With the recent pickup in macro volatility across rates, credit, and global equity markets, it is prudent to take a look around the investment landscape and determine themes that should guide your asset allocation over the remainder of 2013.
While the impact of asset allocation mix relative to security selection on portfolio performance is large, the magnitude is also a source of great debate. Yale professor Roger Ibbotson offers a great review of this debate, but for the purposes of this article, let's make the simplifying assumption that the impact of asset allocation on your portfolio is very important.
Much of what is written on Seeking Alpha is searching for relative outperformance on the security level rather than the portfolio level. Imagine two investors who both entered 2013 with allocations to five asset classes: large cap domestic stocks, small cap domestic stocks, emerging market stocks, high yield bonds, and investment grade bonds. As seen by their respective hypothetical 2013 performances tabled below, investor A has outperformed Investor B with every security selection in these five asset classes.
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Investor A Outperforms With Every Stock Pick...
But Investor B Has A Better Portfolio Performance
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When adding in their respective weights to these five security classes, investor B has actually outperformed in 2013. In probability and statistics, this is known as the Yule-Simpson effect, a paradox in which a trend that appears in different groups of data disappears when these groups of data are combined, and the reverse trend is revealed. By looking at only the first table, the conclusion can be reached that Investor A has been a better investor in 2013 when in fact that investor has underperformed the portfolio of Investor B.
Why the return to Statistics 201? Even if Seeking Alpha readers are able to glean alpha in their individual security selections, getting asset allocation decisions incorrect can lead to vast underperformance. Below are the macro calls that are driving my current asset allocation decisions. Getting these macro calls right will hopefully drive investor performance.
1. The Federal Reserve Will Be Slow To Remove Monetary Accommodation
The recent pickup in domestic market volatility has been a function of the market's re-pricing of the terminus of monetary accommodation from the Federal Reserve. Yesterday's FOMC meeting suggested that asset purchases will end by mid-2014. Expect this unwind to be data dependent, with the pace of support removal a function of the progress in the labor market. With inflation still near historic lows, and unemployment above the Fed's target, the central bank has headroom to continue monetary accommodation. Markets have reacted negatively to the specter of the removal of accommodation. Remember that we are talking first about a reduction in the current level of Treasury and Agency MBS. We are still likely two full years away from the Fed embarking on its traditional method of tightening monetary policy through increases in the Fed Funds rate.
2. Rising Volatility Upon the Fed's Ultimate Exit Will Create Investment Opportunities
Expect the unwind to be data dependent, and as investors bounce from one economic data point to another, we are likely to see a pickup in volatility. Part of the effect of the Federal Reserve's monetary policy has been to reduce volatility in rate, credit, and equity markets. With the Federal Reserve making it clear that they would provide downside protection in the event of a weakening economy, the market resembled a protective put payoff structure. Like with option prices, an increase in volatility will make this put more expensive as the Fed withdrawals support over time.
Fed induced volatility will not be a U.S.-only phenomenon. Given the fact that the U.S. is one of the largest trading partners of many countries around the globe, a multitude of currencies are pegged to the dollar and therefore influenced by our monetary policy.
3. The Easy Money Has Been Made
With U.S. stocks having more than doubled from the crisis-level trough and bond prices still near record highs, future returns are going to be hard to come by. While I expect that volatility will pickup from its historically low recent levels, we will see an ebb and flow in volatility. Yesterday's post-FOMC move was rather severe, but markets will adjust to the fact that the Fed is still buying $85bn of agency mortgages and Treasuries in the near-term and that the investment paradigm will be slower to adjust from its former dynamic than the extreme shift the market is currently pricing. Reductions in volatility should be viewed as an opportunity to purchase downside hedges, which were formerly being provided by the Fed. Low volatility, while potentially fleeting, allows for inexpensive hedging, and investors should expect lower forward returns and keep an eye on protecting their portfolio from downside.
4. Dividend Stocks Will Remain Important Demographically and For Investors Slow to Return Cash to the Market
Rising rates in late May and early June prompted outflows from investments that have paid steady income streams. Is the correction in dividend stocks a harbinger of future losses or a buying opportunity? Investors should not correlate the losses in dividend stocks from the first fifty basis point increase in rates over a more extended rate normalization. In the 200bp rate increase in 1994, dividend stocks did not materially underperform. Members of the retiring Baby Boomer generation may be incentivized to keep a larger portion of their portfolio in dividend paying stocks given anemic returns in traditional fixed income asset classes. Dividend stocks are still relatively inexpensive compared to Treasuries and investment grade corporate debt.
