Government policy, debt concerns join slowing global growth to jolt markets
Waddell & Reed Asset Strategy Fund – August 2011
We have seen tremendous volatility in recent weeks. In our view, the world is debating the status and viability of economies and markets in two primary ways. There clearly is uncertainty surrounding macro risk and policy mistakes in a deflationary environment. We think the consensus argument surrounds whether there will be continued negative reaction to policy mistakes in the U.S. and in Europe, compounded by the fact that we are in a deflationary environment in which regulators have few tools to combat the problems of overleveraged developed economies. The counter argument focuses on the sustainability of corporate earnings growth, which has far exceeded nominal growth rates of gross domestic product (GDP) in the U.S., Europe and Japan. We are on the side of believing more sustainability to earnings growth exists — sustainability that will help fuel at least limited global growth — rather than siding with the policy mistake/deflationary argument.
Policy mistakes magnified in a deflationary environment
The risk of a deflation policy mistake seems to be front and center in the market’s mind, along with concern that we are heading into another global recession. We are surprised by the change in perception with respect to the U.S. economy. All along, we thought that nominal GDP in the U.S was going to be subpar for some time. So far, that has been the case, as nominal GDP in the first half of 2011 was roughly just 4 percent. The composition of GDP actually shouldn’t have been surprising, given the oil price shock and supply chain disruption from Japan. Inventory and exports both detracted from GDP in the first half of the year. Importantly, S&P 500 revenue growth in the first half of 2011 was 11 percent. Profitability was 18 percent. We expected and are getting a sluggish developed market recovery.
Working through the two big events in the first half of the year that restrained growth — the oil price shock due to unrest in the Middle East and the supply chain disruption out of Japan — we think we’ll recover some of that growth in the second half, although we think it will still be subdued at around 2 percent. That means in a good quarter, when inventory and exports can swing, we could see 3 to 4 percent growth; in a bad quarter, we could see zero growth. Perception of that growth, however, has changed markedly in the last few weeks as policy makers have stepped forth.
Staying the allocation course amid uncertainty
The Fund is allocated largely the way it was a month ago, with approximately 85 percent of investments in equities, 14 percent in gold bullion and 1 percent in cash. The Fund has not been hedged during the last month, despite the market’s volatility, and is not hedged now. Clearly, we are concerned about risk and managing downside risk remains our priority. However, we also take seriously our mandate to produce a positive, currency-adjusted return over a three-year period. To that end, we have used the market’s recent volatility to reposition the Fund in a way we think is more efficacious given our one- and three-year outlooks. We remain focused on global growth.
Policy questions and a lack of confidence
The crux of the broader problem is that we don’t see coherent fiscal policy. There is no fiscal policy “magic bullet” that will spur growth, which will remain subdued. Neither U.S. political party has done anything to create growth. The two tactics on the table — raising taxes and cutting spending — are both repressive to growth.
We have long believed that the U.S. economy is suffering a consumer balance sheet recession. Interestingly, the top 10 percent of income earners have continued to show accelerating growth sequentially. From the first quarter to the second quarter, the high end got better. From June to July, the high end got better. But we think the real risk to the economic recovery doesn’t have to do with the balance sheet recession — it has far more to do with confidence among the high-end spenders, corporate CEOs and CFOs that are retrenching due to the uncertainty that the politicians and policy makers have created. We think the reflexivity risk is far greater than the sluggish growth risk. The data through July show that the high end has held in well; we will be watching closely to see if that continues in the face of stock market volatility.
With respect to monetary policy, the Federal Reserve has made it clear it is going to fight deflation vehemently. By locking funding in through mid-2013, the Fed is trying to encourage investors to take duration and asset risk. By locking in low rates, they are forcing investors out on the risk curve. While this commitment may not be a massive change to the consensus expectation for Fed tightening, it did give leveraged players certainty to carry. The market’s response was immediate: mortgages, leveraged players and leveraged mortgage REITS all saw price explosions. The Fed wants to reinvigorate a credit cycle that will drive asset prices higher. This has been and, we believe, will continue to be the strategy going forward. The best price indicator we have seen is the price of gold going higher, which tells us inflation expectations are rising. We think we’ll see a bigger credit cycle than the one we just exited. The locking in of funding will drive stock buy backs, credit expansions from companies and will encourage the private sector — mainly corporations and investment players — to leverage capital.
The mid- to longer-term outlook is shadowed by fiscal and monetary issues. Nonetheless, there are places where we feel growth is prevalent and accelerating, and we have tried to steer the portfolio toward those places.
Recent developments in Europe
In July, due to market action in Italy, Europe was forced to come up with broad-scale changes to the European Financial Stability Fund (EFSF). Those changes expanded that bailout fund’s tool box, so now it can directly buy back bonds of the periphery nations, take preemptive measures where it deems fit, and provide capital to European banking systems. These were all very important changes that gave Europe the power to contain problems in the periphery. Unfortunately, the size of the EFSF was not increased, and currently stands at $440 billion (U.S.).
