FOFViewForm Object
(
    [form:protected] => FOFForm Object
        (
            [model:protected] => LegacyinterfaceModelCommentaries Object
                (
                    [default_behaviors:protected] => Array
                        (
                            [0] => filters
                            [1] => access
                        )

                    [__state_set:protected] => 1
                    [_db:protected] => JDatabaseDriverMysqli Object
                        (
                            [name] => mysqli
                            [nameQuote:protected] => `
                            [nullDate:protected] => 0000-00-00 00:00:00
                            [_database:JDatabaseDriver:private] => joomla
                            [connection:protected] => mysqli Object
                                (
                                    [affected_rows] => 1
                                    [client_info] => mysqlnd 5.0.11-dev - 20120503 - $Id: 15d5c781cfcad91193dceae1d2cdd127674ddb3e $
                                    [client_version] => 50011
                                    [connect_errno] => 0
                                    [connect_error] => 
                                    [errno] => 0
                                    [error] => 
                                    [error_list] => Array
                                        (
                                        )

                                    [field_count] => 1
                                    [host_info] => Localhost via UNIX socket
                                    [info] => 
                                    [insert_id] => 0
                                    [server_info] => 5.5.46
                                    [server_version] => 50546
                                    [stat] => Uptime: 3371453  Threads: 1  Questions: 1282370  Slow queries: 0  Opens: 76  Flush tables: 1  Open tables: 69  Queries per second avg: 0.380
                                    [sqlstate] => 00000
                                    [protocol_version] => 10
                                    [thread_id] => 105969
                                    [warning_count] => 0
                                )

                            [count:protected] => 17
                            [cursor:protected] => 
                            [debug:protected] => 
                            [limit:protected] => 0
                            [log:protected] => Array
                                (
                                )

                            [timings:protected] => Array
                                (
                                )

                            [callStacks:protected] => Array
                                (
                                )

                            [offset:protected] => 0
                            [options:protected] => Array
                                (
                                    [driver] => mysqli
                                    [host] => localhost
                                    [user] => joomlauser
                                    [password] => default
                                    [database] => joomla
                                    [prefix] => ap_
                                    [select] => 1
                                    [port] => 3306
                                    [socket] => 
                                )

                            [sql:protected] => 
SELECT COUNT(*)
FROM (
SELECT `#__legacyinterface_commentaries`.*
FROM `#__legacyinterface_commentaries`
WHERE (`access` IN ('1','1'))) AS a
                            [tablePrefix:protected] => ap_
                            [utf:protected] => 1
                            [errorNum:protected] => 0
                            [errorMsg:protected] => 
                            [transactionDepth:protected] => 0
                            [disconnectHandlers:protected] => Array
                                (
                                )

                        )

                    [event_after_delete:protected] => onContentAfterDelete
                    [event_after_save:protected] => onContentAfterSave
                    [event_before_delete:protected] => onContentBeforeDelete
                    [event_before_save:protected] => onContentBeforeSave
                    [event_change_state:protected] => onContentChangeState
                    [event_clean_cache:protected] => 
                    [id_list:protected] => Array
                        (
                            [0] => 0
                        )

                    [id:protected] => 0
                    [input:protected] => FOFInput Object
                        (
                            [options:protected] => Array
                                (
                                )

                            [filter:protected] => JFilterInput Object
                                (
                                    [tagsArray] => Array
                                        (
                                        )

                                    [attrArray] => Array
                                        (
                                        )

                                    [tagsMethod] => 0
                                    [attrMethod] => 0
                                    [xssAuto] => 1
                                    [tagBlacklist] => Array
                                        (
                                            [0] => applet
                                            [1] => body
                                            [2] => bgsound
                                            [3] => base
                                            [4] => basefont
                                            [5] => embed
                                            [6] => frame
                                            [7] => frameset
                                            [8] => head
                                            [9] => html
                                            [10] => id
                                            [11] => iframe
                                            [12] => ilayer
                                            [13] => layer
                                            [14] => link
                                            [15] => meta
                                            [16] => name
                                            [17] => object
                                            [18] => script
                                            [19] => style
                                            [20] => title
                                            [21] => xml
                                        )

                                    [attrBlacklist] => Array
                                        (
                                            [0] => action
                                            [1] => background
                                            [2] => codebase
                                            [3] => dynsrc
                                            [4] => lowsrc
                                        )

                                )

                            [data:protected] => Array
                                (
                                    [start] => 40
                                    [limitstart] => 40
                                    [option] => com_legacyinterface
                                    [view] => commentaries
                                    [Itemid] => 616
                                    [layout] => 
                                    [task] => browse
                                    [directionTable] => asc
                                    [sortTable] => published_on
                                    [filter_order] => published_on
                                    [filter_order_Dir] => desc
                                    [savestate] => 1
                                    [base_path] => /var/www/html/apcms/components/com_legacyinterface
                                )

                            [inputs:protected] => Array
                                (
                                    [get] => JInput Object
                                        (
                                            [options:protected] => Array
                                                (
                                                )

                                            [filter:protected] => JFilterInput Object
                                                (
                                                    [tagsArray] => Array
                                                        (
                                                        )

                                                    [attrArray] => Array
                                                        (
                                                        )

                                                    [tagsMethod] => 0
                                                    [attrMethod] => 0
                                                    [xssAuto] => 1
                                                    [tagBlacklist] => Array
                                                        (
                                                            [0] => applet
                                                            [1] => body
                                                            [2] => bgsound
                                                            [3] => base
                                                            [4] => basefont
                                                            [5] => embed
                                                            [6] => frame
                                                            [7] => frameset
                                                            [8] => head
                                                            [9] => html
                                                            [10] => id
                                                            [11] => iframe
                                                            [12] => ilayer
                                                            [13] => layer
                                                            [14] => link
                                                            [15] => meta
                                                            [16] => name
                                                            [17] => object
                                                            [18] => script
                                                            [19] => style
                                                            [20] => title
                                                            [21] => xml
                                                        )

                                                    [attrBlacklist] => Array
                                                        (
                                                            [0] => action
                                                            [1] => background
                                                            [2] => codebase
                                                            [3] => dynsrc
                                                            [4] => lowsrc
                                                        )

                                                )

                                            [data:protected] => Array
                                                (
                                                    [start] => 40
                                                )

                                            [inputs:protected] => Array
                                                (
                                                    [get] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                    [start] => 40
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [post] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [cookie] => JInputCookie Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                    [get] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
                                                                                            [0] => applet
                                                                                            [1] => body
                                                                                            [2] => bgsound
                                                                                            [3] => base
                                                                                            [4] => basefont
                                                                                            [5] => embed
                                                                                            [6] => frame
                                                                                            [7] => frameset
                                                                                            [8] => head
                                                                                            [9] => html
                                                                                            [10] => id
                                                                                            [11] => iframe
                                                                                            [12] => ilayer
                                                                                            [13] => layer
                                                                                            [14] => link
                                                                                            [15] => meta
                                                                                            [16] => name
                                                                                            [17] => object
                                                                                            [18] => script
                                                                                            [19] => style
                                                                                            [20] => title
                                                                                            [21] => xml
                                                                                        )

                                                                                    [attrBlacklist] => Array
                                                                                        (
                                                                                            [0] => action
                                                                                            [1] => background
                                                                                            [2] => codebase
                                                                                            [3] => dynsrc
                                                                                            [4] => lowsrc
                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                    [start] => 40
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [post] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
                                                                                            [0] => applet
                                                                                            [1] => body
                                                                                            [2] => bgsound
                                                                                            [3] => base
                                                                                            [4] => basefont
                                                                                            [5] => embed
                                                                                            [6] => frame
                                                                                            [7] => frameset
                                                                                            [8] => head
                                                                                            [9] => html
                                                                                            [10] => id
                                                                                            [11] => iframe
                                                                                            [12] => ilayer
                                                                                            [13] => layer
                                                                                            [14] => link
                                                                                            [15] => meta
                                                                                            [16] => name
                                                                                            [17] => object
                                                                                            [18] => script
                                                                                            [19] => style
                                                                                            [20] => title
                                                                                            [21] => xml
                                                                                        )

                                                                                    [attrBlacklist] => Array
                                                                                        (
                                                                                            [0] => action
                                                                                            [1] => background
                                                                                            [2] => codebase
                                                                                            [3] => dynsrc
                                                                                            [4] => lowsrc
                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [cookie] => JInputCookie Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
                                                                                            [0] => applet
                                                                                            [1] => body
                                                                                            [2] => bgsound
                                                                                            [3] => base
                                                                                            [4] => basefont
                                                                                            [5] => embed
                                                                                            [6] => frame
                                                                                            [7] => frameset
                                                                                            [8] => head
                                                                                            [9] => html
                                                                                            [10] => id
                                                                                            [11] => iframe
                                                                                            [12] => ilayer
                                                                                            [13] => layer
                                                                                            [14] => link
                                                                                            [15] => meta
                                                                                            [16] => name
                                                                                            [17] => object
                                                                                            [18] => script
                                                                                            [19] => style
                                                                                            [20] => title
                                                                                            [21] => xml
                                                                                        )

                                                                                    [attrBlacklist] => Array
                                                                                        (
                                                                                            [0] => action
                                                                                            [1] => background
                                                                                            [2] => codebase
                                                                                            [3] => dynsrc
                                                                                            [4] => lowsrc
                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [files] => JInputFiles Object
                                                                        (
                                                                            [decodedData:protected] => Array
                                                                                (
                                                                                )

                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
                                                                                            [0] => applet
                                                                                            [1] => body
                                                                                            [2] => bgsound
                                                                                            [3] => base
                                                                                            [4] => basefont
                                                                                            [5] => embed
                                                                                            [6] => frame
                                                                                            [7] => frameset
                                                                                            [8] => head
                                                                                            [9] => html
                                                                                            [10] => id
                                                                                            [11] => iframe
                                                                                            [12] => ilayer
                                                                                            [13] => layer
                                                                                            [14] => link
                                                                                            [15] => meta
                                                                                            [16] => name
                                                                                            [17] => object
                                                                                            [18] => script
                                                                                            [19] => style
                                                                                            [20] => title
                                                                                            [21] => xml
                                                                                        )

                                                                                    [attrBlacklist] => Array
                                                                                        (
                                                                                            [0] => action
                                                                                            [1] => background
                                                                                            [2] => codebase
                                                                                            [3] => dynsrc
                                                                                            [4] => lowsrc
                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                    [get] => JInput Object
                                                                                        (
                                                                                            [options:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
                                                                                                    [tagsArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [attrArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [tagsMethod] => 0
                                                                                                    [attrMethod] => 0
                                                                                                    [xssAuto] => 1
                                                                                                    [tagBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => applet
                                                                                                            [1] => body
                                                                                                            [2] => bgsound
                                                                                                            [3] => base
                                                                                                            [4] => basefont
                                                                                                            [5] => embed
                                                                                                            [6] => frame
                                                                                                            [7] => frameset
                                                                                                            [8] => head
                                                                                                            [9] => html
                                                                                                            [10] => id
                                                                                                            [11] => iframe
                                                                                                            [12] => ilayer
                                                                                                            [13] => layer
                                                                                                            [14] => link
                                                                                                            [15] => meta
                                                                                                            [16] => name
                                                                                                            [17] => object
                                                                                                            [18] => script
                                                                                                            [19] => style
                                                                                                            [20] => title
                                                                                                            [21] => xml
                                                                                                        )

                                                                                                    [attrBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => action
                                                                                                            [1] => background
                                                                                                            [2] => codebase
                                                                                                            [3] => dynsrc
                                                                                                            [4] => lowsrc
                                                                                                        )

                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
                                                                                                    [start] => 40
                                                                                                )

                                                                                            [inputs:protected] => Array
                                                                                                (
                                                                                                )

                                                                                        )

                                                                                    [post] => JInput Object
                                                                                        (
                                                                                            [options:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
                                                                                                    [tagsArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [attrArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [tagsMethod] => 0
                                                                                                    [attrMethod] => 0
                                                                                                    [xssAuto] => 1
                                                                                                    [tagBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => applet
                                                                                                            [1] => body
                                                                                                            [2] => bgsound
                                                                                                            [3] => base
                                                                                                            [4] => basefont
                                                                                                            [5] => embed
                                                                                                            [6] => frame
                                                                                                            [7] => frameset
                                                                                                            [8] => head
                                                                                                            [9] => html
                                                                                                            [10] => id
                                                                                                            [11] => iframe
                                                                                                            [12] => ilayer
                                                                                                            [13] => layer
                                                                                                            [14] => link
                                                                                                            [15] => meta
                                                                                                            [16] => name
                                                                                                            [17] => object
                                                                                                            [18] => script
                                                                                                            [19] => style
                                                                                                            [20] => title
                                                                                                            [21] => xml
                                                                                                        )

                                                                                                    [attrBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => action
                                                                                                            [1] => background
                                                                                                            [2] => codebase
                                                                                                            [3] => dynsrc
                                                                                                            [4] => lowsrc
                                                                                                        )

                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [inputs:protected] => Array
                                                                                                (
                                                                                                )

                                                                                        )

                                                                                    [cookie] => JInputCookie Object
                                                                                        (
                                                                                            [options:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
                                                                                                    [tagsArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [attrArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [tagsMethod] => 0
                                                                                                    [attrMethod] => 0
                                                                                                    [xssAuto] => 1
                                                                                                    [tagBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => applet
                                                                                                            [1] => body
                                                                                                            [2] => bgsound
                                                                                                            [3] => base
                                                                                                            [4] => basefont
                                                                                                            [5] => embed
                                                                                                            [6] => frame
                                                                                                            [7] => frameset
                                                                                                            [8] => head
                                                                                                            [9] => html
                                                                                                            [10] => id
                                                                                                            [11] => iframe
                                                                                                            [12] => ilayer
                                                                                                            [13] => layer
                                                                                                            [14] => link
                                                                                                            [15] => meta
                                                                                                            [16] => name
                                                                                                            [17] => object
                                                                                                            [18] => script
                                                                                                            [19] => style
                                                                                                            [20] => title
                                                                                                            [21] => xml
                                                                                                        )

                                                                                                    [attrBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => action
                                                                                                            [1] => background
                                                                                                            [2] => codebase
                                                                                                            [3] => dynsrc
                                                                                                            [4] => lowsrc
                                                                                                        )

                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [inputs:protected] => Array
                                                                                                (
                                                                                                )

                                                                                        )

                                                                                    [files] => JInputFiles Object
                                                                                        (
                                                                                            [decodedData:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [options:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [filter:protected] => JFilterInput Object
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                                                                                                    [attrArray] => Array
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                                                                                            [data:protected] => Array
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                                                                                            [inputs:protected] => Array
                                                                                                (
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                                                                                    [env] => JInput Object
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                                                                                            [options:protected] => Array
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                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
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                                                                                            [data:protected] => Array
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                                                                                            [inputs:protected] => Array
                                                                                                (
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                                                                                    [request] => JInput Object
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                                                                                            [options:protected] => Array
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                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
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                                                                                                        )

                                                                                                    [attrArray] => Array
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                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
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                                                                                                    [limitstart] => 40
                                                                                                    [option] => com_legacyinterface
                                                                                                    [view] => commentaries
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                                                                                            [inputs:protected] => Array
                                                                                                (
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                                                                                        )

                                                                                    [server] => JInput Object
                                                                                        (
                                                                                            [options:protected] => Array
                                                                                                (
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                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
                                                                                                    [tagsArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [attrArray] => Array
                                                                                                        (
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                                                                                                    [tagsMethod] => 0
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                                                                                                    [xssAuto] => 1
                                                                                                    [tagBlacklist] => Array
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                                                                                                    [attrBlacklist] => Array
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                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
                                                                                                    [HTTP_AUTHORIZATION] => 
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                                                                                                    [HTTP_ACCEPT_ENCODING] => x-gzip, gzip, deflate
                                                                                                    [HTTP_USER_AGENT] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                                                    [HTTP_ACCEPT] => text/html,application/xhtml+xml,application/xml;q=0.9,*/*;q=0.8
                                                                                                    [PATH] => /sbin:/usr/sbin:/bin:/usr/bin
                                                                                                    [SERVER_SIGNATURE] => 
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                                                                                                    [SERVER_NAME] => ap.hubtech.tv
                                                                                                    [SERVER_ADDR] => 10.28.13.29
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                                                                                                    [DOCUMENT_ROOT] => /var/www/html/apcms
                                                                                                    [REQUEST_SCHEME] => http
                                                                                                    [CONTEXT_PREFIX] => 
                                                                                                    [CONTEXT_DOCUMENT_ROOT] => /var/www/html/apcms
                                                                                                    [SERVER_ADMIN] => ben@hubtech.tv
                                                                                                    [SCRIPT_FILENAME] => /var/www/html/apcms/index.php
                                                                                                    [REMOTE_PORT] => 35810
                                                                                                    [GATEWAY_INTERFACE] => CGI/1.1
                                                                                                    [SERVER_PROTOCOL] => HTTP/1.0
                                                                                                    [REQUEST_METHOD] => GET
                                                                                                    [QUERY_STRING] => start=40
                                                                                                    [REQUEST_URI] => /?start=40
                                                                                                    [SCRIPT_NAME] => /index.php
                                                                                                    [PHP_SELF] => /index.php
                                                                                                    [REQUEST_TIME_FLOAT] => 1508628174.935
                                                                                                    [REQUEST_TIME] => 1508628174
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                                                                                            [inputs:protected] => Array
                                                                                                (
                                                                                                )

                                                                                        )

                                                                                    [session] => JInput Object
                                                                                        (
                                                                                            [options:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
                                                                                                    [tagsArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [attrArray] => Array
                                                                                                        (
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                                                                                                    [tagsMethod] => 0
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                                                                                                    [xssAuto] => 1
                                                                                                    [tagBlacklist] => Array
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                                                                                                            [4] => basefont
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                                                                                                            [12] => ilayer
                                                                                                            [13] => layer
                                                                                                            [14] => link
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                                                                                                    [attrBlacklist] => Array
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                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
                                                                                                    [__default] => Array
                                                                                                        (
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                                                                                                            [session.timer.start] => 1508628175
                                                                                                            [session.timer.last] => 1508628175
                                                                                                            [session.timer.now] => 1508628175
                                                                                                            [session.client.browser] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                                                            [registry] => Joomla\Registry\Registry Object
                                                                                                                (
                                                                                                                    [data:protected] => stdClass Object
                                                                                                                        (
                                                                                                                            [com_legacyinterface] => stdClass Object
                                                                                                                                (
                                                                                                                                    [commentaries] => stdClass Object
                                                                                                                                        (
                                                                                                                                            [limitstart] => 40
                                                                                                                                            [filter_order] => published_on
                                                                                                                                            [filter_order_Dir] => desc
                                                                                                                                        )

                                                                                                                                )

                                                                                                                        )

                                                                                                                )

                                                                                                            [user] => JUser Object
                                                                                                                (
                                                                                                                    [isRoot:protected] => 
                                                                                                                    [id] => 0
                                                                                                                    [name] => 
                                                                                                                    [username] => 
                                                                                                                    [email] => 
                                                                                                                    [password] => 
                                                                                                                    [password_clear] => 
                                                                                                                    [block] => 
                                                                                                                    [sendEmail] => 0
                                                                                                                    [registerDate] => 
                                                                                                                    [lastvisitDate] => 
                                                                                                                    [activation] => 
                                                                                                                    [params] => 
                                                                                                                    [groups] => Array
                                                                                                                        (
                                                                                                                            [0] => 9
                                                                                                                        )

                                                                                                                    [guest] => 1
                                                                                                                    [lastResetTime] => 
                                                                                                                    [resetCount] => 
                                                                                                                    [requireReset] => 
                                                                                                                    [_params:protected] => Joomla\Registry\Registry Object
                                                                                                                        (
                                                                                                                            [data:protected] => stdClass Object
                                                                                                                                (
                                                                                                                                )

                                                                                                                        )

                                                                                                                    [_authGroups:protected] => Array
                                                                                                                        (
                                                                                                                            [0] => 1
                                                                                                                        )

                                                                                                                    [_authLevels:protected] => Array
                                                                                                                        (
                                                                                                                            [0] => 1
                                                                                                                            [1] => 1
                                                                                                                        )

                                                                                                                    [_authActions:protected] => 
                                                                                                                    [_errorMsg:protected] => 
                                                                                                                    [_errors:protected] => Array
                                                                                                                        (
                                                                                                                        )

                                                                                                                    [aid] => 0
                                                                                                                )

                                                                                                        )

                                                                                                )

                                                                                            [inputs:protected] => Array
                                                                                                (
                                                                                                )

                                                                                        )

                                                                                    [jrequest] => JInput Object
                                                                                        (
                                                                                            [options:protected] => Array
                                                                                                (
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                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
                                                                                                    [tagsArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [attrArray] => Array
                                                                                                        (
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                                                                                                    [tagsMethod] => 0
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                                                                                                    [xssAuto] => 1
                                                                                                    [tagBlacklist] => Array
                                                                                                        (
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                                                                                                            [4] => basefont
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                                                                                                            [12] => ilayer
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                                                                                                            [17] => object
                                                                                                            [18] => script
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                                                                                                            [20] => title
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                                                                                                    [attrBlacklist] => Array
                                                                                                        (
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                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [inputs:protected] => Array
                                                                                                (
                                                                                                )

                                                                                        )

                                                                                )

                                                                        )

                                                                    [env] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
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                                                                                    [tagsMethod] => 0
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                                                                                    [attrBlacklist] => Array
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                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [request] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
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                                                                            [filter:protected] => JFilterInput Object
                                                                                (
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                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
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                                                                                    [attrBlacklist] => Array
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                                                                                )

                                                                            [data:protected] => Array
                                                                                (
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                                                                                    [limitstart] => 40
                                                                                    [option] => com_legacyinterface
                                                                                    [view] => commentaries
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                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [server] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
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                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
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                                                                                    [attrBlacklist] => Array
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                                                                                )

                                                                            [data:protected] => Array
                                                                                (
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                                                                                    [HTTP_HOST] => ap.hubtech.tv
                                                                                    [HTTP_ACCEPT_ENCODING] => x-gzip, gzip, deflate
                                                                                    [HTTP_USER_AGENT] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                                    [HTTP_ACCEPT] => text/html,application/xhtml+xml,application/xml;q=0.9,*/*;q=0.8
                                                                                    [PATH] => /sbin:/usr/sbin:/bin:/usr/bin
                                                                                    [SERVER_SIGNATURE] => 
                                                                                    [SERVER_SOFTWARE] => Apache/2.4.16 (Amazon) PHP/5.5.31
                                                                                    [SERVER_NAME] => ap.hubtech.tv
                                                                                    [SERVER_ADDR] => 10.28.13.29
                                                                                    [SERVER_PORT] => 80
                                                                                    [REMOTE_ADDR] => 54.166.245.10
                                                                                    [DOCUMENT_ROOT] => /var/www/html/apcms
                                                                                    [REQUEST_SCHEME] => http
                                                                                    [CONTEXT_PREFIX] => 
                                                                                    [CONTEXT_DOCUMENT_ROOT] => /var/www/html/apcms
                                                                                    [SERVER_ADMIN] => ben@hubtech.tv
                                                                                    [SCRIPT_FILENAME] => /var/www/html/apcms/index.php
                                                                                    [REMOTE_PORT] => 35810
                                                                                    [GATEWAY_INTERFACE] => CGI/1.1
                                                                                    [SERVER_PROTOCOL] => HTTP/1.0
                                                                                    [REQUEST_METHOD] => GET
                                                                                    [QUERY_STRING] => start=40
                                                                                    [REQUEST_URI] => /?start=40
                                                                                    [SCRIPT_NAME] => /index.php
                                                                                    [PHP_SELF] => /index.php
                                                                                    [REQUEST_TIME_FLOAT] => 1508628174.935
                                                                                    [REQUEST_TIME] => 1508628174
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [session] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
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                                                                                            [4] => basefont
                                                                                            [5] => embed
                                                                                            [6] => frame
                                                                                            [7] => frameset
                                                                                            [8] => head
                                                                                            [9] => html
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                                                                                            [11] => iframe
                                                                                            [12] => ilayer
                                                                                            [13] => layer
                                                                                            [14] => link
                                                                                            [15] => meta
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                                                                                            [19] => style
                                                                                            [20] => title
                                                                                            [21] => xml
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                                                                                    [attrBlacklist] => Array
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                                                                                            [2] => codebase
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                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                    [__default] => Array
                                                                                        (
                                                                                            [session.counter] => 1
                                                                                            [session.timer.start] => 1508628175
                                                                                            [session.timer.last] => 1508628175
                                                                                            [session.timer.now] => 1508628175
                                                                                            [session.client.browser] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                                            [registry] => Joomla\Registry\Registry Object
                                                                                                (
                                                                                                    [data:protected] => stdClass Object
                                                                                                        (
                                                                                                            [com_legacyinterface] => stdClass Object
                                                                                                                (
                                                                                                                    [commentaries] => stdClass Object
                                                                                                                        (
                                                                                                                            [limitstart] => 40
                                                                                                                            [filter_order] => published_on
                                                                                                                            [filter_order_Dir] => desc
                                                                                                                        )

                                                                                                                )

                                                                                                        )

                                                                                                )

                                                                                            [user] => JUser Object
                                                                                                (
                                                                                                    [isRoot:protected] => 
                                                                                                    [id] => 0
                                                                                                    [name] => 
                                                                                                    [username] => 
                                                                                                    [email] => 
                                                                                                    [password] => 
                                                                                                    [password_clear] => 
                                                                                                    [block] => 
                                                                                                    [sendEmail] => 0
                                                                                                    [registerDate] => 
                                                                                                    [lastvisitDate] => 
                                                                                                    [activation] => 
                                                                                                    [params] => 
                                                                                                    [groups] => Array
                                                                                                        (
                                                                                                            [0] => 9
                                                                                                        )

                                                                                                    [guest] => 1
                                                                                                    [lastResetTime] => 
                                                                                                    [resetCount] => 
                                                                                                    [requireReset] => 
                                                                                                    [_params:protected] => Joomla\Registry\Registry Object
                                                                                                        (
                                                                                                            [data:protected] => stdClass Object
                                                                                                                (
                                                                                                                )

                                                                                                        )

                                                                                                    [_authGroups:protected] => Array
                                                                                                        (
                                                                                                            [0] => 1
                                                                                                        )

                                                                                                    [_authLevels:protected] => Array
                                                                                                        (
                                                                                                            [0] => 1
                                                                                                            [1] => 1
                                                                                                        )

                                                                                                    [_authActions:protected] => 
                                                                                                    [_errorMsg:protected] => 
                                                                                                    [_errors:protected] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [aid] => 0
                                                                                                )

                                                                                        )

                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [jrequest] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
                                                                                            [0] => applet
                                                                                            [1] => body
                                                                                            [2] => bgsound
                                                                                            [3] => base
                                                                                            [4] => basefont
                                                                                            [5] => embed
                                                                                            [6] => frame
                                                                                            [7] => frameset
                                                                                            [8] => head
                                                                                            [9] => html
                                                                                            [10] => id
                                                                                            [11] => iframe
                                                                                            [12] => ilayer
                                                                                            [13] => layer
                                                                                            [14] => link
                                                                                            [15] => meta
                                                                                            [16] => name
                                                                                            [17] => object
                                                                                            [18] => script
                                                                                            [19] => style
                                                                                            [20] => title
                                                                                            [21] => xml
                                                                                        )

                                                                                    [attrBlacklist] => Array
                                                                                        (
                                                                                            [0] => action
                                                                                            [1] => background
                                                                                            [2] => codebase
                                                                                            [3] => dynsrc
                                                                                            [4] => lowsrc
                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                )

                                                        )

                                                    [files] => JInputFiles Object
                                                        (
                                                            [decodedData:protected] => Array
                                                                (
                                                                )

                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [env] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [request] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                    [start] => 40
                                                                    [limitstart] => 40
                                                                    [option] => com_legacyinterface
                                                                    [view] => commentaries
                                                                    [Itemid] => 616
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [server] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                    [HTTP_AUTHORIZATION] => 
                                                                    [HTTP_HOST] => ap.hubtech.tv
                                                                    [HTTP_ACCEPT_ENCODING] => x-gzip, gzip, deflate
                                                                    [HTTP_USER_AGENT] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                    [HTTP_ACCEPT] => text/html,application/xhtml+xml,application/xml;q=0.9,*/*;q=0.8
                                                                    [PATH] => /sbin:/usr/sbin:/bin:/usr/bin
                                                                    [SERVER_SIGNATURE] => 
                                                                    [SERVER_SOFTWARE] => Apache/2.4.16 (Amazon) PHP/5.5.31
                                                                    [SERVER_NAME] => ap.hubtech.tv
                                                                    [SERVER_ADDR] => 10.28.13.29
                                                                    [SERVER_PORT] => 80
                                                                    [REMOTE_ADDR] => 54.166.245.10
                                                                    [DOCUMENT_ROOT] => /var/www/html/apcms
                                                                    [REQUEST_SCHEME] => http
                                                                    [CONTEXT_PREFIX] => 
                                                                    [CONTEXT_DOCUMENT_ROOT] => /var/www/html/apcms
                                                                    [SERVER_ADMIN] => ben@hubtech.tv
                                                                    [SCRIPT_FILENAME] => /var/www/html/apcms/index.php
                                                                    [REMOTE_PORT] => 35810
                                                                    [GATEWAY_INTERFACE] => CGI/1.1
                                                                    [SERVER_PROTOCOL] => HTTP/1.0
                                                                    [REQUEST_METHOD] => GET
                                                                    [QUERY_STRING] => start=40
                                                                    [REQUEST_URI] => /?start=40
                                                                    [SCRIPT_NAME] => /index.php
                                                                    [PHP_SELF] => /index.php
                                                                    [REQUEST_TIME_FLOAT] => 1508628174.935
                                                                    [REQUEST_TIME] => 1508628174
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [session] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                    [__default] => Array
                                                                        (
                                                                            [session.counter] => 1
                                                                            [session.timer.start] => 1508628175
                                                                            [session.timer.last] => 1508628175
                                                                            [session.timer.now] => 1508628175
                                                                            [session.client.browser] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                            [registry] => Joomla\Registry\Registry Object
                                                                                (
                                                                                    [data:protected] => stdClass Object
                                                                                        (
                                                                                            [com_legacyinterface] => stdClass Object
                                                                                                (
                                                                                                    [commentaries] => stdClass Object
                                                                                                        (
                                                                                                            [limitstart] => 40
                                                                                                            [filter_order] => published_on
                                                                                                            [filter_order_Dir] => desc
                                                                                                        )

                                                                                                )

                                                                                        )

                                                                                )

                                                                            [user] => JUser Object
                                                                                (
                                                                                    [isRoot:protected] => 
                                                                                    [id] => 0
                                                                                    [name] => 
                                                                                    [username] => 
                                                                                    [email] => 
                                                                                    [password] => 
                                                                                    [password_clear] => 
                                                                                    [block] => 
                                                                                    [sendEmail] => 0
                                                                                    [registerDate] => 
                                                                                    [lastvisitDate] => 
                                                                                    [activation] => 
                                                                                    [params] => 
                                                                                    [groups] => Array
                                                                                        (
                                                                                            [0] => 9
                                                                                        )

                                                                                    [guest] => 1
                                                                                    [lastResetTime] => 
                                                                                    [resetCount] => 
                                                                                    [requireReset] => 
                                                                                    [_params:protected] => Joomla\Registry\Registry Object
                                                                                        (
                                                                                            [data:protected] => stdClass Object
                                                                                                (
                                                                                                )

                                                                                        )

                                                                                    [_authGroups:protected] => Array
                                                                                        (
                                                                                            [0] => 1
                                                                                        )

                                                                                    [_authLevels:protected] => Array
                                                                                        (
                                                                                            [0] => 1
                                                                                            [1] => 1
                                                                                        )

                                                                                    [_authActions:protected] => 
                                                                                    [_errorMsg:protected] => 
                                                                                    [_errors:protected] => Array
                                                                                        (
                                                                                        )

                                                                                    [aid] => 0
                                                                                )

                                                                        )

                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [jrequest] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                )

                                        )

                                    [post] => JInput Object
                                        (
                                            [options:protected] => Array
                                                (
                                                )

                                            [filter:protected] => JFilterInput Object
                                                (
                                                    [tagsArray] => Array
                                                        (
                                                        )

                                                    [attrArray] => Array
                                                        (
                                                        )

                                                    [tagsMethod] => 0
                                                    [attrMethod] => 0
                                                    [xssAuto] => 1
                                                    [tagBlacklist] => Array
                                                        (
                                                            [0] => applet
                                                            [1] => body
                                                            [2] => bgsound
                                                            [3] => base
                                                            [4] => basefont
                                                            [5] => embed
                                                            [6] => frame
                                                            [7] => frameset
                                                            [8] => head
                                                            [9] => html
                                                            [10] => id
                                                            [11] => iframe
                                                            [12] => ilayer
                                                            [13] => layer
                                                            [14] => link
                                                            [15] => meta
                                                            [16] => name
                                                            [17] => object
                                                            [18] => script
                                                            [19] => style
                                                            [20] => title
                                                            [21] => xml
                                                        )

                                                    [attrBlacklist] => Array
                                                        (
                                                            [0] => action
                                                            [1] => background
                                                            [2] => codebase
                                                            [3] => dynsrc
                                                            [4] => lowsrc
                                                        )

                                                )

                                            [data:protected] => Array
                                                (
                                                )

                                            [inputs:protected] => Array
                                                (
                                                )

                                        )

                                    [cookie] => JInputCookie Object
                                        (
                                            [options:protected] => Array
                                                (
                                                )

                                            [filter:protected] => JFilterInput Object
                                                (
                                                    [tagsArray] => Array
                                                        (
                                                        )

                                                    [attrArray] => Array
                                                        (
                                                        )

                                                    [tagsMethod] => 0
                                                    [attrMethod] => 0
                                                    [xssAuto] => 1
                                                    [tagBlacklist] => Array
                                                        (
                                                            [0] => applet
                                                            [1] => body
                                                            [2] => bgsound
                                                            [3] => base
                                                            [4] => basefont
                                                            [5] => embed
                                                            [6] => frame
                                                            [7] => frameset
                                                            [8] => head
                                                            [9] => html
                                                            [10] => id
                                                            [11] => iframe
                                                            [12] => ilayer
                                                            [13] => layer
                                                            [14] => link
                                                            [15] => meta
                                                            [16] => name
                                                            [17] => object
                                                            [18] => script
                                                            [19] => style
                                                            [20] => title
                                                            [21] => xml
                                                        )

                                                    [attrBlacklist] => Array
                                                        (
                                                            [0] => action
                                                            [1] => background
                                                            [2] => codebase
                                                            [3] => dynsrc
                                                            [4] => lowsrc
                                                        )

                                                )

                                            [data:protected] => Array
                                                (
                                                )

                                            [inputs:protected] => Array
                                                (
                                                )

                                        )

                                    [files] => JInputFiles Object
                                        (
                                            [decodedData:protected] => Array
                                                (
                                                )

                                            [options:protected] => Array
                                                (
                                                )

                                            [filter:protected] => JFilterInput Object
                                                (
                                                    [tagsArray] => Array
                                                        (
                                                        )

                                                    [attrArray] => Array
                                                        (
                                                        )

                                                    [tagsMethod] => 0
                                                    [attrMethod] => 0
                                                    [xssAuto] => 1
                                                    [tagBlacklist] => Array
                                                        (
                                                            [0] => applet
                                                            [1] => body
                                                            [2] => bgsound
                                                            [3] => base
                                                            [4] => basefont
                                                            [5] => embed
                                                            [6] => frame
                                                            [7] => frameset
                                                            [8] => head
                                                            [9] => html
                                                            [10] => id
                                                            [11] => iframe
                                                            [12] => ilayer
                                                            [13] => layer
                                                            [14] => link
                                                            [15] => meta
                                                            [16] => name
                                                            [17] => object
                                                            [18] => script
                                                            [19] => style
                                                            [20] => title
                                                            [21] => xml
                                                        )

                                                    [attrBlacklist] => Array
                                                        (
                                                            [0] => action
                                                            [1] => background
                                                            [2] => codebase
                                                            [3] => dynsrc
                                                            [4] => lowsrc
                                                        )

                                                )

                                            [data:protected] => Array
                                                (
                                                )

                                            [inputs:protected] => Array
                                                (
                                                )

                                        )

                                    [env] => JInput Object
                                        (
                                            [options:protected] => Array
                                                (
                                                )

                                            [filter:protected] => JFilterInput Object
                                                (
                                                    [tagsArray] => Array
                                                        (
                                                        )

                                                    [attrArray] => Array
                                                        (
                                                        )

                                                    [tagsMethod] => 0
                                                    [attrMethod] => 0
                                                    [xssAuto] => 1
                                                    [tagBlacklist] => Array
                                                        (
                                                            [0] => applet
                                                            [1] => body
                                                            [2] => bgsound
                                                            [3] => base
                                                            [4] => basefont
                                                            [5] => embed
                                                            [6] => frame
                                                            [7] => frameset
                                                            [8] => head
                                                            [9] => html
                                                            [10] => id
                                                            [11] => iframe
                                                            [12] => ilayer
                                                            [13] => layer
                                                            [14] => link
                                                            [15] => meta
                                                            [16] => name
                                                            [17] => object
                                                            [18] => script
                                                            [19] => style
                                                            [20] => title
                                                            [21] => xml
                                                        )

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                                    [title] => Voya Fixed Income Perspectives – January 2015
                                    [slug] => voya_013015
                                    [fulltext] => 

Voya Investment Management’s fixed income strategies cover a broad range of maturities, sectors and instruments, giving investors wide latitude to create a new portfolio structure or complement an existing one.