5. Fixed Income Investors Should Prefer Moving Out the Credit Curve Rather than the Yield Curve
In a recent article, I demonstrated that the volatility in Apple's long duration bonds has been greater than the volatility of its equity. Even though Apple's (AAPL) bonds are senior in the capital structure to its stock, increasing interest rate volatility has made for a more variable return profile for the long bonds. Expect long duration instruments to continue to exhibit high volatility. Alternatively, in an improving economic environment that allows for the withdrawal of Fed support, defaults on speculative grade credit should remain low. The recent sell-off in high yield has been largely driven by selling pressure to meet redemptions of retail outflows, and not a change in the fundamental credit profile of the sector. High yield credit spreads still remain high relative to expected losses, and should absorb some of the future rate increases better than higher quality, long duration instruments, which could see large price declines during a backup in interest rates.
6. Consumer Consumption Growth Will Offset Fiscal Headwinds in the United States
While the reductions in government spending are proving to be a headwind to economic growth, private sector growth has remained strong. Households have been buoyed by rising home prices, improved investment returns, and increased net worth. Investors should remember that consumer spending is more than three times the size of government spending in our economy, and a stronger consumer should translate into stronger U.S. growth.
7. Emerging Markets Will Eventually Benefit From Faster Growth in the Developed World
Emerging markets have historically been a high beta function of the developed world, and this most recent market move has not been an exception. Record low interest rates in the developed world have weakened developed market currencies, hampering emerging market exporters. Additionally, slow growth in the developed world and slowing growth in China has led to falling commodity prices, chief exports of many emerging economies. Traditionally in bull markets, emerging markets have bested U.S. stocks, but market uncertainties has sent investment flows to the U.S. and other safe haven markets.
If the stronger economic growth presaged by the Fed's desire to remove accommodative policy comes to fruition, expect emerging markets to outperform given their recent laggard status. This will however potentially be a very volatile trade; long-term investors may find it desirable to rotate investment funds to geographies with expected faster future growth rates and less of a fiscal overhang from their sovereign.
8. Asia Could Be The New Europe
European governments are being forced by voters to end the era of austerity, but attempts at economic harmonization between EU members continues. While it has been a halting and sometimes maddening process for global investors, a stronger European Union is slowly emerging. In recent years, the goal for Europe was to not provide a negative contribution to global growth while it addresses its structural issues. Pro-cyclical investment policies in the near term could lead to positive, albeit very modest, contributions to worldwide expansion.
On the other side of the world, efforts to end two decades of slow growth and deflation in Japan through aggressive monetary accommodation will temporarily inflate asset prices, but longer-term structural reforms could prove difficult to implement. A weaker yen and redirection of foreign capital flows pressures other southeast Asian economies. Coupled with decelerating economic growth in China, the pickup in volatility in Asia demands increased equity risk premia on the continent.
9. Beware of Zombies
The absence of creative destructionism during the credit crisis prompted by low costs of capital and an increased level of government intervention resulted in lower levels of corporate defaults and bankruptcies. Companies that should have went out of business during the financial crisis have in many cases reconstituted their balance sheets, pushing future distress out several years. As investment capital finds investment projects that would be uneconomic in a higher rate environment, the potential for future distress increases. If low costs of capital prompt commodity producers and miners to undertake projects that would be unavailable in higher cost of capital regimes, prices and profits could be depressed for these industries in forward periods. Homebuilders in the United States can borrow unsecured funds as speculative grade companies today cheaper than they could as investment grade companies pre-crisis. These stocks were amongst the best performers in 2012. Are investors sure that homebuilders, fueled by cheap financing, will not bring too much supply to a recovering market? Avoiding providing investment capital to businesses that have simply pushed out financial distress will be an important driver of returns. Sometimes missing investments that go to zero is more important than catching the outperformers.
10. M&A Activity Will Rise
Given the expectation of rising rates, investors contemplating re-leveraging transactions may be incentivized to pull forward transactions. An increase in foreign exchange volatility could also spark additional cross-broader activity. Given that these transactions are traditionally at a premium to market prices, increased M&A activity could provide an additional support to equity markets.
Asset allocation decisions are the predominant drivers of portfolio performance. Risk tolerance and investment horizons vary for each investor; hopefully this ten point framing of investment themes can help investors form their own market thesis with respect to their own portfolio constraints in this changing market environment.