Week in Review
Last week saw strong performance in global markets with all major indices rmly in positive territory. Abroad, emerging markets slightly outperformed developed international. At home, large-cap equities outperformed small caps. The US. bond market also had positive performance despite the 10-year Treasury yield inching up a few basis points to close the week at 2.26%.
One of the major highlights during the week was the release of minutes from the October Federal Open Market Committee (FOMC) meeting. The release had a hawkish tone and showed that Federal Reserve (Fed) officials believe conditions may be met for an interest rate hike at the next policy meeting in December. Since the release, the probability of a December hike implied by Fed funds futures increased to 72%, the two-year Treasury bond yield increased to over 90 basis points for the rst time since 2010, and the dollar index increased to its highest level since March of this year. The fact that both equities and the long end of the Treasury curve rallied after the release suggests markets may be ready for the hike.
A Trip to Newport Beach
The weather in CLS’s hometown of Omaha, NE. was unpleasant last week. Day after day of low temperatures, high wind, and heavy rain gave way to snow to kick off the weekend. Fortunately for me, I was not in Omaha to endure it. Instead, I spent that time in constant sunshine, 80 degree temperatures, and a view of the ocean. I was in Newport Beach, attending PIMCO’s 2015 Wealth Management Forum.
At the forum, PIMCO’s top portfolio managers covered everything from their overarching philosophy and process to their investment outlook. For me, there were two key takeaways from the trip. First, PIMCO’s investment process is robust, and has a deep and talented bench of investment professionals behind it. Second their investment outlook is consistent with CLS in a few important areas.
PIMCO has been promoting the idea of the “New Neutral.” In basic terms, the firm contends that high debt and deficit levels combined with negative demographic trends will lead to lower growth rates moving forward. The conclusions drawn from this concept are consistent with CLS’s own outlook. First, while growth has not been robust domestically, overall economic data has achieved a sufficient level of strength for the Fed to reduce its unprecedented seven-year stretch of accommodative monetary policy. Ultimately, the upward move in rates is expected to be slow, with the terminal level lower than in previous rate hike cycles. To state it another way, the neutral level of interest rates, – the level at which interest rates are neither accommodative nor contractionary – will be lower than in the past. In light of this, investors typically need not fear large losses in their bond portfolios. The coupons received will likely more than cover any negative price return, and they will have the opportunity to be reinvested at higher rates. It is this feature of bonds that often lends to them being referred to as self-healing assets.
Another area where outlooks are consistent is related to equities. Both PIMCO and CLS believe equity returns will be positive but below average moving forward. Therefore, we are both emphasizing international over domestic due to more attractive starting valuations abroad.
Alternatives to Market-Cap Weighting
Investors in the U.S. have billions of dollars allocated to passively managed bond portfolios, but there is a major flaw in the way the indices these portfolios track are constructed. The indices use a weighting methodology that allocates based on market capitalization of debt. As a lender, is it prudent to lend more to a firm simply because they have the highest level of debt? At CLS, we believe the answer is no.
Within our fixed-income portfolios, we emphasize ETFs that utilize alternatives to a simple market-cap weighting scheme, which includes smart beta and actively managed ETFs.
Smart beta ETFs utilize superior fundamentals or valuations to determine how much is allocated across issuers. Another benefit of smart beta comes through rebalancing. Periodically, these ETFs will rebalance portfolio weights back to their non-market-cap-focused targets. Doing this involves selling the priciest bonds and buying the cheapest. Actively managed ETFs also help avoid the suboptimal market-cap weighting method. Utilizing actively managed ETFs allows CLS to pair individual security selection from strong bond managers like PIMCO, Fidelity, and DoubleLine (in partnership with SSGA) with CLS’s broad asset allocation decisions, effectively diversifying the sources of alpha generation.