We offer investment strategies across the  yield curve and credit spectrum, as well as in specialized disciplines that focus on individual market sectors. We build portfolios one bond at a time, with a critical review of each security by experienced fixed income managers. As of September 30, 2014, Voya Investment Management managed $125 billion in fixed income strategies in the United States.

Bond Market Outlook

  • Global Interest Rates: Valuations are generally rich, but we see no near-term catalyst for a global rate selloff given the flood of liquidity coming from central banks.
  • Global Currencies: We remain overweight   the U.S. dollar and underweight the euro and Japanese yen. We also favor the British pound and Swiss franc versus the euro.
  • Corporates: We remain mildly constructive on the credit markets in 2015, as valuations have improved, balance sheets remain healthy, and the domestic economy remains strong.
  • High Yield: The asset class is attractive and poised to outperform most other fixed income asset classes once oil prices stabilize.
  • Mortgages: Increased volatility and low interest rates are negative for agency MBS, though we are more constructive on non-agency MBS and CMBS.
  • Emerging Markets: While lower commodity prices help stem inflation and easy monetary policies could support emerging markets assets, the sector is likely to remain under pressure.

 Macro Overview

  • Resolutions that promise sweeping change can be inspiring in concept but daunting to implement. But after the new year’s shaky start — characterized by a spike in equity and interest rate volatility, continued weakness in oil and commodity prices, and a strengthening dollar — the European Central Bank finally moved beyond rhetoric, revealing a concrete game plan to defeat the euro zone’s own version of “deflategate” in 2015 and beyond.
  • With negative deposit rates in Germany, anti-austerity politics gaining momentum in Greece and near-zero euro zone inflation, it had become clear that Mario Draghi’s July 2012 pledge to do “whatever it takes” to keep the currency bloc intact would require more than just an assortment  of ineffective half-measures. Enter the ECB’s historic pledge to purchase €60 billion of assets per month through September 2016. And while the inclusion of sovereign debt in the program drew headlines, the most important detail may be the plan’s seemingly open-ended nature; Draghi’s focus on pushing inflation up to the central bank’s target suggests that purchases could extend beyond the stated end date should sufficient progress here be lacking. The ECB’s open-ended resolution may be intended to backstop the currency union and stabilize financial markets; if the U.S. QE experience is any indication, this will also buy policymakers time to address the fiscal, social and political issues underpinning the euro zone’s very real growth and inflation woes.
  • China’s growth is slowing, meanwhile, and the U.S., though relatively strong, is by no means immune to the spillover effects of global growth and commodity weakness, increased global monetary accommodation and domestic issues like moribund wage growth. As such, we do not expect any sweeping changes to Fed policy anytime soon.
  • While the front-end of the U.S. yield curve is susceptible to the Fed, we see no near-term catalyst for a selloff in global rates. We remain overweight a variety of spread sectors, including U.S. investment grade corporates and U.S. high yield, as recent spread widening leaves valuations compelling despite low yields. Though volatility has picked up, a new default cycle is unlikely in the near term, particularly among U.S.-focused credits.

Sector Overviews

Rates have rallied substantially across the euro zone, and the euro weakened against the dollar. Falling developed market yields have given way to a strong performance in the Treasury market. The Treasury curve has continued to flatten, with yield on the 30-year rallying to all-time  lows while the ten-year is nearly 100 bps lower than a year ago.

We are underweight interest rate risk in the U.S., concentrated in the front end of the curve, though we have closed underweights in interest rate risk denominated in other currencies. Valuations are generally  rich, but we see no near-term catalyst for a global rate selloff given the liquidity that will result from the ECB’s new asset-purchase program.

Global  Currencies

·         We continue to favor the U.S. dollar versus the euro and Japanese yen. Versus the euro, we also favor the British pound and Swiss franc. The   yen may have already experienced most of its weakening, with the BOJ’s bond-buying announcement well in the past. The ECB’s new bond-buying program has already had a weakening effect on the euro, which should persist. That said, the size and speed of further euro devaluation is mitigated by lower U.S. interest rates and the EUR/USD selloff of the last few months.

Investment Grade Corporates

·         Corporate performance has continued to be weak, though there are tentative signs of stabilization and we remain mildly constructive on the credit markets in 2015. Oil prices appear to be trying to find a bottom, whlie corporate spreads search for stability; long-dated bonds and energy bonds both have shown signs of life since mid-January. While corporate balance sheets remain healthy and domestically sourced earnings should be strong, international earnings could be negatively impacted by weakness in global growth and strength in the U.S. dollar.

·         The ECB action, while supportive of spreads, does create a potential negative in that ECB bond buying also will contribute to lower Treasury yields. Any move lower in oil also would pressure corporate fundamentals; while lower oil prices are a general economic positive, corporate bond markets have a disproportionate exposure to the energy industry.

High Yield Corporates

·         The high yield market has struggled to gain traction thus far in 2015, and there remains a significant divergence between the performance of energy and non-energy issues. Within energy, we have seen an increased bifurcation between well-positioned “haves” and “have-nots” as opposed to the indiscriminate selling we saw when the oil price decline began to accelerate in late 2014. Other commodity-related sectors (coal, iron ore, etc.) continue to follow a similar path to oil-related issuers.

·         Our fundamental view of high yield credit quality is largely unchanged. Spreads are justifi  ly wider, as risks have increased, but the U.S. economic recovery appears solid enough to prevent a turn in the credit cycle. With ex-energy spreads above the long-term average and defaults likely to remain well below the historical average, it seems that high yield investors are being more than adequately compensated for credit risk. At current levels, high yield bonds also likely have the ability to absorb at least a portion of an eventual rise in interest rates. As such, high  yield should outperform most other fixed income asset classes over the coming year, though stabilization in oil prices is needed.

Mortgages

·         Agency MBS has struggled in early 2015, driven by a confluence of factors. A dip in primary mortgage rates has re-introduced refinancing fears, while the Fed no longer adding MBS to its balance sheet has reduced this source of demand. And although the ECB’s announcement appears bullish for spread assets, the purchases could pressure U.S. rates, a negative for the agency MBS market.

·         We are more constructive on securitized credit markets — including non- agency MBS and CMBS — given solid fundamentals, strong technicals, attractive relative value and insulation from volatility. Non-agencies   have been well bid since the beginning of the year; supply has picked up sharply the past two weeks, and competition for assets has remained fierce. The CMBS market started the year quietly before activity picked up sharply mid-January. Spreads and volatility in CMBS have been quite manageable relative to the corporate debt markets.

Emerging Markets

·         Emerging markets are contending with slow economic growth, a re-rating of systematically important countries like Russia and Brazil, idiosyncratic geopolitical events and falling commodity prices. While reduced commodity prices could stem inflation pressures and continued easy monetary policy in the developed world could support EM assets, negative sentiment toward the sector persists. Both the corporate and the sovereign indexes have stumbled out of the gate in 2015, and we remain cautious on emerging markets overall.

Past performance does not guarantee future results.

This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein   reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without

limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.

Voya Investment Management Co. LLC (“Voya”) is exempt from the requirement to hold an Australian financial services license under the Corporations Act 2001 (Cth) (“Act”) in respect of the financial services it provides in Australia. Voya is regulated by the SEC under U.S. laws, which differ from Australian laws.

This document or communication is being provided to you on the basis of your representation that you are a wholesale client (within the meaning of section 761G of the Act), and must not be provided to any other person without the written consent of Voya, which may be withheld in its absolute discretion.

©2015 Voya Investments Distributor, LLC • 230 Park Ave, New York, NY 10169

CID# 163124

[description] => Voya Investment Management’s fixed income strategies cover a broad range of maturities, sectors and instruments, giving investors wide latitude to create a new portfolio structure or complement an existing one. [author] => Christine Hurtsellers, Matt Toms [legacyinterface_firm_id] => 481 [published_on] => 2015-01-30 [digest_date] => 2015-01-30 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-30 18:54:12 [created_by] => 948 [modified_on] => 2015-01-30 19:19:09 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2485 [hits] => 0 ) [1] => stdClass Object ( [legacyinterface_commentary_id] => 2391 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15628 [apv_conversation_id] => 3364 [content_type] => market-commentary [title] => The Unintended Consequences of "Sophisticated" Performance Measurement [slug] => tocqueville_012915 [fulltext] =>

Investment performance measurement is a striking example of an originally good idea made bad by its success.  It is true that a standardized way of measuring performance is necessary to weed out money managers’ claims that are outrageous, plain dishonest, or even merely “selective.”  But unfortunately, too many imitators embraced the original concepts; and as the size of the performance-consulting industry grew exponentially, more gimmicks were incorporated in addition to the simple indicators used early on by measurement pioneers.  Today, these augmented concepts are very widely used, often inadequately so, and in my opinion have frequently become counterproductive.
 

OUTSTANDING INVESTORS vs. CONSULTANTS
 

Most exceptionally successful long-term investors have proclaimed, at one time or another, their skepticism about investment consultants and the growing use of performance benchmarks aimed at splicing performances among investment styles, geographies, company sizes, sectors, etc.  The skeptics have included the likes of Warren Buffett, Charlie Munger, Peter Lynch, Martin Whitman, Jim Rogers, Seth Klarman, Georges Soros, Howard Marks, et al.  Recently a new Oxford University paper joined this critique.  The Financial Times of September 22, 2014, cites a study by a team of from Oxford University’s Saïd Business School, which analyzed consultants for more than 90 per cent of the retirement market.  It concludes, “On an equal-weighted basis, U.S. equity funds recommended by consultants underperformed other funds by 1.1 per cent a year between 1999 and 2011.”
 

Why should the record of consultants be so disappointing?  Certainly not because they are stupid or ignorant.  In fact, most are not only highly educated, but also are very proficient in math and statistics as well as highly articulate in their presentations.
 

Instead, I believe that their problem is rooted in the fact that what was once a practice has become a business.  This business requires consultants to foster a growing appetite for their services among clients, by creating a need for more frequent measurement and decision-making.  Thus, measuring and critiquing performance has become a quarterly practice – and at times, more often than that.
 

Unfortunately, in investing, a quarter or even a year is almost always a totally irrelevant period.
 

MEASURING PERFORMANCE OVER RELEVANT PERIODS
 

When I referred above to successful long-term investors, I did not mean successful over three, five, or even ten years, which in investment history amount to little more than one fashion or style season.  I mean a stretch of years encompassing several cycles, with bull and bear markets as well as many fads and fashions and their aftermaths.
 

If one overlooks the “noise” of superficial hiccups and false signals, economic events really progress at a near-tectonic pace that does not require constant monitoring.  Except for occasional accidents, corporate fortunes do not change in three months either, and new business strategies often take several years to bear fruit – or not.
 

Over shorter periods, it is mostly crowd psychology that moves markets.  Thus, trying to measure how well a portfolio has performed over three or six months really amounts to measuring how well a manager has participated in the mood-induced ups and downs of a bipolar group (the investing crowd).  Once we realize this, the risks of quarterly performance-measurement become clearer.
 

THE COUNTERPRODUCTIVE AVOIDANCE OF VOLATILITY
 

Over time, as the performance of a majority of hedge funds and the consultants who recommend them has proven disappointing, it appears that the selling argument of this relatively new industry has shifted from “superior returns” to “acceptable returns with lower risk.”  This too, I am afraid, reflects a dangerous misunderstanding.
 

Consultants – and the academics who gave them their theoretical arguments (including Nobel laureates) – cannot quantify risk.  This is because risk can only be measured for individual investments rather than groups or indexes; it necessitates exhaustive analysis; and it cannot be summed up easily in a single statistic.  So, a consensus developed among consultants to use volatility as a substitute for risk in their calculations.  And, eventually, they even began to call it “risk.”  But this is a serious misinterpretation.  Financial risk refers to the possibility of permanently losing some or all of your equity in an investment.  Volatility merely refers to the amplitude of price fluctuations within given periods.
 

Since the principal determinant of short- and medium-term price fluctuations is the mood of the investing crowd (as opposed to changes in the fundamental value of companies, for example), most successful investors welcome volatility.  Over their longer time horizon, they recognize short-term volatility as a periodic opportunity to find unrecognized value or growth.
 

By definition, for an investor to be better than the majority, he or she needs to be different.  This implies that he or she can also, occasionally, be worse.  Bernie Madoff’s notorious Ponzi scheme, where he sold billions of his funds to investors by producing made-up performance statistics (the investments did not actually exist), was particularly smart in one respect:  The performances “produced” and implicitly promised were not outrageous.  Good investors achieved similar results over the years.  But one giveaway was (or should have been) that this performance showed no volatility:  Almost the same results were achieved period after period.  A good analysis should have told investors that this kind of performance could not be achieved without occasional shortfalls.  Merely statistical methods did not.
 

Most performance consultants try to minimize or eliminate volatility.  In doing so, they all but abandon the possibility of being durably better than the majority; but, in my view, they do not reduce true risk, which can only be avoided through extensive fundamental (not just statistical) analysis of specific investments.
 

THE GOAL: NOT RELATIVE PERFORMANCE, BUT ABSOLUTE RETURN
 

Another criticism aimed at consultants by highly successful investors is their primary focus (also out of business necessity) on performance relative to various fabricated benchmarks, rather than on absolute results, which would answer the question, “Am I becoming richer after inflation and taxes or not?”
 

Seth Klarman, founder of the Baupost Group, is at 57 years old often regarded as one of the very best investors of his generation.  In his 1991 book, Margin of Safety (which is out of print but can be bought for around $2000 on the Internet), he makes the argument that I summarize here:
 

Most institutional investors have become locked into a short-term, relative-performance derby.  Their short-term orientation may be exacerbated by the increasing popularity of pension-fund consultants.  Money managers motivated to outperform an index or a peer group of managers may lose sight of whether their investments are attractive or even sensible in an absolute sense.  They then really act as speculators:  They try to guess what others are going to do and then try to do it first.
 

Not only are money managers thus forced into becoming short-term traders, but when obliged to invest against a benchmark, suddenly everything for them becomes relative.  Instead of asking, “Is what I am buying cheap?” the manager begins asking, “Is the asset I am buying cheap relative to the benchmark?”  As performance measurement increasingly deviates from the original goal of money management – absolute returns – the ultimate nonsense may become having to reward a manager for losing only 30 percent (for example) if his benchmark (often chosen by the consultant) was down 50 percent!
 

Michael Edesess, a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, recently reviewed a paper by three academics from Boston University and the London School of Economics.  The paper, entitled “Asset Management Contracts and Equilibrium Prices,” argues that measuring and evaluating manager performance by comparing it to a market index may be distorting prices across the whole market.  Edesess goes one step further:
 

One inescapable conclusion is that the practice of evaluating managers by monitoring their performance against an index benchmark should be jettisoned – even if there’s no immediately obvious alternative to replace it.
 

STATISTICS vs. NAVIGATING ABILITY
 

What makes a good portfolio manager?  First, the choice of a discipline that makes sense based on both theory and experience; and second, the faithful application of that discipline through economic and market cycles.  Performance-measurement services are not readily useful for that purpose because, as famous finance author Charles D. Ellis reminded us, they do not report results; they only report statistics.
 

In fact, from a client’s perspective, investment performance should be assessed more as a manager’s navigating ability than as a crude statistic:  How has a portfolio performed in different economic and market environments; did it perform as expected from the chosen discipline or not; and if not, why?  Assessing a portfolio manager’s “seaworthiness” thus requires a multi-cycle perspective and a more subtle understanding of where any over- or underperformance came from.  For example, a good statistical performance attained by not following a promised discipline usually is a warning of future trouble.
 

THE LIMITS OF DIVERSIFICATION
 

I will not go so far as Warren Buffett in saying that diversification is what you use when you are not sure of your choices.  The fact is that one is never a hundred percent certain of one’s choices.  So, it seems desirable to diversify, though there is much disagreement among practitioners over the optimal degree of diversification. The debate is an old one: is it better to spread your eggs among many baskets, to reduce the risk of breaking, or to put all your eggs in one basket and carefully watch that basket? Personally, I favor one basket, albeit a large one, because I am concerned that too many investments may wind up working at cross-purpose. Similarly, over-diversifying among managers appears counterproductive to me, especially since it often results either in overlapping portfolio positions (which defeats diversification efforts) or, on the other hand, in contradictory positions in different portfolios, which tend to offset each other’s impact on performance.
 

Another argument against diversifying among managers is that, to my knowledge at least, most of the firms that have had superior long-term records have not done it.  However, very often, their funds are not managed by an individual, but by a very close-knit team.  This is an intelligent way to critically vet both new investment ideas and new talent, thus enhancing portfolio management while ensuring the continuity of the organization and its disciplines.
 

This promise rings particularly true when a managing organization’s culture closely aligns its managers’ fortunes to those of its clients.  Seth Klarman pointed out that a client probably would not choose to dine at a restaurant whose chef always ate elsewhere.  He thought an investment client would no more be satisfied with a money manager who does not eat his or her own cooking.  Many investment managers treat OPM – “other people’s money” – differently than their own.  If, in contrast, your manager has all his or her eggs in your common basket, you can at least feel assured that the basket is being watched.
 

François Sicart
January 14, 2015
 

Disclosure: This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.

© Tocqueville Asset Management

[description] => Sicart believes a measure of investment success should encompass "several cycles, with bull and bear markets as well as many fads and fashions and their aftermaths." He notes that "economic events really progress at a near-tectonic pace," so "a quarter or even a year is almost always a totally irrelevant period." [author] => Francois Sicart [legacyinterface_firm_id] => 431 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 16:35:00 [created_by] => 948 [modified_on] => 2015-01-29 16:38:12 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2457 [hits] => 0 ) [2] => stdClass Object ( [legacyinterface_commentary_id] => 2392 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15632 [apv_conversation_id] => 3368 [content_type] => market-commentary [title] => The Strange Case of the Current Small-Cap Cycle [slug] => royce_012915 [fulltext] =>

Through much of this long recovery for equity prices following the market bottom on March 9, 2009, specifically the period from 2011-2014, many active small-cap approaches, our own included, struggled to beat their benchmarks. The initial years of the cycle (2009-2010) were strong on both an absolute and relative basis for the majority of our Featured Funds. However, the last four calendar years saw many of our portfolios coming up short on a relative basis.

We can accept relative underperformance for a one-year period with equanimity. A three-year period is more difficult to swallrow because it represents to us the threshold between the short and long terms. However, we could ultimately accept that too, provided we saw strong signs of market or economic changes that looked likely to benefit our disciplined approach. A five-year underperformance period, on the other hand, is another matter entirely. (It bears mentioning that the respective five-year average annual total returns for both our flagship, Royce Pennsylvania Mutual Fund ("PMF") (+12.8%), and the Russell 2000 (+15.5%) were well in excess of their respective historical rolling monthly five-year averages of 9.8% and 7.6% since the small-cap index's inception on 12/31/78.)

This most recent underperformance period led us to attempt to answer two critical questions that are important to us and that we know have been on the minds of our investors: First, what forces have helped to shape the current cycle and contributed to the relative advantage for the small-cap index? Second, what signs, if any, reveal that some of these forces may be ebbing or reversing?

Three specific market conditions have resulted in relative performance challenges: when small-cap stocks are generating returns well above their long-term averages, when there is lowerthan- usual volatility for small-cap stocks, and/or when credit spreads—or the cost of capital—is declining. When only one of these conditions was present, our relative performance often suffered, if only in the short run. Yet for much of the past five years, each of these three conditions converged.

Before looking more closely at these developments, we want to emphasize that our belief in the cyclical nature of financial markets is fundamental and unshakeable. We were not surprised to find, then, that all three were showing signs of abating at the end of 2014. And while we cannot predict future performance patterns, we are nonetheless encouraged by many of our Featured Funds' long-term histories, especially following similar underperformance periods.

Credit Spreads* and Royce Returns

The availability of capital for businesses expands and contracts over time. In 2008, capital was understandably both quite scarce and very expensive. Contrast this with 2013 when capital was widely available.

One metric used to assess the price, or cost, of capital is the difference in yield between U.S. Treasury bonds and high-yield bonds. When this yield differential, or yield spread, is high, the cost of capital is also, which often causes problems for highly leveraged businesses.

When the cost of capital declines and the yield spread drops, it creates a potential advantage for the kind of highly leveraged stocks that we typically avoid. Yet many high-leverage stocks find homes in the Russell 2000. When the cost of capital was declining (and the yield spread was narrow), these stocks contributed to the index's stellar performance. The reverse held true when the cost of capital rose, expanding the yield spread. As a result, our relative performance has often correlated with movements in high-yield credit spreads. As shown in the table below, from 1996-2014 PMF slightly underperformed when the credit spread range contracted, typically had a slight excess return when this range was narrow (and more stable), and had a more decisive advantage when the range widened—that is, when the cost of capital rose.

Average of One-Year PMF Excess Returns by Credit Spread Rate of Change
From 12/31/96 through 12/31/14 (%)

 CREDIT SPREAD
RATE OF CHANGE
AVERAGE EXCESS
RETURN
Tercile 1 (Credit Spreads Narrow) -12.2 to -0.9 -3.8
Tercile 2 (Credit Spreads Stable) -0.9 to 0.8 0.2
Tercile 3 (Credit Spreads Widen) 0.8 to 14.1 7.0

We are therefore encouraged by the recent increase in the cost of capital. From a peak of 21.8% at the end of 2008, yield spreads contracted all the way down to 3.4% in the early summer of 2014 and have already begun to widen. They stood at 5.0% at the end of 2014.

Volatility is an Ally

Low volatility environments have historically been challenging for most active managers, including ourselves. The reason is that differentiation lies at the core of active management. We evaluate multiple aspects of a company and then judge whether or not the current stock price reflects the long-term prospects we see.

Opportunities to purchase what we deem to be attractively undervalued companies occur more frequently when stock prices are volatile. The following table shows that over the past 36 years, our investment approach with PMF on average generated excess returns versus the Russell 2000 in most market environments—except those with the lowest volatility. But for most of the last five years, volatility has been falling and has remained low, which has created a more difficult environment for active managers to outpace their benchmarks.

Average of Five-Year Monthly Rolling Statistics
From 12/31/78 through 12/31/14 (%)

 QUNTILES
FUND12345
Russell 2000 Standard Deviation 14.19 17.50 20.09 21.90 23.55
Russell 2000 Performance 14.91 14.34 12.00 7.20 3.86
PMF Performance 12.88 15.77 15.07 12.25 7.22
PMF Excess Return vs. Russell 2000 -2.03 1.43 3.07 5.06 3.36

It's worth pointing out that since the second quarter of 2014 U.S. small-caps have seen increased volatility. If the trend continues, it should create more opportunities for us to buy at attractive prices.

How Long Can High Returns Last?

From the inception of the Russell 2000 (12/31/78) through the end of 2014, there were 373 monthly trailing five-year return periods. In 27% of those periods, five-year average annual total returns were greater than 15%. The five-year period ended 12/31/14 was one of these periods, with the small-cap index returning 15.5%. While such high return periods are not the norm, they have historically been challenging for active mangers such as ourselves. In fact, when trailing five-year returns for the Russell 2000 were 15% or greater, PMF underperformed 51% of the time.

Our expectation going forward is for something closer to small-cap's five-year average annual total rolling return of 7.6%. Such periods, as can be seen in the table below, were favorable to our approach.

Five-Year Rolling Returns
Russell 2000 Average Annual Total Returns from 12/31/78 through 12/31/14 (%)

 < 5%5% - 10%10% - 15%> 15%
Number of Periods 81 101 90 101
% of Periods 22% 27% 24% 27%
PMF Average Excess Return 3.56% 4.64% 0.76% -0.13%

...So What Happens Next?

In our experience, markets are cyclical. Most trends reverse, though they can linger for longer than initially anticipated (or desired). The three trends we have examined—narrow credit spreads, lower-thanaverage volatility, and higher-than-usual small-cap returns—all showed signs of reversing in the latter part of 2014.

We view these shifts as part of the eventual normalization of the financial markets, by which we mean lower average annual returns with higher volatility. We see these developments as being accompanied by an eventual increase in the cost of capital, driven both by higher interest rates and wider credit spreads, which is a natural result of an ongoing economic expansion. A higher cost of capital usually has a significant and negative effect on highly leveraged businesses.

We thought it might be instructive to look at relative performance following historical underperformance periods. We identified 36 five-year spans from the Russell 2000 inception when PMF underperformed the Russell 2000 by 3.0% or more on an average annual basis. We then looked at the relative performance, as measured by excess returns, in the subsequent five-year periods. In 92% of them (33 of the 36), the Fund outpaced its benchmark. Moreover, the average excess return for all 36 subsequent average annual five-year periods was a healthy 6.4% per year.

Past performance is no guarantee of future results. That being said, and looking closely at history, particularly within the context of the highly anomalous period we have just endured, we suspect that investors may be able to appreciate why we are so optimistic about the prospects for both the relative and absolute performance of our disciplined, value-oriented approaches.

PMF vs. Russell 2000
Subsequent 5-Year Excess Return Following Each Monthly Rolling 5-Year Period of Relative Underperformance in Excess of 300 BPS (%)

Royce Pennsylvania Mutual Fund [PENNX]
Average Annual Total Returns as of Quarter-End 12/31/14 (%)

 QTR*1 YR3 YR5 YR10 YR15 YR20 YR30 YR40 YR
Pennsylvania Mutual 5.30 -0.70 15.45 12.80 7.97 10.74 11.32 11.55 16.28
Russell 2000 9.73 4.89 19.21 15.55 7.77 7.38 9.63 10.27 N/A
Annual Operating Expenses: 0.93%

Not Annualized

Important Performance and Expense Information

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed on or before 1/30/15 within 180 days of purchase, and after 1/30/15 within 30 days of purchase, may be subject to a 1% redemption fee. All redemption fees are payable to the Fund and are not reflected in the performance shown above; if such fees were reflected, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. Operating expenses reflect the Fund’s total annual operating expenses for the Investment Class as of the Fund’s most current prospectus and include management fees, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through it’s investment in mutual funds, hedge funds, private equity funds, and other investment companies.

Important Disclosure Information

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Royce Pennsylvania Mutual Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 25% of its net assets in foreign securities (measured at the time of investment), which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.) Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. Standard deviation is a statistical measure within which a fund's total returns have varied over time. The greater the standard deviation, the greater a fund's volatility. Please read the prospectus for a more complete discussion of risk.

* Credit spread data source: B of A Merrill Lynch US High Yield Master II Option-Adjusted Spread

© The Royce Funds

[description] => For much of the past five years, small-cap stocks have generated returns well above their monthly rolling five-year averages. In addition, lower-than-usual volatility within the asset class and a decline in the cost of capital spurred by the Fed’s monetary stimulus programs have created an unfriendly environment for active stock pickers such as ourselves. Our latest research, however, suggests that some of these conditions were abating late in 2014, which might benefit those investors who focus on fundamentals and try to use volatility to create longer-term opportunities. [author] => Team [legacyinterface_firm_id] => 379 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 16:42:08 [created_by] => 948 [modified_on] => 2015-01-29 17:13:02 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2458 [hits] => 0 ) [3] => stdClass Object ( [legacyinterface_commentary_id] => 2393 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15629 [apv_conversation_id] => 3365 [content_type] => market-commentary [title] => We Didn’t Start the Fire [slug] => rsw_012915 [fulltext] =>

History shows that what starts as an overall lack of fear, becomes outright complacency, which inevitably leads to the "Minsky Moment" of instability.

Virtually every major Central Bank has outright expressed, or at the very least implied to market participants that not only do they have "our backs", but our backsides too!   

If distorted markets create distorted behavior, we can logically infer that unprecedented   excesses exist somewhere in the system and probably in many places.

The entire financial system has been re-stocked with dry kindling and oil is the most likely match.

Today, the hot debate centers on whether plunging oil prices are a boost to or detractor from, economic growth.  One view is that declining oil prices enhances consumer spending power, as fewer dollars spent at the pump allows more to be spent on discretionary items.  The counter argument is that a collapse in price causes both a reduction in energy related investment (CAPEX), and a loss of high paying jobs which combine to offset the simulative effects of lower crude prices.  There is little doubt of the truth in both arguments, but it's probably not too early to declare which carries the most weight.  In the final analysis however, the answer to the following two questions is more important.

  • Is oil the latest victim to be claimed by deflation, and is its decline forecasting a world economic slowdown or worse?
  • Does the speed and scope of the collapse create systemic risk?

We will address such questions more directly later.

We begin by describing what we believe to be the economic/financial environment in which oil's unexpected plunge occurred.  Much like Einstein's "Theory of Everything" that seeks to explain comprehensively how the universe functions, today's economic predicament may be explained by the  Hyman Minsky's (economist) "Financial Instability Hypothesis".  Its "unifying" feature is that it not only deals with economics and markets, but with its corresponding human behavior.  Oversimplified, it states that "stability is destabilizing".  More fully explained, it describes that periods of stability create behavioral responses that erode margins of safety, reduce liquidity, increase debt relative to income and profits, and raises the price of risky assets relative to safe assets.  All of these combine to weaken the ability of the economy to withstand even modest adverse shocks.  

History shows that what starts as an overall lack of fear, becomes outright complacency, inevitably leads to the "Minsky Moment" of instability.  Think about human nature.  Even If a person feels that they will be partially indemnified from substantial loss or personal harm in any pursuit, their risk tolerance increases.  We at RSW, would further make the point that this principle appears to be the unifying force between every major Central Bank in the world as they attempt to:

  • Create and maintain historically unsustainable levels of volatility.
  • Lower interest rates to drive market participants into riskier asset classes.
  • Coax investors to accept lower levels of liquidity.
  • "Force" investors out on the yield curve (buy longer maturity debt) to enhance their income.

Let's take the theory and apply it to both today, and that period leading up to the housing crisis.  With the benefit of hindsight most would concede that Alan Greenspan, by keeping the Fed Funds rate at 1% for too long, contributed to the housing boom.  This created an atmosphere of the "Fed has our backs" that made extreme speculation and leverage not seem so extreme.  Liquidity wasn't an issue, debt versus cash flow wasn't a concern, adjustable rate loans were “OK” because rates would always stay low, and housing will never exhibit a meaningful nationwide decline.  Against this backdrop, packaged loans and "structured debt" became all the rage.  In summary, the Fed didn't light the match but they did supply the dry kindling to assist in creating an impressive blaze.  

Fast forward to today.  Virtually every major Central Bank has outright expressed, or at the very least implied to market participants that not only do they have "our backs", but our backsides too!   Today is it fair to say that Hyman Minsky's Instability hypothesis is now on steroids and injected globally?  What the world's Central Banks have done collectively in the last 5 or 6 years makes what Alan Greenspan did look like a tightening.  The world's risk appetite has dramatically increased.  Additionally, they have accepted weakened covenants (fewer promises to lenders as specified in the bond documents) without blinking, and all of this has been done with a sense that Central Banks won't let anything bad happen.

To continue our analogy the entire financial system has been re-stocked with dry kindling and oil is the most likely match.  While almost no one believes that this match burns as hot as subprime mortgages, remember Minsky's hypothesis: 

All of the excesses combine to weaken the ability of the economy to withstand even modest adverse shocks. 

This period in worldwide financial history is unprecedented.  If distorted markets create distorted behavior, we can logically infer that unprecedented excesses exist somewhere in the system, and probably in many places.  The match may not burn as hot, but with the pile of kindling being higher and drier it is undoubtedly easier to ignite. Could oil be the asset class that trips us into meaningfully slower economic activity and upsets the "risk markets"? 

So, Are Plunging Oil Prices a Boost or a Detriment to Economic Activity?

It's now time to vote.  While there is still time to allow events to unfold, we admit to a bias that the plunge in oil prices is a net negative to our economic health.  We arrive at that decision using the same logic as the majority of mainstream economists.  For years, we have read and seen economic reports that contended that the "shale revolution" would add 100 to 150 percentage points to GDP.  It was the "American Renaissance" and an "American success story".  It was told that even though the cost of extracting oil and gas was relatively expensive, the increased capital investment (CAPEX), the creation of many high paying jobs, and the resulting increase in consumer spending would rule the day over higher cost.  If the initial forecasts were accurate, the reversal of those two forces, should cause a noticeable weakening in GDP.   

For those of us charged with managing money, whether GDP slows or speeds is important but not an earth shattering consideration.  However, the two questions posed at the beginning of this musing are the ones that have significant consequences if answered incorrectly.  Shown again they are:

  • Is oil the latest victim to be claimed by deflation, and is its decline forecasting a world economic slowdown or worse?
  • Does the speed and scope of the collapse create systemic risk?

While we have already addressed the first question and have a strong opinion, our conviction level for the second one is weaker.   Minsky (long periods of stability may serve to mask stealth instabilities) would have felt at home with the following economic/market events:

  • Shale boom created a surge in energy related borrowing that now represents around 18% of the high yield bond market. 
  • Wall Street and community banks are huge lenders to this sector, tied to oil revenues.
  • As revenues contract the ability of borrowers to repay principal and interest is diminished.
  • There have already been a small number of bankruptcies, does it increase?
  • There are serious dislocations in the currency markets exacerbated by oil.  Does this worsen?

Yes, the environment described herein breeds systemic risk, but recent events also demand a certain amount of humility.  If we didn't see oil's sudden collapse to $45 from $106, we shouldn't feel very confident of the next $10 move, or what effect it can have on economies or financial systems.  What can be said, with a higher level of confidence, and with a sense of historical fact about human response is that somewhere in the financial system there exists outsized risk and diminished risk controls.  As you may recall the last time we began commenting about a hazard such as this, was in RSW's Q1 2007 commentary where we said:  "It is no longer out of place to fear both a financial event where securities and institutions of all kinds are affected, and an economic contraction caused by a severely damaged consumer".

One final note of caution in this era of Central Bank omnipotence is warranted.  From RSW's perspective, all too often investors misinterpret the message of the Fed, or any Central Bank.  All these "bankers" can do is whisper into your ear that they will not be the proximate cause of increased volatility.  They will also promise not to be the cause of economic and financial disruptions.  Lastly, they will insist that a collapse in the price of oil is not their doing.  But that doesn't mean that they can prevent it from happening, or stop it when it starts, or control the unintended consequences that result.  None of this means however, that they didn't provide all of the ingredients to ensure that the flame burns hot.  Rest assured, and have no doubt, that if some major dislocation befalls the financial system, the Fed and all of their Central Bank brethren, in their best Billy Joel  voice will all claim: "We Didn't Start the Fire".

© RSW Investments

[description] => History shows that what starts as an overall lack of fear, becomes outright complacency, which inevitably leads to the "Minsky Moment" of instability. Virtually every major Central Bank has outright expressed, or at the very least implied to market participants that not only do they have "our backs", but our backsides too! If distorted markets create distorted behavior, we can logically infer that unprecedented excesses exist somewhere in the system and probably in many places. The entire financial system has been re-stocked with dry kindling and oil is the most likely match. [author] => Robert Waas [legacyinterface_firm_id] => 530 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 16:50:02 [created_by] => 948 [modified_on] => 2015-01-29 16:51:18 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2459 [hits] => 0 ) [4] => stdClass Object ( [legacyinterface_commentary_id] => 2394 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15630 [apv_conversation_id] => 3366 [content_type] => market-commentary [title] => Commodity Outlook 2015: Watching the Supply Response Across Markets​ [slug] => pimco_012915 [fulltext] =>
  • Today’s low oil prices should allow for supply and demand to come back into alignment by year-end, led by a decline in the U.S. output growth rate and a modest increase in global demand.
  • We expect continued oversupply to weigh on natural gas prices this year, but some semblance of balance may return to this market in 2016.
  • Grain prices may experience pressure in 2015 as low oil prices pass through to corn prices, which may cause producers to switch to higher-priced crops.
  • With production growth likely having peaked, we expect metals prices to stabilize this year.

