As we commence the New Year, our thesis has not changed from that which we held 12 months ago; namely, U.S. interest rates are artificially low and the U.S. economy is performing better than general consensus believes. To fully clarify where we find ourselves at this stage of the economic cycle, we’ll first examine the trading dynamics witnessed in the just concluded fourth quarter, followed by a discussion of our current positioning and expectations for the coming year.
Following a summer of frightening headlines foretelling the demise of the Euro, default by one or more sovereign nations, a credit rating downgrade of U.S. government debt, and a systemic collapse of the banking system, investors willingly ignored improving fundamentals and focused instead on the barrage of doomsday scenarios proffered by the print and broadcast media. As the year came to a close, the three biggest concerns were the “turn” effect, fear of a sovereign default-induced banking problem, and the misinterpretation of the success of “operation twist.”
The “turn” pertains to the concept that banks and financial institutions must be fully funded when they close the books for year-end, also known as the “turn” of the year. While I don’t recall a single instance when a bank or financial institution was unable to fund itself at year end it, nevertheless, is an annual folly that creates unnecessary nervousness in the short maturity bond market. However, with investors fearful of European bank-induced systemic risk, year-end funding concerns spread to the debt of the banking sector and weighed on bank bond prices into the final trading day of the year. So much so that money center bank paper with less than a year to maturity were readily trading with a yield-to-maturity in excess of 3.0%.
At the other end of the extreme, investors continued to demonstrate an insatiable appetite for U.S. Treasury notes. Particularly perplexing was the logic in buying Treasury notes with long dated maturities. Anecdotal evidence points to a misconception among investors that the current Federal Reserve open market operation, colloquially know as “operation twist,” is taking long maturity bond supply out of the market. In fact we believe that the exact opposite is the case. In January 2011, the supply of U.S. Treasury bonds with a maturity of 20 years or more totaled approximately $400 billion, according to Barclays Capital. Today, that number is now approximately $500 Billion, a 23% increase in supply. We commend the Fed on an excellent marketing job, but as the misconception is realized and supply continues to pile up in 2012, the Fed is not likely to be able to maintain a 30-year interest rate in line with or below the rate of inflation.
Looking forward, we find the international investment landscape to be similar to that which was in place in 2003. Then, as now, it seemed unlikely that Europe would be a principal driver of global economic growth. Aggressive investors were shunning the continent in favor of emerging markets, with particular focus on China. Investors were fascinated with the growth potential of the burgeoning middle class, and the corresponding profit opportunity that growth would offer. History has shown that a growing middle class is accompanied by an increased demand in everything from food and shelter, durable and non-durable goods, and luxury items. From that demand is born a virtuous cycle of economic growth and profit potential. Much of what was anticipated eight years ago has come to pass. According to Reuters, more than 13 million automobiles were sold in China last year, which is a 900% increase in sales compared to the 1.3 million units sold there in 2003. Growth of that magnitude can be found in broad aspects of the economy across the emerging markets. Certainly, the current challenge faced by the Chinese central planners to cool the property sector without stalling the economy is likely to prove a daunting challenge and one that has given investors pause. Perhaps even more damaging to investor confidence has been the numerous high profile accounting scandals that have surfaced in the last year. Holding aside the short-term policy tweaks of the Central Bank and the petty malfeaseance said to be inherint in small and medium sized business, the secular growth story that was expected to dominate the 21st century eight years ago is still very much alive and well. The only change is that in 2003 China enjoyed a foreign exchange reserve of $403 million. As of September 2011, reserves have ballooned to $3.2 trillion according to the State Administration of Foreign Exchange of the People’s Republic of China. With such a pool of reserves and a middle class growing by more than 10 million persons annually, one would expect China to drive economic growth for decades to come.
Given the scenario described above, we expect that European fiscal and balance sheet issues will continue to “spook” investors, but will not destabilize growth. The United States will likely continue to experience accelerating economic growth and falling unemployment, while the driver of the Global economy for the foreseeable future will be China. With that view, we’ve structured the portfolio to reflect three driving biases; overweight credit, long U.S. dollar, and avoidance of interest rate sensitivity.
In positioning for our bullish credit outlook, we’ve built an overweight exposure to U.S. bank and brokerage paper. While we anticipate that the sector will continue to be subject to headline risk and price volatility, we’re of the opinion that current valuations ignore the business risk reduction that has taken place in the sector since the financial crisis. Similarly, we favor Australian and Canadian banks for their conservative management and spread stability relative to risk free interest rates. Conversely, except for a select few names, we continue to avoid European banks.
Further expanding upon our credit bullishness, we continue to find exceptional value in both taxable and tax-exempt municipal bonds. At year end, our exposure to the municipal market had risen to 10% from 3.25% at the beginning of last year. The irony is that while municipalities have made steady progress in closing budget deficits and correcting flawed fiscal policies, municipal bonds continue to suffer from the “baby and the bath water” syndrome that has plagued the market for more than a year.
While our bullish credit view extends to a number of non-U.S. issuers, we do not favor investment in non-U.S. dollar denominated investments. At the commencement of 2011, a popular investment theme among strategists was investment in local currency denominated emerging market debt. The rationale hinged on a belief that countries like Brazil and Russia were in better fiscal shape than the U.S. and, hence holding bonds in those local currencies would offer the added value of currency appreciation and incremental yield. Advocates of the strategy became much less vocal as the year progressed and losses in the strategy began to mount. For the year, the Indian Rupee, lost 18%, the Brazilian Real and Mexican Peso both lost more than 12%, and the Russian Ruble lost more than 5%. As we’ve articulated previously, investment in fixed income instruments denominated in local currency result in “equity-like” risk for “fixed income-like” return. Currently, we see no opportunities in which both yield-to-maturity and currency valuation would prompt us to buy local currency-denominated emerging market debt. Similarly, for reasons discussed above, we are avoiding Euro-denominated debt as well. For the time being, we are staunchly dollar focused.
The mortgage backed securities (MBS) market falls solidly between our bullish and bearish call. With the risk of a possible sharp rise in rates looming, we deem mortgage-backed securities as being at an even greater risk to price deterioration. Due to the structure of mortgage-backed securities and the mathematics involved in pricing the securities, the price of MBS fall faster than Treasury securities in a rising rate environment. However, offsetting the rate rise risk is the ongoing speculation that the Fed is poised to launch QE 3, with the exclusive mandate of buying mortgage-backed securities. With that, we’re maintaining our MBS position for now, but will keep a watchful eye on the market for deterioration in the fundamentals.
Finally, we continue to view the short term interest rate hedge position as very attractive from a reward/risk tradeoff perspective because it affords us the opportunity to hedge the portfolio for very little cost through a short position in Fed Fund futures and interest rate options on LIBOR interest rates. Both Fed Fund and LIBOR interest rates continue to remain at rates very close to zero and do not expect this to change given the Federal Reserve’s pledge to keep interest rate near zero until at least mid -2013.
To conclude, as we evaluate the investment landscape for the coming twelve months, we believe the Halyard Fixed Income Fund is well positioned to perform as economic growth continues to expand, Europe continues on a path of slow but steady resolution to their debt and budget concerns, and investors develop a heightened appetite for risky assets and a distaste for U.S. government debt.