Investors should expect the market swings of 2015 to carry over into the new year, driven largely by concerns over weak global growth. We are recommending that clients consider high-yield bonds and other asset classes that can offer the prospect of solid gains that diverge from the path of traditional stocks and bonds.
Turbulence in various stock markets will probably persist in 2016 as global growth slows because of weakness in emerging economies including China, a leading engine for the world economy during the past decade.
Investor concerns about slowing growth have sprung up here and there since 2011 but had yet to set back equities until this year. From 2012 until 2014, the MSCI All Country World Index annually rose by an average of 14.1%. In 2015, though, three trends began to weigh on stock prices: equity valuations rose above their historical average, record central-bank stimulus failed to fuel faster growth, and corporations, having already wrung out significant inefficiencies, made fewer gains in streamlining and improving profit margins, especially in the U.S. Heading into 2016, these trends show no sign of fading.
Adjusting to these headwinds, we favor trimming weightings in stocks, bonds and cash. Mindful that inflation erodes the value of cash and interest rates stuck near zero hold down bond returns, we are focusing on strategies with lower correlations to these traditional asset classes. One of our alternatives is high-yield bonds, which offer attractive returns compared with stocks and other fixed income securities. We also continue to see opportunities in hedged equity strategies, real estate and emerging market small-cap stocks.
We believe this group of alternative assets to be less vulnerable than stocks to the risk of flagging economic growth, and less vulnerable than bonds to rising interest rates. The world economy is on pace to grow 3.1% this year, 0.3 percentage point less than in 2014, according to an estimate in October by the International Monetary Fund. As recently as July, the IMF estimated 3.3% global growth for 2015. “With declining commodity prices, depreciating emerging market currencies and increasing financial market volatility, downside risks to the outlook have risen,” the IMF said in October.
China, the world’s No. 2 economy, grew 7.3% in 2014. The IMF is predicting a figure of 6.8% this year and 6.3% in 2016. These paces are far below China’s annual average growth of nearly 10% from 1979 until 2014. “Previous excesses in real estate, credit and investment continue to unwind, with a further moderation in the growth rates of investment, especially in residential real estate,” the IMF said in its World Economic Outlook. Chinese President Xi Jinping announced on Nov. 3 that Beijing would accept an annual growth rate of 6.5% from 2016 until 2020, a step down from the annual target of about 7% from 2011 until the end of this year.
From Sizzle to Fizzle
Robust expansions in China and other emerging economies such as Brazil and Russia helped buoy the world economy following the financial crisis last decade, a period when the U.S., Europe and Japan floundered. This year, though, growth among emerging market economies is expected to fall to 4% from 4.6% in 2014, according to the IMF. Brazil’s economy is likely to shrink this year by 3%, while Russia is expected to decline by 3.8%.
Along with weakening global growth, the Federal Reserve poses a near-term risk to stock and bond prices. Fed officials, noting improvement in the U.S. labor market, have hinted that they will raise the benchmark interest rate from a record low during their Dec. 15-16 monetary policy meeting. It would be the Fed’s first increase since 2006.
No matter the investment environment, we size up an asset class by focusing on a comparison of potential gains with downside risk. Since 2009, we have identified eight opportunities to shift portfolio allocations to capitalize on a determined upside/downside mismatch. Six of these moves have benefited client portfolios.
For example, in 2009 we advocated reallocating a portion of funds from a broad market orientation in stocks and bonds into commodities, which we forecast would benefit from monetary easing and rising demand in emerging markets. From Oct. 31, 2009, until Nov. 14, 2011, the UBS/Bloomberg CMCI rose 9.7% on an annualized basis compared with an 8.8% annualized return by a 50/50 blend of the Russell 3000® Index and Barclays Aggregate Bond Index.
In 2011, with the economies of Japan and the eurozone slumping, we called for a shift from international equities into U.S. stocks. From April 7, 2011, until Sept. 30, 2015, the Russell 3000® Index of U.S. stocks surged on an annualized basis by 10.5% compared with a 2% annualized gain by the MSCI EAFE Index of international developed market stocks.
The typical yield on high-yield bonds rose to nearly 7.5% as of Oct. 31, 2015, from 5% in June 2014. This is meaningfully higher than the earnings yield for stocks in the Standard & Poor’s 500 Index and the yield on the 10-year U.S. Treasury bond.
Today, we believe that high-yield bonds provide a compelling option for investors in a low tax bracket or with the ability to invest through a tax-advantaged structure like an IRA. The typical yield on such bonds recently surged to nearly 7.5% as of Oct. 31 from 5% in June 2014. Meanwhile, as shown in the chart on page 5, the earnings yield fell for stocks in the Standard & Poor’s 500 Index and the yield on U.S. Treasuries meandered within a narrow range below 2%.
During stock market corrections, high-yield bonds tend to decline less than equities. From May 21, 2015, until Aug. 25, 2015, the S&P 500 Index fell 11.9% compared with a 4.3% decline by high-yield bonds.
Goldilocks for High-Yield
Our outlook for the economy in 2016 suggests that corporate bonds may outperform equities. In our view, growth may be too weak to drive up corporate earnings and stock prices significantly. At the same time, the mix of moderate growth with low inflation that we foresee is generally positive for corporate credit. Slow but stable growth means that most companies can repay debt, keeping the risk of default low. Also, low inflation argues against a sudden rise in interest rates that would undercut bond prices.