The last few years have been challenging for commodity returns. Years of big investment led supply to catch up to demand in one market after another. The process started in 2007 with natural gas, followed by base metals in 2011, grains in 2013 and, most recently, oil, with surging supply leading to steep price declines.

While slow global economic growth since the 2008 financial collapse and a deceleration in the Chinese economy have been strong headwinds to all commodity subsector returns, we think that the level and timing of supply growth explain much of the price weakness and, more importantly, why the timing of this price weakness has varied across commodity markets. We believe the speed of the supply response will drive returns over the next one to two years.

Overall, absent a genuine surge in the global economy, 2015 likely won’t see a strong rebound in commodity prices; instead, we could see a year of relatively flat returns.

Oil prices will likely stabilize and even move marginally higher
Oil was the last of the major commodity markets to see prices adjust to a large supply shock as the Arab Spring and Iranian sanctions delayed the day of reckoning. However, oil prices had a stunning decline of 50% during the second half of 2014, the result of weak global demand combined with high non-OPEC production and a change in Saudi Arabia’s willingness to serve as the global swing-supplier (see our December 2014 Viewpoint, “OPEC Post-Mortem: All Eyes on U.S. Shale​,” by Greg Sharenow). This has created a surplus of roughly 1 million barrels per day (b/d) in the oil market. For the markets to rebalance, this surplus must be stored for future use, and future production growth rates need to decline. We believe we are near that point, and that oil prices will stabilize and even experience some small recovery over the coming months.

Prices could break lower if storage capacity falls short. But we believe any drop would be brief given that Brent below $50/bbl and Canadian oil in the low $30s are already quite close to cash operating costs, slowing the capital expenditures (capex) required to sustain output. In addition, unlike in 2008–2009, when the market last saw a material surplus, today’s functioning capital markets and low yields should allow for maximized storage utilization.

Longer term, we expect global oil demand to continue to grow at close to 1 million b/d each year. Growth in non-OPEC production, centered in the U.S., will be needed to meet that demand ‒ just not the 1.7 million b/d growth of this past year. The Department of Mineral Resources in North Dakota estimates that prices need to sustain $55/bbl on average at the well head (equating to roughly $65/bbl for WTI) to stabilize production at current levels, which implies current prices are already reducing the outlook for growth by more than 0.25 million b/d relative to last year in just North Dakota. In addition, with the five-year forward price of Brent at just over $70/bbl, the same long-end price seen during the heart of the credit crisis, we believe the forward market is below the marginal cost for too many global oil projects, such as deepwater and Canadian oil sands.

In our view, current prices should allow for supply and demand to come back into alignment by year-end, led by a decline in the growth rate of U.S. output and a modest increase in global demand partly due to lower oil prices. We expect the market will anticipate this tightening as evidence of slowing investment accumulates, which should ease the downward price pressure.

However, there is considerable uncertainty in this outlook for competing reasons. Energy has become the largest sector within the high-yield space due to tremendous debt issuance in recent years to finance the massive growth in shale production. This capital will become scarcer as the markets impose greater discipline and higher financing costs on producers, which in turn could accelerate the reduction in U.S. output growth. On the other hand, we expect downward pressure on costs as drilling expenditures slow and producers drive efficiency gains. The magnitude of this improvement will play an important role in where the long end of the curve settles.

While this outlook should offer some solace for investors that most of the pain is over, we expect the oil market to remain in contango, where front-month futures contracts (i.e., those closer to the current date) are at a discount to longer-dated contracts, due to the oil surplus being put into storage. In other words, the futures curve is already embedding a decent improvement in prices.

One positive for investors going forward is seasonal: Oil prices have historically rallied during the first half of the year. The market has largely overlooked this and other potential positive catalysts – such as growing financial stress in oil-producing nations and the upcoming presidential election in Nigeria – that could destabilize output.

Natural gas faces another year of weak pricing
The 2015 outlook for natural gas is for continued oversupply to weigh on prices. Warmer-than-usual winter weather could cut household demand, which could lead to a more severe price response as power generation might not prove to be the backstop it used to be. Unlike in 2012, when coal-to-gas switching helped balance the market, more of today’s coal generation has already been replaced with natural gas, leaving less capacity to absorb further natural gas surplus.

The outlook improves as the time horizon extends. The outlook for natural gas production associated with shale oil production is considerably lower than before. With natural gas liquids (NGLs) pricing at 15-year lows, the benefits of NGLs as a byproduct of tight oil drilling are all but gone. Growing industrial demand, additional coal plant retirements due to environmental regulations, increasing exports to Mexico and the completion of the first U.S. liquefied natural gas (LNG) export plant at the end of the year could return the natural gas market to some semblance of balance in 2016, particularly should U.S. production growth finally slow. While the forward curve is already pricing in an improvement in natural gas prices, we believe there is upside in 2016 and beyond.

We have a bearish bias on agriculture
Despite a negative year overall, agricultural commodities rallied nearly 20% during the final quarter of 2014. Those gains went mostly unnoticed given the large declines in oil during that time. The rally was largely driven by increased sovereign risk for Russia, a major grain producer. The high correlation between Russian sovereign credit default swap levels and grain prices is similar to what we saw during the unrest in Crimea early in the year. We think there are limits to that relationship at the current level of oil prices, however, given the link between corn and oil prices via ethanol. The recent oil price drop has put pressure on ethanol prices to the point that the spread between end-of-2015 ethanol and corn prices is below breakeven for ethanol producers. If these levels are realized, we expect a reduction in ethanol production, which would reduce demand and prices for corn. As a result, we think today’s low oil prices will eventually pass through to lower corn prices, which, in turn, will generally put pressure on other grain prices as producers switch to higher priced crops.

Lower oil prices also mean lower production costs for grains: Fuel is 10% of the variable cost of producing a grain like corn, and fertilizer is closer to 40%. Given current input prices, the one-year forward corn price is therefore likely 5% over marginal production costs and allows for a decent margin for farmers. As always, a drought can cause an upside surprise, but given current long-range weather models, we view this as unlikely and have a general bearish bias to the agricultural sector, and grains in particular.

Metals prices should stabilize
We divide metals into two major sectors: base metals and precious metals. We see precious metals as more of a currency, with prices moving up and down in response to global real yields. Today, gold prices are broadly consistent with U.S. real yields; however, with real yields globally very low, the Federal Reserve likely to hike rates this year and the U.S. dollar likely to strengthen further, we see some downside risk to gold prices.

In aggregate, the Chinese economic slowdown and the country’s rotation to a more consumer-oriented economy from direct investment have been big headwinds to base metals demand and sentiment. Lower oil prices and the stronger U.S. dollar, particularly against floating emerging market currencies, have also been a distinct negative.

Despite this, the industrial metals index was down only 6.5% in 2014 and was actually higher midyear until oil went materially lower. In our view, this outperformance demonstrates that base metals overall are further along in the supply-adjustment cycle than energy is.

For 2015, we see competing impulses of lower oil prices reducing production costs versus a better U.S. economy and the potential for China to advance infrastructure investment to ensure adequate economic activity. With production growth likely having peaked, we expect metals prices to stabilize this year.

On balance, we are neutral on commodities in 2015
In aggregate, we expect a year of only moderate returns in commodities, with gains in oil offset by declines in other sectors like natural gas, agriculture and precious metals. A stronger dollar and continued low global inflation, both of which have weighed on commodities over the last several months, are likely to remain headwinds for performance in 2015. Still, we continue to view commodities as a good diversifier and a potent inflation hedge in a broader portfolio of stocks and nominal bonds, both of which have a negative inflation beta.

All investments contain risk and may lose value. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world.

©2015, PIMCO.

[description] => Today’s low oil prices should allow for supply and demand to come back into alignment by year-end, led by a decline in the U.S. output growth rate and a modest increase in global demand. We expect continued oversupply to weigh on natural gas prices this year, but some semblance of balance may return to this market in 2016. Grain prices may experience pressure in 2015 as low oil prices pass through to corn prices, which may cause producers to switch to higher-priced crops. With production growth likely having peaked, we expect metals prices to stabilize this year. [author] => Nicholas Johnson, Greg Sharenow [legacyinterface_firm_id] => 335 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 16:53:04 [created_by] => 948 [modified_on] => 2015-01-29 16:53:23 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2460 [hits] => 0 ) [5] => stdClass Object ( [legacyinterface_commentary_id] => 2395 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15631 [apv_conversation_id] => 3367 [content_type] => market-commentary [title] => What's Up? Quantitative Easing and Inflation [slug] => research_012915 [fulltext] =>

The Fed has ceased its program of quantitative easing (QE) and may soon begin to raise interest rates. Japan has embarked on an even more aggressive program of QE. The European Central Bank (ECB) has just begun QE. In a related development, the Swiss National Bank (SNB) recently stopped pegging the Swiss franc to the euro. Many investors are asking, “What does all this monetary turmoil mean?” 

 

It’s no wonder investors are perplexed. QE’s direct and indirect effects are complex, and the fact that various polities are at different stages of implementation doesn’t make it any easier to understand the dynamics. I don’t have all the answers, but I will try to explain QE in plain language, why central banks have adopted it, and how it can affect inflation and security prices. I’ll also comment on what’s happening now. 

 

Central Banking 101

In the normal functioning of a fractional reserve banking system (McLeay et al., 2014), commercial banks create money when they take deposits and make loans. Central banks limit the amount of money that commercial banks can create by managing reserve requirements. They provide liquidity to the banking system by lending directly to banks through the discount window. Central banks also influence interest rates and the pace of money creation by buying and selling securities through open market operations.

 

The primary objective and typical standard of success for central banks is stable prices. Price stability no longer means zero inflation; it is seen as a low and steady inflation rate, along with stable expectations of future inflation. For small countries with large trade sectors, the foreign exchange value of the currency may be a better measure of price stability. In the extreme, small countries sometimes choose to adopt exchange-rate stability as a primary objective and peg their currency to a larger global currency, such as the U.S. dollar or euro.

 

Executing monetary policy becomes trickier with additional objectives. The Fed, unlike other central banks, has a dual mandate of maintaining stable prices and fostering maximum employment. All central banks share financial market stability as an objective. Perhaps the most important function of a central bank is lender of last resort.

 

Quantitative Easing

QE is a policy consisting of large, sustained, and publicly announced programs of open market operations (The Economist, 2014). QE is not money creation; it’s more accurately described as reserve creation. A central bank buys securities and pays for them with bank reserves (liabilities of the central bank and assets of commercial banks), thereby increasing the central bank’s balance sheet and the reserves of its member banks.

 

The linkage between QE and the money supply is indirect. Banks will use new reserves to create money, but only when reserves are an active constraint on lending. When banks do not wish to lend and/or borrowers do not wish to borrow, then reserves are an inactive constraint. When banks seek to increase their capital and borrowers strive to pay down their debts, QE does not increase the money supply and therefore does not cause inflation. When reserves are an inactive constraint on borrowing and lending, a central bank engaged in buying securities is said to be “pushing on a string.”

 

Has QE succeeded? The answer depends on the central bankers’ intentions—their objective for adopting a policy of QE in the first place (Samuelson, 2014). During the global financial crisis (GFC), the first round of QE seems to have been effective in averting a financial collapse.1 A central bank can act as lender of last resort by making loans directly to individual banks through its discount window. During the GFC, however, many distressed financial institutions were not banks and so did not have access to the discount window. In addition, the banks that did have access hesitated to borrow because of the stigma attached to demonstrating a need for government support. Through QE, the Fed and the Bank of England (BOE) provided liquidity to the financial system by buying large quantities of securities from the market rather than waiting for banks to show up at the discount window.

 

Beyond providing the liquidity necessary to avoid financial panics and bank runs, can QE increase economic output and employment? On this question the evidence is distinctly mixed. Certainly, a central bank can hold interest rates lower than market-determined levels, in the process inflating capital asset prices. We have many examples, both historical and current, of central banks engineering capital asset price appreciation (Kindelberger and Aliber, 2011).

 

Some believe that, when an economy is operating below its potential growth rate, lowering interest rates to inflate capital asset prices indirectly stimulates the economy through a wealth effect: People who own stocks, bonds, and houses will spend more if they feel wealthier. Others worry that intentionally inflating capital asset prices distorts markets, creates bubbles, and leads to malinvestment. Arbitrating this question, which harks back to the debate between John Maynard Keynes and Friedrich von Hayek, is beyond the scope of this article. Nonetheless, it is possible that both are right.

 

Money Printing

Money printing is different from QE. Money printing is inflationary by definition. If the central bank rapidly prints a lot more currency and immediately puts it into circulation, then more money is chasing the same amount of goods and services. The hyperinflation Zimbabwe experienced in the 1990s is a memorable example. A central bank could distribute the newly printed currency directly by dropping it from a helicopter, as in Milton Freidman’s thought experiment (Friedman, 2005), repeated by Ben Bernanke in his famous 2002 speech. More likely in the 21st century, a central bank would opt for the electronic version of printing money by crediting the checking accounts of private citizens and/or government agencies.

 

A central bank may monetize the national debt—and facilitate increasing the deficit—by purchasing newly issued government bonds with the proceeds transferred into the checking accounts of government agencies.2 This, too, amounts to printing money. In other words, QE plus substantial fiscal stimulus is money printing and may cause inflation.

 

What’s Happening Now?

The United States and the United Kingdom adopted QE at the onset of the GFC. They did not pair QE with fiscal stimulus. They did not increase government deficits; the reverse is true. Banks chose to hold the proceeds of QE as excess reserves rather than increasing their pace of lending and thereby creating money. While QE was in progress, the Fed and the BOE were pushing on a string. 

 

In these circumstances, QE is not inflationary. It may become inflationary if it achieves its intended purpose of stimulating more economic activity by fueling bank lending and money creation. Indeed, many are concerned that, if and when loan demand accelerates, the Fed and the BOE will need to drain the excess reserves created by QE from the system in order to avoid rapid money creation and inflation.

 

Others are less worried because of another recent monetary innovation—paying interest on reserves (Cochrane, 2014). By paying interest on reserves, central banks can raise rates as required to prevent inflation without reducing their balance sheets and shrinking the excess reserves of member banks. Why would a commercial bank lend to risky private clients at a rate below what it can earn risk-free by holding reserves at the central bank? In practice, monetary policy conducted by paying interest on bank reserves is untested. Even if the economics are sensible, the politics of such a transfer of wealth by the central bank to commercial banks seem awkward at best.

 

The ECB just started QE. Because of the concern about already unsustainable levels of government debt, Europe appears unlikely to pair this QE with fiscal stimulus. The ECB will probably be pushing on a string, as were the Fed and BOE. This is why Paul Krugman bemoans austerity in Europe (Krugman, 2014).

 

Japan, however, appears to be flirting with a more aggressive form of debt monetization, combining QE with increasing fiscal deficits. The country seems close to testing what happens to a modern developed economy when it intentionally chooses money printing as its macro-economic policy. Watch Japan.

 

Endnotes

1. I say “seems to have been” rather than definitively “was” because we cannot know the counterfactual.

2. A central bank can also monetize the debt in another, somewhat more benign manner: funding deficit spending by purchasing outstanding government bonds and returning the cash flows to government agencies.

 

References

Bernanke, Ben S. 2002. “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” Remarks before the National Economists Club, Washington, D.C. (November 21). Available at http://www.federalreserve.gov/boarddocs/Speeches/2002/20021121/default.htm

 

Cochrane, John. 2014. “A Few Things the Fed Has Done Right.” Wall Street Journal (August 21). Available at http://johnhcochrane.blogspot.com/2014/09/a-few-things-fed-has-done-right-oped.html

 

The Economist. 2014. “What Is Quantitative Easing?” The Economist Explains (January 14). Available at http://www.economist.com/blogs/economist-explains/2014/01/economist-explains-7

 

Friedman, Milton. 2005. The Optimum Quantity of Money, Revised Edition. Chicago: Aldine Transaction.  

 

Kindleberger, Charles P., and Robert Z. Aliber. 2011. Manias, Panics and Crashes: A History of Financial Crises, Sixth Edition. New York: Palgrave Macmillan.

 

Krugman, Paul. 2014. “What’s the Matter With Europe?” New York Times (August 13). Available at http://krugman.blogs.nytimes.com/2014/08/13/whats-the-matter-with-europe/

 

McLeay, Michael, Amar Radia, and Ryland Thomas. 2014. “Money Creation in the Modern Economy.” Bank of England Quarterly Commentary (First Quarter). Available at http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf

 

Samuelson, Robert. 2014. “Did the Fed’s QE Actually Help?” Real Clear Markets (November 10). Available at http://www.realclearmarkets.com/articles/2014/11/10/did_the_feds_qe_actually_help__101383.html

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Disclaimer

The information, tools and material presented herein are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities, investment products or other financial instruments, nor to constitute any advice or recommendation with respect to such securities, investment products or other financial instruments. This research report is prepared for general circulation. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. You should independently evaluate particular investments and consult an independent financial adviser before making any investments.

Almost a year ago we identified the late cycle symptoms in sector rotations, leading indicators and US treasuries term structure. We briefly review where we stand and conclude that it does not look pretty.

We first identified the late cycle symptoms and analyzed them in details almost a year ago.[1][2] Let us revisit some of the most striking and ongoing developments.

Sector Rotation

First let us cast a glance at the sector performance since our spring 2014 call. In a typical late cycle transforming into recession environment the best performing sectors are utilities, consumer staples and healthcare.[3]

Indeed this is what we see in the market with healthcare (IXV), consumer staples (IXR) and especially utilities (IXU) drastically outperforming the SPX (ES). Also, two of the three usual underperformance suspects underperformed indeed (consumer discretionary and industrials, but not technology).

Now let us look at the sector rotations. According to our research[4] at the level of sectors US equity market is essentially driven by four factors:

- Market itself (SPX)

- Late/early cycle sector rotation (energy vs discretionary)

- Recession sector rotation (staples+utilities vs technology+industrials)

- Growth/value sector rotation (growth vs value)

Late/early sector rotation factor (long energy and materials, short technology and consumer discretionary) has thrown a strange fit rising this spring (late cycle symptom) and falling since (early cycle symptom). It was driven by oil price of course and more intertwined with global developments. Nonetheless the movements were drastic and clearly directional.

Recession sector rotation factor (long utilities and consumer staples, short technology and industrials) is on the rise (though sporadic) since its bottom in January 2014.

Growth vs Value sector rotation factor (as exemplied by the Citigroup Growth minus Citigroup Value combo) is actually on the rise (red line on the chart below).

But when adjusted for SPX and late/ealy sector rotation factor it turns out to be stagnant since the beginning of the summer (aquamarine line on the chart above).

Yield Curve

We mentioned possible yield curve flattening and level downslide about a year ago.[5] It has been ongoing since then. Here is the level (red) and steepening (green) factor.

Both are sliding since December 2013 as well as cumulative factor for TIPS forward rates shown below

Leading Indicators

We reviewed global leading indicators in great details recently[6] so below we will just briefly review the conventional leading indicator (which we comprise of manufacturers new orders for non-defense capital goods, 4-week moving average of initial claims, PMI new orders, average weekly hours of production and non-supervisory employess in manufacturing).

Conclusion

Here are the overall US growth (red) and inflation (green) factors constructed from the large US dataset. Clearly due to oil the inflation factor is losing bottom.

The conclusion is not obvious though yield curve term structure is telling. Supposedly it all depends now on how serious the FED ongoing commitment to raise short term rates is.

As usually, let us watch the developments carefully and risk manage accordingly.

© Dynamika Capital L.L.C.



[1] Dynamika Commentary, “Watch out for the late cycle symptoms”, 30 March 2014

[2] Dynamika Commentary, “Monitoring the late cycle symptoms”, 1 June 2014

[3] Dynamika Commentary, “Where are we in the business cycle?”, 17 November 2013

[4] Dynamika Commentary, “Sector Rotations”, 3 October 2014

[5] Dynamika Commentary, “Where do the leading indicators lead?”, 28 February 2014

[6] Dynamika Commentary, “Unsettling interplay of leading indicators”, 24 December 2014

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No one expected the Federal Reserve to make any changes to monetary policy at today’s meeting and there were no surprises. The Fed continued to say it would be “patient” before raising short-term interest rates, which means the Fed is very unlikely to raise rates through at least April.

However, the Fed did make some noticeable changes to the language in the statement, upgrading its assessment of both economic growth and the labor market, while recognizing both lower inflation (due to falling energy prices) and lower market-based measures of inflation expectations. Ultimately, though, the Fed’s forecast is that the eventual end of energy price declines as well as the improving labor market will push inflation back up toward its target of 2%.

Unlike the past several meetings, this one appears to have been much less contentious. Three voting members dissented at the December meeting; this time, no one dissented, the first time that’s happened since the meeting in June 2014. Both the hawks and doves who previously dissented are no longer voting members this year.

All of this is consistent with our view that the Fed is still on track to start raising rates in June. It is unlikely to raise rates at every meeting, as was done in the past two prolonged rate hike cycles under Alan Greenspan in the late 1990s and Ben Bernanke in the middle of the prior decade. Instead, the Fed will probably raise rates at every other meeting for the first year, before embarking on a more aggressive path in the second half of 2016 and beyond.

Another issue is when the Fed’s balance sheet will go back to normal. We’re still forecasting that the Fed will keep reinvesting principal payments from its asset holdings to maintain the balance sheet at roughly $4.4 trillion through at least late 2015.

The bottom line is that while the Fed is still behind the curve, it’s at least finally pointed in the right direction, and, barring some major shift in its outlook for the economy, the clock is ticking on rate hikes. Nominal GDP – real GDP growth plus inflation – is up 4.3% in the past year and up at a 4.0% annual rate in the past two years. A federal funds target rate of nearly zero is too low given this growth. It’s also too low given well-tailored policy tools like the Taylor Rule.

In the meantime, hyperinflation is not in the cards; the Fed will keep paying banks enough to keep the money multiplier depressed. But, given loose policy, we expect gradually faster growth in nominal GDP for the next couple of years. In turn, the bull market in equities will continue and the bond market is due for a fall.

 This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy. 

© First Trust Advisors

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As 2015 unfolds, we think the stage of the economic cycle in the U.S., as well as what is happening to global competitors, could prove beneficial for small-cap stocks.

After a prolonged period of economic fits and starts, 2014 may eventually be remembered for the domestic economy breaking through and investors recognizing the recovery as having staying power. The year saw persistent declines in the U.S. unemployment rate and a positive-sloping yield curve typically associated with continued growth. The Institute for Supply Management’s much watched Purchasing Managers’ Index (PMI) also paints a steady picture of economic activity with 19 consecutive months of readings above 50, indicating an expanding economy.

As the chart below illustrates, when expansions begin to reach maturity, historically small-caps have outstripped their larger counterparts. The reasons they do well can vary, but include their nimbleness to adapt to changing client needs and their attractiveness to firms looking for acquisition targets to boost sales volume in a maturing environment.

Given the murky global picture, we believe smaller stocks may have an additional catalyst for outperforming larger names. While the U.S. appears to have crossed the hurdle of a sustainable upward trajectory, leaders in Europe are looking to monetary policy to revive a moribund situation. Japan recently slipped back into recession territory after a tax hike in April. China, too, has seen its growth prospects flag, which is having a ripple effect around the world.

Not surprisingly, the relative strength at home has led to a strengthening dollar as foreign investors look for safe havens to put their money to work. Last year, the Euro lost 11.97% of its value relative to the U.S. dollar and the Yen was down 13.74%. As a result, domestic products will likely face competitive headwinds abroad from a pricing perspective. Similarly, revenues generated overseas could contribute less to the bottom line. These trends are likely to have the greatest impact on larger companies.

As represented by the S&P 500, more than 46% of all sales* in 2013 were derived from outside the United States. In contrast, constituents in the Russell 2000® Index generated approximately 16% of their revenues** in 2013 from abroad. During the latest complete fiscal year, Russell 2000® constituents reported 26.4% of their sales*** came from foreign markets. Given the relatively low level of income smaller companies generate outside of U.S. borders, we believe they are poised to benefit from a stronger domestic currency.

*“Bears Stalk the ‘Goldilocks’ Stock Market,” Tom Lauricella, The Wall Street Journal, 10/11/2014
**“Russell Investments Small Cap Perspectives,” Russell 2000® Index Quarterly Analysis, 12/31/2013
***FactSet Research Systems Inc. and Heartland Advisors, Inc., as of 1/20/2015

Disclosure:

Past performance does not guarantee future results.

The statements and opinions expressed are those of the author. Any discussion of investment strategies represent the portfolio manager’s views when presented and are subject to change without notice. Investing involves risk, including the potential loss of principal. There is no guarantee that any particular investment strategy will be successful. Economic predictions are based on estimates and are subject to change.

Data sources from FactSet: Copyright 2015 FactSet Research Systems, Inc., FactSet Fundamentals. All rights reserved.

Definitions: ISM Manufacturing PMI (Purchasing Managers Index): is an index based on surveys of more than 300 manufacturing firms by the Institute for Supply Management (ISM). The PMI index is an indicator of the economic health of the manufacturing sector based on five major indicators: new orders, inventory levels, production, supplier deliveries, and the employment environment. A reading under 50 represents a contraction, while a reading at 50 represents no change. Yield Curve: is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. In a positive-sloping yield curve, short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. A negative, or inverted, yield curve occurs when short-term debt instruments have a higher yield that long-term debt instrument of the same credit quality. Russell 2000® Index: includes the 2000 firms from the Russell 3000® Index with the smallest market capitalizations. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of the Frank Russell Investment Group. S&P 500 Index: is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. All indices are unmanaged. It is not possible to invest directly in an index.

CFA is a trademark owned by the CFA Institute.

©2015 Heartland Advisors

2015008

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The Federal Open Market Committee (FOMC) concluded its meeting on an optimistic note. There were no dissents, following three at the December 2014 meeting. 

Key points from today’s statement:

    1. FOMC members, for the first time since the Great Recession, view the current expansion as “solid.” They assessed the pace of activity as “moderate” at the previous meeting.
    1. The Fed noted that job gains were “strong,” another first for the current expansion. But it left unchanged the reference to underutilization of labor resources.
    1. Low inflation readings are seen to reflect mostly a decline in energy prices. Inflation is expected to head lower in the near term and then move gradually toward the Fed’s 2.0% target as the “transitory” influence of lower energy prices dissipates and labor market conditions improve.
    1. The Fed continues to differentiate between market-based and survey-based inflation expectations, with the latter seen as stable.
    1. The Fed did away with the “considerable time” phrase. It retained the language indicating it can be “patient” in normalizing interest rates.
    1. The statement notes that “international developments” are another factor that will influence its evaluation of progress toward the dual mandate of full employment and price stability.
    1. Although the Fed noted that economic activity is solid, the forward-looking statement mentions that it expects economic activity to expand at a “moderate” pace. The Committee also sees risks to the economic outlook as evenly balanced.
  1. We continue to expect monetary policy tightening to commence in September 2015.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

© Northern Trust

[description] => The Federal Open Market Committee (FOMC) concluded its meeting on an optimistic note. There were no dissents, following three at the December 2014 meeting. [author] => Team [legacyinterface_firm_id] => 317 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 17:52:19 [created_by] => 948 [modified_on] => 2015-01-29 17:52:33 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2465 [hits] => 0 ) [10] => stdClass Object ( [legacyinterface_commentary_id] => 2400 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15637 [apv_conversation_id] => 3373 [content_type] => market-commentary [title] => Games People Play [slug] => janus_012915 [fulltext] =>

My mother taught me how to play Monopoly – the game – and the markets over 40 years past have taught me how to play Monopoly – the financial economy. Financial markets and our finance-based economy are actually quite similar to the game in terms of the rules and strategies it takes to win. Monopoly’s real-time bank (the Fed) distributes money to players at the beginning and then continues to create more and more credit as the economy passes go. The cash in Monopoly isn’t credit and the player can’t borrow, so in this respect the game and the reality are quite different, but the addition of cash liquifies the player in a similar way that the Fed creates money out of thin air to liquify today’s finance-based system and create growth in the real economy.

Good players know that it is critical to move quickly around the board, make acquisitions and then develop the properties by creating hotels. Three hotels on each property are desirable and of course as every Monopoly pro knows, it’s not Boardwalk or Park Place that are the key holdings but the Oranges and the Reds. Same thing in reality’s markets, I would suggest. Which companies and which investments to overweight and how much leverage to use usually point to the eventual winners. But an ample amount of cash is important as well as you land on other owners’ properties. You need liquidity to pay rent or service debt – otherwise you sell assets at a discounted price and are swiftly out of the game. That reminds me of Lehman Brothers and its aftermath. Early in Monopoly, property is king but later in the game, cash becomes king and those without cash and the ability to get it go bankrupt.

It appears however, that since 2008 the rules of the finance-based economy have been substantially changed. Perhaps Parker Brothers will have to come with a new version of its own which incorporates the modern day methodology of central banks using Quantitative Easing and the outright purchase and occasional guarantee of private securities and public stocks to keep the game going. It’s as if Monopoly’s bank, which has a limited amount of 1, 5, 10 … dollar bills in each game box had “virtually” added trillions of dollars more in order to keep players solvent, in the hopes that some of it would trickle out to the real economy. With interest rates near zero and banks and other financial intermediaries sitting on trillions of Dollars, Euros, and Yen, why wouldn’t they lend it out to the private economy in hopes that they could obtain a higher return on their money? Sounds commonsensical, doesn’t it? Not in reality.

Well to be fair, in some cases and some countries they have. Bank loans in the U.S., for instance, are currently growing at 8% year over year and our economy appears to be growing at a 3% real and nominal growth rate with inflation at 0%. Still, even with the U.S. growing at an acceptable rate for now, its recovery over the past 5 years has been anemic compared to historic norms, and other developed economies are faring much worse. Many appear to be facing new recessions even with interest rates at 0% or – incredibly – negative rates. German and Swiss 5 year yields cost the lender money. Surreal to say the least. Before 2008, economists and historians would not have believed such a condition could exist, but here it is with individual sovereign countries and their respective central banks pushing each other out of the way in a race to the bottom of interest rates – wherever that is – and a race to the bottom in terms of currency valuations. Central bankers claim that they are doing no such thing, but that bravado should be dismissed out of hand. You can’t accuse them of lying but you can accuse them of distorting reality.

If all of them collectively could be labeled “Parker Brothers,” like the creator of the board game,players would be justified in saying that competitive devaluations and the purchase of bonds at near zero interest rates is indeed a significant distortion of the markets and – more importantly – capitalism’s rules which have been the foundation of growth for centuries, long before Parker Brothers central bankers came into existence in the early part of the 20th century. Even as the financial system morphed from the gold standard, to the Bretton Woods Dollar standard in 1944, and then the abandonment of any standard in 1971, capitalism seemed to be on firm ground. Incentives to lend, borrow, and invest for a profit were never challenged on a secular basis prior to 2008, except in Japan. There may have been recessions where such an appeal was eliminated at the margin, but no – capitalism was king. It was, as Francis Fukuyama proclaimed, “The End of History” – game, set, match – as Communism and other similar economic systems headed for the trash bin.

But the distortions created by post 2008 Parker Brothers have called Fukuyama’s forecast into question. There can be no doubt that negative or even zero percent interest rates cannot be a permanent rule on Monopoly’s new board. Investors and game players do not logically give money away; a mattress ultimately becomes a more attractive haven. And most importantly – because the markets and the financial sector are ultimately the servants of the real economy – growth is challenged and stunted.

In a new world, returns on real investment – ROI’s and ROE’s – become so low that the risk of a new project or the purchase of green hotels offer too little return for too much risk. Like the endgame in Monopoly where cash becomes king at the game’s conclusion, cash accumulates in corporate coffers or is used to repurchase stock in the financial economy. Investment in plant and equipment is deferred. Structural headwinds such as aging demographics and abnormally high debt/GDP ratios do not offer the player a “get out of jail free” card, in fact they help keep the cell door closed. Hope is challenged.

In the final analysis, while there is no better system than capitalism, it is incumbent upon it and its policymakers to promote a future condition which offers hope as opposed to despair. Capitalism depends on hope – rational hope that an investor gets his or her money back with an attractive return. Without it, capitalism morphs and breaks down at the margin. The global economy in January of 2015 is at just that point with its zero percent interest rates.

Officials at the Federal Reserve – the most powerful and strongest of Parker Brothers – seem to now appreciate the hole that they have dug by allowing interest rates to go too low for too long. Despite reasonable growth, some of them recognize the system’s distortion if only because inflation is going down, not up, in the process. Other Parker Brothers countries face deflation in the midst of negative interest rates. But the Fed, uniquely in my opinion, will move up the Monopoly board’s interest rates in late 2015, hoping to avoid landing on the figurative Park Place and Boardwalk in the process. It won’t however, move quickly – capitalism has been damaged by the change in rules since 2008. Caution, therefore will prevail in the U.S. and elsewhere for a long time. Bonds despite their ridiculous yields will not easily be threatened with a new bear market.Investors should expect as well, that because of the slow unwinding of zero percent rates in the U.S., that U.S. and global stocks will be supported. Their heyday is over however. In effect, equity holders now own the Greens, the Blues and the railroads on Monopoly’s board while the Reds and the Oranges belong to another era. Returns in the real economy are too low partially because of the misguided efforts of Parker Brothers bankers. There is no doubt that structural secular stagnation factors such as demographics, high debt, and technology have contributed significantly as well. Fiscal policy has been anemic since 2010.

In the final analysis, an investor – a player – must be cognizant of future low and in some cases negative total returns in 2015 and beyond. Capitalism’s distortion, with its near term deflation, poses a small but not insignificant risk to what my mother warned was the final destination for all games – entertainment or real. “In the end,” she said, “all of the tokens, all of the hotels, all of the properties – they all go back in the box.” The strong odds are that 2015’s distorted capitalism continues with anemic growth, but the box rests on the family room coffee table, waiting, waiting, for its turn.

-William H. Gross

© Janus Capital Group

[description] => My mother taught me how to play Monopoly – the game – and the markets over 40 years past have taught me how to play Monopoly – the financial economy. Financial markets and our finance-based economy are actually quite similar to the game in terms of the rules and strategies it takes to win. Monopoly’s real-time bank (the Fed) distributes money to players at the beginning and then continues to create more and more credit as the economy passes go. [author] => William Gross [legacyinterface_firm_id] => 242 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 17:54:44 [created_by] => 948 [modified_on] => 2015-01-29 17:54:58 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2466 [hits] => 0 ) [11] => stdClass Object ( [legacyinterface_commentary_id] => 2401 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15638 [apv_conversation_id] => 3374 [content_type] => market-commentary [title] => U.S. Long Bond: Panic Buying [slug] => charter_012915 [fulltext] =>

The demand for long-term Treasury bonds has reached panic proportions.  A casual inspection of price history suggests that the rally since December 2013 is “too steep, too fast.”  An alternative measure of intensity – the ratio of 30-year to 10-year bond prices – is also flashing red.  The price of 30’s relative to 10’s is rising at a pace not seen since the panic of 2008.  Can an important top be far ahead?   

 

© Charter Trust Company

[description] => The demand for long-term Treasury bonds has reached panic proportions. A casual inspection of price history suggests that the rally since December 2013 is “too steep, too fast.” An alternative measure of intensity – the ratio of 30-year to 10-year bond prices – is also flashing red. The price of 30’s relative to 10’s is rising at a pace not seen since the panic of 2008. Can an important top be far ahead? [author] => Mark Ungewitter [legacyinterface_firm_id] => 81 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 17:56:20 [created_by] => 948 [modified_on] => 2015-01-29 17:58:51 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2467 [hits] => 0 ) [12] => stdClass Object ( [legacyinterface_commentary_id] => 2402 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15639 [apv_conversation_id] => 3375 [content_type] => market-commentary [title] => Advice for Investing in Today’s Volatile Markets: 5 Points [slug] => calamos_012915 [fulltext] =>

Yesterday, I appeared as a guest on CNBC’s “Closing Bell.” One of the topics we discussed was market volatility and the role of lower-volatility equity strategies, which seek to avoid downside without foregoing the opportunity to participate in stocks’ upside. The interview was similar to many of the recent conversations that I’ve had with investors. Here are some of the key points I’ve been making in these conversations.