To put that into perspective, the Italian market currently has €1.6 trillion (euro) in debt outstanding, while Spain has €680 billion in debt outstanding. The bailout fund isn’t large enough to contain the issues. That’s forced the European Central Bank (ECB), which has the unlimited ability to expand its balance sheet, to step in and bridge the gap. The market put tremendous pressure on the curve in the periphery, and the ECB subsequently bought a large amount of debt in both Spain and Italy to try to bring back the interest rates in those curves. Spreads in Spain and Italy got as high as 400 basis points; right now, they’re hovering around 270 to 280 basis points. The ECB essentially brought Europe back from the brink.
The changes to the EFSF are now going to have to go through parliaments in Europe. That will begin in September and we hope by the beginning of October the EFSF will be fully operational with all of its new powers. In the interim, it is highly likely the ECB will have to continue to expand its balance sheets to provide stability to the marketplace.
We think the problem with Europe all along is that it has announced measures to deal with its crisis and then it hedged those measures. We’re seeing a game of chicken between the policy makers in Europe, the ECB and the marketplace. The market puts pressure on Europe and the ECB to act, Europe and the ECB act and spreads come down, and then they start hedging their actions and the market spreads right back out. To keep this situation stable, we feel the ECB is really going to have to be on the Spanish and Italian curves. The good news is it has the tools to do it. Ireland, Portugal and Greece are different situations; Greece is going to be restructured in a soft manner, while Portugal and Ireland are both on bailout facilities and are going to have to continue to implement austerity plans, which will likely be very painful.
Ultimately, we think there should be tighter fiscal integration in the euro zone, which points to the euro bond. That has many implications in Europe. The euro bond is problematic both for Germany and for poor countries, which will have to use their credit ratings to support it. It’s not popular among constituents, and it has dramatic ramifications in the periphery, where sovereignty is probably going to be extracted from those countries in exchange for using the common credit rating of the euro zone. Both of those are going to be very difficult to put through politically and will create a lot of noise in the marketplace going forward. It has to happen, however, to provide stability to the euro and get a common credit rating that will allow rates to come down. We think Italy stands to benefit tremendously. The debt load there is now 119 percent of GDP at the public level. Because of its labor market, Italy has a structurally low-growth economy with a potential GDP of 1 to 1.5 percent.
The changes at the EFSF will also likely allow it to provide capital into the Spanish banking system. Spain had a large real estate bubble that put a lot of pressure on its banking system. Many of the smaller banks in Spain need capital, but the market simply isn’t willing to provide that capital. The EFSF can now provide that capital to Spain’s banking system, which should help it go forward.
We are expecting Europe to get a handle on Italy and Spain, but it will be a drawn-out process with significant pressure on both countries by the market as well as political pressure and there will be a lot of volatility. We may see a bank or two go bankrupt, particularly in Spain, but wide-scale bankruptcies out of the core are highly unlikely. The type of write downs that may need to be taken in Greece are simply not severe enough to warrant that. They may have to engage in some restructuring, but Europe now has the policy tools to deal with the Italian and Spanish issues.
Pressure on emerging markets
Emerging markets have been under considerable pressure to raise rates to fight off inflation from currency carry as well as a vigorous rebound in economic growth. One of the benefits of the sell-off in commodities, specifically in energy prices, is that it will allow emerging market policy makers to slow their tightening measures. Inflation in China, for example, is 6.5 percent. We believe we’ve seen the peak in inflation there, so the question then becomes, “Will growth crash?”
We think China’s growth will moderate in the 8 to 9 percent range on a real basis, with 13 to 14 percent nominally, which is far more important for revenue growth. While China won’t be aggressively loosening monetary policy, the majority of the tightening is behind us, which should allow for better growth in the second half of the year than we saw in the last quarter. For India, another large economy with strong nominal growth, falling energy prices will be a huge benefit. It will take a lot of pressure off the government and India’s central bank.
Bullish on corporate earnings
We have been bullish on corporate earnings, partly because we believe management teams are skeptical of the recovery. They have not believed the recovery they’ve seen in revenue and are loathe to spend, which is partly why unemployment in the U.S. is more than 9 percent; companies are not hiring. Capital expenditures are still running under depreciation despite the fact they were up 30 percent in the second quarter of 2011. Margins are staying far higher than the bears are willing to admit. S&P 500 companies generated 11 percent revenue growth in the second quarter vs. nominal U.S. GDP of 4 percent. More than two times nominal GDP was produced in the top line with bottom line profitability at 18 percent.
The antithesis of sluggish growth is going to be better-than-expected profit growth, because companies are sourcing their revenue growth and costs from outside the U.S. and profitability is dropping within the
U.S. We see companies with cash flow yields, dividend yields and return on invested capital that are as strong as they have ever been. The market appears to us to be in one of the cheapest quintiles of free cash flow and earnings yield as far back as we can see. The market today, on a “cheapness” basis — based on cash flow generations, margins, incremental margins and return on capital — appears to us to be about as cheap as it was in the fourth quarter of 2008 and the first quarter of 2009.