High-yield bonds are also attractive because of their low correlation to other types of bonds. In fact, high-yield bonds outperformed Treasuries during seven corrections in the Treasury market since 1992. When, for example, the yield on Treasuries rose 1.64 percentage points from July 24, 2012, until Jan. 1, 2014, Treasuries fell by 4.3% while high-yield bonds surged 14.5%. (Please see the table on the next page.)
High-yield bonds have also typically outperformed equities when stock markets fall. For example, from May 21 until Aug. 25 of this year, the S&P 500 Index plunged 11.9% while the typical high-yield bond declined 4.3%. In short, high-yield bonds will probably provide a favorable counter-current to stocks and bonds. (Please see the story on page 8.)
To be sure, high-yield bonds are “tax inefficient” and not for every investor. Specifically, all of the cash flow from yield is considered and taxed as ordinary income, and could cut in half the return for investors in the highest tax brackets, depending on their state of residency. Therefore, investors should most strongly consider buying high-yield bonds in an IRA or other tax-advantaged account.
Hedged equity strategies, real estate, and emerging market small-cap stocks—the other opportunities we see in reallocation—also offer lower correlations to traditional stocks. By utilizing certain and creative hedges, managers can isolate the strengths or weaknesses of a company from its correlation to the broad stock market. They can take a long position in a stock when they expect it to rise or a short position should they expect the stock to fall. Such a flexible approach is especially appealing when the stock market is flat or falling.*
Outside the "Gateway"
The location-specific nature of real estate provides an advantage in diversification. While both stock and bond markets tend to react to changes in the global or national economy, the performance of real estate largely hinges on management skill and the health of a local economy. We are particularly attracted to income-producing properties outside the “gateway” markets of New York, San Francisco and Miami.
Our shift within equities targets small-cap stocks that are leveraging the growth of Asia’s middle class. We prefer avoiding the rich valuations of consumer staple stocks, investing instead in consumer discretionary stocks and companies with indirect exposure to the consumer. These include life insurance and family-oriented health care firms. Accordingly, we are focused on increasing our exposure to managers whose strategies echo these investment themes.
Investors should keep in mind that it is very unlikely that traditional equities and bonds will gain at the same pace during the next few years as during the period since 2009. Moreover, cash does not offer a promising return. The Fed and other central banks have purchased record amounts of bonds with the aim of driving down interest rates and spurring growth. The policy of so-called quantitative easing has pushed investors into riskier, higheryielding assets and out of cash, which is eroded by inflation.
By looking beyond a standard roster of stocks, bonds and cash, to alternatives like high-yield bonds, hedged equity strategies, real estate and emerging market small-cap stocks, investors can find opportunities for solid, risk-adjusted returns in a decelerating global economy.*
Beating Other Bonds
High-yield bonds significantly outperformed U.S. Treasuries during seven corrections in the Treasury market since 1992.
Please download The Advisory to read other articles in this issue including:
Diamonds In The Rough
By Tom Graff, CFA, Head of Fixed Income
Weak commodity prices and flagging emerging market economies have dimmed the outlook for energy and metals companies, and are shaking up the high-yield bond market. Through conservative, bottom-up analysis, we are taking advantage of current market dynamics to buy attractively priced debt in companies with solid revenues and limited vulnerability to an economic downturn.
By Mark Kodenski, Private Client Portfolio Manager
Stock market corrections can prompt investors to impulse selling or other moves that are often harmful to their long-term financial well-being. By walking through four steps with a client, we can refocus his or her mindset on the fundamental issues that help safeguard financial stability and achieve steady outperformance.
Ensuring Legacies Last
By Joe Ferlise, Strategic Advisor
Heirs who are unprepared for an inheritance may find that a big windfall can quickly become a mixed blessing. An essential step in estate planning is making sure beneficiaries know all the responsibilities and challenges that accompany the management of increasing wealth.
The views expressed are those of the authors and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance. In addition, these views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients or other clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients and is for informational purposes only. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication.
MSCI All Country World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes. The developed market country indexes included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indexes included are: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates. UBS Bloomberg CMCI Composite USD Total Return is a diversified commodity index family made up of 27 components. CMCI offers the ability to gain exposure to the broad commodity markets, specific sectors including energy, industrial metals, precious metals, agriculture and livestock as well as individual components. It also includes a time dimension by allowing investment across different tenors.
The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market. The Russell 3000® Index is constructed to provide a comprehensive, unbiased, and stable barometer of the broad market and is completely reconstituted annually to ensure new and growing equities are reflected.
Barclays Aggregate Bond Index is an unmanaged, market-value weighted index comprised of taxable U.S. investment grade, fixed rate bond market securities, including government, government agency, corporate, asset-backed, and mortgage-backed securities between one and 10 years. MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. (Source: MSCI).
The Bank of America Merrill Lynch High Yield Cash Pay Index is an unmanaged index used as a general measure of market performance consisting of fixed-rate, coupon-bearing bonds with an outstanding par which is greater than or equal to $50 million, a maturity range greater than or equal to one year and must be less than BBB/Baa3 rated but not in default.
The Bank of America Merrill Lynch U.S. Treasury Index tracks the performance of U.S. dollar denominated sovereign debt publicly issued by the U.S. government in its domestic market. Qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $1 billion. Qualifying securities must have at least 18 months to final maturity at the time of issuance. The S&P 500 Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include: market capitalization, financial viability, liquidity, public float, sector representation, and corporate structure. An index constituent must also be considered a U.S. company.
*Investments may be available for Qualified Purchasers or Accredited Investors only.