In my view:

  1. Volatility will likely continue at an elevated level. Falling commodity prices, global growth fears and political uncertainties in the euro zone are among the factors that will add to volatility in the markets over these next months.
  2. The U.S. stock market can continue to advance for 2015. The U.S. economy looks set to continue its expansion, supported by accommodative Fed policy, healthy job growth, and good corporate profit growth. Valuations are attractive by a number of our favored measures, and especially for growth companies.
  3. Investors need to look through the short-term volatility and position their portfolios proactively and strategically. Downside protection is important. Investors need to settle into an allocation that won’t tempt them to market time or sell into weakness.
  4. Diversification is important—but bonds aren’t necessarily the right answer, or the only answer. We believe there are risks in the bond market. Short-term rates may stay low through much of 2015, as the Fed takes a “patient” approach. Even so, it’s important to remember when rates move, they can move quickly and take investors by surprise. Also, many factors can influence long-term rates, beyond what the Fed does.
  5. Lower-volatility equity approaches are especially well suited to this environment. What can investors do if they are concerned about market downside but don’t want to abandon their long-term goals? I believe strategies that include both stocks and convertibles can be especially advantageous for investors who are struggling with the “afraid to be in the market, afraid to be out of the market” dynamic. 

    Convertible securities combine stock and bond attributes, providing the opportunity for upside participation and downside protection. More specifically, convertibles can benefit from upwardly rising stock markets because they are equity sensitive, while their fixed income attributes may provide a floor of sorts when the stock market is volatile. Compared to traditional fixed income securities, they are less sensitive to interest rates, so investors may not have to scramble when rates do begin to rise. However, because all convertibles do not have the same upside and downside attributes, they must be actively managed to provide the right risk/reward balance between upside participation and potential downside protection.

For a closer look at how we pursue lower-volatility equity participation, please see my paper, “Asset Allocation Strategies for Volatile Markets.”

Asset allocation and diversification do not guarantee investment returns and do not eliminate the risk of loss.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The information in this report should not be considered a recommendation to purchase or sell any particular security. Convertible securities entail credit risk and interest rate risk. The price of equity securities may rise or fall because of changes in the broad market or changes in a company's financial condition, sometimes rapidly or unpredictably. Equity securities are subject to "stock market risk" meaning that stock prices in general may decline over short or extended periods of time.

18058a 0115O C

© Calamos Investments

[description] => In my view: (1) Volatility will likely continue at an elevated level. Falling commodity prices, global growth fears and political uncertainties in the euro zone are among the factors that will add to volatility in the markets over these next months. (2) The U.S. stock market can continue to advance for 2015. (3) Investors need to look through the short-term volatility and position their portfolios proactively and strategically. (4) Diversification is important—but bonds aren’t necessarily the right answer. (5) Lower-volatility equity approaches are especially well suited to this environment. [author] => John Calamos [legacyinterface_firm_id] => 487 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 18:15:54 [created_by] => 948 [modified_on] => 2015-01-29 18:16:15 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2468 [hits] => 0 ) [13] => stdClass Object ( [legacyinterface_commentary_id] => 2403 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15640 [apv_conversation_id] => 3377 [content_type] => market-commentary [title] => Municipal Market Update: What’s Ahead in 2015 [slug] => pimco_012915a [fulltext] =>
  • Municipal bonds ended 2014 as one of the best-performing asset classes - buoyed by investors' search for yield in a low interest-rate environment. For 2015, we are positioned cautiously for greater volatility in the fixed income markets.
  • We currently prefer revenue-backed bonds over most general obligation (GO) debt, as these sectors typically benefit from dedicated revenue streams and do not have the pension challenges that many state and local governments face.

Joe Deane, head of municipal bond portfolio management at PIMCO, portfolio manager Julie Callahan, and Sean McCarthy, head of the municipal credit research team, discuss munis’ strong showing in 2014, our outlook for credit and what we expect in the year ahead.

Q: What factors contributed to the great year municipal bonds had?
Joe Deane: Municipal bonds surprised many by ending the year as one of the best-performing asset classes – buoyed by investors’ search for yield in a low interest-rate environment. The Barclays Municipal Bond Index was up 9.05% for the year and this strong performance was attributable to a combination of factors.

Demand turned positive in the first quarter of the year from returning retail investors, who had pulled out of the market in 2013, and continued to improve throughout 2014. Municipal mutual funds received $21.4 billion in net inflows for the year – compared with outflows of $62.7 billion in 2013. Crossover investors such as banks and insurance companies also took advantage of attractive relative valuations, particularly early in the year. This returning demand was coupled with low market supply as municipalities remain reluctant to take on additional debt – even at today’s very low rates. Total supply of $335 billion for the year ended in line with 2013 levels, but aggregate new money issuance declined year over year and remains well below pre-recession levels.

Improving perceptions of credit risk in the municipal market have also been additive. The market was rattled midyear by a spate of downgrades in Puerto Rico, but since then, the commonwealth has bought itself some time with new debt issuance, and negative credit headlines have largely receded for the time being. It’s important to note that many state and local governments are still grappling with substantial unfunded pension liabilities, but it will likely take some time before the effects of this come to light. In the meantime, the market has seen some positives, including California’s rating upgrade, following voters’ passage of Proposition 2, which establishes a rainy day fund for the state, and improving tax revenues across a number of states, stemming from the strengthening U.S. economy.

Q: Sean, would you elaborate on Puerto Rico and discuss PIMCO’s outlook for credit more broadly?
Sean McCarthy: The Puerto Rico credit story continues to evolve, with the economy moving sideways as the government strives to address its fiscal and debt crisis. The market anticipates a $2.9 billion petroleum tax deal late first quarter which will support efforts to ring-fence the island’s central government from a key public agency. This is the second time in 12 months that Puerto Rico has urgently needed to print a new transaction to bolster the central government’s liquidity position.

The successful placement of the petroleum tax-backed deal may allow Puerto Rico’s current administration another fiscal year to address remaining budgetary challenges and implement comprehensive tax reform. However, the island has additional near-term refunding needs that must still be addressed, and a restructuring of the publicly-owned electric utility is likely in the next several months. We also believe there are increased risks related to the execution of policy and reform ahead of the island’s elections in 2016.

Looking beyond Puerto Rico, credit quality across state and local municipalities is expected to continue to improve in 2015. States are still exhibiting fiscal restraint, but are expected to modestly expand general fund expenditures in the 2015 and 2016 fiscal years. Conditions have improved due to increased economic activity and several years of revenue, aided in some instances by temporary tax measures taken to close structural budget deficits. However, recovery from the recession has been slower than typical and several states must contend with mandatory spending requirements and rising costs related to an aging population. There are also several states that have still not taken decisive steps to combat their large and growing unfunded pension and other post-retirement debt burdens. And many of these same actors are experiencing a tepid economic recovery. We expect retirement obligations will continue to be a major credit theme and will have an adverse effect on the credit quality of several key states in 2015 and beyond. In addition, recent changes imposed by the Governmental Accounting Standards Board (GASB) are likely to reveal that pension burdens are greater than previously reported.

Local government credit quality is also improving, but the recovery is slower than in the states, due in part to a lag in the frequency of assessments affecting property tax collections and an uneven recovery in housing across regions of the U.S. Local government agencies must also contend with large unfunded retirement obligations and often have less revenue flexibility to adjust to higher cost structures versus the states. In many instances, local government agencies are also adjusting to reduced intergovernmental transfers from the state relative to pre-recession levels.

Finally, we would note that the sharp drop in crude oil from June 2014 highs is likely to have a bifurcated effect on state and local government credit quality. The drop in crude to current levels is the equivalent of a tax cut for consumers at the gas pump, which could contribute to increased sales tax receipts and benefit certain municipal asset classes, including toll roads. On the other hand, the drop in crude will result in some budgetary stress for the energy-producing states, but we believe that this pressure will be absorbed over the current and following fiscal year as the states make necessary midyear adjustments. In addition, the largest U.S. energy-producing states either have ample budgetary reserves or depend less on oil and gas revenues to fund their operating budgets, as severance taxes collected on the extraction of oil and gas are often used to fund capital projects or reserves. There may be some isolated pockets of stress for local municipalities and counties in regions with a high dependence on energy. These communities may be affected by layoffs and a reduction of capital spending by drilling companies, and lower property tax collections from parcels with wells that are shuttered.

Q: Julie, why is active management so important in this market environment, especially in the context of the ladder strategies that you manage?
Julie Callahan: As Joe and I have discussed previously, today’s municipal market is large, fragmented and localized, with over $3.6 trillion in outstanding debt among more than 78,000 municipal issuers.* The financial crisis essentially transformed this vast market from a Treasury-centric market – with widespread use of insurance – into a credit market. Now, municipal issues trade to the strength of their underlying creditworthiness, making active management and credit due diligence much more important today.

This is part of the reason we’ve seen such success with our municipal ladder strategies. Many financial advisors, who had assembled and managed their own municipal bond ladders in the past, are turning to active managers like PIMCO because they don’t have the resources to conduct the rigorous credit due diligence that’s needed on their own. We currently manage $3.5 billion in ladder strategies (as of December 31, 2014), and our credit team has independently analyzed and rated every security in our portfolios.

Importantly, at PIMCO, our investment process has never relied on insurance or external credit rating agencies. Instead, we employ rigorous and ongoing credit analysis at both the issuer and obligor levels and have our own internal rating system – our analysts develop their own ratings, including their outlook on how those ratings might develop over the year. This forward-looking approach helps to mitigate credit risk and volatility across all of our municipal bond portfolios and was the reason we began to de-risk the Puerto Rico positions in our tax-exempt dedicated national and state-specific portfolios in 2011 – long before the island’s debt saw significant price declines.

Also, as Joe and Sean both mentioned, there are state and local budgetary problems that will play out over a long time horizon. Because investors in ladder strategies allocate a portion of their portfolios to longer-maturity municipal bonds and primarily expect to buy and hold these positions, they need to be confident that their investment manager’s credit research is forward-looking, so they don’t have unpleasant portfolio surprises five years from now.

Additionally, with rates expected to rise in the latter half of 2015, we expect increased market volatility. Skilled active managers can quickly take advantage of dislocations in the muni market that can stem from Federal Reserve (the Fed) policies, Treasury rate moves or negative headlines.

Q: Joe, have there been any recent changes to the way the team manages munis?
Deane: Our day-to-day portfolio management has not changed at all. In fact, Julie and I as well as the rest of the team continue to manage our portfolios the same way we’ve been managing them throughout our careers – by investing in attractive, high quality municipal issues.

Importantly, the team continues to benefit from PIMCO’s robust investment process, which adds value from top to bottom. The firm’s macro outlook is developed at our quarterly economic forums and distilled into investment guidelines by our Investment Committee (IC). One change that’s been a positive for our business over the past year has been a closer reporting relationship up to PIMCO’s CIOs and IC. The IC typically meets four times a week and is critical in setting investment strategy and risk targets across the firm. Having a closer link to the IC and to the senior thought leaders at the firm has definitely been a positive for our team.

From the bottom-up, we emphasize proprietary research, security selection and ongoing surveillance provided by our dedicated team of municipal analysts who leverage the expertise of more than 60 firm-wide credit analysts. Each municipal bond we own is monitored on an ongoing basis. We never rely on agency ratings, as Julie mentioned earlier, and we’re always on the lookout for indications of a potential downgrade.

Q: What’s your outlook for 2015, Joe? Can we expect more of the same?
Deane: Given last year’s strong returns, we’re positioned cautiously for greater volatility in the fixed income markets. We’re maintaining an up-in-credit quality bias and favor liquid securities that would be more resilient in adverse market conditions. In keeping with our investment thesis, we prefer revenue-backed bonds over most GO debt, as these sectors typically benefit from dedicated revenue streams and don’t have the pension challenges that many state and local governments face. While we remain underweight to GO debt generally, we’re investing in select GOs in geographies that are tied to a continued recovery in U.S. housing and are less vulnerable to pension issues.

Because PIMCO expects that the Fed will likely begin raising rates in the second half of 2015, we are also maintaining an underweight duration positioning across most of our strategies to help protect investor returns in a period of rising interest rates due to the high correlation between municipal bond yields and Treasury rates.

It’s important to note that there is also pent-up supply in the system. Net supply has been negative for three years in a row, meaning that new issuance levels have been lower than the amount of debt that has matured or been called. In the midterm elections, voters approved $37 billion of $44 billion in ballot measures, the highest level since the downturn, which is a sign that state and local governments are beginning to think about new capital projects again. However, with state general fund spending below the 25-year historical average, weak wage growth, and uncertain funding for road projects from the Highway Trust Fund, we expect many states to remain cautious with respect to new money issuance. Whether this pent-up supply comes to market remains to be seen, and will be the result of state and local government confidence in the economy as well as the rate environment.

If supply does pick up, it could put pressure on the market, as supply and demand imbalances can have a major impact on muni market returns. Importantly, this can create some very attractive valuations for active managers, like PIMCO, with the credit resources and market presence to take advantage of these market inefficiencies.

Past performance is not a guarantee or a reliable indicator of future results. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included.

This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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[description] => Municipal bonds ended 2014 as one of the best-performing asset classes - buoyed by investors' search for yield in a low interest-rate environment. For 2015, we are positioned cautiously for greater volatility in the fixed income markets. We currently prefer revenue-backed bonds over most general obligation (GO) debt, as these sectors typically benefit from dedicated revenue streams and do not have the pension challenges that many state and local governments face. [author] => Joseph Deane, Julie Callahan, Sean McCarthy [legacyinterface_firm_id] => 335 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 18:18:00 [created_by] => 948 [modified_on] => 2015-01-29 18:19:47 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2469 [hits] => 0 ) [14] => stdClass Object ( [legacyinterface_commentary_id] => 2404 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15641 [apv_conversation_id] => 3378 [content_type] => market-commentary [title] => A Very, Very, Very, Very Black Swan? [slug] => columbia_012915 [fulltext] =>

Nassim Taleb’s book “The Black Swan” effectively demonstrates that seemingly highly improbable events are much more common than expected, often with significant consequences. In fact, experts are often blind to these occurrences because past data is not necessarily a good predictor of the future.

Most investors are aware a black swan event hit the Swiss franc earlier this month. After capping the value of the Swiss franc (CHF) relative to the euro at 1.20 since 2011, the Swiss National Bank (SNB) surprised the markets, suddenly abandoning its policy. The franc instantly soared by around 19% versus the euro, causing tremors in various corners of the capital markets.

Currencies generally don’t move in big chunks like was experienced by the Swiss franc on January 15. In fact, during the year ending January 14, 2015, the CHF/EUR traded in the 1.20-1.24 range, and volatility averaged just 0.1% per day. A fairly small move of at least 0.2% would occur in just 5% of days and a change of 0.3% or greater would be expected less than 1% of the time. Goldman Sachs’ CFO was quoted last week that the move in the franc was “something like a 20+ standard deviation move,” while the math suggests it was actually a much rarer event. For perspective, a six standard deviation normally distributed event occurs once every 1.4 million years. If there were such a thing as a very, very, very, very (repeat “very” for a long time) black swan, this 20+ standard deviation event would be it. But previously unexpected moves like the CHF experienced occur with seemingly regularity, proving Taleb’s point that these types of events happen much more frequently than the models suggest.

So did the seemingly impossible just happen, are the risk models flawed, or are the models being relied upon incorrectly? I think it is the latter. The models are mathematically sound, but most rely on some key assumptions including stable volatility and correlations, as well as normally distributed outcomes. These models would correctly predict the incredible improbability of the move in the Swiss franc if the past year’s volatility in the CHF/EUR were stationary. Those that banked on the past to predict the likelihood of future price changes received a rude awakening.

FXCM, Inc., an online foreign currency exchange, made highly-levered margin loans to its customers based on the assumption that past volatility would continue. When the assumption failed, the appreciation of the CHF ripped through its customers’ posted margins, leaving FXCM suddenly holding the bag for its customers’ busted trades; its balance sheet had a $225 million hole to fill, overnight. The company faced sudden insolvency, but has been thrown a lifeline in the form of an extractive emergency loan by Leucadia National that apparently has wiped out most of the value for common shareholders.

While some funds benefitted, others were damaged. As a group, hedge funds were more short the CHF than at any point in the past 18 months, according to the CFTC, based on the belief that the SNB would continue to cap the Franc’s value. Some went belly-up overnight. This story is reminiscent of Long Term Capital Management’s leveraged trades in 1998 that brought down that previously very successful firm.

Investors uninvolved in trading the Swiss franc (aka: “most of us”) can learn important lessons from these events. Risk is not a bad thing. In fact, it is necessary in order to earn a return. Risk models can be extremely helpful tool to understand relative exposures in a portfolio, and used as a framework for portfolio construction in an effort to maximize risk-adjusted returns. They are particularly accurate when volatility is stable.

But it is important to remember the future is unknowable, and markets are constantly changing and very unpredictable. Risk models are extremely helpful to construct well-rounded portfolios, but shouldn’t be relied upon exclusively. Independent thinking, experience, pre-mortems (asking oneself “if I am going to be wrong, why would that be?”), and out-of-the-box scenario analysis can be very important complements to risk models.

The seeds of this “improbable” event were sown several years ago when the SNB decided to cap the franc relative to the euro. In my opinion, the unprecedented and unconventional monetary policy adopted by the United States, Japan and recently the EU will spawn other black swans in coming years.

Investors should regularly stack up their current portfolio to their long-term objectives and time horizon. Specifically, it is important to avoid a sense of complacency after an extended period of stable volatility or correlations. Understanding obvious and hidden risks in a portfolio, and being cognizant that supposed black swans can occur much more frequently than models suggest can help investors compound their returns at greater rates in the long run.

Disclosure

The views expressed are as of 1/26/15, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.

This material may contain certain statements that may be deemed forward-looking. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable.

Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.

Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC.

© 2015 Columbia Management Investment Distributors, Inc. All rights reserved.

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[description] => Nassim Taleb’s book “The Black Swan” effectively demonstrates that seemingly highly improbable events are much more common than expected, often with significant consequences. In fact, experts are often blind to these occurrences because past data is not necessarily a good predictor of the future. Most investors are aware a black swan event hit the Swiss franc earlier this month. [author] => Jay Leopold [legacyinterface_firm_id] => 96 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 18:22:44 [created_by] => 948 [modified_on] => 2015-01-29 18:23:22 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2470 [hits] => 0 ) [15] => stdClass Object ( [legacyinterface_commentary_id] => 2405 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15642 [apv_conversation_id] => 3379 [content_type] => market-commentary [title] => 3 Things - Fed Mistake, ECB QE, Housing [slug] => streettalk_012915 [fulltext] =>

The Fed May Be Making A Mistake

On Wednesday, the Federal Reserve made their latest monetary policy announcement.  Janet Yellen, the current Chairwoman, made several statements that led the markets to believe that they remain on course for increasing the overnight lending rate this year. 

*FED SAYS ECONOMY HAS BEEN  `EXPANDING AT A SOLID PACE'
*FED CITES `STRONG JOB GAINS' AND LOWER UNEMPLOYMENT RATE
*FED SAYS INFLATION EXPECTED TO DECLINE FURTHER IN NEAR TERM

However, the real state of economic expansion, as discussed yesterday, is highly questionable as the global deflationary forces have already begun to wash back onto domestic shores.  While the Federal Reserve stated they were not worried about the decline in oil prices, as it boosts disposable household incomes, it is a point that they should reconsider since there is little evidence supporting that claim.

Retail-Sales-Oil-Prices-011515

In addition, the strong job gains, as examined earlier this week are also quite suspect.  Given that the employment numbers are likely extremely overinflated, which accounts for the extremely low labor force participation rates and declining wage growth, the negative feedback loop to employment could occur very quickly.

Employment-BD-Adj-011515

The real concern for investors and individuals is the actual economy. There is clearly something amiss within the economic landscape, and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get out of the potential trap they have gotten themselves into without cratering the economy, and the financial markets, in the process.

It is my expectation, unless these deflationary trends reverse course in very short order, that if the Fed raises rates it will invoke a fairly negative response from both the markets and economy.  However, I also believe that the Fed understands that we are closer to the next economic recession than not.  For the Federal Reserve, the worst case scenario is being caught with rates at the "zero bound" when that occurs. For this reason, while raising rates will likely spark a potential recession and market correction, from the Fed’s perspective this might be the “lesser of two evils.”  

The ECB’s QE May Lead To Further Declines In Euro Equities

There is much hope that the ECB’s newly minted QE program of €60 billion a month will be the spark that creates inflation in the Eurozone, sparks economic growth and boosts asset prices.  It is a lofty objective to say the least considering there is very little evidence that QE programs either create inflation or economic growth.  A quick look at Japan and the U.S. suggests that the ECB will likely be disappointed on both counts.

Inflation-US-Japan-012115

However, when it came to asset growth, the Federal Reserve was very successful as the liquidity that was pumped into the system was recycled into the financial markets.  As I have shown many times in the past, there was a high degree of correlation between the expansion of the Fed’s balance sheet and the S&P 500 index.

Fed-Balance-Sheet-SP500-012815

The reason this worked in the U.S. was because the excess reserves created by the quantitative easing program yielded a positive interest carry. This is not the case in the Eurozone where the reserves created by the bond buying program with the ECB are held with a negative interest rate.  This makes the program much less attractive to sellers of the bonds.

However, there is another issue that was recently pointed out by the very smart gentlemen at GaveKal Research:

“When we overlay the MSCI Europe, we find a somewhat surprising relationship-- equities have risen as the central banks' assets have contracted over the last several years, implying that asset purchases (inverted on the following chart) could actually be negative for stocks:”

ECB-Balance-Sheet-MSCI-012815

“We have no way of knowing for sure whether or not this pattern will hold, but this chart would seem to suggest that MSCI Europe equities could decline ~30% by the end of 2016.”

Given that the majority of the Eurozone is either near or in recession, there is little reason to hope that a QE program the size that is being suggested by the ECB will be effective. However, there is currently little evidence that investors should be betting heavily on a resurgence of international asset prices. As shown in the chart below the correlation between domestic and international equities has been quite high and more correlated to the Federal Reserve’s repetitive QE programs. 

International-SP500-QE-012815

With the domestic markets now struggling due to lack of liquidity, it is unlikely that international equities will provide any safety net for investors. Of course, while the mainstream media may be telling you to keep investing in stocks, it is clear that the“smart money” has been heading into the safety of bonds.

Low-Interest Rates Failing To Spark Housing Recovery

Dr. Ed Yardeni penned an interesting note recently stating:

“In particular, US exporters could suffer if the greenback continues to strengthen. However, that could be offset by stronger US consumer spending and home building.”

There is currently little evidence that US consumer spending is getting stronger.  But the point I want to address today is this continued hope for a revival of home ownership in the U.S. That hope is grounded in the belief that if more people buy homes, not even considering whether they can afford it or not, it will boost the economic recovery. This has been one of the points that the Federal Reserve have pointed to in supporting their monetary interventions.

However, despite abnormally low interest rates, home ownership rates in the U.S., as I showed in “Housing, Not Much Recovery,” have fallen markedly while renters now make up the majority. The percentage of apartments, relative to total new home construction, is near the highest levels on record which explains the chart below.

Housing-NationOfRenters-110414

More importantly, given that the Federal Reserve has spent the last six years artificially suppressing interest rates to boost borrowing and home buying, it has been of only marginal success.  Considering the trillion’s of taxpayer dollars spent on bank bailouts, TARP, mortgage fraud forgiveness, HAMP, HARP, etc., the results are quite disappointing.

Housing-Process-Index-012815

Now, with the Fed set to start raising interest rates, the collapse in energy prices, and rising concerns about financial market stability, don’t be surprised to see housing activity begin to slow in the months ahead.  

Real estate related investments are already far ahead of the underlying activity as investors have chased “yield and hope.”  Both of those reasons are quite devoid of fundamental realities that have subsequently tended to have a nasty bite when ignored.

Lance Roberts

Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of "Street Talk with Lance Roberts", Chief Editor of "The X-Factor" Investment Newsletter and the Streettalklive daily blog. Follow Lance on Facebook, Twitter and Linked-In.

© Streettalk Live

[description] => On Wednesday, the Federal Reserve made their latest monetary policy announcement. Janet Yellen, the current Chairwoman, made several statements that led the markets to believe that they remain on course for increasing the overnight lending rate this year. [author] => Lance Roberts [legacyinterface_firm_id] => 400 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 18:24:46 [created_by] => 948 [modified_on] => 2015-01-29 18:25:17 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2471 [hits] => 0 ) [16] => stdClass Object ( [legacyinterface_commentary_id] => 2406 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15643 [apv_conversation_id] => 3380 [content_type] => market-commentary [title] => Momentum X 2: Unleashing the True Power of Momentum [slug] => keystone_012915 [fulltext] =>

“Momentum is the premier market anomaly and is above suspicion“   - Fama & French

The power of momentum in the financial markets is one of the most researched and documented market anomalies. Morningstar notes that “The Big Two” factors in factor-based investment strategies are value and momentum1. Momentum is one of the most robust approaches in terms of its applicability and reliability. Since just 1993 there have been nearly 400 published momentum papers, making it one of the most heavily researched finance topics over the past twenty years. Extensive academic research has shown that momentum works in virtually all markets and time periods, from Victorian ages up to the present.

Momentum investing is based on the idea of trend following. Like Sir Isaac Newton’s theory of momentum, the concept is that an object in motion tends to stay in motion – but not forever. Momentum strategies simply try to identify a trend in its early stages by measuring and comparing price momentum with the hopes that the trend continues. Momentum strategies use a dynamic process to analyze the price movement of an investment or group of investments.

There are many ways to measure momentum. Relative Strength (RS), for example, is a momentum-based strategy that measures the movement of a predefined group of investments across a period of time. The investment showing the best price movement is said to have the highest relative strength. The concept is fairly simple – invest in the one showing the most relative strength and periodically re-calculate and adjust the portfolio if needed so it always contains the investment of highest relative strength.

Because it stems from an entirely different mind-set based on technical analysis rather than fundamental data, RS has the potential to add a powerful dimension to a traditional portfolio.

The graph below, calculated by Arrow Funds2, illustrates the historical growth of the S&P500 Value Index, S&P500 Growth Index and Momentum, based on the Fama-French size/momentum large-cap model (see: http//mba.tuck.dartmouth.edu). The historical data makes a compelling argument for momentum.

PAST PERFORMANCE IS NO INDICATION OF FUTURE RETURNS. The graph at left is based on index data and published academic models. The index and blended data assumes quarterly rebalancing and reinvestment of dividends, but does not include fees. Indexes are not available for direct investment. Data sources: FactSet and Fama-French Library.

At Keystone Wealth Advisors, we’ve confirmed this research with our own. The chart below is a hypothetical back test that shows the results of a very simple relative momentum methodology of investing in the highest relative strength ETF from a group composed of four ETFs giving exposure to the S&P500, small/midcap US stocks, developed foreign stocks, and emerging market stocks from January 2003 to June 2014. It rebalances monthly. (All charts in this paper represent a hypothetical back test using the referenced ETFs. Returns are total return, reflecting the reinvestment of dividends, but do not reflect any transaction costs or advisory fees).

 

Clearly the relative momentum approach produces a bigger total return than the buy-and-hold approach with the S&P500 Index. However, the portfolio still has a significant maximum drawdown exceeding 60%.

Despite its edge over time and particularly during bull markets in stocks, the one thing that momentum investing does not address effectively is the large drawdowns that can still occur by maintaining a 100% allocation to stocks, even if always invested in those of the  highest relative strength. The term “relative” simply means that something performs better than something else on a relative or comparative basis and this method did indeed produce better relative performance as measured against the S&P500 index. Within this context, if we focus our attention away from the periods of positive returns in the stock market to periods of decline, a relative performance of negative 25% compared to a negative 40% is still defined as good.

How do we address the issue of severe drawdowns to get a better solution for the real needs of investors? What if we could avoid most of the severe declines that occur in stocks and limit the size of the drawdowns? The answer is introducing another level of momentum into the mix known as absolute momentum. Absolute momentum adds an additional level of scrutiny to the trend of the assets in the group. Instead of just comparing various stock investments to each other and investing in the highest relative strength stock position, absolute momentum says that you will invest in the highest relative strength stock investments only if they are showing a positive price trend, or absolute momentum. A simply way to implement this is to add a deemed risk-free asset into the group that is ranked right along with all of the equity positions.

So, the next level is adding short term US treasury bills into the list. This next step has been referred to as “dual momentum” because we are looking at both relative momentum and absolute momentum at the same time. In this hypothetical back test the same equity ETFs are used as in the example above and an ETF representing short term treasuries is also a candidate from January 2003 to June 2014. It rebalances monthly. This means that when the ranking is done each month the top ETF could be the short term treasury ETF or any of the equity ETFs. The short term treasuries are quite broadly accepted as risk-free assets and cash equivalent.

 

Adding the absolute momentum level shows significant benefits over using only the relative momentum approach only. This is primarily because the portfolio can move to the short term treasury bonds when the equities lose momentum in relation to the treasuries. In this case the total return is improved and the maximum drawdown is reduced from a negative 63% to a negative 23%. Recovering from a 23% decline is much easier than recovering from a 63% decline.

Now, what if we use long term treasuries instead of short term treasuries? Using long term treasuries adds a little bit more sensitivity and the opportunity for growth when out of stocks instead of just the safety of cash. The chart below shows the results of a hypothetical back test using the exact same methodology and group of equity ETFs as above but also using an ETF that tracks long term treasuries instead of just short term treasuries from January 2003 to June 2014. It also rebalances monthly.

Not only does the total return improve even more, but the maximum drawdown is reduced further to 18.6%.

The dual momentum approach (blending relative momentum with absolute momentum) has been extensively researched by others, such as Gary Antonacci of Portfolio Management Associates, LLC. In his 2012 research paper entitled “Risk Premia Harvesting Through Dual Momentum” he shows his findings that both relative momentum and absolute momentum can enhance returns, but that combining them gives the best results.

Antonacci says: “… we need to distinguish clearly between relative and absolute momentum. When we consider two assets, momentum is positive on a relative basis if one asset has appreciated more than the other has. However, momentum is negative on an absolute basis if both assets have declined in value over time. It is possible for an asset to have positive relative and negative absolute momentum. Positive absolute momentum exists when the excess return of an asset is positive over the look back period, regardless of its performance relative to other assets.” 

His conclusion?: “The combination of relative and absolute momentum makes diversification more efficient by selectively utilizing assets only when both their relative and absolute momentum are positive, and these assets are more likely to appreciate. A dual momentum approach bears market risk when it makes the most sense, i.e., when there is positive absolute, as well as relative, momentum. Module-based dual momentum, serving as a strong alpha overlay, can help capture risk premia from volatile assets, while at the same time, defensively adapting to regime change.”

This figure from his research paper demonstrates his findings:

Two additional pieces of research that address this concept well are:

Generalized Momemtum and Flexible Asset Allocation (FAA) An Heuristic Approach – Wouter J. Keller and Hugo S.van Putten, December 24, 2012

Adaptive Asset Allocation: A Primer – Adam Butler, CFA, Michael Philbrick, Rodrigo Gordillo, and David Varadi, September 2013

Conclusion:

It is the combining of both relative momentum AND absolute momentum (dual momentum or Momentum2) that really unleashes the power of momentum investing. Not only does it keep the assets invested in the areas of highest relative strength during bull markets, but it can move the portfolio to assets with potentially positive absolute momentum when stocks are in decline and help dramatically reduce portfolio drawdown.

2 Arrow Quarterly Bullseye Report, 1st Quarter 2014, published by Arrow Funds.

IMPORTANT DISCLOSURES:

No current or prospective client should assume future performance of any specific investment strategy will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client's investment portfolio. Historical performance results for market indices and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark.

Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information on products and services. It should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein.

The hypothetical and back tested information, including the projected success of dual momentum, does not represent any actual trading, but was achieved solely by the means of retroactive application of a model designed with the benefit of our hindsight and modification. The results do not reflect the impact of material economic and market factors that may have had on our decision making at the time of the event, had we been actually managing any client assets in this strategy. The model, after achieving desired results, did not materially change. Actual trading results of in this strategy would be lower than the results in this illustration due to trading costs, management fees, and other potential costs. Prospective clients should not base investment decisions on back-tested performance as no client achieved the returns stated above. The purpose of back-tested performance is to test the investment ideas, investment strategy developed (and modifications) to achieve stated results. Past results, including hypothetical and back-tested results are not a guarantee or predictor of future results.

Indexes cannot be invested in directly, do not have trading costs or fees associated with them and are total return (reinvestment of dividends and capital gains). S&P 500 Index is owned by Standard and Poor’s; data is S&P. US Small/Midcap Index is Standard & Poor's Completion Index, a broadly diversified index of stocks of small and medium-size U.S. companies; data by S&P. Emerging Markets Index is MSCI Emerging Markets Index, data by MSCI. Developed Foreign is MSCI EAFE Index, data by MSCI. US Treasuries (long term) Index is Barclays U.S. 20+ Year Treasury Bond Index; data by Barclays. No part of this article may be reproduced in any form, or referred to in any other publication, without proper reference.

©2015, Keystone Wealth Advisors, LLC.

[description] => Momentum is one of the most researched market anomalies and has become widely accepted and used in a variety of ways for investment management. When used in practice is it most commonly referred to as relative strength or relative momentum. What happens if we combine the power of relative momentum with absolute momentum? [author] => Gordon Nelson [legacyinterface_firm_id] => 531 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 20:21:49 [created_by] => 948 [modified_on] => 2015-01-29 20:32:08 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2472 [hits] => 0 ) [17] => stdClass Object ( [legacyinterface_commentary_id] => 2407 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15662 [apv_conversation_id] => 3420 [content_type] => market-commentary [title] => Contrarian View: A More Balanced Approach to Rate Risk in 2015 [slug] => invesco_012915 [fulltext] =>

The threat of higher interest rates is dominating many 2015 outlooks for investors and professional forecasters alike. Consensus expectations call for the Federal Reserve (Fed) to begin tightening in the second half of the year, with market rates to rise in concert and bond prices to fall. But the changing composition of voting members on the Federal Open Market Committee (FOMC) is a looming variable that I believe will likely impact the pace and severity of Fed action.

A more dovish Fed favoring low interest rate— combined with indications of global economic slowdown and falling asset prices — may translate into a more benign rate environment for 2015 than expected. With this in mind, investors may want to reconsider stripping away all interest rate exposure from their income allocation and instead consider a more diversified and balanced maturity structure.

FOMC rotation favors dovish views

In my view, the January 2015 changes to the membership of the FOMC will bring about an even more dovish weighting to voting, based on historical voting patterns and public comments made by members.

  • Three voters viewed as hawks or hawkish because they favor higher interest rates — Charles Plosser, Richard Fisher and Loretta Mester — are rotating off.
  • The only dovish voter stepping aside is Narayana Kocherlakota, who actually has a fairly balanced history of voting patterns.
  • Committee additions include three with dovish views: Charles Evans, Dennis Lockhart and John Williams.
  • President Barack Obama can fill two additional vacancies, and I would expect his appointments to carry dovish inclinations.
  • Jeffrey Lacker, who has expressed very hawkish views, also joins the FOMC, but he will likely be the loner at that end of the spectrum.

FOMC 2015: Dominant Doves May Create a More Patient Fed

Implications for investors

If a more dovish Fed takes a slower, steadier approach to tightening than anticipated, fixed investments with longer average durations may not be the portfolio-killers they might otherwise be in an environment where the interest rate rises more rapidly. In fact, peppering portfolios with some exposure to longer duration may offer an opportunity for enhanced yield and total return, as well as diversification from equity risk. While a fixed income allocation built for Fed tightening may still be appropriate for many investors, blending a little duration into a portfolio may be beneficial if rates once again defy expectations and continue to fall.

Adding duration into a fixed income allocation

After talking to their financial advisors, investors may want to consider increasing their exposure to high-quality, longer-duration strategies. For example:

Important information

The Federal Open Market Committee (FOMC) is a 12-member committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.

Duration is a measure of the sensitivity of the price of a fixed income investment to interest rate changes.

*Effective July 8, 2014, the Fund’s name, investment objective, investment policy, investment strategies and underlying index changed. The Fund’s name changed from PowerShares Insured National Municipal Bond Portfolio to PowerShares National AMT-Free Municipal Bond Portfolio, and the underlying index changed from BofA Merrill Lynch National Insured Long-Term Core Plus Municipal Securities Index to BofA Merrill Lynch National Long-Term Core Plus Municipal Securities Index.

Before investing, investors should carefully read the prospectus/summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the Fund call 800 983 0903 or visit invescopowershares.com for the prospectus/ summary prospectus.

Diversification does not guarantee a profit or eliminate the risk of loss.

There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Underlying Index.

Investments in fixed-income securities, such as notes and bonds, carry interest rate and credit risk. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. Credit risk is the risk of loss on an investment due to the deterioration of an issuer’s financial health. Due to anticipated Federal Reserve Board policy changes, there is a risk that interest rates will rise in the near future.

For BAB and PZA, municipal securities may be affected by political changes as well as uncertainties in the municipal market related to taxation, legislative changes or the rights of municipal security holders. The market for municipal bonds may also be less liquid than for taxable bonds.