When to hedge
We are often asked why we aren’t hedging the portfolio. For us to provide a real rate of return in a nominal interest rate environment that is as low as it is, we are going to have to embrace volatility at some point in the investment cycle. We look at and manage downside risk on a rolling three-year basis. We understand that our client base at times does not want to embrace volatility, but therein lies the opportunity set that we see in real returns. We think the real return in equities is far higher than in any other asset class. The cost/benefit question we have to ask ourselves is, “Should we embrace the volatility and will it reward the Fund with return over that three-year period in time?” Right now, we think the answer is yes.
Another factor to consider is the cost of hedging. There are several primary valuation measures we track when we’re looking for opportunities to hedge the portfolio. We look at the level of implied volatility on various indices versus realized volatility on those indices; we look at skew, being the cost of puts relative to the cost of calls; and we look at the term structure of the volatility surfaces of those indexes as well as the implied vs. realized correlation. What we see right now is that because investors seem to be leery of equities and will pay anything to strip volatility out of their portfolios, hedging has become extremely expensive — it’s currently three standard deviations above the average cost of buying puts on any global index. The cost of those puts is in the 99th percentile on every index that we’re looking at. It’s the most expensive we’ve seen. Right now, it wouldn’t be unusual to pay 5 to 6 percent for a put option that will go until the end of the year and that is 5 percent out of the money. To break even on that, the market would have to go down 11 percent from here. And because you’re paying 5 to 6 percent up front for that option, if the market goes up 5 to 6 percent, you’re not going to participate in any of the rebound from these low levels. That’s what you’re paying in terms of opportunity cost and how much downside you’re going to need from this point. We realize there is going to be some volatility, but when you systemically overpay for protection, you cut your legs off in terms of your potential return opportunity. Those are the things we continue to watch and when those valuation metrics come down, we will look for opportunities to layer in some hedges at a reasonable price.
We are often asked why we aren’t using index futures, given that they’re less expensive. Granted, the cost of futures is lower on a commission basis and debt spreads, and volumes are extremely high right now. In terms of liquidity, we have plenty to choose from. But what we have to look at is the opportunity cost of using futures. On a volatile day when everyone is getting whipsawed and the market is up 5 percent and you’re using futures, that isn’t going to be a true return to the Fund in terms of what you’re paying on those futures when the market goes up. Correlations are high right now, so we have the ability to use a lot of different tools in the derivatives universe to effectively hedge the portfolio. We aren’t doing that now because we think the risk is to the upside.
A flexible strategy
We do wish to underscore that we take risk management exceptionally seriously. That is our first mandate. We have the flexibility to orient the Fund in a way where we see, over a three-year period, what we think are the best opportunities for risk and reward. We are taking that opportunity to generate what we feel is optimal risk/return. And from that perspective, as well as an historical performance perspective, we believe we are succeeding in our mission.
Of the 35 Class A funds in the Morningstar World Allocation category that had at least a 3-year track record through July, only six had downside capture ratios1 vs. the S&P 500 Index that were lower than the Ivy Asset Strategy Fund.The Fund had a downside capture ratio of
53.7 — meaning that, over the 3-year period ended July 31, 2011, the Fund only incurred a little more than half the losses of the S&P 500 Index in periods when the index fell.
We also should note that the upside capture ratio of the Fund exceeded all seven of the peer funds that had lower downside capture ratios1 during the 3-year period ended July 31, 2011 — a volatile period that included the market decline of late 2008/early 2009, the ensuing run-up in the second half of 2009 and early 2010, the mid-2010 correction and the post-crisis highs of April 2011.
In general, the Morningstar World Allocation funds that had better downside capture ratios were more devoted to holding cash and other assets that generally haven’t performed well when equity markets rose. In short, the Fund has offered a good balance of downside protection and upside potential.
1 Downside Capture Ratio measures a manager’s performance in down markets. A down market is defined as those periods (months or quarters) in which market return is less than zero. In essence, it tells you what percentage of the down-market was captured by the manager. For example, if the ratio is 110, the manager has captured 110% of the down-market and therefore underperformed the market on the downside. Upside Capture Ratio is a similar indicator, measuring a manager’s performance in up markets. In those markets, a higher ratio means the manager outperformed the market on the upside. (Source: Morningstar)
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through August 9, 2011, and are subject to change due to market conditions or other factors.
Risk Factors: As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These and other risks are more fully described in the fund’s prospectus. The Fund may allocate from 0-100% of its assets between stocks, bonds and short-term instruments, across domestic and foreign securities, therefore, the Fund may invest up to 100% of its assets in foreign securities. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The fund may focus its investments in certain regions or industries, thereby increasing its potential vulnerability to market volatility. The Fund may use short-selling or derivatives to hedge various instruments, for risk management purposes or to increase investment income or gain in the Fund. These techniques involve additional risk, as short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss for the fund, and the value of investments in derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative’s value is derived. Investing in physical commodities, such as gold, exposes the Fund to other risk considerations such as potentially severe price fluctuations over short periods of time and storage costs that exceed the custodial and/or brokerage costs associated with the Fund’s other holdings. These and other risks are more fully described in the fund’s prospectus. Not all funds or fund classes may be offered at all broker/ dealers.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the Ivy funds, call your financial advisor or visit us at www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing.