March 2013 - Return of Market Volatility
February was a choppy month, experiencing a calm environment early in the month and a spike in broader market volatility later on. After seeing the S&P 500 rise to 1530, its highest level since October 2007, US stocks declined 1.8%, European stocks dropped by 3,5% and the VIX volatility index jumped to its highest level year-to-date. Leading to the shift in sentiment were a few items: first, the Italian election results on February 25th created a surprise and a clear rejection of the austerity program Italy badly needs.
Second, the Euro-area PMI (index of industrial activity) slipped 1.3 to 47.3 and reversed three consecutive months of gains, indicating a slowing recovery. Third, further polarization in US politics has led to full sequestration spending cuts as of March 1st . Finally in China, unease increased as the government began to signal discomfort with the growth of credit and housing prices as fears about the economy faded.
Other events which dominated markets were the release of the minutes of the Fed’s January meeting and Bernanke’s testimony to Congress. The last two rounds of FOMC minutes raised the concern that the Fed is genuinely concerned about the costs associated with further asset purchases, to the point where it may reduce purchases before the desired improvement on the labor markets is realized. Bernanke’s testimony eased some of those concerns as he downplayed most of those risks and concluded that the benefits are still seen as outweighing the costs. Subsequently the 10-year US Treasury rate dropped by 0,15% to 1,85% as fears of an early removal of liquidity faded.
Yes, risks to our positive outlook on markets have increased recently, but are not sufficient to reverse the risk rally, in our view. We continue to be invested in cash-flow generating assets such as high-yield bonds (with a preference for US High Yield) and high dividend-yielding equities (with a preference for US Equities).
These views are predicated on the high risk premium that still exists on these assets vs. the safer ones and on fading global macro risks. The risk factors mentioned above have stalled the rally but have not reversed it.
A deepening of risks is not inconceivable, but requires a significant worsening in policy decisions and economic data than what we have seen so far.
Although Italian election results came as a significant negative surprise for markets, we don’t think it has the potential to derail the relative Euro peace that has been in place since June of last year. Our base case remains that the center right and left parties will be able to create a coalition and that the political impasse will only have a relatively localized impact on European markets (cf. Spanish yields, which edged down last week, even as Italian yields have spiked higher).
US sequestration spending cuts are now a reality and should have been priced in by the markets. A Congressional refusal to further lift or suspend the debt limit in May to July are very unlikely.
In terms of our positions, our equity model portfolio generates an average 5% dividend and is positioned to gain from an inflationary scenario in the US, driven by the ongoing open-ended QE program. The stock selection consists of oil and precious metal companies, US REITs and global consumer goods companies with a strong global brand.
In the fixed income space, we continue to favor US High Yield bonds, where realized default rates have continued to come down in February for a sixth consecutive month. The US High Yield default rate is now just 1.2%, its lowest since June 2012. Although the asset class continues to see outflows, we remain confident that a combination of low interest rates, low default rates, high risk premium will continue to support it through 2013, but clearly to a lesser extent compared to last year, as the market remains vulnerable to increases in Treasury rates.
Now more than ever, with bank deposit rates being so low and valuations in some corners of the market looking expensive, good name picking and rigorous risk management are essential.