For BAB, there is no guarantee that municipalities will continue to take advantage of the BAB program in the future and there can be no assurance that BABs will be actively traded. Furthermore, under the American Recovery and Reinvestment Act of 2009, the ability of municipalities to issue BABs expired on Dec. 31, 2010. As a result, the number of available BABs in the market is limited. In addition, illiquidity of the BABs may negatively affect the value of the BABs.

For PZA, there is no guarantee that the Fund’s income will be exempt from federal or state income taxes

For PCY, the Fund will invest in foreign bonds and, because foreign exchanges may be open on days when the Fund does not price its shares, the value of the non-US securities in the Fund’s portfolio may change on days when you will not be able to purchase or sell your shares.

For PCY, sovereign debt securities are subject to the additional risk that – under some political, diplomatic, social or economic circumstances – some developing countries that issue lower quality debt securities may be unable or unwilling to make principal or interest payments as they come due. The fund may have limited legal recourse against the issuer and/or guarantor of sovereign debt when default occurs. As a holder of government debt, the Fund may be requested to participate in the rescheduling of such debt and to extend further loans to government debtors.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

All data provided by Invesco unless otherwise noted. 

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

©2015 Invesco Ltd. All rights reserved.

[description] => The threat of higher interest rates is dominating many 2015 outlooks for investors and professional forecasters alike. Consensus expectations call for the Federal Reserve (Fed) to begin tightening in the second half of the year, with market rates to rise in concert and bond prices to fall. But the changing composition of voting members on the Federal Open Market Committee (FOMC) is a looming variable that I believe will likely impact the pace and severity of Fed action. [author] => Scott Eldridge [legacyinterface_firm_id] => 225 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 21:20:49 [created_by] => 948 [modified_on] => 2015-02-02 15:34:23 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2473 [hits] => 0 ) [18] => stdClass Object ( [legacyinterface_commentary_id] => 2381 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15618 [apv_conversation_id] => 3348 [content_type] => market-commentary [title] => Sell-off in Corporate Credit Creates Income Opportunities for 2015 [slug] => eaton_012815 [fulltext] =>

SUMMARY

  • In 2014, U.S. short-term rates inched up in anticipation of Fed tightening, while global weakness reduced upward pressure on long-term rates.
  • Lower U.S. long-term rates were a tail wind for most fixed-income sectors.
  • We expect a flattening yield curve in 2015, and view this as a positive for floating-rate loans, high-yield bonds and municipal bonds relative to U.S. Treasurys.
  • Investors should be prepared for more price volatility; a longer-term focus can help bridge choppy patches that may be more technically than fundamentally driven.

The broad backdrop for the bond market in 2014 consisted of divergent macro forces in the U.S and the rest of the world. In the U.S., as signs increased that the recovery was gaining steam, the market looked to signals from the U.S. Federal Reserve (the Fed) for clues about when it would formally begin to tighten monetary policy by raising the federal funds (fed funds) rate. But in Europe, Japan and China, central banks pursued looser policies as the global economy weakened – except for the U.S., at least so far. This divergence can be seen most dramatically in the excess yield of U.S. 10-year debt compared with Spain, Germany and Japan. This is the first time in five years the U.S. has yielded more than Spain (Exhibit A), while the spread over German debt widened to 163 basis points (bps), compared with a five-year average spread of 44 bps.

This sets the stage for a flattening yield curve, with U.S. short-term rates creeping up in anticipation of Fed tightening, while continuing global weakness reduces upward pressure on long-term rates. The flattening we anticipate would be a continuation of a trend we have seen in the past year. The income investment strategies that we feel are most attractive this year are those that sold off in the fourth quarter of 2014 and are likely to fare well in a flattening scenario. First, we review 2014 performance.

A good year for bonds

In general, bond market performance in 2014 benefited from the 87-bps decline in the 10-Year U.S. Treasury yield over the course of the year. Not only was there a lack of substantial pressure from the global economy to put a floor on rates, but the re-emergence of market volatility in October brought back “flight to quality” as a force that helped boost Treasury prices and lower yields. As a result, most fixed-income sectors posted positive total returns for the year, in marked contrast to 2013, when only high-yield bonds and floating-rate loans were in the black (Exhibit B).

The last two years offer a lesson in how investor sentiment can drive short-term swings in bond prices, even when the economic environment has not changed substantially, as was the case in 2013 and 2014. For example, total return on municipal bonds swung from -2.9% in 2013 to 9.8% in 2014. Our generally positive view of the municipal sector has been fairly consistent over the past two years, as we have seen steady improvement in the financial condition of many state and local governments. (An extensive look at our take on municipals was in the November 24, 2014 issue of Barron’s.) Indeed, the sector was one of our top recommendations in this report one year ago.

The 2013 underperformance of the municipal market was largely driven by negative headlines about the difficulties faced by a relative handful of issuers such as Detroit and Puerto Rico. Last year, however, as the brightening view of the municipal landscape gained more acceptance and the impact of the new 2013 tax rates sunk in, the tide of investment flows reversed into the sector. In investment jargon, these were technically driven price moves, where supply and demand were a greater factor in the changes than the fundamentals.

Market technicals also played a significant role in explaining performance in the high-yield bond and floating-rate loan markets over the past two years. As noted, high yield bonds and floating-rate loans led the pack in 2013, but were near the bottom last year. In this case, the two had been beneficiaries in 2013 of the global search for yield, as investors poured money into the sectors. But in 2014, concerns about increasing levels of risk in the market – i.e., issuance by some less-creditworthy borrowers at the margin – led to a turnaround in flows. Nevertheless, high-yield had a total return of 2.5% and floating-rate, 1.6% – positive, but well below their respective coupon income. Again, technicals outweighed fundamentals, as corporate America generally continued along the same improvement track over the two-year period.

Credit sectors have fared well in earlier rising-rate cycles

Considering the potential impact of a flattening yield curve serves a useful purpose, because investment discussions often talk about “rising rates” without mention of where on the yield curve that may happen. Except for the historic intervention of quantitative easing, which ended in October, the Fed largely manages monetary policy at the short end of the yield curve.

Exhibit C (top) shows that certain credit-sensitive fixed-income sectors have small, but positive, correlation with changes in the fed funds rate, meaning that historically, total returns of these sectors have actually been positive when the Fed has raised short-term rates. The implication is that if the Fed tightens this year, as is now expected, and long-term U.S. rates remain tethered by continuing relatively weak global growth, capital losses are not likely to be realized in certain fixed-income credit sectors. Exhibit C (bottom) shows a different picture when the 10 Yr. U.S. Treasury yield has risen. During those periods, all sectors have lost value, except floating-rate and high-yield. Floating-rate loans have near-zero duration, while high-yield bonds have relatively high cash flows that cushion the impact of rising rates on price.

Investment implications for 2015

  • Floating-rate loans– As discussed, floating-rate loans have historically done well in periods of rising rates – whether at the short or long end of the yield curve. Given very low average historical credit losses, yields are relatively attractive at greater than 5% as of December 31, 2014. The sector has recently experienced a sell-off, in part due to negative headlines, and prices have fallen below par, meaning there is room for capital appreciation. At this phase of the credit cycle, we favor high-quality issuers who are most likely to meet their obligations and provide the income stream investors expect.
  • High yield – High-yield bonds should be relatively unharmed in a flattening-yield-curve environment, due to a restored “yield cushion.” Thanks to price volatility in the fourth quarter of 2014, yields increased to 6.7% at yearend. Another plus for the sector is that default rates, an important indicator and component of total return for high-yield debt, are near historic lows.
  • Municipal – We believe general improvements in state and local government finances are likely to continue and that tax rates remain a major concern for investors. In our opinion, the sector remains attractive relative to U.S. Treasurys. The longer end of the municipal yield curve appears to offer slightly better value, with 30-year AAA municipals yielding 100% of equivalent-duration U.S. Treasurys, although the longer end is vulnerable if long-term Treasury rates rise significantly. This is not our expected scenario, but investors who are concerned about potential price volatility might consider an intermediate to slightly longer duration portfolio, an opportunistic muni credit approach, or a laddered muni bond portfolio – one which holds bonds with a sequence of maturities from short to long. As the shorter-term bonds mature, the principal can be invested in longer-maturity bonds with higher yields, helping to cushion the impact of potential price declines in the portfolio due to rising interest rates.
  • Emerging market– This sector sold off in 2013. Last year, we expected more of a recovery but got a mixed one: Local currency-denominated bonds lost 5.7%, while dollar-denominated emerging-market bonds had a total return of 6.2%, largely because of the strength of the U.S. dollar. Both dollar and non-dollar have attractive yields, with the latter also offering exposure to other currencies and a hedge against the dollar. Bear in mind that emerging-market debt historically has been volatile. Local currency debt currently may be best-suited for longer-term investors, given our current expectation of continuing near-term strength in the U.S. dollar.

Keeping volatility in perspective

We anticipate volatility will continue to be a factor in 2015 for all market sectors. The phenomenon isn’t new – and bond market sector leadership has a long history of changing year to year. But sharper moves – price gaps, if you will – are becoming more routine. This has largely been attributed to lower inventories of bonds now being held by primary dealers (those who deal directly with the Fed) in response to new regulation. By making markets in bonds, such dealers have helped supply liquidity that has tended to smooth out price movements.

Regardless of the cause, we believe that greater volatility makes it more important than ever for long-term investors to prepare for it – to stay the course and resist action unless price declines reflect deteriorating fundamentals. Referring back to the recent municipal market volatility, investors who sold in 2013 based on negative headlines and technical factors would have missed the comeback in 2014. Staying the course is easier said than done, but volatility should be an occasion for investors to remind themselves of their objective and time horizon. If it is medium- to longer-term, the downside of “capitulating” to a patch of negative investor sentiment should be carefully considered.

Of course, volatility can be an investor’s friend, by providing attractive price entry levels for fundamentally sound investments. We touch on two strategies that seek opportunities that volatility may provide:

  • Absolute return– Absolute return strategies typically pursue long and short value opportunities across global bond markets. They seek to generate return that has low correlation to both stock and bond markets – a prudent strategy when either market sells off. Such strategies tend to do better in volatile markets, but less so in steady-state or trending markets.
  • Multisector income – Given that leadership can shift quickly in the bond market, multisector strategies are designed to take advantage of an expanded global opportunity set that is continually in flux. Multisector strategies seek total return by investing in value opportunities in individual securities across diverse U.S. and international income sectors. Returns can vary significantly from broad bond market benchmarks like the Barclays U.S. Aggregate Bond Index.

Value in closed-end funds

The closed-end funds in Exhibit D are examples of diverse income sectors being offered with a “value cushion” -- where the market price of a fund share is below the net asset value of the bonds in the fund’s portfolio. For example, the Morningstar U.S. closed-end national muni fund universe on December 31, 2014 traded at a 7.2% discount to NAV, for a yield of 5.5% and a taxable-equivalent yield at the top 43.4% rate of 9.7%.1 Another good example is the closed-end fund multisector bond universe, which had an 8.5% yield at yearend.

Looking ahead

We believe 2015 is likely to bring higher short-term rates and a flatter yield curve, along with greater overall volatility in the bond market. We feel investors will be best positioned for this environment by sticking with issues of qualilty companies or jurisdictions within each income sector.

We believe that bond picking and active professional management will be especially valuable in 2015. For example, a number of high-yield bonds were issued by energy companies. If low oil prices persist, it will be particularly important for portfolio managers to separate the winners from the losers in the sector. In our view, 2014 gave rise to excellent income opportunities, and we look forward to helping you pursue these in the new year.

1Taxable-equivalent yield refers to the yield an investor in a particular tax bracket would have to earn on a taxable investment to have the same after-tax yield as on a given tax-free security such as a municipal bond. In this example, we assume the investor is in the current maximum federal tax bracket of 43.4% (which includes the new tax from the Affordable Care Act). The investor would need a taxable yield of 9.7% to match the after-tax yield on a municipal bond of 5.5%. A portion of income may be subject to federal income and/or alternative minimum tax.

Index Definitions

BofA/Merrill Lynch U.S. High Yield Index is an unmanaged index of below-investment-grade U.S. corporate bonds.

The S&P/LSTA Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.

BofA/Merrill Lynch U.S. Mortgage-Backed Securities Index is an unmanaged index of the U.S. mortgage-backed securities market.

BofA/Merrill Lynch AAA-A US Corporate Index consists of U.S. dollar-denominated investment-grade corporate debt securities rated between AAA and A.

BofA/Merrill Lynch U.S. Treasury Index is an unmanaged index of U.S. Treasury securities with remaining maturities between 7 and 10 years.

BofA/Merrill Lynch Municipal Index tracks the performance of U.S. dollar-denominated investment-grade tax-exempt debt publicly issued by U.S. and its territories, and their political subdivisions, in the U.S. domestic market. Securities must have at least a one-year term remaining to maturity and a fixed coupon schedule.

JPMorgan Government Bond Index - Emerging Markets Global Diversified (GBI-EM) is an unmanaged index of local currency bonds with maturities of more than one year issued by emerging-market governments.

JPMorgan Emerging Markets Bond Index Plus (EMBI+) is an unmanaged free float-adjusted market-capitalization-weighted index designed to measure the debt market performance of U.S. dollar-denominated emerging markets.

BofA Merrill Lynch Indexes: BofA Merrill Lynch™ indexes not for redistribution or other uses; provided “as is,” without warranties, and with no liability. Eaton Vance has prepared this report, BofA/Merrill Lynch does not endorse it, or guarantee, review, or endorse Eaton Vance’s products.

Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Historical performance of the index illustrates market trends and does not represent the past or future performance.

About Risk

An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. As interest rates rise, the value of certain income investments is likely to decline. An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Investments involving higher risk do not necessarily mean higher return potential. Diversification cannot ensure a profit or eliminate the risk of loss.

Elements of this commentary include comparisons of different asset classes, each of which has distinct risk and return characteristics. Every investment carries risk, and principal values and performance will fluctuate with all asset classes shown, sometimes substantially. Asset classes shown are not insured by the FDIC and are not deposits or other obligations of, or guaranteed by, any depository institution. All asset classes shown are subject to risks, including possible loss of principal invested.

The principal risks involved with investing in the asset classes shown are interest-rate risk, credit risk and liquidity risk, with each asset class shown offering a distinct combination of these risks. Generally, considered along a spectrum of risk and return potential, U.S. Treasury securities (which are guaranteed as to the payment of principal and interest by the U.S. government) offer lower credit risk, higher levels of liquidity, higher interest-rate risk and lower return potential, whereas asset classes such as high-yield corporate bonds and emerging-market bonds offer higher credit risk, lower levels of liquidity, lower interest-rate risk and higher return potential. Other asset classes shown, such as municipal and investment-grade bonds, carry different levels of each of these risk and return characteristics, and as a result generally fall varying degrees along the risk/return spectrum.

Costs and expenses associated with investing in asset classes shown will vary, sometimes substantially, depending upon specific investment vehicles chosen. No investment in the asset classes shown is insured or guaranteed, unless explicitly stated for a specific investment vehicle. Interest income earned on asset classes shown is subject to ordinary federal, state and local income taxes, excepting U.S. Treasury securities (exempt from state and local income taxes) and municipal securities (exempt from federal income taxes, with certain securities exempt from federal, state and local income taxes). In addition, federal and/or state capital gains taxes may apply to investments that are sold at a profit. Eaton Vance does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision.

About Eaton Vance

Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors. For more information, visit eatonvance.com.

The views expressed in this Insight are those of the author and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.

This Insight may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing.

©2015 Eaton Vance Distributors, Inc. | Member FINRA/SIPC | Two International Place, Boston, MA 02110 | 800.836.2414 |eatonvance.com.

[description] => In this insight, Payson puts last year’s bond market volatility and performance in perspective and points out potential investment opportunities across market sectors in 2015. [author] => Payson Swaffield [legacyinterface_firm_id] => 124 [published_on] => 2015-01-28 [digest_date] => 2015-01-28 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-28 15:27:09 [created_by] => 948 [modified_on] => 2015-01-28 15:27:28 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2447 [hits] => 0 ) [19] => stdClass Object ( [legacyinterface_commentary_id] => 2382 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15619 [apv_conversation_id] => 3349 [content_type] => market-commentary [title] => Thoughts on Energy [slug] => leuthold_012815 [fulltext] =>

We’re not certain that the historic rout in the Energy sector is over, and even if we were our Group Selection (GS) Scores would likely prohibit us from loading up on Energy subgroups for at least a few more months. Pure valuation work has certainly proven misleading, with our Energy “relative valuation composite” (Chart 1) suggesting the sector stood on the brink of extreme undervaluation even before it became unglued in the sector half of the year. For what it’s worth, today Energy’s relative valuation level (a composite of Normalized P/E, Price/Cash Flow and Price-to-Book ratios) is the lowest in our 25-year history for this sector.

Chart 1

http://leutholdgroup.com/sites/leutholdgroup.com/files/charts/2015-january-stock-market-asset-15.jpg


Chart 2

http://leutholdgroup.com/sites/leutholdgroup.com/files/charts/2015-january-stock-market-asset-16.jpg

 

Last decade we frequently discussed the “Three Act Play” then unfolding in commodities, with the terminal act producing a 2006-2008 surge in commodity-oriented equities and a commensurate binge in capital spending. While all of the commodity sector participated, Energy certainly played either a lead or a co-starring role (Chart 2).

But we’ve seen the “Third Act” of similar plays before. They are inevitably self-correcting, with excessive speculation and overinvestment sowing the seeds for the next decline. Other analysts might call the Third Act the “distribution” or “public participation” phase, while students of Elliott Wave theory would call it a terminal “fifth wave.” At any rate, the general rule of thumb is that all of the upside move occurring during a Third Act is wiped out during the ensuing bear market. The Energy sector decline of 2008-2009 didn’t quite accomplish that feat, but the latest sell-off has—perhaps a positive sign.  

Chart 3

http://leutholdgroup.com/sites/leutholdgroup.com/files/charts/2015-january-stock-market-asset-17.jpg

 

Energy’s peak-to-trough decline of   –26.7% (to-date) is the second bear-market decline of magnitude suffered by the sector during the current cyclical bull market (Chart 3). The first was a –28.4% drop in mid-2011. Next, we compare these moves to other significant sector declines occurring outside of a broader bear market. 

How common are “self-contained” sector bear markets like the one just experienced in Energy? We scanned S&P for sector declines of 20% or more which occurred outside of S&P 500 cyclical bear markets. There were only 19 other instances since 1990.

·         Financials (four instances) was the most vulnerable sector to big declines independent of cyclical bear markets. Consumer Discretionary is the lone sector that did not suffer a stand-alone decline of 20%.

·         The encouraging news is that once a “rogue” decline in the respective sector has ended, relative performance (on average) over the next three, six, and 12 months has been good. The sector in question outperformed the S&P 500 by an average of 15% in the year following its “stand-alone bear market” low (… albeit with a few notable failures).

http://leutholdgroup.com/sites/leutholdgroup.com/files/styles/article-asset-large/public/charts/2015-january-stock-market-asset-18.jpg?itok=51GHNYJ5

© 2015 The Leuthold Group

[description] => We’re not certain that the historic rout in the Energy sector is over, and even if we were our Group Selection (GS) Scores would likely prohibit us from loading up on Energy subgroups for at least a few more months. Last decade we frequently discussed the “Three Act Play” then unfolding in commodities, with the terminal act producing a 2006-2008 surge in commodity-oriented equities and a commensurate binge in capital spending. While all of the commodity sector participated, Energy certainly played either a lead or a co-starring role. 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Voya Investment Management’s fixed income strategies cover a broad range of maturities, sectors and instruments, giving investors wide latitude to create a new portfolio structure or complement an existing one.

We offer investment strategies across the  yield curve and credit spectrum, as well as in specialized disciplines that focus on individual market sectors. We build portfolios one bond at a time, with a critical review of each security by experienced fixed income managers. As of September 30, 2014, Voya Investment Management managed $125 billion in fixed income strategies in the United States.

Bond Market Outlook

  • Global Interest Rates: Valuations are generally rich, but we see no near-term catalyst for a global rate selloff given the flood of liquidity coming from central banks.
  • Global Currencies: We remain overweight   the U.S. dollar and underweight the euro and Japanese yen. We also favor the British pound and Swiss franc versus the euro.
  • Corporates: We remain mildly constructive on the credit markets in 2015, as valuations have improved, balance sheets remain healthy, and the domestic economy remains strong.
  • High Yield: The asset class is attractive and poised to outperform most other fixed income asset classes once oil prices stabilize.
  • Mortgages: Increased volatility and low interest rates are negative for agency MBS, though we are more constructive on non-agency MBS and CMBS.
  • Emerging Markets: While lower commodity prices help stem inflation and easy monetary policies could support emerging markets assets, the sector is likely to remain under pressure.

 Macro Overview

  • Resolutions that promise sweeping change can be inspiring in concept but daunting to implement. But after the new year’s shaky start — characterized by a spike in equity and interest rate volatility, continued weakness in oil and commodity prices, and a strengthening dollar — the European Central Bank finally moved beyond rhetoric, revealing a concrete game plan to defeat the euro zone’s own version of “deflategate” in 2015 and beyond.
  • With negative deposit rates in Germany, anti-austerity politics gaining momentum in Greece and near-zero euro zone inflation, it had become clear that Mario Draghi’s July 2012 pledge to do “whatever it takes” to keep the currency bloc intact would require more than just an assortment  of ineffective half-measures. Enter the ECB’s historic pledge to purchase €60 billion of assets per month through September 2016. And while the inclusion of sovereign debt in the program drew headlines, the most important detail may be the plan’s seemingly open-ended nature; Draghi’s focus on pushing inflation up to the central bank’s target suggests that purchases could extend beyond the stated end date should sufficient progress here be lacking. The ECB’s open-ended resolution may be intended to backstop the currency union and stabilize financial markets; if the U.S. QE experience is any indication, this will also buy policymakers time to address the fiscal, social and political issues underpinning the euro zone’s very real growth and inflation woes.
  • China’s growth is slowing, meanwhile, and the U.S., though relatively strong, is by no means immune to the spillover effects of global growth and commodity weakness, increased global monetary accommodation and domestic issues like moribund wage growth. As such, we do not expect any sweeping changes to Fed policy anytime soon.
  • While the front-end of the U.S. yield curve is susceptible to the Fed, we see no near-term catalyst for a selloff in global rates. We remain overweight a variety of spread sectors, including U.S. investment grade corporates and U.S. high yield, as recent spread widening leaves valuations compelling despite low yields. Though volatility has picked up, a new default cycle is unlikely in the near term, particularly among U.S.-focused credits.

Sector Overviews

Rates have rallied substantially across the euro zone, and the euro weakened against the dollar. Falling developed market yields have given way to a strong performance in the Treasury market. The Treasury curve has continued to flatten, with yield on the 30-year rallying to all-time  lows while the ten-year is nearly 100 bps lower than a year ago.

We are underweight interest rate risk in the U.S., concentrated in the front end of the curve, though we have closed underweights in interest rate risk denominated in other currencies. Valuations are generally  rich, but we see no near-term catalyst for a global rate selloff given the liquidity that will result from the ECB’s new asset-purchase program.

Global  Currencies

·         We continue to favor the U.S. dollar versus the euro and Japanese yen. Versus the euro, we also favor the British pound and Swiss franc. The   yen may have already experienced most of its weakening, with the BOJ’s bond-buying announcement well in the past. The ECB’s new bond-buying program has already had a weakening effect on the euro, which should persist. That said, the size and speed of further euro devaluation is mitigated by lower U.S. interest rates and the EUR/USD selloff of the last few months.

Investment Grade Corporates

·         Corporate performance has continued to be weak, though there are tentative signs of stabilization and we remain mildly constructive on the credit markets in 2015. Oil prices appear to be trying to find a bottom, whlie corporate spreads search for stability; long-dated bonds and energy bonds both have shown signs of life since mid-January. While corporate balance sheets remain healthy and domestically sourced earnings should be strong, international earnings could be negatively impacted by weakness in global growth and strength in the U.S. dollar.

·         The ECB action, while supportive of spreads, does create a potential negative in that ECB bond buying also will contribute to lower Treasury yields. Any move lower in oil also would pressure corporate fundamentals; while lower oil prices are a general economic positive, corporate bond markets have a disproportionate exposure to the energy industry.

High Yield Corporates

·         The high yield market has struggled to gain traction thus far in 2015, and there remains a significant divergence between the performance of energy and non-energy issues. Within energy, we have seen an increased bifurcation between well-positioned “haves” and “have-nots” as opposed to the indiscriminate selling we saw when the oil price decline began to accelerate in late 2014. Other commodity-related sectors (coal, iron ore, etc.) continue to follow a similar path to oil-related issuers.

·         Our fundamental view of high yield credit quality is largely unchanged. Spreads are justifi  ly wider, as risks have increased, but the U.S. economic recovery appears solid enough to prevent a turn in the credit cycle. With ex-energy spreads above the long-term average and defaults likely to remain well below the historical average, it seems that high yield investors are being more than adequately compensated for credit risk. At current levels, high yield bonds also likely have the ability to absorb at least a portion of an eventual rise in interest rates. As such, high  yield should outperform most other fixed income asset classes over the coming year, though stabilization in oil prices is needed.

Mortgages

·         Agency MBS has struggled in early 2015, driven by a confluence of factors. A dip in primary mortgage rates has re-introduced refinancing fears, while the Fed no longer adding MBS to its balance sheet has reduced this source of demand. And although the ECB’s announcement appears bullish for spread assets, the purchases could pressure U.S. rates, a negative for the agency MBS market.

·         We are more constructive on securitized credit markets — including non- agency MBS and CMBS — given solid fundamentals, strong technicals, attractive relative value and insulation from volatility. Non-agencies   have been well bid since the beginning of the year; supply has picked up sharply the past two weeks, and competition for assets has remained fierce. The CMBS market started the year quietly before activity picked up sharply mid-January. Spreads and volatility in CMBS have been quite manageable relative to the corporate debt markets.

Emerging Markets

·         Emerging markets are contending with slow economic growth, a re-rating of systematically important countries like Russia and Brazil, idiosyncratic geopolitical events and falling commodity prices. While reduced commodity prices could stem inflation pressures and continued easy monetary policy in the developed world could support EM assets, negative sentiment toward the sector persists. Both the corporate and the sovereign indexes have stumbled out of the gate in 2015, and we remain cautious on emerging markets overall.

Past performance does not guarantee future results.

This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein   reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without

limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.

Voya Investment Management Co. LLC (“Voya”) is exempt from the requirement to hold an Australian financial services license under the Corporations Act 2001 (Cth) (“Act”) in respect of the financial services it provides in Australia. Voya is regulated by the SEC under U.S. laws, which differ from Australian laws.

This document or communication is being provided to you on the basis of your representation that you are a wholesale client (within the meaning of section 761G of the Act), and must not be provided to any other person without the written consent of Voya, which may be withheld in its absolute discretion.

©2015 Voya Investments Distributor, LLC • 230 Park Ave, New York, NY 10169

CID# 163124

[description] => Voya Investment Management’s fixed income strategies cover a broad range of maturities, sectors and instruments, giving investors wide latitude to create a new portfolio structure or complement an existing one. [author] => Christine Hurtsellers, Matt Toms [legacyinterface_firm_id] => 481 [published_on] => 2015-01-30 [digest_date] => 2015-01-30 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-30 18:54:12 [created_by] => 948 [modified_on] => 2015-01-30 19:19:09 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2485 [hits] => 0 ) [1] => stdClass Object ( [legacyinterface_commentary_id] => 2391 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15628 [apv_conversation_id] => 3364 [content_type] => market-commentary [title] => The Unintended Consequences of "Sophisticated" Performance Measurement [slug] => tocqueville_012915 [fulltext] =>

Investment performance measurement is a striking example of an originally good idea made bad by its success.  It is true that a standardized way of measuring performance is necessary to weed out money managers’ claims that are outrageous, plain dishonest, or even merely “selective.”  But unfortunately, too many imitators embraced the original concepts; and as the size of the performance-consulting industry grew exponentially, more gimmicks were incorporated in addition to the simple indicators used early on by measurement pioneers.  Today, these augmented concepts are very widely used, often inadequately so, and in my opinion have frequently become counterproductive.
 

OUTSTANDING INVESTORS vs. CONSULTANTS
 

Most exceptionally successful long-term investors have proclaimed, at one time or another, their skepticism about investment consultants and the growing use of performance benchmarks aimed at splicing performances among investment styles, geographies, company sizes, sectors, etc.  The skeptics have included the likes of Warren Buffett, Charlie Munger, Peter Lynch, Martin Whitman, Jim Rogers, Seth Klarman, Georges Soros, Howard Marks, et al.  Recently a new Oxford University paper joined this critique.  The Financial Times of September 22, 2014, cites a study by a team of from Oxford University’s Saïd Business School, which analyzed consultants for more than 90 per cent of the retirement market.  It concludes, “On an equal-weighted basis, U.S. equity funds recommended by consultants underperformed other funds by 1.1 per cent a year between 1999 and 2011.”
 

Why should the record of consultants be so disappointing?  Certainly not because they are stupid or ignorant.  In fact, most are not only highly educated, but also are very proficient in math and statistics as well as highly articulate in their presentations.
 

Instead, I believe that their problem is rooted in the fact that what was once a practice has become a business.  This business requires consultants to foster a growing appetite for their services among clients, by creating a need for more frequent measurement and decision-making.  Thus, measuring and critiquing performance has become a quarterly practice – and at times, more often than that.
 

Unfortunately, in investing, a quarter or even a year is almost always a totally irrelevant period.
 

MEASURING PERFORMANCE OVER RELEVANT PERIODS
 

When I referred above to successful long-term investors, I did not mean successful over three, five, or even ten years, which in investment history amount to little more than one fashion or style season.  I mean a stretch of years encompassing several cycles, with bull and bear markets as well as many fads and fashions and their aftermaths.
 

If one overlooks the “noise” of superficial hiccups and false signals, economic events really progress at a near-tectonic pace that does not require constant monitoring.  Except for occasional accidents, corporate fortunes do not change in three months either, and new business strategies often take several years to bear fruit – or not.
 

Over shorter periods, it is mostly crowd psychology that moves markets.  Thus, trying to measure how well a portfolio has performed over three or six months really amounts to measuring how well a manager has participated in the mood-induced ups and downs of a bipolar group (the investing crowd).  Once we realize this, the risks of quarterly performance-measurement become clearer.
 

THE COUNTERPRODUCTIVE AVOIDANCE OF VOLATILITY
 

Over time, as the performance of a majority of hedge funds and the consultants who recommend them has proven disappointing, it appears that the selling argument of this relatively new industry has shifted from “superior returns” to “acceptable returns with lower risk.”  This too, I am afraid, reflects a dangerous misunderstanding.
 

Consultants – and the academics who gave them their theoretical arguments (including Nobel laureates) – cannot quantify risk.  This is because risk can only be measured for individual investments rather than groups or indexes; it necessitates exhaustive analysis; and it cannot be summed up easily in a single statistic.  So, a consensus developed among consultants to use volatility as a substitute for risk in their calculations.  And, eventually, they even began to call it “risk.”  But this is a serious misinterpretation.  Financial risk refers to the possibility of permanently losing some or all of your equity in an investment.  Volatility merely refers to the amplitude of price fluctuations within given periods.
 

Since the principal determinant of short- and medium-term price fluctuations is the mood of the investing crowd (as opposed to changes in the fundamental value of companies, for example), most successful investors welcome volatility.  Over their longer time horizon, they recognize short-term volatility as a periodic opportunity to find unrecognized value or growth.
 

By definition, for an investor to be better than the majority, he or she needs to be different.  This implies that he or she can also, occasionally, be worse.  Bernie Madoff’s notorious Ponzi scheme, where he sold billions of his funds to investors by producing made-up performance statistics (the investments did not actually exist), was particularly smart in one respect:  The performances “produced” and implicitly promised were not outrageous.  Good investors achieved similar results over the years.  But one giveaway was (or should have been) that this performance showed no volatility:  Almost the same results were achieved period after period.  A good analysis should have told investors that this kind of performance could not be achieved without occasional shortfalls.  Merely statistical methods did not.
 

Most performance consultants try to minimize or eliminate volatility.  In doing so, they all but abandon the possibility of being durably better than the majority; but, in my view, they do not reduce true risk, which can only be avoided through extensive fundamental (not just statistical) analysis of specific investments.
 

THE GOAL: NOT RELATIVE PERFORMANCE, BUT ABSOLUTE RETURN
 

Another criticism aimed at consultants by highly successful investors is their primary focus (also out of business necessity) on performance relative to various fabricated benchmarks, rather than on absolute results, which would answer the question, “Am I becoming richer after inflation and taxes or not?”
 

Seth Klarman, founder of the Baupost Group, is at 57 years old often regarded as one of the very best investors of his generation.  In his 1991 book, Margin of Safety (which is out of print but can be bought for around $2000 on the Internet), he makes the argument that I summarize here:
 

Most institutional investors have become locked into a short-term, relative-performance derby.  Their short-term orientation may be exacerbated by the increasing popularity of pension-fund consultants.  Money managers motivated to outperform an index or a peer group of managers may lose sight of whether their investments are attractive or even sensible in an absolute sense.  They then really act as speculators:  They try to guess what others are going to do and then try to do it first.
 

Not only are money managers thus forced into becoming short-term traders, but when obliged to invest against a benchmark, suddenly everything for them becomes relative.  Instead of asking, “Is what I am buying cheap?” the manager begins asking, “Is the asset I am buying cheap relative to the benchmark?”  As performance measurement increasingly deviates from the original goal of money management – absolute returns – the ultimate nonsense may become having to reward a manager for losing only 30 percent (for example) if his benchmark (often chosen by the consultant) was down 50 percent!
 

Michael Edesess, a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, recently reviewed a paper by three academics from Boston University and the London School of Economics.  The paper, entitled “Asset Management Contracts and Equilibrium Prices,” argues that measuring and evaluating manager performance by comparing it to a market index may be distorting prices across the whole market.  Edesess goes one step further:
 

One inescapable conclusion is that the practice of evaluating managers by monitoring their performance against an index benchmark should be jettisoned – even if there’s no immediately obvious alternative to replace it.
 

STATISTICS vs. NAVIGATING ABILITY
 

What makes a good portfolio manager?  First, the choice of a discipline that makes sense based on both theory and experience; and second, the faithful application of that discipline through economic and market cycles.  Performance-measurement services are not readily useful for that purpose because, as famous finance author Charles D. Ellis reminded us, they do not report results; they only report statistics.
 

In fact, from a client’s perspective, investment performance should be assessed more as a manager’s navigating ability than as a crude statistic:  How has a portfolio performed in different economic and market environments; did it perform as expected from the chosen discipline or not; and if not, why?  Assessing a portfolio manager’s “seaworthiness” thus requires a multi-cycle perspective and a more subtle understanding of where any over- or underperformance came from.  For example, a good statistical performance attained by not following a promised discipline usually is a warning of future trouble.
 

THE LIMITS OF DIVERSIFICATION
 

I will not go so far as Warren Buffett in saying that diversification is what you use when you are not sure of your choices.  The fact is that one is never a hundred percent certain of one’s choices.  So, it seems desirable to diversify, though there is much disagreement among practitioners over the optimal degree of diversification. The debate is an old one: is it better to spread your eggs among many baskets, to reduce the risk of breaking, or to put all your eggs in one basket and carefully watch that basket? Personally, I favor one basket, albeit a large one, because I am concerned that too many investments may wind up working at cross-purpose. Similarly, over-diversifying among managers appears counterproductive to me, especially since it often results either in overlapping portfolio positions (which defeats diversification efforts) or, on the other hand, in contradictory positions in different portfolios, which tend to offset each other’s impact on performance.
 

Another argument against diversifying among managers is that, to my knowledge at least, most of the firms that have had superior long-term records have not done it.  However, very often, their funds are not managed by an individual, but by a very close-knit team.  This is an intelligent way to critically vet both new investment ideas and new talent, thus enhancing portfolio management while ensuring the continuity of the organization and its disciplines.
 

This promise rings particularly true when a managing organization’s culture closely aligns its managers’ fortunes to those of its clients.  Seth Klarman pointed out that a client probably would not choose to dine at a restaurant whose chef always ate elsewhere.  He thought an investment client would no more be satisfied with a money manager who does not eat his or her own cooking.  Many investment managers treat OPM – “other people’s money” – differently than their own.  If, in contrast, your manager has all his or her eggs in your common basket, you can at least feel assured that the basket is being watched.
 

François Sicart
January 14, 2015
 

Disclosure: This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.