Long-Term Inflation Protection is Underpriced
Since the 2008 financial crisis, a major goal of many central banks across the globe has been to ref;ate their economies, or push low levels of inflation back toward their targets. One consequence of their lack of success to date has been an absence of inflation fears. With no fear of inflation comes a lower perceived value in protection by the broad market. The complacency in the market has made Treasury Inflation- Protected Securities (TIPS) one of the most attractive areas in fixed income. In fact, as of the end of October, TIPS have been cheaper only 7% of the time since they were first issued in 1997.
So how do you evaluate the attractiveness of TIPS? One of the most common metrics is the breakeven rate. This is calculated by subtracting the real yield on TIPS by the nominal Treasury bond yield of the same maturity. Looking at the 10-year maturity, the current breakeven rate is 1.64%. In essence, the breakeven rate provides a market-based expectation of inflation on average for the next 10 years. If the realized rate of inflation over the next 10 years comes in above the current breakeven rate of 1.64%, TIPS will outperform nominal Treasuries. Both history and the Fed mandate suggest this is likely.
The S&P 500® Index is an unmanaged composite of 500-large capitalization companies. This index is widely used by professional investors as a performance benchmark for large cap stocks. The Russell 3000 Index is an unmanaged index considered representative of the U.S. stock market. The index is composed of the 3,000 largest U.S. stocks. The Russell 2000® is an index comprised of the 2,000 smallest companies on the Russell 3000 list and offers investors access to small-cap companies. It is a widely recognized indicator of small capitalization company performance. The MSCI EAFE International Index is a composite index which tracks performance of international equity securities in 21 developed countries in Europe, Australia, Asia, and the Far East. The MSCI All-Countries World Index, excluding U.S. (ACWI ex US) is an index considered representative of stock markets of developed and emerging markets, excluding those of the US. The Barclay’s Capital U.S. Aggregate Bond® Index measures the performance of the total United States investment-grade bond market. The Barclay’s Capital 1-3 Month U.S. Treasury Bill® Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. The Equity Baseline (EBP) is a blended index comprised of 60% domestic equity (represented by the Russell 3000 Index) and 40% international equity (represented by the MSCI ACWI ex US Index), rebalanced daily. An index is an unmanaged group of stocks considered to be representative of different segments of the stock market in general. You cannot invest directly in an index.
The views expressed herein are exclusively those of CLS Investments, LLC (CLS), and are not meant as investment advice and are subject to change. CLS is not a liated with any companies listed above. No part of this report may be reproduced in any manner without the express written permission of CLS. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument. CLS is not making any comment as to the suitability of any funds mentioned, or any investment product for use in any portfolio. There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss. This information is prepared for general information only. 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. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance. Individual client accounts may vary. Investing in any security involves certain non-diversifiable risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk. These risks are in addition to any specific, or diversifiable, risks associated with particular investment styles or strategies. The graphs and charts contained in this work are for informational purposes only.
An ETF is a type of investment company whose investment objective is to achieve the same return as a particular index, sector, or basket. To achieve this, an ETF will primarily invest in all of the securities, or a representative sample of the securities, that are included in the selected index, sector, or basket. ETFs are subject to the same risks as an individual stock, as well as additional risks based on the sector the ETF invests in. Fixed Income is an investment style designed to return income on a periodic basis. Generally, fixed income strategies invest in bonds, real estate, loans, and other types of debt instruments. Diversifiable risks associated with xed income investing include, but are not limited to, opportunity risk, credit risk, reinvestment risk, and call risk. Smart beta is an investment style where a manager passively follows an index designed to take advantage of perceived systematic biases or ineffciencies in the market. Treasury Securities are securities issued by the U.S. Government. Generally issued to fund its operations and backed by the full faith and credit of the U.S. Government, treasury securities are considered extremely low risk investments and may include: Treasury Bills (T-Bills), Treasury Notes, Treasury Bonds (T-Bonds), or Treasury Inflation Protected Securities (TIPS). The return on treasury investments is measured by the Treasury Yield. The primary diversifiable risk is opportunity risk.