment methodology, process and optimization technology give us a disciplined and stable framework for the introduction of non-traditional and alternative asset categories. The expected lower correlations among these non-traditional asset classes provide important diversification and risk control benefits. Because the type of risk control will vary with the desired risk target of the portfolio, these non-traditional asset diversifiers carry different weights depending on whether the portfolio is conservative or aggressive. For example, the fixed income portion of our conservative portfolios includes short duration fixed income and floating rate notes while our more aggressive portfolios will have an exposure to low volatility equities. Because of the stability of our process, we can introduce these different ideas into the portfolios and provide a more consistent long term outcome. It is hard to do this with less stable processes.
Attractive liquid ETF alternatives are difficult to find but are an important component of our investment portfolios, with their diversification contributing to reduced volatility. One of the challenges in finding an alternative asset ETF is our reluctance to invest in securities that are not “pure” ETFs, such as ETNs (exchange traded notes) or ETFs that create K1 income, due to their capital structure. In time, we expect that additional attractive liquid alternative categories will be introduced into the marketplace.
We consider “alts” to fit into two categories: alternative strategies and alternative asset classes. The first is an investment technique different and perhaps unique in that it has low correlation to traditional asset classes. Some examples of alternative strategies are managed futures, hedged equity, merger arbitrage, and global macro. The second type of alternative constitutes a non-traditional investment class of securities that also show low correlation to traditional asset categories. We consider such an alternative asset class to include low volatility equities, gold, emerging bonds, REITs, TIPs and similar assets.
We go on to break down alternatives into three components: fixed income complements, equity complements, and diversifiers. Fixed income complements, such as strategic income, help to diversify within the fixed income class. Equity complements, such as hedged equity and merger arbitrage strategies, are designed to get equity exposure while reducing equity risk. Diversifiers including gold, managed futures and market neutral strategies, help to reduce the volatility of a traditional stock/bond portfolio. We believe this form of categorization can help in the investment decision-making process.
Our alternatives exposure are in place in the expectation that the current equity run and low interest rate environment may end.
For a detailed summary of our Portfolio performance during the quarter, please see our individual fact sheets or contact us for detailed information.
We are pleased that our overall performance in all portfolios was positive, but somewhat disappointed with our index-relative return. We invest for all seasons. In a strong equity environment, we expect to be a little behind our index, while in declining equity environments we hope to outperform a little. Our diversifying positions in low volatility equities, non-traditional asset categories and alternative assets are designed to keep returns more consistent over time and to aid in risk control, factors we believe will help the long-term investor. Our global portfolios, while they have a high degree of international exposure, are positioned to have more US equities than non-US equities because our investors live in the US and are most impacted by US economic growth. The US stock market significantly outperformed both developed and emerging markets in the first quarter. Overweighting to value and small capitalization stocks and underweighting to US treasuries and European equities helped relative performance, while overexposure to gold, Emerging Markets and Canadian equities hurt relative performance.
At this writing, we have made no material changes to the portfolios. We believe in our process and have given great thought to the positioning of the portfolios with respect to our long-term expectations of capital market returns. We remain cautiously optimistic for the equity markets and not yet ready to abandon fixed income markets, where we remain shorter duration with exposure to credit risk. We believe that it is important to maintain downside protection from investor loss through exposure to alternative and lower volatility assets, even at the expense of somewhat lower returns when markets are positive.
Hope springs eternal in the human breast. Hope brings joy and happiness, which is the essence of life. We now celebrate the first quarter amid record corporate profits and increased economic activity. The good news now present is not a false hope, but a continuation of a global economic cycle that began before 2013. We expect the good news to continue, but remain on the alert for areas of financial stress.
Island Light’s investment methodology is designed on a process called “Enlightened Investing”. Enlightened Investing is a stable approach to portfolio management, emphasizing quantitative principles and proven investment practices, while accentuating asset allocation as the most important determinant of long-term success in investment planning. This approach is designed for the long-term investor.
For more information about Island Light’s Enlightened Investing methodology, or for further information regarding any of our portfolio construction, tactical overlay, estimation methods, performance information or anything else that comes to mind, please contact us at 508-687-0061 or email us at
Matthew V. Pierce, President