© Tocqueville Asset Management

[description] => Sicart believes a measure of investment success should encompass "several cycles, with bull and bear markets as well as many fads and fashions and their aftermaths." He notes that "economic events really progress at a near-tectonic pace," so "a quarter or even a year is almost always a totally irrelevant period." [author] => Francois Sicart [legacyinterface_firm_id] => 431 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 16:35:00 [created_by] => 948 [modified_on] => 2015-01-29 16:38:12 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2457 [hits] => 0 ) [2] => stdClass Object ( [legacyinterface_commentary_id] => 2392 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15632 [apv_conversation_id] => 3368 [content_type] => market-commentary [title] => The Strange Case of the Current Small-Cap Cycle [slug] => royce_012915 [fulltext] =>

Through much of this long recovery for equity prices following the market bottom on March 9, 2009, specifically the period from 2011-2014, many active small-cap approaches, our own included, struggled to beat their benchmarks. The initial years of the cycle (2009-2010) were strong on both an absolute and relative basis for the majority of our Featured Funds. However, the last four calendar years saw many of our portfolios coming up short on a relative basis.

We can accept relative underperformance for a one-year period with equanimity. A three-year period is more difficult to swallrow because it represents to us the threshold between the short and long terms. However, we could ultimately accept that too, provided we saw strong signs of market or economic changes that looked likely to benefit our disciplined approach. A five-year underperformance period, on the other hand, is another matter entirely. (It bears mentioning that the respective five-year average annual total returns for both our flagship, Royce Pennsylvania Mutual Fund ("PMF") (+12.8%), and the Russell 2000 (+15.5%) were well in excess of their respective historical rolling monthly five-year averages of 9.8% and 7.6% since the small-cap index's inception on 12/31/78.)

This most recent underperformance period led us to attempt to answer two critical questions that are important to us and that we know have been on the minds of our investors: First, what forces have helped to shape the current cycle and contributed to the relative advantage for the small-cap index? Second, what signs, if any, reveal that some of these forces may be ebbing or reversing?

Three specific market conditions have resulted in relative performance challenges: when small-cap stocks are generating returns well above their long-term averages, when there is lowerthan- usual volatility for small-cap stocks, and/or when credit spreads—or the cost of capital—is declining. When only one of these conditions was present, our relative performance often suffered, if only in the short run. Yet for much of the past five years, each of these three conditions converged.

Before looking more closely at these developments, we want to emphasize that our belief in the cyclical nature of financial markets is fundamental and unshakeable. We were not surprised to find, then, that all three were showing signs of abating at the end of 2014. And while we cannot predict future performance patterns, we are nonetheless encouraged by many of our Featured Funds' long-term histories, especially following similar underperformance periods.

Credit Spreads* and Royce Returns

The availability of capital for businesses expands and contracts over time. In 2008, capital was understandably both quite scarce and very expensive. Contrast this with 2013 when capital was widely available.

One metric used to assess the price, or cost, of capital is the difference in yield between U.S. Treasury bonds and high-yield bonds. When this yield differential, or yield spread, is high, the cost of capital is also, which often causes problems for highly leveraged businesses.

When the cost of capital declines and the yield spread drops, it creates a potential advantage for the kind of highly leveraged stocks that we typically avoid. Yet many high-leverage stocks find homes in the Russell 2000. When the cost of capital was declining (and the yield spread was narrow), these stocks contributed to the index's stellar performance. The reverse held true when the cost of capital rose, expanding the yield spread. As a result, our relative performance has often correlated with movements in high-yield credit spreads. As shown in the table below, from 1996-2014 PMF slightly underperformed when the credit spread range contracted, typically had a slight excess return when this range was narrow (and more stable), and had a more decisive advantage when the range widened—that is, when the cost of capital rose.

Average of One-Year PMF Excess Returns by Credit Spread Rate of Change
From 12/31/96 through 12/31/14 (%)

 CREDIT SPREAD
RATE OF CHANGE
AVERAGE EXCESS
RETURN
Tercile 1 (Credit Spreads Narrow) -12.2 to -0.9 -3.8
Tercile 2 (Credit Spreads Stable) -0.9 to 0.8 0.2
Tercile 3 (Credit Spreads Widen) 0.8 to 14.1 7.0

We are therefore encouraged by the recent increase in the cost of capital. From a peak of 21.8% at the end of 2008, yield spreads contracted all the way down to 3.4% in the early summer of 2014 and have already begun to widen. They stood at 5.0% at the end of 2014.

Volatility is an Ally

Low volatility environments have historically been challenging for most active managers, including ourselves. The reason is that differentiation lies at the core of active management. We evaluate multiple aspects of a company and then judge whether or not the current stock price reflects the long-term prospects we see.

Opportunities to purchase what we deem to be attractively undervalued companies occur more frequently when stock prices are volatile. The following table shows that over the past 36 years, our investment approach with PMF on average generated excess returns versus the Russell 2000 in most market environments—except those with the lowest volatility. But for most of the last five years, volatility has been falling and has remained low, which has created a more difficult environment for active managers to outpace their benchmarks.

Average of Five-Year Monthly Rolling Statistics
From 12/31/78 through 12/31/14 (%)

 QUNTILES
FUND12345
Russell 2000 Standard Deviation 14.19 17.50 20.09 21.90 23.55
Russell 2000 Performance 14.91 14.34 12.00 7.20 3.86
PMF Performance 12.88 15.77 15.07 12.25 7.22
PMF Excess Return vs. Russell 2000 -2.03 1.43 3.07 5.06 3.36

It's worth pointing out that since the second quarter of 2014 U.S. small-caps have seen increased volatility. If the trend continues, it should create more opportunities for us to buy at attractive prices.

How Long Can High Returns Last?

From the inception of the Russell 2000 (12/31/78) through the end of 2014, there were 373 monthly trailing five-year return periods. In 27% of those periods, five-year average annual total returns were greater than 15%. The five-year period ended 12/31/14 was one of these periods, with the small-cap index returning 15.5%. While such high return periods are not the norm, they have historically been challenging for active mangers such as ourselves. In fact, when trailing five-year returns for the Russell 2000 were 15% or greater, PMF underperformed 51% of the time.

Our expectation going forward is for something closer to small-cap's five-year average annual total rolling return of 7.6%. Such periods, as can be seen in the table below, were favorable to our approach.

Five-Year Rolling Returns
Russell 2000 Average Annual Total Returns from 12/31/78 through 12/31/14 (%)

 < 5%5% - 10%10% - 15%> 15%
Number of Periods 81 101 90 101
% of Periods 22% 27% 24% 27%
PMF Average Excess Return 3.56% 4.64% 0.76% -0.13%

...So What Happens Next?

In our experience, markets are cyclical. Most trends reverse, though they can linger for longer than initially anticipated (or desired). The three trends we have examined—narrow credit spreads, lower-thanaverage volatility, and higher-than-usual small-cap returns—all showed signs of reversing in the latter part of 2014.

We view these shifts as part of the eventual normalization of the financial markets, by which we mean lower average annual returns with higher volatility. We see these developments as being accompanied by an eventual increase in the cost of capital, driven both by higher interest rates and wider credit spreads, which is a natural result of an ongoing economic expansion. A higher cost of capital usually has a significant and negative effect on highly leveraged businesses.

We thought it might be instructive to look at relative performance following historical underperformance periods. We identified 36 five-year spans from the Russell 2000 inception when PMF underperformed the Russell 2000 by 3.0% or more on an average annual basis. We then looked at the relative performance, as measured by excess returns, in the subsequent five-year periods. In 92% of them (33 of the 36), the Fund outpaced its benchmark. Moreover, the average excess return for all 36 subsequent average annual five-year periods was a healthy 6.4% per year.

Past performance is no guarantee of future results. That being said, and looking closely at history, particularly within the context of the highly anomalous period we have just endured, we suspect that investors may be able to appreciate why we are so optimistic about the prospects for both the relative and absolute performance of our disciplined, value-oriented approaches.

PMF vs. Russell 2000
Subsequent 5-Year Excess Return Following Each Monthly Rolling 5-Year Period of Relative Underperformance in Excess of 300 BPS (%)

Royce Pennsylvania Mutual Fund [PENNX]
Average Annual Total Returns as of Quarter-End 12/31/14 (%)

 QTR*1 YR3 YR5 YR10 YR15 YR20 YR30 YR40 YR
Pennsylvania Mutual 5.30 -0.70 15.45 12.80 7.97 10.74 11.32 11.55 16.28
Russell 2000 9.73 4.89 19.21 15.55 7.77 7.38 9.63 10.27 N/A
Annual Operating Expenses: 0.93%

Not Annualized

Important Performance and Expense Information

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed on or before 1/30/15 within 180 days of purchase, and after 1/30/15 within 30 days of purchase, may be subject to a 1% redemption fee. All redemption fees are payable to the Fund and are not reflected in the performance shown above; if such fees were reflected, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. Operating expenses reflect the Fund’s total annual operating expenses for the Investment Class as of the Fund’s most current prospectus and include management fees, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through it’s investment in mutual funds, hedge funds, private equity funds, and other investment companies.

Important Disclosure Information

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Royce Pennsylvania Mutual Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 25% of its net assets in foreign securities (measured at the time of investment), which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.) Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. Standard deviation is a statistical measure within which a fund's total returns have varied over time. The greater the standard deviation, the greater a fund's volatility. Please read the prospectus for a more complete discussion of risk.

* Credit spread data source: B of A Merrill Lynch US High Yield Master II Option-Adjusted Spread

© The Royce Funds

[description] => For much of the past five years, small-cap stocks have generated returns well above their monthly rolling five-year averages. In addition, lower-than-usual volatility within the asset class and a decline in the cost of capital spurred by the Fed’s monetary stimulus programs have created an unfriendly environment for active stock pickers such as ourselves. Our latest research, however, suggests that some of these conditions were abating late in 2014, which might benefit those investors who focus on fundamentals and try to use volatility to create longer-term opportunities. [author] => Team [legacyinterface_firm_id] => 379 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 16:42:08 [created_by] => 948 [modified_on] => 2015-01-29 17:13:02 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2458 [hits] => 0 ) [3] => stdClass Object ( [legacyinterface_commentary_id] => 2393 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15629 [apv_conversation_id] => 3365 [content_type] => market-commentary [title] => We Didn’t Start the Fire [slug] => rsw_012915 [fulltext] =>

History shows that what starts as an overall lack of fear, becomes outright complacency, which inevitably leads to the "Minsky Moment" of instability.

Virtually every major Central Bank has outright expressed, or at the very least implied to market participants that not only do they have "our backs", but our backsides too!   

If distorted markets create distorted behavior, we can logically infer that unprecedented   excesses exist somewhere in the system and probably in many places.

The entire financial system has been re-stocked with dry kindling and oil is the most likely match.

Today, the hot debate centers on whether plunging oil prices are a boost to or detractor from, economic growth.  One view is that declining oil prices enhances consumer spending power, as fewer dollars spent at the pump allows more to be spent on discretionary items.  The counter argument is that a collapse in price causes both a reduction in energy related investment (CAPEX), and a loss of high paying jobs which combine to offset the simulative effects of lower crude prices.  There is little doubt of the truth in both arguments, but it's probably not too early to declare which carries the most weight.  In the final analysis however, the answer to the following two questions is more important.

  • Is oil the latest victim to be claimed by deflation, and is its decline forecasting a world economic slowdown or worse?
  • Does the speed and scope of the collapse create systemic risk?

We will address such questions more directly later.

We begin by describing what we believe to be the economic/financial environment in which oil's unexpected plunge occurred.  Much like Einstein's "Theory of Everything" that seeks to explain comprehensively how the universe functions, today's economic predicament may be explained by the  Hyman Minsky's (economist) "Financial Instability Hypothesis".  Its "unifying" feature is that it not only deals with economics and markets, but with its corresponding human behavior.  Oversimplified, it states that "stability is destabilizing".  More fully explained, it describes that periods of stability create behavioral responses that erode margins of safety, reduce liquidity, increase debt relative to income and profits, and raises the price of risky assets relative to safe assets.  All of these combine to weaken the ability of the economy to withstand even modest adverse shocks.  

History shows that what starts as an overall lack of fear, becomes outright complacency, inevitably leads to the "Minsky Moment" of instability.  Think about human nature.  Even If a person feels that they will be partially indemnified from substantial loss or personal harm in any pursuit, their risk tolerance increases.  We at RSW, would further make the point that this principle appears to be the unifying force between every major Central Bank in the world as they attempt to:

  • Create and maintain historically unsustainable levels of volatility.
  • Lower interest rates to drive market participants into riskier asset classes.
  • Coax investors to accept lower levels of liquidity.
  • "Force" investors out on the yield curve (buy longer maturity debt) to enhance their income.

Let's take the theory and apply it to both today, and that period leading up to the housing crisis.  With the benefit of hindsight most would concede that Alan Greenspan, by keeping the Fed Funds rate at 1% for too long, contributed to the housing boom.  This created an atmosphere of the "Fed has our backs" that made extreme speculation and leverage not seem so extreme.  Liquidity wasn't an issue, debt versus cash flow wasn't a concern, adjustable rate loans were “OK” because rates would always stay low, and housing will never exhibit a meaningful nationwide decline.  Against this backdrop, packaged loans and "structured debt" became all the rage.  In summary, the Fed didn't light the match but they did supply the dry kindling to assist in creating an impressive blaze.  

Fast forward to today.  Virtually every major Central Bank has outright expressed, or at the very least implied to market participants that not only do they have "our backs", but our backsides too!   Today is it fair to say that Hyman Minsky's Instability hypothesis is now on steroids and injected globally?  What the world's Central Banks have done collectively in the last 5 or 6 years makes what Alan Greenspan did look like a tightening.  The world's risk appetite has dramatically increased.  Additionally, they have accepted weakened covenants (fewer promises to lenders as specified in the bond documents) without blinking, and all of this has been done with a sense that Central Banks won't let anything bad happen.

To continue our analogy the entire financial system has been re-stocked with dry kindling and oil is the most likely match.  While almost no one believes that this match burns as hot as subprime mortgages, remember Minsky's hypothesis: 

All of the excesses combine to weaken the ability of the economy to withstand even modest adverse shocks. 

This period in worldwide financial history is unprecedented.  If distorted markets create distorted behavior, we can logically infer that unprecedented excesses exist somewhere in the system, and probably in many places.  The match may not burn as hot, but with the pile of kindling being higher and drier it is undoubtedly easier to ignite. Could oil be the asset class that trips us into meaningfully slower economic activity and upsets the "risk markets"? 

So, Are Plunging Oil Prices a Boost or a Detriment to Economic Activity?

It's now time to vote.  While there is still time to allow events to unfold, we admit to a bias that the plunge in oil prices is a net negative to our economic health.  We arrive at that decision using the same logic as the majority of mainstream economists.  For years, we have read and seen economic reports that contended that the "shale revolution" would add 100 to 150 percentage points to GDP.  It was the "American Renaissance" and an "American success story".  It was told that even though the cost of extracting oil and gas was relatively expensive, the increased capital investment (CAPEX), the creation of many high paying jobs, and the resulting increase in consumer spending would rule the day over higher cost.  If the initial forecasts were accurate, the reversal of those two forces, should cause a noticeable weakening in GDP.   

For those of us charged with managing money, whether GDP slows or speeds is important but not an earth shattering consideration.  However, the two questions posed at the beginning of this musing are the ones that have significant consequences if answered incorrectly.  Shown again they are:

  • Is oil the latest victim to be claimed by deflation, and is its decline forecasting a world economic slowdown or worse?
  • Does the speed and scope of the collapse create systemic risk?

While we have already addressed the first question and have a strong opinion, our conviction level for the second one is weaker.   Minsky (long periods of stability may serve to mask stealth instabilities) would have felt at home with the following economic/market events:

  • Shale boom created a surge in energy related borrowing that now represents around 18% of the high yield bond market. 
  • Wall Street and community banks are huge lenders to this sector, tied to oil revenues.
  • As revenues contract the ability of borrowers to repay principal and interest is diminished.
  • There have already been a small number of bankruptcies, does it increase?
  • There are serious dislocations in the currency markets exacerbated by oil.  Does this worsen?

Yes, the environment described herein breeds systemic risk, but recent events also demand a certain amount of humility.  If we didn't see oil's sudden collapse to $45 from $106, we shouldn't feel very confident of the next $10 move, or what effect it can have on economies or financial systems.  What can be said, with a higher level of confidence, and with a sense of historical fact about human response is that somewhere in the financial system there exists outsized risk and diminished risk controls.  As you may recall the last time we began commenting about a hazard such as this, was in RSW's Q1 2007 commentary where we said:  "It is no longer out of place to fear both a financial event where securities and institutions of all kinds are affected, and an economic contraction caused by a severely damaged consumer".

One final note of caution in this era of Central Bank omnipotence is warranted.  From RSW's perspective, all too often investors misinterpret the message of the Fed, or any Central Bank.  All these "bankers" can do is whisper into your ear that they will not be the proximate cause of increased volatility.  They will also promise not to be the cause of economic and financial disruptions.  Lastly, they will insist that a collapse in the price of oil is not their doing.  But that doesn't mean that they can prevent it from happening, or stop it when it starts, or control the unintended consequences that result.  None of this means however, that they didn't provide all of the ingredients to ensure that the flame burns hot.  Rest assured, and have no doubt, that if some major dislocation befalls the financial system, the Fed and all of their Central Bank brethren, in their best Billy Joel  voice will all claim: "We Didn't Start the Fire".

© RSW Investments

[description] => History shows that what starts as an overall lack of fear, becomes outright complacency, which inevitably leads to the "Minsky Moment" of instability. Virtually every major Central Bank has outright expressed, or at the very least implied to market participants that not only do they have "our backs", but our backsides too! If distorted markets create distorted behavior, we can logically infer that unprecedented excesses exist somewhere in the system and probably in many places. The entire financial system has been re-stocked with dry kindling and oil is the most likely match. [author] => Robert Waas [legacyinterface_firm_id] => 530 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 16:50:02 [created_by] => 948 [modified_on] => 2015-01-29 16:51:18 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2459 [hits] => 0 ) [4] => stdClass Object ( [legacyinterface_commentary_id] => 2394 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15630 [apv_conversation_id] => 3366 [content_type] => market-commentary [title] => Commodity Outlook 2015: Watching the Supply Response Across Markets​ [slug] => pimco_012915 [fulltext] =>
  • Today’s low oil prices should allow for supply and demand to come back into alignment by year-end, led by a decline in the U.S. output growth rate and a modest increase in global demand.
  • We expect continued oversupply to weigh on natural gas prices this year, but some semblance of balance may return to this market in 2016.
  • Grain prices may experience pressure in 2015 as low oil prices pass through to corn prices, which may cause producers to switch to higher-priced crops.
  • With production growth likely having peaked, we expect metals prices to stabilize this year.

The last few years have been challenging for commodity returns. Years of big investment led supply to catch up to demand in one market after another. The process started in 2007 with natural gas, followed by base metals in 2011, grains in 2013 and, most recently, oil, with surging supply leading to steep price declines.

While slow global economic growth since the 2008 financial collapse and a deceleration in the Chinese economy have been strong headwinds to all commodity subsector returns, we think that the level and timing of supply growth explain much of the price weakness and, more importantly, why the timing of this price weakness has varied across commodity markets. We believe the speed of the supply response will drive returns over the next one to two years.

Overall, absent a genuine surge in the global economy, 2015 likely won’t see a strong rebound in commodity prices; instead, we could see a year of relatively flat returns.

Oil prices will likely stabilize and even move marginally higher
Oil was the last of the major commodity markets to see prices adjust to a large supply shock as the Arab Spring and Iranian sanctions delayed the day of reckoning. However, oil prices had a stunning decline of 50% during the second half of 2014, the result of weak global demand combined with high non-OPEC production and a change in Saudi Arabia’s willingness to serve as the global swing-supplier (see our December 2014 Viewpoint, “OPEC Post-Mortem: All Eyes on U.S. Shale​,” by Greg Sharenow). This has created a surplus of roughly 1 million barrels per day (b/d) in the oil market. For the markets to rebalance, this surplus must be stored for future use, and future production growth rates need to decline. We believe we are near that point, and that oil prices will stabilize and even experience some small recovery over the coming months.

Prices could break lower if storage capacity falls short. But we believe any drop would be brief given that Brent below $50/bbl and Canadian oil in the low $30s are already quite close to cash operating costs, slowing the capital expenditures (capex) required to sustain output. In addition, unlike in 2008–2009, when the market last saw a material surplus, today’s functioning capital markets and low yields should allow for maximized storage utilization.

Longer term, we expect global oil demand to continue to grow at close to 1 million b/d each year. Growth in non-OPEC production, centered in the U.S., will be needed to meet that demand ‒ just not the 1.7 million b/d growth of this past year. The Department of Mineral Resources in North Dakota estimates that prices need to sustain $55/bbl on average at the well head (equating to roughly $65/bbl for WTI) to stabilize production at current levels, which implies current prices are already reducing the outlook for growth by more than 0.25 million b/d relative to last year in just North Dakota. In addition, with the five-year forward price of Brent at just over $70/bbl, the same long-end price seen during the heart of the credit crisis, we believe the forward market is below the marginal cost for too many global oil projects, such as deepwater and Canadian oil sands.

In our view, current prices should allow for supply and demand to come back into alignment by year-end, led by a decline in the growth rate of U.S. output and a modest increase in global demand partly due to lower oil prices. We expect the market will anticipate this tightening as evidence of slowing investment accumulates, which should ease the downward price pressure.

However, there is considerable uncertainty in this outlook for competing reasons. Energy has become the largest sector within the high-yield space due to tremendous debt issuance in recent years to finance the massive growth in shale production. This capital will become scarcer as the markets impose greater discipline and higher financing costs on producers, which in turn could accelerate the reduction in U.S. output growth. On the other hand, we expect downward pressure on costs as drilling expenditures slow and producers drive efficiency gains. The magnitude of this improvement will play an important role in where the long end of the curve settles.

While this outlook should offer some solace for investors that most of the pain is over, we expect the oil market to remain in contango, where front-month futures contracts (i.e., those closer to the current date) are at a discount to longer-dated contracts, due to the oil surplus being put into storage. In other words, the futures curve is already embedding a decent improvement in prices.

One positive for investors going forward is seasonal: Oil prices have historically rallied during the first half of the year. The market has largely overlooked this and other potential positive catalysts – such as growing financial stress in oil-producing nations and the upcoming presidential election in Nigeria – that could destabilize output.

Natural gas faces another year of weak pricing
The 2015 outlook for natural gas is for continued oversupply to weigh on prices. Warmer-than-usual winter weather could cut household demand, which could lead to a more severe price response as power generation might not prove to be the backstop it used to be. Unlike in 2012, when coal-to-gas switching helped balance the market, more of today’s coal generation has already been replaced with natural gas, leaving less capacity to absorb further natural gas surplus.

The outlook improves as the time horizon extends. The outlook for natural gas production associated with shale oil production is considerably lower than before. With natural gas liquids (NGLs) pricing at 15-year lows, the benefits of NGLs as a byproduct of tight oil drilling are all but gone. Growing industrial demand, additional coal plant retirements due to environmental regulations, increasing exports to Mexico and the completion of the first U.S. liquefied natural gas (LNG) export plant at the end of the year could return the natural gas market to some semblance of balance in 2016, particularly should U.S. production growth finally slow. While the forward curve is already pricing in an improvement in natural gas prices, we believe there is upside in 2016 and beyond.

We have a bearish bias on agriculture
Despite a negative year overall, agricultural commodities rallied nearly 20% during the final quarter of 2014. Those gains went mostly unnoticed given the large declines in oil during that time. The rally was largely driven by increased sovereign risk for Russia, a major grain producer. The high correlation between Russian sovereign credit default swap levels and grain prices is similar to what we saw during the unrest in Crimea early in the year. We think there are limits to that relationship at the current level of oil prices, however, given the link between corn and oil prices via ethanol. The recent oil price drop has put pressure on ethanol prices to the point that the spread between end-of-2015 ethanol and corn prices is below breakeven for ethanol producers. If these levels are realized, we expect a reduction in ethanol production, which would reduce demand and prices for corn. As a result, we think today’s low oil prices will eventually pass through to lower corn prices, which, in turn, will generally put pressure on other grain prices as producers switch to higher priced crops.

Lower oil prices also mean lower production costs for grains: Fuel is 10% of the variable cost of producing a grain like corn, and fertilizer is closer to 40%. Given current input prices, the one-year forward corn price is therefore likely 5% over marginal production costs and allows for a decent margin for farmers. As always, a drought can cause an upside surprise, but given current long-range weather models, we view this as unlikely and have a general bearish bias to the agricultural sector, and grains in particular.

Metals prices should stabilize
We divide metals into two major sectors: base metals and precious metals. We see precious metals as more of a currency, with prices moving up and down in response to global real yields. Today, gold prices are broadly consistent with U.S. real yields; however, with real yields globally very low, the Federal Reserve likely to hike rates this year and the U.S. dollar likely to strengthen further, we see some downside risk to gold prices.

In aggregate, the Chinese economic slowdown and the country’s rotation to a more consumer-oriented economy from direct investment have been big headwinds to base metals demand and sentiment. Lower oil prices and the stronger U.S. dollar, particularly against floating emerging market currencies, have also been a distinct negative.

Despite this, the industrial metals index was down only 6.5% in 2014 and was actually higher midyear until oil went materially lower. In our view, this outperformance demonstrates that base metals overall are further along in the supply-adjustment cycle than energy is.

For 2015, we see competing impulses of lower oil prices reducing production costs versus a better U.S. economy and the potential for China to advance infrastructure investment to ensure adequate economic activity. With production growth likely having peaked, we expect metals prices to stabilize this year.

On balance, we are neutral on commodities in 2015
In aggregate, we expect a year of only moderate returns in commodities, with gains in oil offset by declines in other sectors like natural gas, agriculture and precious metals. A stronger dollar and continued low global inflation, both of which have weighed on commodities over the last several months, are likely to remain headwinds for performance in 2015. Still, we continue to view commodities as a good diversifier and a potent inflation hedge in a broader portfolio of stocks and nominal bonds, both of which have a negative inflation beta.

All investments contain risk and may lose value. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world.

©2015, PIMCO.

[description] => Today’s low oil prices should allow for supply and demand to come back into alignment by year-end, led by a decline in the U.S. output growth rate and a modest increase in global demand. We expect continued oversupply to weigh on natural gas prices this year, but some semblance of balance may return to this market in 2016. Grain prices may experience pressure in 2015 as low oil prices pass through to corn prices, which may cause producers to switch to higher-priced crops. With production growth likely having peaked, we expect metals prices to stabilize this year. [author] => Nicholas Johnson, Greg Sharenow [legacyinterface_firm_id] => 335 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 16:53:04 [created_by] => 948 [modified_on] => 2015-01-29 16:53:23 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2460 [hits] => 0 ) [5] => stdClass Object ( [legacyinterface_commentary_id] => 2395 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15631 [apv_conversation_id] => 3367 [content_type] => market-commentary [title] => What's Up? Quantitative Easing and Inflation [slug] => research_012915 [fulltext] =>

The Fed has ceased its program of quantitative easing (QE) and may soon begin to raise interest rates. Japan has embarked on an even more aggressive program of QE. The European Central Bank (ECB) has just begun QE. In a related development, the Swiss National Bank (SNB) recently stopped pegging the Swiss franc to the euro. Many investors are asking, “What does all this monetary turmoil mean?” 

 

It’s no wonder investors are perplexed. QE’s direct and indirect effects are complex, and the fact that various polities are at different stages of implementation doesn’t make it any easier to understand the dynamics. I don’t have all the answers, but I will try to explain QE in plain language, why central banks have adopted it, and how it can affect inflation and security prices. I’ll also comment on what’s happening now. 

 

Central Banking 101

In the normal functioning of a fractional reserve banking system (McLeay et al., 2014), commercial banks create money when they take deposits and make loans. Central banks limit the amount of money that commercial banks can create by managing reserve requirements. They provide liquidity to the banking system by lending directly to banks through the discount window. Central banks also influence interest rates and the pace of money creation by buying and selling securities through open market operations.

 

The primary objective and typical standard of success for central banks is stable prices. Price stability no longer means zero inflation; it is seen as a low and steady inflation rate, along with stable expectations of future inflation. For small countries with large trade sectors, the foreign exchange value of the currency may be a better measure of price stability. In the extreme, small countries sometimes choose to adopt exchange-rate stability as a primary objective and peg their currency to a larger global currency, such as the U.S. dollar or euro.

 

Executing monetary policy becomes trickier with additional objectives. The Fed, unlike other central banks, has a dual mandate of maintaining stable prices and fostering maximum employment. All central banks share financial market stability as an objective. Perhaps the most important function of a central bank is lender of last resort.

 

Quantitative Easing

QE is a policy consisting of large, sustained, and publicly announced programs of open market operations (The Economist, 2014). QE is not money creation; it’s more accurately described as reserve creation. A central bank buys securities and pays for them with bank reserves (liabilities of the central bank and assets of commercial banks), thereby increasing the central bank’s balance sheet and the reserves of its member banks.

 

The linkage between QE and the money supply is indirect. Banks will use new reserves to create money, but only when reserves are an active constraint on lending. When banks do not wish to lend and/or borrowers do not wish to borrow, then reserves are an inactive constraint. When banks seek to increase their capital and borrowers strive to pay down their debts, QE does not increase the money supply and therefore does not cause inflation. When reserves are an inactive constraint on borrowing and lending, a central bank engaged in buying securities is said to be “pushing on a string.”

 

Has QE succeeded? The answer depends on the central bankers’ intentions—their objective for adopting a policy of QE in the first place (Samuelson, 2014). During the global financial crisis (GFC), the first round of QE seems to have been effective in averting a financial collapse.1 A central bank can act as lender of last resort by making loans directly to individual banks through its discount window. During the GFC, however, many distressed financial institutions were not banks and so did not have access to the discount window. In addition, the banks that did have access hesitated to borrow because of the stigma attached to demonstrating a need for government support. Through QE, the Fed and the Bank of England (BOE) provided liquidity to the financial system by buying large quantities of securities from the market rather than waiting for banks to show up at the discount window.

 

Beyond providing the liquidity necessary to avoid financial panics and bank runs, can QE increase economic output and employment? On this question the evidence is distinctly mixed. Certainly, a central bank can hold interest rates lower than market-determined levels, in the process inflating capital asset prices. We have many examples, both historical and current, of central banks engineering capital asset price appreciation (Kindelberger and Aliber, 2011).

 

Some believe that, when an economy is operating below its potential growth rate, lowering interest rates to inflate capital asset prices indirectly stimulates the economy through a wealth effect: People who own stocks, bonds, and houses will spend more if they feel wealthier. Others worry that intentionally inflating capital asset prices distorts markets, creates bubbles, and leads to malinvestment. Arbitrating this question, which harks back to the debate between John Maynard Keynes and Friedrich von Hayek, is beyond the scope of this article. Nonetheless, it is possible that both are right.

 

Money Printing

Money printing is different from QE. Money printing is inflationary by definition. If the central bank rapidly prints a lot more currency and immediately puts it into circulation, then more money is chasing the same amount of goods and services. The hyperinflation Zimbabwe experienced in the 1990s is a memorable example. A central bank could distribute the newly printed currency directly by dropping it from a helicopter, as in Milton Freidman’s thought experiment (Friedman, 2005), repeated by Ben Bernanke in his famous 2002 speech. More likely in the 21st century, a central bank would opt for the electronic version of printing money by crediting the checking accounts of private citizens and/or government agencies.

 

A central bank may monetize the national debt—and facilitate increasing the deficit—by purchasing newly issued government bonds with the proceeds transferred into the checking accounts of government agencies.2 This, too, amounts to printing money. In other words, QE plus substantial fiscal stimulus is money printing and may cause inflation.

 

What’s Happening Now?

The United States and the United Kingdom adopted QE at the onset of the GFC. They did not pair QE with fiscal stimulus. They did not increase government deficits; the reverse is true. Banks chose to hold the proceeds of QE as excess reserves rather than increasing their pace of lending and thereby creating money. While QE was in progress, the Fed and the BOE were pushing on a string. 

 

In these circumstances, QE is not inflationary. It may become inflationary if it achieves its intended purpose of stimulating more economic activity by fueling bank lending and money creation. Indeed, many are concerned that, if and when loan demand accelerates, the Fed and the BOE will need to drain the excess reserves created by QE from the system in order to avoid rapid money creation and inflation.

 

Others are less worried because of another recent monetary innovation—paying interest on reserves (Cochrane, 2014). By paying interest on reserves, central banks can raise rates as required to prevent inflation without reducing their balance sheets and shrinking the excess reserves of member banks. Why would a commercial bank lend to risky private clients at a rate below what it can earn risk-free by holding reserves at the central bank? In practice, monetary policy conducted by paying interest on bank reserves is untested. Even if the economics are sensible, the politics of such a transfer of wealth by the central bank to commercial banks seem awkward at best.

 

The ECB just started QE. Because of the concern about already unsustainable levels of government debt, Europe appears unlikely to pair this QE with fiscal stimulus. The ECB will probably be pushing on a string, as were the Fed and BOE. This is why Paul Krugman bemoans austerity in Europe (Krugman, 2014).

 

Japan, however, appears to be flirting with a more aggressive form of debt monetization, combining QE with increasing fiscal deficits. The country seems close to testing what happens to a modern developed economy when it intentionally chooses money printing as its macro-economic policy. Watch Japan.

 

Endnotes

1. I say “seems to have been” rather than definitively “was” because we cannot know the counterfactual.

2. A central bank can also monetize the debt in another, somewhat more benign manner: funding deficit spending by purchasing outstanding government bonds and returning the cash flows to government agencies.

 

References

Bernanke, Ben S. 2002. “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” Remarks before the National Economists Club, Washington, D.C. (November 21). Available at http://www.federalreserve.gov/boarddocs/Speeches/2002/20021121/default.htm

 

Cochrane, John. 2014. “A Few Things the Fed Has Done Right.” Wall Street Journal (August 21). Available at http://johnhcochrane.blogspot.com/2014/09/a-few-things-fed-has-done-right-oped.html

 

The Economist. 2014. “What Is Quantitative Easing?” The Economist Explains (January 14). Available at http://www.economist.com/blogs/economist-explains/2014/01/economist-explains-7

 

Friedman, Milton. 2005. The Optimum Quantity of Money, Revised Edition. Chicago: Aldine Transaction.  

 

Kindleberger, Charles P., and Robert Z. Aliber. 2011. Manias, Panics and Crashes: A History of Financial Crises, Sixth Edition. New York: Palgrave Macmillan.

 

Krugman, Paul. 2014. “What’s the Matter With Europe?” New York Times (August 13). Available at http://krugman.blogs.nytimes.com/2014/08/13/whats-the-matter-with-europe/

 

McLeay, Michael, Amar Radia, and Ryland Thomas. 2014. “Money Creation in the Modern Economy.” Bank of England Quarterly Commentary (First Quarter). Available at http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf

 

Samuelson, Robert. 2014. “Did the Fed’s QE Actually Help?” Real Clear Markets (November 10). Available at http://www.realclearmarkets.com/articles/2014/11/10/did_the_feds_qe_actually_help__101383.html

[description] => In a recent piece from Research Affiliates, Chris Brightman, chief investment officer, provides "Central Banking 101," noting that just within the last several months the Fed has ceased its program of quantitative easing (QE) and may soon begin to raise interest rates, Japan has embarked on an even more aggressive program of QE and the European Central Bank (ECB) has just begun QE. In a related development, the Swiss National Bank (SNB) recently stopped pegging the Swiss franc to the euro. Many investors are asking, “What does all this monetary turmoil mean?” [author] => Chris Brightman [legacyinterface_firm_id] => 364 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 16:57:03 [created_by] => 948 [modified_on] => 2015-01-29 17:04:04 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2461 [hits] => 0 ) [6] => stdClass Object ( [legacyinterface_commentary_id] => 2396 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15633 [apv_conversation_id] => 3369 [content_type] => market-commentary [title] => Is US Sliding Into Recession? [slug] => dynamika_012915 [fulltext] =>

Disclaimer

The information, tools and material presented herein are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities, investment products or other financial instruments, nor to constitute any advice or recommendation with respect to such securities, investment products or other financial instruments. This research report is prepared for general circulation. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. You should independently evaluate particular investments and consult an independent financial adviser before making any investments.

Almost a year ago we identified the late cycle symptoms in sector rotations, leading indicators and US treasuries term structure. We briefly review where we stand and conclude that it does not look pretty.

We first identified the late cycle symptoms and analyzed them in details almost a year ago.[1][2] Let us revisit some of the most striking and ongoing developments.

Sector Rotation

First let us cast a glance at the sector performance since our spring 2014 call. In a typical late cycle transforming into recession environment the best performing sectors are utilities, consumer staples and healthcare.[3]

Indeed this is what we see in the market with healthcare (IXV), consumer staples (IXR) and especially utilities (IXU) drastically outperforming the SPX (ES). Also, two of the three usual underperformance suspects underperformed indeed (consumer discretionary and industrials, but not technology).

Now let us look at the sector rotations. According to our research[4] at the level of sectors US equity market is essentially driven by four factors:

- Market itself (SPX)

- Late/early cycle sector rotation (energy vs discretionary)

- Recession sector rotation (staples+utilities vs technology+industrials)

- Growth/value sector rotation (growth vs value)

Late/early sector rotation factor (long energy and materials, short technology and consumer discretionary) has thrown a strange fit rising this spring (late cycle symptom) and falling since (early cycle symptom). It was driven by oil price of course and more intertwined with global developments. Nonetheless the movements were drastic and clearly directional.

Recession sector rotation factor (long utilities and consumer staples, short technology and industrials) is on the rise (though sporadic) since its bottom in January 2014.

Growth vs Value sector rotation factor (as exemplied by the Citigroup Growth minus Citigroup Value combo) is actually on the rise (red line on the chart below).

But when adjusted for SPX and late/ealy sector rotation factor it turns out to be stagnant since the beginning of the summer (aquamarine line on the chart above).

Yield Curve

We mentioned possible yield curve flattening and level downslide about a year ago.[5] It has been ongoing since then. Here is the level (red) and steepening (green) factor.

Both are sliding since December 2013 as well as cumulative factor for TIPS forward rates shown below

Leading Indicators

We reviewed global leading indicators in great details recently[6] so below we will just briefly review the conventional leading indicator (which we comprise of manufacturers new orders for non-defense capital goods, 4-week moving average of initial claims, PMI new orders, average weekly hours of production and non-supervisory employess in manufacturing).

Conclusion

Here are the overall US growth (red) and inflation (green) factors constructed from the large US dataset. Clearly due to oil the inflation factor is losing bottom.

The conclusion is not obvious though yield curve term structure is telling. Supposedly it all depends now on how serious the FED ongoing commitment to raise short term rates is.

As usually, let us watch the developments carefully and risk manage accordingly.

© Dynamika Capital L.L.C.



[1] Dynamika Commentary, “Watch out for the late cycle symptoms”, 30 March 2014

[2] Dynamika Commentary, “Monitoring the late cycle symptoms”, 1 June 2014

[3] Dynamika Commentary, “Where are we in the business cycle?”, 17 November 2013

[4] Dynamika Commentary, “Sector Rotations”, 3 October 2014

[5] Dynamika Commentary, “Where do the leading indicators lead?”, 28 February 2014

[6] Dynamika Commentary, “Unsettling interplay of leading indicators”, 24 December 2014

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No one expected the Federal Reserve to make any changes to monetary policy at today’s meeting and there were no surprises. The Fed continued to say it would be “patient” before raising short-term interest rates, which means the Fed is very unlikely to raise rates through at least April.

However, the Fed did make some noticeable changes to the language in the statement, upgrading its assessment of both economic growth and the labor market, while recognizing both lower inflation (due to falling energy prices) and lower market-based measures of inflation expectations. Ultimately, though, the Fed’s forecast is that the eventual end of energy price declines as well as the improving labor market will push inflation back up toward its target of 2%.

Unlike the past several meetings, this one appears to have been much less contentious. Three voting members dissented at the December meeting; this time, no one dissented, the first time that’s happened since the meeting in June 2014. Both the hawks and doves who previously dissented are no longer voting members this year.

All of this is consistent with our view that the Fed is still on track to start raising rates in June. It is unlikely to raise rates at every meeting, as was done in the past two prolonged rate hike cycles under Alan Greenspan in the late 1990s and Ben Bernanke in the middle of the prior decade. Instead, the Fed will probably raise rates at every other meeting for the first year, before embarking on a more aggressive path in the second half of 2016 and beyond.

Another issue is when the Fed’s balance sheet will go back to normal. We’re still forecasting that the Fed will keep reinvesting principal payments from its asset holdings to maintain the balance sheet at roughly $4.4 trillion through at least late 2015.

The bottom line is that while the Fed is still behind the curve, it’s at least finally pointed in the right direction, and, barring some major shift in its outlook for the economy, the clock is ticking on rate hikes. Nominal GDP – real GDP growth plus inflation – is up 4.3% in the past year and up at a 4.0% annual rate in the past two years. A federal funds target rate of nearly zero is too low given this growth. It’s also too low given well-tailored policy tools like the Taylor Rule.

In the meantime, hyperinflation is not in the cards; the Fed will keep paying banks enough to keep the money multiplier depressed. But, given loose policy, we expect gradually faster growth in nominal GDP for the next couple of years. In turn, the bull market in equities will continue and the bond market is due for a fall.

 This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy. 

© First Trust Advisors

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As 2015 unfolds, we think the stage of the economic cycle in the U.S., as well as what is happening to global competitors, could prove beneficial for small-cap stocks.

After a prolonged period of economic fits and starts, 2014 may eventually be remembered for the domestic economy breaking through and investors recognizing the recovery as having staying power. The year saw persistent declines in the U.S. unemployment rate and a positive-sloping yield curve typically associated with continued growth. The Institute for Supply Management’s much watched Purchasing Managers’ Index (PMI) also paints a steady picture of economic activity with 19 consecutive months of readings above 50, indicating an expanding economy.

As the chart below illustrates, when expansions begin to reach maturity, historically small-caps have outstripped their larger counterparts. The reasons they do well can vary, but include their nimbleness to adapt to changing client needs and their attractiveness to firms looking for acquisition targets to boost sales volume in a maturing environment.

Given the murky global picture, we believe smaller stocks may have an additional catalyst for outperforming larger names. While the U.S. appears to have crossed the hurdle of a sustainable upward trajectory, leaders in Europe are looking to monetary policy to revive a moribund situation. Japan recently slipped back into recession territory after a tax hike in April. China, too, has seen its growth prospects flag, which is having a ripple effect around the world.

Not surprisingly, the relative strength at home has led to a strengthening dollar as foreign investors look for safe havens to put their money to work. Last year, the Euro lost 11.97% of its value relative to the U.S. dollar and the Yen was down 13.74%. As a result, domestic products will likely face competitive headwinds abroad from a pricing perspective. Similarly, revenues generated overseas could contribute less to the bottom line. These trends are likely to have the greatest impact on larger companies.

As represented by the S&P 500, more than 46% of all sales* in 2013 were derived from outside the United States. In contrast, constituents in the Russell 2000® Index generated approximately 16% of their revenues** in 2013 from abroad. During the latest complete fiscal year, Russell 2000® constituents reported 26.4% of their sales*** came from foreign markets. Given the relatively low level of income smaller companies generate outside of U.S. borders, we believe they are poised to benefit from a stronger domestic currency.

*“Bears Stalk the ‘Goldilocks’ Stock Market,” Tom Lauricella, The Wall Street Journal, 10/11/2014
**“Russell Investments Small Cap Perspectives,” Russell 2000® Index Quarterly Analysis, 12/31/2013
***FactSet Research Systems Inc. and Heartland Advisors, Inc., as of 1/20/2015

Disclosure:

Past performance does not guarantee future results.

The statements and opinions expressed are those of the author. Any discussion of investment strategies represent the portfolio manager’s views when presented and are subject to change without notice. Investing involves risk, including the potential loss of principal. There is no guarantee that any particular investment strategy will be successful. Economic predictions are based on estimates and are subject to change.

Data sources from FactSet: Copyright 2015 FactSet Research Systems, Inc., FactSet Fundamentals. All rights reserved.

Definitions: ISM Manufacturing PMI (Purchasing Managers Index): is an index based on surveys of more than 300 manufacturing firms by the Institute for Supply Management (ISM). The PMI index is an indicator of the economic health of the manufacturing sector based on five major indicators: new orders, inventory levels, production, supplier deliveries, and the employment environment. A reading under 50 represents a contraction, while a reading at 50 represents no change. Yield Curve: is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. In a positive-sloping yield curve, short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. A negative, or inverted, yield curve occurs when short-term debt instruments have a higher yield that long-term debt instrument of the same credit quality. Russell 2000® Index: includes the 2000 firms from the Russell 3000® Index with the smallest market capitalizations. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of the Frank Russell Investment Group. S&P 500 Index: is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. All indices are unmanaged. It is not possible to invest directly in an index.

CFA is a trademark owned by the CFA Institute.

©2015 Heartland Advisors

2015008

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The Federal Open Market Committee (FOMC) concluded its meeting on an optimistic note. There were no dissents, following three at the December 2014 meeting. 

Key points from today’s statement:

    1. FOMC members, for the first time since the Great Recession, view the current expansion as “solid.” They assessed the pace of activity as “moderate” at the previous meeting.
    1. The Fed noted that job gains were “strong,” another first for the current expansion. But it left unchanged the reference to underutilization of labor resources.
    1. Low inflation readings are seen to reflect mostly a decline in energy prices. Inflation is expected to head lower in the near term and then move gradually toward the Fed’s 2.0% target as the “transitory” influence of lower energy prices dissipates and labor market conditions improve.
    1. The Fed continues to differentiate between market-based and survey-based inflation expectations, with the latter seen as stable.
    1. The Fed did away with the “considerable time” phrase. It retained the language indicating it can be “patient” in normalizing interest rates.
    1. The statement notes that “international developments” are another factor that will influence its evaluation of progress toward the dual mandate of full employment and price stability.
    1. Although the Fed noted that economic activity is solid, the forward-looking statement mentions that it expects economic activity to expand at a “moderate” pace. The Committee also sees risks to the economic outlook as evenly balanced.
  1. We continue to expect monetary policy tightening to commence in September 2015.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

© Northern Trust

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My mother taught me how to play Monopoly – the game – and the markets over 40 years past have taught me how to play Monopoly – the financial economy. Financial markets and our finance-based economy are actually quite similar to the game in terms of the rules and strategies it takes to win. Monopoly’s real-time bank (the Fed) distributes money to players at the beginning and then continues to create more and more credit as the economy passes go. The cash in Monopoly isn’t credit and the player can’t borrow, so in this respect the game and the reality are quite different, but the addition of cash liquifies the player in a similar way that the Fed creates money out of thin air to liquify today’s finance-based system and create growth in the real economy.

Good players know that it is critical to move quickly around the board, make acquisitions and then develop the properties by creating hotels. Three hotels on each property are desirable and of course as every Monopoly pro knows, it’s not Boardwalk or Park Place that are the key holdings but the Oranges and the Reds. Same thing in reality’s markets, I would suggest. Which companies and which investments to overweight and how much leverage to use usually point to the eventual winners. But an ample amount of cash is important as well as you land on other owners’ properties. You need liquidity to pay rent or service debt – otherwise you sell assets at a discounted price and are swiftly out of the game. That reminds me of Lehman Brothers and its aftermath. Early in Monopoly, property is king but later in the game, cash becomes king and those without cash and the ability to get it go bankrupt.

It appears however, that since 2008 the rules of the finance-based economy have been substantially changed. Perhaps Parker Brothers will have to come with a new version of its own which incorporates the modern day methodology of central banks using Quantitative Easing and the outright purchase and occasional guarantee of private securities and public stocks to keep the game going. It’s as if Monopoly’s bank, which has a limited amount of 1, 5, 10 … dollar bills in each game box had “virtually” added trillions of dollars more in order to keep players solvent, in the hopes that some of it would trickle out to the real economy. With interest rates near zero and banks and other financial intermediaries sitting on trillions of Dollars, Euros, and Yen, why wouldn’t they lend it out to the private economy in hopes that they could obtain a higher return on their money? Sounds commonsensical, doesn’t it? Not in reality.

Well to be fair, in some cases and some countries they have. Bank loans in the U.S., for instance, are currently growing at 8% year over year and our economy appears to be growing at a 3% real and nominal growth rate with inflation at 0%. Still, even with the U.S. growing at an acceptable rate for now, its recovery over the past 5 years has been anemic compared to historic norms, and other developed economies are faring much worse. Many appear to be facing new recessions even with interest rates at 0% or – incredibly – negative rates. German and Swiss 5 year yields cost the lender money. Surreal to say the least. Before 2008, economists and historians would not have believed such a condition could exist, but here it is with individual sovereign countries and their respective central banks pushing each other out of the way in a race to the bottom of interest rates – wherever that is – and a race to the bottom in terms of currency valuations. Central bankers claim that they are doing no such thing, but that bravado should be dismissed out of hand. You can’t accuse them of lying but you can accuse them of distorting reality.

If all of them collectively could be labeled “Parker Brothers,” like the creator of the board game,players would be justified in saying that competitive devaluations and the purchase of bonds at near zero interest rates is indeed a significant distortion of the markets and – more importantly – capitalism’s rules which have been the foundation of growth for centuries, long before Parker Brothers central bankers came into existence in the early part of the 20th century. Even as the financial system morphed from the gold standard, to the Bretton Woods Dollar standard in 1944, and then the abandonment of any standard in 1971, capitalism seemed to be on firm ground. Incentives to lend, borrow, and invest for a profit were never challenged on a secular basis prior to 2008, except in Japan. There may have been recessions where such an appeal was eliminated at the margin, but no – capitalism was king. It was, as Francis Fukuyama proclaimed, “The End of History” – game, set, match – as Communism and other similar economic systems headed for the trash bin.

But the distortions created by post 2008 Parker Brothers have called Fukuyama’s forecast into question. There can be no doubt that negative or even zero percent interest rates cannot be a permanent rule on Monopoly’s new board. Investors and game players do not logically give money away; a mattress ultimately becomes a more attractive haven. And most importantly – because the markets and the financial sector are ultimately the servants of the real economy – growth is challenged and stunted.

In a new world, returns on real investment – ROI’s and ROE’s – become so low that the risk of a new project or the purchase of green hotels offer too little return for too much risk. Like the endgame in Monopoly where cash becomes king at the game’s conclusion, cash accumulates in corporate coffers or is used to repurchase stock in the financial economy. Investment in plant and equipment is deferred. Structural headwinds such as aging demographics and abnormally high debt/GDP ratios do not offer the player a “get out of jail free” card, in fact they help keep the cell door closed. Hope is challenged.

In the final analysis, while there is no better system than capitalism, it is incumbent upon it and its policymakers to promote a future condition which offers hope as opposed to despair. Capitalism depends on hope – rational hope that an investor gets his or her money back with an attractive return. Without it, capitalism morphs and breaks down at the margin. The global economy in January of 2015 is at just that point with its zero percent interest rates.

Officials at the Federal Reserve – the most powerful and strongest of Parker Brothers – seem to now appreciate the hole that they have dug by allowing interest rates to go too low for too long. Despite reasonable growth, some of them recognize the system’s distortion if only because inflation is going down, not up, in the process. Other Parker Brothers countries face deflation in the midst of negative interest rates. But the Fed, uniquely in my opinion, will move up the Monopoly board’s interest rates in late 2015, hoping to avoid landing on the figurative Park Place and Boardwalk in the process. It won’t however, move quickly – capitalism has been damaged by the change in rules since 2008. Caution, therefore will prevail in the U.S. and elsewhere for a long time. Bonds despite their ridiculous yields will not easily be threatened with a new bear market.Investors should expect as well, that because of the slow unwinding of zero percent rates in the U.S., that U.S. and global stocks will be supported. Their heyday is over however. In effect, equity holders now own the Greens, the Blues and the railroads on Monopoly’s board while the Reds and the Oranges belong to another era. Returns in the real economy are too low partially because of the misguided efforts of Parker Brothers bankers. There is no doubt that structural secular stagnation factors such as demographics, high debt, and technology have contributed significantly as well. Fiscal policy has been anemic since 2010.

In the final analysis, an investor – a player – must be cognizant of future low and in some cases negative total returns in 2015 and beyond. Capitalism’s distortion, with its near term deflation, poses a small but not insignificant risk to what my mother warned was the final destination for all games – entertainment or real. “In the end,” she said, “all of the tokens, all of the hotels, all of the properties – they all go back in the box.” The strong odds are that 2015’s distorted capitalism continues with anemic growth, but the box rests on the family room coffee table, waiting, waiting, for its turn.

-William H. Gross

© Janus Capital Group

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The demand for long-term Treasury bonds has reached panic proportions.  A casual inspection of price history suggests that the rally since December 2013 is “too steep, too fast.”  An alternative measure of intensity – the ratio of 30-year to 10-year bond prices – is also flashing red.  The price of 30’s relative to 10’s is rising at a pace not seen since the panic of 2008.  Can an important top be far ahead?   

 

© Charter Trust Company

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Yesterday, I appeared as a guest on CNBC’s “Closing Bell.” One of the topics we discussed was market volatility and the role of lower-volatility equity strategies, which seek to avoid downside without foregoing the opportunity to participate in stocks’ upside. The interview was similar to many of the recent conversations that I’ve had with investors. Here are some of the key points I’ve been making in these conversations.

In my view:

  1. Volatility will likely continue at an elevated level. Falling commodity prices, global growth fears and political uncertainties in the euro zone are among the factors that will add to volatility in the markets over these next months.
  2. The U.S. stock market can continue to advance for 2015. The U.S. economy looks set to continue its expansion, supported by accommodative Fed policy, healthy job growth, and good corporate profit growth. Valuations are attractive by a number of our favored measures, and especially for growth companies.
  3. Investors need to look through the short-term volatility and position their portfolios proactively and strategically. Downside protection is important. Investors need to settle into an allocation that won’t tempt them to market time or sell into weakness.
  4. Diversification is important—but bonds aren’t necessarily the right answer, or the only answer. We believe there are risks in the bond market. Short-term rates may stay low through much of 2015, as the Fed takes a “patient” approach. Even so, it’s important to remember when rates move, they can move quickly and take investors by surprise. Also, many factors can influence long-term rates, beyond what the Fed does.
  5. Lower-volatility equity approaches are especially well suited to this environment. What can investors do if they are concerned about market downside but don’t want to abandon their long-term goals? I believe strategies that include both stocks and convertibles can be especially advantageous for investors who are struggling with the “afraid to be in the market, afraid to be out of the market” dynamic. 

    Convertible securities combine stock and bond attributes, providing the opportunity for upside participation and downside protection. More specifically, convertibles can benefit from upwardly rising stock markets because they are equity sensitive, while their fixed income attributes may provide a floor of sorts when the stock market is volatile. Compared to traditional fixed income securities, they are less sensitive to interest rates, so investors may not have to scramble when rates do begin to rise. However, because all convertibles do not have the same upside and downside attributes, they must be actively managed to provide the right risk/reward balance between upside participation and potential downside protection.

For a closer look at how we pursue lower-volatility equity participation, please see my paper, “Asset Allocation Strategies for Volatile Markets.”

Asset allocation and diversification do not guarantee investment returns and do not eliminate the risk of loss.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The information in this report should not be considered a recommendation to purchase or sell any particular security. Convertible securities entail credit risk and interest rate risk. The price of equity securities may rise or fall because of changes in the broad market or changes in a company's financial condition, sometimes rapidly or unpredictably. Equity securities are subject to "stock market risk" meaning that stock prices in general may decline over short or extended periods of time.

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© Calamos Investments

[description] => In my view: (1) Volatility will likely continue at an elevated level. Falling commodity prices, global growth fears and political uncertainties in the euro zone are among the factors that will add to volatility in the markets over these next months. (2) The U.S. stock market can continue to advance for 2015. (3) Investors need to look through the short-term volatility and position their portfolios proactively and strategically. (4) Diversification is important—but bonds aren’t necessarily the right answer. (5) Lower-volatility equity approaches are especially well suited to this environment. [author] => John Calamos [legacyinterface_firm_id] => 487 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 18:15:54 [created_by] => 948 [modified_on] => 2015-01-29 18:16:15 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2468 [hits] => 0 ) [13] => stdClass Object ( [legacyinterface_commentary_id] => 2403 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15640 [apv_conversation_id] => 3377 [content_type] => market-commentary [title] => Municipal Market Update: What’s Ahead in 2015 [slug] => pimco_012915a [fulltext] =>
  • Municipal bonds ended 2014 as one of the best-performing asset classes - buoyed by investors' search for yield in a low interest-rate environment. For 2015, we are positioned cautiously for greater volatility in the fixed income markets.
  • We currently prefer revenue-backed bonds over most general obligation (GO) debt, as these sectors typically benefit from dedicated revenue streams and do not have the pension challenges that many state and local governments face.

Joe Deane, head of municipal bond portfolio management at PIMCO, portfolio manager Julie Callahan, and Sean McCarthy, head of the municipal credit research team, discuss munis’ strong showing in 2014, our outlook for credit and what we expect in the year ahead.

Q: What factors contributed to the great year municipal bonds had?
Joe Deane: Municipal bonds surprised many by ending the year as one of the best-performing asset classes – buoyed by investors’ search for yield in a low interest-rate environment. The Barclays Municipal Bond Index was up 9.05% for the year and this strong performance was attributable to a combination of factors.

Demand turned positive in the first quarter of the year from returning retail investors, who had pulled out of the market in 2013, and continued to improve throughout 2014. Municipal mutual funds received $21.4 billion in net inflows for the year – compared with outflows of $62.7 billion in 2013. Crossover investors such as banks and insurance companies also took advantage of attractive relative valuations, particularly early in the year. This returning demand was coupled with low market supply as municipalities remain reluctant to take on additional debt – even at today’s very low rates. Total supply of $335 billion for the year ended in line with 2013 levels, but aggregate new money issuance declined year over year and remains well below pre-recession levels.

Improving perceptions of credit risk in the municipal market have also been additive. The market was rattled midyear by a spate of downgrades in Puerto Rico, but since then, the commonwealth has bought itself some time with new debt issuance, and negative credit headlines have largely receded for the time being. It’s important to note that many state and local governments are still grappling with substantial unfunded pension liabilities, but it will likely take some time before the effects of this come to light. In the meantime, the market has seen some positives, including California’s rating upgrade, following voters’ passage of Proposition 2, which establishes a rainy day fund for the state, and improving tax revenues across a number of states, stemming from the strengthening U.S. economy.

Q: Sean, would you elaborate on Puerto Rico and discuss PIMCO’s outlook for credit more broadly?
Sean McCarthy: The Puerto Rico credit story continues to evolve, with the economy moving sideways as the government strives to address its fiscal and debt crisis. The market anticipates a $2.9 billion petroleum tax deal late first quarter which will support efforts to ring-fence the island’s central government from a key public agency. This is the second time in 12 months that Puerto Rico has urgently needed to print a new transaction to bolster the central government’s liquidity position.

The successful placement of the petroleum tax-backed deal may allow Puerto Rico’s current administration another fiscal year to address remaining budgetary challenges and implement comprehensive tax reform. However, the island has additional near-term refunding needs that must still be addressed, and a restructuring of the publicly-owned electric utility is likely in the next several months. We also believe there are increased risks related to the execution of policy and reform ahead of the island’s elections in 2016.

Looking beyond Puerto Rico, credit quality across state and local municipalities is expected to continue to improve in 2015. States are still exhibiting fiscal restraint, but are expected to modestly expand general fund expenditures in the 2015 and 2016 fiscal years. Conditions have improved due to increased economic activity and several years of revenue, aided in some instances by temporary tax measures taken to close structural budget deficits. However, recovery from the recession has been slower than typical and several states must contend with mandatory spending requirements and rising costs related to an aging population. There are also several states that have still not taken decisive steps to combat their large and growing unfunded pension and other post-retirement debt burdens. And many of these same actors are experiencing a tepid economic recovery. We expect retirement obligations will continue to be a major credit theme and will have an adverse effect on the credit quality of several key states in 2015 and beyond. In addition, recent changes imposed by the Governmental Accounting Standards Board (GASB) are likely to reveal that pension burdens are greater than previously reported.

Local government credit quality is also improving, but the recovery is slower than in the states, due in part to a lag in the frequency of assessments affecting property tax collections and an uneven recovery in housing across regions of the U.S. Local government agencies must also contend with large unfunded retirement obligations and often have less revenue flexibility to adjust to higher cost structures versus the states. In many instances, local government agencies are also adjusting to reduced intergovernmental transfers from the state relative to pre-recession levels.

Finally, we would note that the sharp drop in crude oil from June 2014 highs is likely to have a bifurcated effect on state and local government credit quality. The drop in crude to current levels is the equivalent of a tax cut for consumers at the gas pump, which could contribute to increased sales tax receipts and benefit certain municipal asset classes, including toll roads. On the other hand, the drop in crude will result in some budgetary stress for the energy-producing states, but we believe that this pressure will be absorbed over the current and following fiscal year as the states make necessary midyear adjustments. In addition, the largest U.S. energy-producing states either have ample budgetary reserves or depend less on oil and gas revenues to fund their operating budgets, as severance taxes collected on the extraction of oil and gas are often used to fund capital projects or reserves. There may be some isolated pockets of stress for local municipalities and counties in regions with a high dependence on energy. These communities may be affected by layoffs and a reduction of capital spending by drilling companies, and lower property tax collections from parcels with wells that are shuttered.

Q: Julie, why is active management so important in this market environment, especially in the context of the ladder strategies that you manage?
Julie Callahan: As Joe and I have discussed previously, today’s municipal market is large, fragmented and localized, with over $3.6 trillion in outstanding debt among more than 78,000 municipal issuers.* The financial crisis essentially transformed this vast market from a Treasury-centric market – with widespread use of insurance – into a credit market. Now, municipal issues trade to the strength of their underlying creditworthiness, making active management and credit due diligence much more important today.

This is part of the reason we’ve seen such success with our municipal ladder strategies. Many financial advisors, who had assembled and managed their own municipal bond ladders in the past, are turning to active managers like PIMCO because they don’t have the resources to conduct the rigorous credit due diligence that’s needed on their own. We currently manage $3.5 billion in ladder strategies (as of December 31, 2014), and our credit team has independently analyzed and rated every security in our portfolios.

Importantly, at PIMCO, our investment process has never relied on insurance or external credit rating agencies. Instead, we employ rigorous and ongoing credit analysis at both the issuer and obligor levels and have our own internal rating system – our analysts develop their own ratings, including their outlook on how those ratings might develop over the year. This forward-looking approach helps to mitigate credit risk and volatility across all of our municipal bond portfolios and was the reason we began to de-risk the Puerto Rico positions in our tax-exempt dedicated national and state-specific portfolios in 2011 – long before the island’s debt saw significant price declines.

Also, as Joe and Sean both mentioned, there are state and local budgetary problems that will play out over a long time horizon. Because investors in ladder strategies allocate a portion of their portfolios to longer-maturity municipal bonds and primarily expect to buy and hold these positions, they need to be confident that their investment manager’s credit research is forward-looking, so they don’t have unpleasant portfolio surprises five years from now.

Additionally, with rates expected to rise in the latter half of 2015, we expect increased market volatility. Skilled active managers can quickly take advantage of dislocations in the muni market that can stem from Federal Reserve (the Fed) policies, Treasury rate moves or negative headlines.

Q: Joe, have there been any recent changes to the way the team manages munis?
Deane: Our day-to-day portfolio management has not changed at all. In fact, Julie and I as well as the rest of the team continue to manage our portfolios the same way we’ve been managing them throughout our careers – by investing in attractive, high quality municipal issues.

Importantly, the team continues to benefit from PIMCO’s robust investment process, which adds value from top to bottom. The firm’s macro outlook is developed at our quarterly economic forums and distilled into investment guidelines by our Investment Committee (IC). One change that’s been a positive for our business over the past year has been a closer reporting relationship up to PIMCO’s CIOs and IC. The IC typically meets four times a week and is critical in setting investment strategy and risk targets across the firm. Having a closer link to the IC and to the senior thought leaders at the firm has definitely been a positive for our team.

From the bottom-up, we emphasize proprietary research, security selection and ongoing surveillance provided by our dedicated team of municipal analysts who leverage the expertise of more than 60 firm-wide credit analysts. Each municipal bond we own is monitored on an ongoing basis. We never rely on agency ratings, as Julie mentioned earlier, and we’re always on the lookout for indications of a potential downgrade.

Q: What’s your outlook for 2015, Joe? Can we expect more of the same?
Deane: Given last year’s strong returns, we’re positioned cautiously for greater volatility in the fixed income markets. We’re maintaining an up-in-credit quality bias and favor liquid securities that would be more resilient in adverse market conditions. In keeping with our investment thesis, we prefer revenue-backed bonds over most GO debt, as these sectors typically benefit from dedicated revenue streams and don’t have the pension challenges that many state and local governments face. While we remain underweight to GO debt generally, we’re investing in select GOs in geographies that are tied to a continued recovery in U.S. housing and are less vulnerable to pension issues.

Because PIMCO expects that the Fed will likely begin raising rates in the second half of 2015, we are also maintaining an underweight duration positioning across most of our strategies to help protect investor returns in a period of rising interest rates due to the high correlation between municipal bond yields and Treasury rates.

It’s important to note that there is also pent-up supply in the system. Net supply has been negative for three years in a row, meaning that new issuance levels have been lower than the amount of debt that has matured or been called. In the midterm elections, voters approved $37 billion of $44 billion in ballot measures, the highest level since the downturn, which is a sign that state and local governments are beginning to think about new capital projects again. However, with state general fund spending below the 25-year historical average, weak wage growth, and uncertain funding for road projects from the Highway Trust Fund, we expect many states to remain cautious with respect to new money issuance. Whether this pent-up supply comes to market remains to be seen, and will be the result of state and local government confidence in the economy as well as the rate environment.

If supply does pick up, it could put pressure on the market, as supply and demand imbalances can have a major impact on muni market returns. Importantly, this can create some very attractive valuations for active managers, like PIMCO, with the credit resources and market presence to take advantage of these market inefficiencies.

Past performance is not a guarantee or a reliable indicator of future results. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included.

This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam and Italy Branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO Asia Pte Ltd (501 Orchard Road #09-03, Wheelock Place, Singapore 238880, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd (Level 19, 363 George Street, Sydney, NSW 2000, Australia), AFSL 246862 and ABN 54084280508, offers services to wholesale clients as defined in the Corporations Act 2001. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1o andar, Rio de Janeiro – RJ Brasil 22210-906. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world.

© 2015, PIMCO.

[description] => Municipal bonds ended 2014 as one of the best-performing asset classes - buoyed by investors' search for yield in a low interest-rate environment. For 2015, we are positioned cautiously for greater volatility in the fixed income markets. We currently prefer revenue-backed bonds over most general obligation (GO) debt, as these sectors typically benefit from dedicated revenue streams and do not have the pension challenges that many state and local governments face. [author] => Joseph Deane, Julie Callahan, Sean McCarthy [legacyinterface_firm_id] => 335 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 18:18:00 [created_by] => 948 [modified_on] => 2015-01-29 18:19:47 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2469 [hits] => 0 ) [14] => stdClass Object ( [legacyinterface_commentary_id] => 2404 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15641 [apv_conversation_id] => 3378 [content_type] => market-commentary [title] => A Very, Very, Very, Very Black Swan? [slug] => columbia_012915 [fulltext] =>

Nassim Taleb’s book “The Black Swan” effectively demonstrates that seemingly highly improbable events are much more common than expected, often with significant consequences. In fact, experts are often blind to these occurrences because past data is not necessarily a good predictor of the future.

Most investors are aware a black swan event hit the Swiss franc earlier this month. After capping the value of the Swiss franc (CHF) relative to the euro at 1.20 since 2011, the Swiss National Bank (SNB) surprised the markets, suddenly abandoning its policy. The franc instantly soared by around 19% versus the euro, causing tremors in various corners of the capital markets.

Currencies generally don’t move in big chunks like was experienced by the Swiss franc on January 15. In fact, during the year ending January 14, 2015, the CHF/EUR traded in the 1.20-1.24 range, and volatility averaged just 0.1% per day. A fairly small move of at least 0.2% would occur in just 5% of days and a change of 0.3% or greater would be expected less than 1% of the time. Goldman Sachs’ CFO was quoted last week that the move in the franc was “something like a 20+ standard deviation move,” while the math suggests it was actually a much rarer event. For perspective, a six standard deviation normally distributed event occurs once every 1.4 million years. If there were such a thing as a very, very, very, very (repeat “very” for a long time) black swan, this 20+ standard deviation event would be it. But previously unexpected moves like the CHF experienced occur with seemingly regularity, proving Taleb’s point that these types of events happen much more frequently than the models suggest.

So did the seemingly impossible just happen, are the risk models flawed, or are the models being relied upon incorrectly? I think it is the latter. The models are mathematically sound, but most rely on some key assumptions including stable volatility and correlations, as well as normally distributed outcomes. These models would correctly predict the incredible improbability of the move in the Swiss franc if the past year’s volatility in the CHF/EUR were stationary. Those that banked on the past to predict the likelihood of future price changes received a rude awakening.

FXCM, Inc., an online foreign currency exchange, made highly-levered margin loans to its customers based on the assumption that past volatility would continue. When the assumption failed, the appreciation of the CHF ripped through its customers’ posted margins, leaving FXCM suddenly holding the bag for its customers’ busted trades; its balance sheet had a $225 million hole to fill, overnight. The company faced sudden insolvency, but has been thrown a lifeline in the form of an extractive emergency loan by Leucadia National that apparently has wiped out most of the value for common shareholders.

While some funds benefitted, others were damaged. As a group, hedge funds were more short the CHF than at any point in the past 18 months, according to the CFTC, based on the belief that the SNB would continue to cap the Franc’s value. Some went belly-up overnight. This story is reminiscent of Long Term Capital Management’s leveraged trades in 1998 that brought down that previously very successful firm.

Investors uninvolved in trading the Swiss franc (aka: “most of us”) can learn important lessons from these events. Risk is not a bad thing. In fact, it is necessary in order to earn a return. Risk models can be extremely helpful tool to understand relative exposures in a portfolio, and used as a framework for portfolio construction in an effort to maximize risk-adjusted returns. They are particularly accurate when volatility is stable.

But it is important to remember the future is unknowable, and markets are constantly changing and very unpredictable. Risk models are extremely helpful to construct well-rounded portfolios, but shouldn’t be relied upon exclusively. Independent thinking, experience, pre-mortems (asking oneself “if I am going to be wrong, why would that be?”), and out-of-the-box scenario analysis can be very important complements to risk models.

The seeds of this “improbable” event were sown several years ago when the SNB decided to cap the franc relative to the euro. In my opinion, the unprecedented and unconventional monetary policy adopted by the United States, Japan and recently the EU will spawn other black swans in coming years.

Investors should regularly stack up their current portfolio to their long-term objectives and time horizon. Specifically, it is important to avoid a sense of complacency after an extended period of stable volatility or correlations. Understanding obvious and hidden risks in a portfolio, and being cognizant that supposed black swans can occur much more frequently than models suggest can help investors compound their returns at greater rates in the long run.

Disclosure

The views expressed are as of 1/26/15, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.

This material may contain certain statements that may be deemed forward-looking. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable.

Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.

Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC.

© 2015 Columbia Management Investment Distributors, Inc. All rights reserved.

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[description] => Nassim Taleb’s book “The Black Swan” effectively demonstrates that seemingly highly improbable events are much more common than expected, often with significant consequences. In fact, experts are often blind to these occurrences because past data is not necessarily a good predictor of the future. Most investors are aware a black swan event hit the Swiss franc earlier this month. [author] => Jay Leopold [legacyinterface_firm_id] => 96 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 18:22:44 [created_by] => 948 [modified_on] => 2015-01-29 18:23:22 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2470 [hits] => 0 ) [15] => stdClass Object ( [legacyinterface_commentary_id] => 2405 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15642 [apv_conversation_id] => 3379 [content_type] => market-commentary [title] => 3 Things - Fed Mistake, ECB QE, Housing [slug] => streettalk_012915 [fulltext] =>

The Fed May Be Making A Mistake

On Wednesday, the Federal Reserve made their latest monetary policy announcement.  Janet Yellen, the current Chairwoman, made several statements that led the markets to believe that they remain on course for increasing the overnight lending rate this year. 

*FED SAYS ECONOMY HAS BEEN  `EXPANDING AT A SOLID PACE'
*FED CITES `STRONG JOB GAINS' AND LOWER UNEMPLOYMENT RATE
*FED SAYS INFLATION EXPECTED TO DECLINE FURTHER IN NEAR TERM

However, the real state of economic expansion, as discussed yesterday, is highly questionable as the global deflationary forces have already begun to wash back onto domestic shores.  While the Federal Reserve stated they were not worried about the decline in oil prices, as it boosts disposable household incomes, it is a point that they should reconsider since there is little evidence supporting that claim.

Retail-Sales-Oil-Prices-011515

In addition, the strong job gains, as examined earlier this week are also quite suspect.  Given that the employment numbers are likely extremely overinflated, which accounts for the extremely low labor force participation rates and declining wage growth, the negative feedback loop to employment could occur very quickly.

Employment-BD-Adj-011515

The real concern for investors and individuals is the actual economy. There is clearly something amiss within the economic landscape, and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get out of the potential trap they have gotten themselves into without cratering the economy, and the financial markets, in the process.

It is my expectation, unless these deflationary trends reverse course in very short order, that if the Fed raises rates it will invoke a fairly negative response from both the markets and economy.  However, I also believe that the Fed understands that we are closer to the next economic recession than not.  For the Federal Reserve, the worst case scenario is being caught with rates at the "zero bound" when that occurs. For this reason, while raising rates will likely spark a potential recession and market correction, from the Fed’s perspective this might be the “lesser of two evils.”  

The ECB’s QE May Lead To Further Declines In Euro Equities

There is much hope that the ECB’s newly minted QE program of €60 billion a month will be the spark that creates inflation in the Eurozone, sparks economic growth and boosts asset prices.  It is a lofty objective to say the least considering there is very little evidence that QE programs either create inflation or economic growth.  A quick look at Japan and the U.S. suggests that the ECB will likely be disappointed on both counts.

Inflation-US-Japan-012115

However, when it came to asset growth, the Federal Reserve was very successful as the liquidity that was pumped into the system was recycled into the financial markets.  As I have shown many times in the past, there was a high degree of correlation between the expansion of the Fed’s balance sheet and the S&P 500 index.

Fed-Balance-Sheet-SP500-012815

The reason this worked in the U.S. was because the excess reserves created by the quantitative easing program yielded a positive interest carry. This is not the case in the Eurozone where the reserves created by the bond buying program with the ECB are held with a negative interest rate.  This makes the program much less attractive to sellers of the bonds.

However, there is another issue that was recently pointed out by the very smart gentlemen at GaveKal Research:

“When we overlay the MSCI Europe, we find a somewhat surprising relationship-- equities have risen as the central banks' assets have contracted over the last several years, implying that asset purchases (inverted on the following chart) could actually be negative for stocks:”

ECB-Balance-Sheet-MSCI-012815

“We have no way of knowing for sure whether or not this pattern will hold, but this chart would seem to suggest that MSCI Europe equities could decline ~30% by the end of 2016.”

Given that the majority of the Eurozone is either near or in recession, there is little reason to hope that a QE program the size that is being suggested by the ECB will be effective. However, there is currently little evidence that investors should be betting heavily on a resurgence of international asset prices. As shown in the chart below the correlation between domestic and international equities has been quite high and more correlated to the Federal Reserve’s repetitive QE programs. 

International-SP500-QE-012815

With the domestic markets now struggling due to lack of liquidity, it is unlikely that international equities will provide any safety net for investors. Of course, while the mainstream media may be telling you to keep investing in stocks, it is clear that the“smart money” has been heading into the safety of bonds.

Low-Interest Rates Failing To Spark Housing Recovery

Dr. Ed Yardeni penned an interesting note recently stating:

“In particular, US exporters could suffer if the greenback continues to strengthen. However, that could be offset by stronger US consumer spending and home building.”

There is currently little evidence that US consumer spending is getting stronger.  But the point I want to address today is this continued hope for a revival of home ownership in the U.S. That hope is grounded in the belief that if more people buy homes, not even considering whether they can afford it or not, it will boost the economic recovery. This has been one of the points that the Federal Reserve have pointed to in supporting their monetary interventions.

However, despite abnormally low interest rates, home ownership rates in the U.S., as I showed in “Housing, Not Much Recovery,” have fallen markedly while renters now make up the majority. The percentage of apartments, relative to total new home construction, is near the highest levels on record which explains the chart below.

Housing-NationOfRenters-110414

More importantly, given that the Federal Reserve has spent the last six years artificially suppressing interest rates to boost borrowing and home buying, it has been of only marginal success.  Considering the trillion’s of taxpayer dollars spent on bank bailouts, TARP, mortgage fraud forgiveness, HAMP, HARP, etc., the results are quite disappointing.

Housing-Process-Index-012815

Now, with the Fed set to start raising interest rates, the collapse in energy prices, and rising concerns about financial market stability, don’t be surprised to see housing activity begin to slow in the months ahead.  

Real estate related investments are already far ahead of the underlying activity as investors have chased “yield and hope.”  Both of those reasons are quite devoid of fundamental realities that have subsequently tended to have a nasty bite when ignored.

Lance Roberts

Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of "Street Talk with Lance Roberts", Chief Editor of "The X-Factor" Investment Newsletter and the Streettalklive daily blog. Follow Lance on Facebook, Twitter and Linked-In.

© Streettalk Live

[description] => On Wednesday, the Federal Reserve made their latest monetary policy announcement. Janet Yellen, the current Chairwoman, made several statements that led the markets to believe that they remain on course for increasing the overnight lending rate this year. [author] => Lance Roberts [legacyinterface_firm_id] => 400 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 18:24:46 [created_by] => 948 [modified_on] => 2015-01-29 18:25:17 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2471 [hits] => 0 ) [16] => stdClass Object ( [legacyinterface_commentary_id] => 2406 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15643 [apv_conversation_id] => 3380 [content_type] => market-commentary [title] => Momentum X 2: Unleashing the True Power of Momentum [slug] => keystone_012915 [fulltext] =>

“Momentum is the premier market anomaly and is above suspicion“   - Fama & French

The power of momentum in the financial markets is one of the most researched and documented market anomalies. Morningstar notes that “The Big Two” factors in factor-based investment strategies are value and momentum1. Momentum is one of the most robust approaches in terms of its applicability and reliability. Since just 1993 there have been nearly 400 published momentum papers, making it one of the most heavily researched finance topics over the past twenty years. Extensive academic research has shown that momentum works in virtually all markets and time periods, from Victorian ages up to the present.

Momentum investing is based on the idea of trend following. Like Sir Isaac Newton’s theory of momentum, the concept is that an object in motion tends to stay in motion – but not forever. Momentum strategies simply try to identify a trend in its early stages by measuring and comparing price momentum with the hopes that the trend continues. Momentum strategies use a dynamic process to analyze the price movement of an investment or group of investments.

There are many ways to measure momentum. Relative Strength (RS), for example, is a momentum-based strategy that measures the movement of a predefined group of investments across a period of time. The investment showing the best price movement is said to have the highest relative strength. The concept is fairly simple – invest in the one showing the most relative strength and periodically re-calculate and adjust the portfolio if needed so it always contains the investment of highest relative strength.

Because it stems from an entirely different mind-set based on technical analysis rather than fundamental data, RS has the potential to add a powerful dimension to a traditional portfolio.

The graph below, calculated by Arrow Funds2, illustrates the historical growth of the S&P500 Value Index, S&P500 Growth Index and Momentum, based on the Fama-French size/momentum large-cap model (see: http//mba.tuck.dartmouth.edu). The historical data makes a compelling argument for momentum.

PAST PERFORMANCE IS NO INDICATION OF FUTURE RETURNS. The graph at left is based on index data and published academic models. The index and blended data assumes quarterly rebalancing and reinvestment of dividends, but does not include fees. Indexes are not available for direct investment. Data sources: FactSet and Fama-French Library.

At Keystone Wealth Advisors, we’ve confirmed this research with our own. The chart below is a hypothetical back test that shows the results of a very simple relative momentum methodology of investing in the highest relative strength ETF from a group composed of four ETFs giving exposure to the S&P500, small/midcap US stocks, developed foreign stocks, and emerging market stocks from January 2003 to June 2014. It rebalances monthly. (All charts in this paper represent a hypothetical back test using the referenced ETFs. Returns are total return, reflecting the reinvestment of dividends, but do not reflect any transaction costs or advisory fees).

 

Clearly the relative momentum approach produces a bigger total return than the buy-and-hold approach with the S&P500 Index. However, the portfolio still has a significant maximum drawdown exceeding 60%.

Despite its edge over time and particularly during bull markets in stocks, the one thing that momentum investing does not address effectively is the large drawdowns that can still occur by maintaining a 100% allocation to stocks, even if always invested in those of the  highest relative strength. The term “relative” simply means that something performs better than something else on a relative or comparative basis and this method did indeed produce better relative performance as measured against the S&P500 index. Within this context, if we focus our attention away from the periods of positive returns in the stock market to periods of decline, a relative performance of negative 25% compared to a negative 40% is still defined as good.

How do we address the issue of severe drawdowns to get a better solution for the real needs of investors? What if we could avoid most of the severe declines that occur in stocks and limit the size of the drawdowns? The answer is introducing another level of momentum into the mix known as absolute momentum. Absolute momentum adds an additional level of scrutiny to the trend of the assets in the group. Instead of just comparing various stock investments to each other and investing in the highest relative strength stock position, absolute momentum says that you will invest in the highest relative strength stock investments only if they are showing a positive price trend, or absolute momentum. A simply way to implement this is to add a deemed risk-free asset into the group that is ranked right along with all of the equity positions.

So, the next level is adding short term US treasury bills into the list. This next step has been referred to as “dual momentum” because we are looking at both relative momentum and absolute momentum at the same time. In this hypothetical back test the same equity ETFs are used as in the example above and an ETF representing short term treasuries is also a candidate from January 2003 to June 2014. It rebalances monthly. This means that when the ranking is done each month the top ETF could be the short term treasury ETF or any of the equity ETFs. The short term treasuries are quite broadly accepted as risk-free assets and cash equivalent.

 

Adding the absolute momentum level shows significant benefits over using only the relative momentum approach only. This is primarily because the portfolio can move to the short term treasury bonds when the equities lose momentum in relation to the treasuries. In this case the total return is improved and the maximum drawdown is reduced from a negative 63% to a negative 23%. Recovering from a 23% decline is much easier than recovering from a 63% decline.

Now, what if we use long term treasuries instead of short term treasuries? Using long term treasuries adds a little bit more sensitivity and the opportunity for growth when out of stocks instead of just the safety of cash. The chart below shows the results of a hypothetical back test using the exact same methodology and group of equity ETFs as above but also using an ETF that tracks long term treasuries instead of just short term treasuries from January 2003 to June 2014. It also rebalances monthly.

Not only does the total return improve even more, but the maximum drawdown is reduced further to 18.6%.

The dual momentum approach (blending relative momentum with absolute momentum) has been extensively researched by others, such as Gary Antonacci of Portfolio Management Associates, LLC. In his 2012 research paper entitled “Risk Premia Harvesting Through Dual Momentum” he shows his findings that both relative momentum and absolute momentum can enhance returns, but that combining them gives the best results.

Antonacci says: “… we need to distinguish clearly between relative and absolute momentum. When we consider two assets, momentum is positive on a relative basis if one asset has appreciated more than the other has. However, momentum is negative on an absolute basis if both assets have declined in value over time. It is possible for an asset to have positive relative and negative absolute momentum. Positive absolute momentum exists when the excess return of an asset is positive over the look back period, regardless of its performance relative to other assets.” 

His conclusion?: “The combination of relative and absolute momentum makes diversification more efficient by selectively utilizing assets only when both their relative and absolute momentum are positive, and these assets are more likely to appreciate. A dual momentum approach bears market risk when it makes the most sense, i.e., when there is positive absolute, as well as relative, momentum. Module-based dual momentum, serving as a strong alpha overlay, can help capture risk premia from volatile assets, while at the same time, defensively adapting to regime change.”

This figure from his research paper demonstrates his findings:

Two additional pieces of research that address this concept well are:

Generalized Momemtum and Flexible Asset Allocation (FAA) An Heuristic Approach – Wouter J. Keller and Hugo S.van Putten, December 24, 2012

Adaptive Asset Allocation: A Primer – Adam Butler, CFA, Michael Philbrick, Rodrigo Gordillo, and David Varadi, September 2013

Conclusion:

It is the combining of both relative momentum AND absolute momentum (dual momentum or Momentum2) that really unleashes the power of momentum investing. Not only does it keep the assets invested in the areas of highest relative strength during bull markets, but it can move the portfolio to assets with potentially positive absolute momentum when stocks are in decline and help dramatically reduce portfolio drawdown.

2 Arrow Quarterly Bullseye Report, 1st Quarter 2014, published by Arrow Funds.

IMPORTANT DISCLOSURES:

No current or prospective client should assume future performance of any specific investment strategy will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client's investment portfolio. Historical performance results for market indices and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark.

Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information on products and services. It should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein.

The hypothetical and back tested information, including the projected success of dual momentum, does not represent any actual trading, but was achieved solely by the means of retroactive application of a model designed with the benefit of our hindsight and modification. The results do not reflect the impact of material economic and market factors that may have had on our decision making at the time of the event, had we been actually managing any client assets in this strategy. The model, after achieving desired results, did not materially change. Actual trading results of in this strategy would be lower than the results in this illustration due to trading costs, management fees, and other potential costs. Prospective clients should not base investment decisions on back-tested performance as no client achieved the returns stated above. The purpose of back-tested performance is to test the investment ideas, investment strategy developed (and modifications) to achieve stated results. Past results, including hypothetical and back-tested results are not a guarantee or predictor of future results.

Indexes cannot be invested in directly, do not have trading costs or fees associated with them and are total return (reinvestment of dividends and capital gains). S&P 500 Index is owned by Standard and Poor’s; data is S&P. US Small/Midcap Index is Standard & Poor's Completion Index, a broadly diversified index of stocks of small and medium-size U.S. companies; data by S&P. Emerging Markets Index is MSCI Emerging Markets Index, data by MSCI. Developed Foreign is MSCI EAFE Index, data by MSCI. US Treasuries (long term) Index is Barclays U.S. 20+ Year Treasury Bond Index; data by Barclays. No part of this article may be reproduced in any form, or referred to in any other publication, without proper reference.

©2015, Keystone Wealth Advisors, LLC.

[description] => Momentum is one of the most researched market anomalies and has become widely accepted and used in a variety of ways for investment management. When used in practice is it most commonly referred to as relative strength or relative momentum. What happens if we combine the power of relative momentum with absolute momentum? [author] => Gordon Nelson [legacyinterface_firm_id] => 531 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 20:21:49 [created_by] => 948 [modified_on] => 2015-01-29 20:32:08 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2472 [hits] => 0 ) [17] => stdClass Object ( [legacyinterface_commentary_id] => 2407 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15662 [apv_conversation_id] => 3420 [content_type] => market-commentary [title] => Contrarian View: A More Balanced Approach to Rate Risk in 2015 [slug] => invesco_012915 [fulltext] =>

The threat of higher interest rates is dominating many 2015 outlooks for investors and professional forecasters alike. Consensus expectations call for the Federal Reserve (Fed) to begin tightening in the second half of the year, with market rates to rise in concert and bond prices to fall. But the changing composition of voting members on the Federal Open Market Committee (FOMC) is a looming variable that I believe will likely impact the pace and severity of Fed action.

A more dovish Fed favoring low interest rate— combined with indications of global economic slowdown and falling asset prices — may translate into a more benign rate environment for 2015 than expected. With this in mind, investors may want to reconsider stripping away all interest rate exposure from their income allocation and instead consider a more diversified and balanced maturity structure.

FOMC rotation favors dovish views

In my view, the January 2015 changes to the membership of the FOMC will bring about an even more dovish weighting to voting, based on historical voting patterns and public comments made by members.

  • Three voters viewed as hawks or hawkish because they favor higher interest rates — Charles Plosser, Richard Fisher and Loretta Mester — are rotating off.
  • The only dovish voter stepping aside is Narayana Kocherlakota, who actually has a fairly balanced history of voting patterns.
  • Committee additions include three with dovish views: Charles Evans, Dennis Lockhart and John Williams.
  • President Barack Obama can fill two additional vacancies, and I would expect his appointments to carry dovish inclinations.
  • Jeffrey Lacker, who has expressed very hawkish views, also joins the FOMC, but he will likely be the loner at that end of the spectrum.

FOMC 2015: Dominant Doves May Create a More Patient Fed

Implications for investors

If a more dovish Fed takes a slower, steadier approach to tightening than anticipated, fixed investments with longer average durations may not be the portfolio-killers they might otherwise be in an environment where the interest rate rises more rapidly. In fact, peppering portfolios with some exposure to longer duration may offer an opportunity for enhanced yield and total return, as well as diversification from equity risk. While a fixed income allocation built for Fed tightening may still be appropriate for many investors, blending a little duration into a portfolio may be beneficial if rates once again defy expectations and continue to fall.

Adding duration into a fixed income allocation

After talking to their financial advisors, investors may want to consider increasing their exposure to high-quality, longer-duration strategies. For example:

Important information

The Federal Open Market Committee (FOMC) is a 12-member committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.

Duration is a measure of the sensitivity of the price of a fixed income investment to interest rate changes.

*Effective July 8, 2014, the Fund’s name, investment objective, investment policy, investment strategies and underlying index changed. The Fund’s name changed from PowerShares Insured National Municipal Bond Portfolio to PowerShares National AMT-Free Municipal Bond Portfolio, and the underlying index changed from BofA Merrill Lynch National Insured Long-Term Core Plus Municipal Securities Index to BofA Merrill Lynch National Long-Term Core Plus Municipal Securities Index.

Before investing, investors should carefully read the prospectus/summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the Fund call 800 983 0903 or visit invescopowershares.com for the prospectus/ summary prospectus.

Diversification does not guarantee a profit or eliminate the risk of loss.

There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Underlying Index.

Investments in fixed-income securities, such as notes and bonds, carry interest rate and credit risk. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. Credit risk is the risk of loss on an investment due to the deterioration of an issuer’s financial health. Due to anticipated Federal Reserve Board policy changes, there is a risk that interest rates will rise in the near future.

For BAB and PZA, municipal securities may be affected by political changes as well as uncertainties in the municipal market related to taxation, legislative changes or the rights of municipal security holders. The market for municipal bonds may also be less liquid than for taxable bonds.

For BAB, there is no guarantee that municipalities will continue to take advantage of the BAB program in the future and there can be no assurance that BABs will be actively traded. Furthermore, under the American Recovery and Reinvestment Act of 2009, the ability of municipalities to issue BABs expired on Dec. 31, 2010. As a result, the number of available BABs in the market is limited. In addition, illiquidity of the BABs may negatively affect the value of the BABs.

For PZA, there is no guarantee that the Fund’s income will be exempt from federal or state income taxes

For PCY, the Fund will invest in foreign bonds and, because foreign exchanges may be open on days when the Fund does not price its shares, the value of the non-US securities in the Fund’s portfolio may change on days when you will not be able to purchase or sell your shares.

For PCY, sovereign debt securities are subject to the additional risk that – under some political, diplomatic, social or economic circumstances – some developing countries that issue lower quality debt securities may be unable or unwilling to make principal or interest payments as they come due. The fund may have limited legal recourse against the issuer and/or guarantor of sovereign debt when default occurs. As a holder of government debt, the Fund may be requested to participate in the rescheduling of such debt and to extend further loans to government debtors.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

All data provided by Invesco unless otherwise noted. 

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

©2015 Invesco Ltd. All rights reserved.

[description] => The threat of higher interest rates is dominating many 2015 outlooks for investors and professional forecasters alike. Consensus expectations call for the Federal Reserve (Fed) to begin tightening in the second half of the year, with market rates to rise in concert and bond prices to fall. But the changing composition of voting members on the Federal Open Market Committee (FOMC) is a looming variable that I believe will likely impact the pace and severity of Fed action. [author] => Scott Eldridge [legacyinterface_firm_id] => 225 [published_on] => 2015-01-29 [digest_date] => 2015-01-29 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-29 21:20:49 [created_by] => 948 [modified_on] => 2015-02-02 15:34:23 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2473 [hits] => 0 ) [18] => stdClass Object ( [legacyinterface_commentary_id] => 2381 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15618 [apv_conversation_id] => 3348 [content_type] => market-commentary [title] => Sell-off in Corporate Credit Creates Income Opportunities for 2015 [slug] => eaton_012815 [fulltext] =>

SUMMARY

  • In 2014, U.S. short-term rates inched up in anticipation of Fed tightening, while global weakness reduced upward pressure on long-term rates.
  • Lower U.S. long-term rates were a tail wind for most fixed-income sectors.
  • We expect a flattening yield curve in 2015, and view this as a positive for floating-rate loans, high-yield bonds and municipal bonds relative to U.S. Treasurys.
  • Investors should be prepared for more price volatility; a longer-term focus can help bridge choppy patches that may be more technically than fundamentally driven.

The broad backdrop for the bond market in 2014 consisted of divergent macro forces in the U.S and the rest of the world. In the U.S., as signs increased that the recovery was gaining steam, the market looked to signals from the U.S. Federal Reserve (the Fed) for clues about when it would formally begin to tighten monetary policy by raising the federal funds (fed funds) rate. But in Europe, Japan and China, central banks pursued looser policies as the global economy weakened – except for the U.S., at least so far. This divergence can be seen most dramatically in the excess yield of U.S. 10-year debt compared with Spain, Germany and Japan. This is the first time in five years the U.S. has yielded more than Spain (Exhibit A), while the spread over German debt widened to 163 basis points (bps), compared with a five-year average spread of 44 bps.

This sets the stage for a flattening yield curve, with U.S. short-term rates creeping up in anticipation of Fed tightening, while continuing global weakness reduces upward pressure on long-term rates. The flattening we anticipate would be a continuation of a trend we have seen in the past year. The income investment strategies that we feel are most attractive this year are those that sold off in the fourth quarter of 2014 and are likely to fare well in a flattening scenario. First, we review 2014 performance.

A good year for bonds

In general, bond market performance in 2014 benefited from the 87-bps decline in the 10-Year U.S. Treasury yield over the course of the year. Not only was there a lack of substantial pressure from the global economy to put a floor on rates, but the re-emergence of market volatility in October brought back “flight to quality” as a force that helped boost Treasury prices and lower yields. As a result, most fixed-income sectors posted positive total returns for the year, in marked contrast to 2013, when only high-yield bonds and floating-rate loans were in the black (Exhibit B).

The last two years offer a lesson in how investor sentiment can drive short-term swings in bond prices, even when the economic environment has not changed substantially, as was the case in 2013 and 2014. For example, total return on municipal bonds swung from -2.9% in 2013 to 9.8% in 2014. Our generally positive view of the municipal sector has been fairly consistent over the past two years, as we have seen steady improvement in the financial condition of many state and local governments. (An extensive look at our take on municipals was in the November 24, 2014 issue of Barron’s.) Indeed, the sector was one of our top recommendations in this report one year ago.

The 2013 underperformance of the municipal market was largely driven by negative headlines about the difficulties faced by a relative handful of issuers such as Detroit and Puerto Rico. Last year, however, as the brightening view of the municipal landscape gained more acceptance and the impact of the new 2013 tax rates sunk in, the tide of investment flows reversed into the sector. In investment jargon, these were technically driven price moves, where supply and demand were a greater factor in the changes than the fundamentals.

Market technicals also played a significant role in explaining performance in the high-yield bond and floating-rate loan markets over the past two years. As noted, high yield bonds and floating-rate loans led the pack in 2013, but were near the bottom last year. In this case, the two had been beneficiaries in 2013 of the global search for yield, as investors poured money into the sectors. But in 2014, concerns about increasing levels of risk in the market – i.e., issuance by some less-creditworthy borrowers at the margin – led to a turnaround in flows. Nevertheless, high-yield had a total return of 2.5% and floating-rate, 1.6% – positive, but well below their respective coupon income. Again, technicals outweighed fundamentals, as corporate America generally continued along the same improvement track over the two-year period.

Credit sectors have fared well in earlier rising-rate cycles

Considering the potential impact of a flattening yield curve serves a useful purpose, because investment discussions often talk about “rising rates” without mention of where on the yield curve that may happen. Except for the historic intervention of quantitative easing, which ended in October, the Fed largely manages monetary policy at the short end of the yield curve.

Exhibit C (top) shows that certain credit-sensitive fixed-income sectors have small, but positive, correlation with changes in the fed funds rate, meaning that historically, total returns of these sectors have actually been positive when the Fed has raised short-term rates. The implication is that if the Fed tightens this year, as is now expected, and long-term U.S. rates remain tethered by continuing relatively weak global growth, capital losses are not likely to be realized in certain fixed-income credit sectors. Exhibit C (bottom) shows a different picture when the 10 Yr. U.S. Treasury yield has risen. During those periods, all sectors have lost value, except floating-rate and high-yield. Floating-rate loans have near-zero duration, while high-yield bonds have relatively high cash flows that cushion the impact of rising rates on price.

Investment implications for 2015

  • Floating-rate loans– As discussed, floating-rate loans have historically done well in periods of rising rates – whether at the short or long end of the yield curve. Given very low average historical credit losses, yields are relatively attractive at greater than 5% as of December 31, 2014. The sector has recently experienced a sell-off, in part due to negative headlines, and prices have fallen below par, meaning there is room for capital appreciation. At this phase of the credit cycle, we favor high-quality issuers who are most likely to meet their obligations and provide the income stream investors expect.
  • High yield – High-yield bonds should be relatively unharmed in a flattening-yield-curve environment, due to a restored “yield cushion.” Thanks to price volatility in the fourth quarter of 2014, yields increased to 6.7% at yearend. Another plus for the sector is that default rates, an important indicator and component of total return for high-yield debt, are near historic lows.
  • Municipal – We believe general improvements in state and local government finances are likely to continue and that tax rates remain a major concern for investors. In our opinion, the sector remains attractive relative to U.S. Treasurys. The longer end of the municipal yield curve appears to offer slightly better value, with 30-year AAA municipals yielding 100% of equivalent-duration U.S. Treasurys, although the longer end is vulnerable if long-term Treasury rates rise significantly. This is not our expected scenario, but investors who are concerned about potential price volatility might consider an intermediate to slightly longer duration portfolio, an opportunistic muni credit approach, or a laddered muni bond portfolio – one which holds bonds with a sequence of maturities from short to long. As the shorter-term bonds mature, the principal can be invested in longer-maturity bonds with higher yields, helping to cushion the impact of potential price declines in the portfolio due to rising interest rates.
  • Emerging market– This sector sold off in 2013. Last year, we expected more of a recovery but got a mixed one: Local currency-denominated bonds lost 5.7%, while dollar-denominated emerging-market bonds had a total return of 6.2%, largely because of the strength of the U.S. dollar. Both dollar and non-dollar have attractive yields, with the latter also offering exposure to other currencies and a hedge against the dollar. Bear in mind that emerging-market debt historically has been volatile. Local currency debt currently may be best-suited for longer-term investors, given our current expectation of continuing near-term strength in the U.S. dollar.

Keeping volatility in perspective

We anticipate volatility will continue to be a factor in 2015 for all market sectors. The phenomenon isn’t new – and bond market sector leadership has a long history of changing year to year. But sharper moves – price gaps, if you will – are becoming more routine. This has largely been attributed to lower inventories of bonds now being held by primary dealers (those who deal directly with the Fed) in response to new regulation. By making markets in bonds, such dealers have helped supply liquidity that has tended to smooth out price movements.

Regardless of the cause, we believe that greater volatility makes it more important than ever for long-term investors to prepare for it – to stay the course and resist action unless price declines reflect deteriorating fundamentals. Referring back to the recent municipal market volatility, investors who sold in 2013 based on negative headlines and technical factors would have missed the comeback in 2014. Staying the course is easier said than done, but volatility should be an occasion for investors to remind themselves of their objective and time horizon. If it is medium- to longer-term, the downside of “capitulating” to a patch of negative investor sentiment should be carefully considered.

Of course, volatility can be an investor’s friend, by providing attractive price entry levels for fundamentally sound investments. We touch on two strategies that seek opportunities that volatility may provide:

  • Absolute return– Absolute return strategies typically pursue long and short value opportunities across global bond markets. They seek to generate return that has low correlation to both stock and bond markets – a prudent strategy when either market sells off. Such strategies tend to do better in volatile markets, but less so in steady-state or trending markets.
  • Multisector income – Given that leadership can shift quickly in the bond market, multisector strategies are designed to take advantage of an expanded global opportunity set that is continually in flux. Multisector strategies seek total return by investing in value opportunities in individual securities across diverse U.S. and international income sectors. Returns can vary significantly from broad bond market benchmarks like the Barclays U.S. Aggregate Bond Index.

Value in closed-end funds

The closed-end funds in Exhibit D are examples of diverse income sectors being offered with a “value cushion” -- where the market price of a fund share is below the net asset value of the bonds in the fund’s portfolio. For example, the Morningstar U.S. closed-end national muni fund universe on December 31, 2014 traded at a 7.2% discount to NAV, for a yield of 5.5% and a taxable-equivalent yield at the top 43.4% rate of 9.7%.1 Another good example is the closed-end fund multisector bond universe, which had an 8.5% yield at yearend.

Looking ahead

We believe 2015 is likely to bring higher short-term rates and a flatter yield curve, along with greater overall volatility in the bond market. We feel investors will be best positioned for this environment by sticking with issues of qualilty companies or jurisdictions within each income sector.

We believe that bond picking and active professional management will be especially valuable in 2015. For example, a number of high-yield bonds were issued by energy companies. If low oil prices persist, it will be particularly important for portfolio managers to separate the winners from the losers in the sector. In our view, 2014 gave rise to excellent income opportunities, and we look forward to helping you pursue these in the new year.

1Taxable-equivalent yield refers to the yield an investor in a particular tax bracket would have to earn on a taxable investment to have the same after-tax yield as on a given tax-free security such as a municipal bond. In this example, we assume the investor is in the current maximum federal tax bracket of 43.4% (which includes the new tax from the Affordable Care Act). The investor would need a taxable yield of 9.7% to match the after-tax yield on a municipal bond of 5.5%. A portion of income may be subject to federal income and/or alternative minimum tax.

Index Definitions

BofA/Merrill Lynch U.S. High Yield Index is an unmanaged index of below-investment-grade U.S. corporate bonds.

The S&P/LSTA Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.

BofA/Merrill Lynch U.S. Mortgage-Backed Securities Index is an unmanaged index of the U.S. mortgage-backed securities market.

BofA/Merrill Lynch AAA-A US Corporate Index consists of U.S. dollar-denominated investment-grade corporate debt securities rated between AAA and A.

BofA/Merrill Lynch U.S. Treasury Index is an unmanaged index of U.S. Treasury securities with remaining maturities between 7 and 10 years.

BofA/Merrill Lynch Municipal Index tracks the performance of U.S. dollar-denominated investment-grade tax-exempt debt publicly issued by U.S. and its territories, and their political subdivisions, in the U.S. domestic market. Securities must have at least a one-year term remaining to maturity and a fixed coupon schedule.

JPMorgan Government Bond Index - Emerging Markets Global Diversified (GBI-EM) is an unmanaged index of local currency bonds with maturities of more than one year issued by emerging-market governments.

JPMorgan Emerging Markets Bond Index Plus (EMBI+) is an unmanaged free float-adjusted market-capitalization-weighted index designed to measure the debt market performance of U.S. dollar-denominated emerging markets.

BofA Merrill Lynch Indexes: BofA Merrill Lynch™ indexes not for redistribution or other uses; provided “as is,” without warranties, and with no liability. Eaton Vance has prepared this report, BofA/Merrill Lynch does not endorse it, or guarantee, review, or endorse Eaton Vance’s products.

Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Historical performance of the index illustrates market trends and does not represent the past or future performance.

About Risk

An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. As interest rates rise, the value of certain income investments is likely to decline. An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Investments involving higher risk do not necessarily mean higher return potential. Diversification cannot ensure a profit or eliminate the risk of loss.

Elements of this commentary include comparisons of different asset classes, each of which has distinct risk and return characteristics. Every investment carries risk, and principal values and performance will fluctuate with all asset classes shown, sometimes substantially. Asset classes shown are not insured by the FDIC and are not deposits or other obligations of, or guaranteed by, any depository institution. All asset classes shown are subject to risks, including possible loss of principal invested.

The principal risks involved with investing in the asset classes shown are interest-rate risk, credit risk and liquidity risk, with each asset class shown offering a distinct combination of these risks. Generally, considered along a spectrum of risk and return potential, U.S. Treasury securities (which are guaranteed as to the payment of principal and interest by the U.S. government) offer lower credit risk, higher levels of liquidity, higher interest-rate risk and lower return potential, whereas asset classes such as high-yield corporate bonds and emerging-market bonds offer higher credit risk, lower levels of liquidity, lower interest-rate risk and higher return potential. Other asset classes shown, such as municipal and investment-grade bonds, carry different levels of each of these risk and return characteristics, and as a result generally fall varying degrees along the risk/return spectrum.

Costs and expenses associated with investing in asset classes shown will vary, sometimes substantially, depending upon specific investment vehicles chosen. No investment in the asset classes shown is insured or guaranteed, unless explicitly stated for a specific investment vehicle. Interest income earned on asset classes shown is subject to ordinary federal, state and local income taxes, excepting U.S. Treasury securities (exempt from state and local income taxes) and municipal securities (exempt from federal income taxes, with certain securities exempt from federal, state and local income taxes). In addition, federal and/or state capital gains taxes may apply to investments that are sold at a profit. Eaton Vance does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision.

About Eaton Vance

Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors. For more information, visit eatonvance.com.

The views expressed in this Insight are those of the author and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.

This Insight may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing.

©2015 Eaton Vance Distributors, Inc. | Member FINRA/SIPC | Two International Place, Boston, MA 02110 | 800.836.2414 |eatonvance.com.

[description] => In this insight, Payson puts last year’s bond market volatility and performance in perspective and points out potential investment opportunities across market sectors in 2015. [author] => Payson Swaffield [legacyinterface_firm_id] => 124 [published_on] => 2015-01-28 [digest_date] => 2015-01-28 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2015-01-28 15:27:09 [created_by] => 948 [modified_on] => 2015-01-28 15:27:28 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 2447 [hits] => 0 ) [19] => stdClass Object ( [legacyinterface_commentary_id] => 2382 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 15619 [apv_conversation_id] => 3349 [content_type] => market-commentary [title] => Thoughts on Energy [slug] => leuthold_012815 [fulltext] =>

We’re not certain that the historic rout in the Energy sector is over, and even if we were our Group Selection (GS) Scores would likely prohibit us from loading up on Energy subgroups for at least a few more months. Pure valuation work has certainly proven misleading, with our Energy “relative valuation composite” (Chart 1) suggesting the sector stood on the brink of extreme undervaluation even before it became unglued in the sector half of the year. For what it’s worth, today Energy’s relative valuation level (a composite of Normalized P/E, Price/Cash Flow and Price-to-Book ratios) is the lowest in our 25-year history for this sector.

Chart 1

http://leutholdgroup.com/sites/leutholdgroup.com/files/charts/2015-january-stock-market-asset-15.jpg


Chart 2

http://leutholdgroup.com/sites/leutholdgroup.com/files/charts/2015-january-stock-market-asset-16.jpg

 

Last decade we frequently discussed the “Three Act Play” then unfolding in commodities, with the terminal act producing a 2006-2008 surge in commodity-oriented equities and a commensurate binge in capital spending. While all of the commodity sector participated, Energy certainly played either a lead or a co-starring role (Chart 2).

But we’ve seen the “Third Act” of similar plays before. They are inevitably self-correcting, with excessive speculation and overinvestment sowing the seeds for the next decline. Other analysts might call the Third Act the “distribution” or “public participation” phase, while students of Elliott Wave theory would call it a terminal “fifth wave.” At any rate, the general rule of thumb is that all of the upside move occurring during a Third Act is wiped out during the ensuing bear market. The Energy sector decline of 2008-2009 didn’t quite accomplish that feat, but the latest sell-off has—perhaps a positive sign.  

Chart 3

http://leutholdgroup.com/sites/leutholdgroup.com/files/charts/2015-january-stock-market-asset-17.jpg

 

Energy’s peak-to-trough decline of   –26.7% (to-date) is the second bear-market decline of magnitude suffered by the sector during the current cyclical bull market (Chart 3). The first was a –28.4% drop in mid-2011. Next, we compare these moves to other significant sector declines occurring outside of a broader bear market. 

How common are “self-contained” sector bear markets like the one just experienced in Energy? We scanned S&P for sector declines of 20% or more which occurred outside of S&P 500 cyclical bear markets. There were only 19 other instances since 1990.

·         Financials (four instances) was the most vulnerable sector to big declines independent of cyclical bear markets. Consumer Discretionary is the lone sector that did not suffer a stand-alone decline of 20%.

·         The encouraging news is that once a “rogue” decline in the respective sector has ended, relative performance (on average) over the next three, six, and 12 months has been good. The sector in question outperformed the S&P 500 by an average of 15% in the year following its “stand-alone bear market” low (… albeit with a few notable failures).

http://leutholdgroup.com/sites/leutholdgroup.com/files/styles/article-asset-large/public/charts/2015-january-stock-market-asset-18.jpg?itok=51GHNYJ5

© 2015 The Leuthold Group

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