DECEMBER 2009

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What a difference a year makes.  Last year at this time we wondered whether the U.S. was headed toward another Great Depression, whether the banks needed additional bailout funds, and whether consumers would continue to curtail their spending.  The CBOE Volatility Index (VIX) peaked above 80 in late 2008, twice as high as the previous peak.  Although the recession was the worst since the early 1980s, today we appear to be in the midst of an economic recovery, with positive GDP growth over the last half of 2009.  The major banks did not fail, but rather, realized solid earnings, and are now being scrutinized for large executive bonuses.  Perhaps due to government stimulus plans, like Cash for Clunkers, consumers cautiously began some spending again.  Additionally, fear left the equity markets, with the VIX approaching its average of 20. 

 

A year ago we were coming off one of the worst investment periods in history, as many institutional portfolios lost over 20% in 2008.  Most asset classes realized double digit losses, with Treasuries and cash the only major investment categories to realize positive returns in 2008.  We experienced quite a reversal last year, with the areas hardest hit in 2008 posting the highest returns in 2009.  Treasuries, on the other hand, were the only major investment category with a negative return last year.  Cash returned a miniscule 0.1% for 2009.

 

The first months of 2009 followed the trend of late 2008, with stock prices falling and credit spreads remaining at historically high levels.  Credit spreads then began to tighten early in 2009, boosting the return of corporate bonds, and developed equity markets began to rally in March.  Lower quality securities tended to outperform higher quality securities, in both the stock and bond markets.  For example, high yield bonds outperformed investment grade corporate bonds throughout the year.  The dollar weakened versus both the pound and euro, contributing to the outperformance of the MSCI EAFE Index, as measured in U.S. dollars.  Emerging markets, which were hit much harder than the developed markets in 2008, doubled the return of the developed markets in 2009, amid strong earnings growth and favorable economic environments.  Commodities and Real Estate Investment Trusts (REITs) also posted handsome returns for the year.  Rising interest rates, however, negatively impacted Treasuries, although Treasury Inflation-Protected Securities (TIPS) returned over 11% as fears of accelerating inflation drove investors to bid up their prices.

  

 

Despite signs of improvements, the U.S. economy still faces headwinds.  Unemployment remains above 10%, credit is still tight, and massive government stimulus programs have yet to be scaled back.  Many are worried about the impact on the economy when the Federal Reserve begins to tighten monetary policy and the government’s stimulus spending begins to fade.  Still others are concerned that inflation could re-ignite due to the massive government budget deficits and fear the Federal Reserve will maintain a loose monetary policy for too long.

 

Now that two highly volatile years are behind us, what does the future hold?  Should we expect a continuation of 2009’s trends, or another reversal?  Before reviewing our outlook and opportunities for 2010, however, we review our recommendations from one year ago.

  

Review of Outlook for 2009

In our 2008 Year in Review, we summarized our recommendations, and stated we would:

• Overweight investment grade credit, which offer attractive yields and the potential for solid returns, and investors collect income while waiting for a market recovery
• Consider high yield bonds as defaults increase
• Consider bank loans due to their attractive prices and high implied yields, but as with high yield bonds, wait until defaults increase
• Underweight Treasuries due to their low yields; but favor TIPS over nominal Treasuries for any Treasury allocations, as TIPS should outperform Treasuries when inflation returns
• Maintain stocks at or above target depending on time horizon and risk tolerance

In hindsight, let us review these recommendations.

• Investment grade credit spreads over Treasuries tightened from nearly 6% points to under 2% points, allowing investment grade corporate bonds to realize high teen returns for 2009.
• Although high yield bond default rates increased to double digits, as we expected, spreads also fell from nearly 20% points over Treasuries to under 6% points, which is close to their historical spread.  Despite the increase in defaults, high yield bond indexes generated returns above 50% for the year.  We did not anticipate spreads to tighten this quickly and investors who were waiting to invest once defaults peaked, which historically is the best time to invest in high yield, failed to participate in this impressive rally.
• Along with corporate bonds, bank loans posted outstanding returns.
• Treasury Inflation-Protected Securities (TIPS) outperformed nominal Treasuries by 15% points in 2009.
• Price-to-earnings ratios on global stocks, which were well below historic averages at the start of the year, expanded to modestly above historic averages by year end.  Investors who re-balanced back to stocks were well rewarded in 2009.

At the beginning of 2009, there were several asset categories with compelling valuations.  Once investors realized we were not headed for a depression and the economic data began to show “less bad news”, valuations returned to recession-like levels instead of depression-like levels.  As the economy showed signs of recovery later in the year, valuations improved further, boosting the equity and credit markets.  Consequently, those asset classes with compelling valuations rallied throughout the year as valuations returned to “more normal” levels.  Although we were surprised with the magnitude of the rally, we were not surprised by the direction.

 

 

Outlook for 2010

So where do we stand today?  After the convincing rebound in 2009, valuations are not nearly as compelling as they were a year ago.  Price-to-earnings ratios are near or above their historic averages for many stock indexes.  Credit spreads approached historic averages, indicating only modest expected return premiums for these sectors.  Below we summarize the opportunities in 2010.

 

Global Equity

• There is a mixed outlook for developed equities.  Although U.S. corporate earnings are expected to increase double digits in 2010, valuations are near or above their long-term averages (see chart below).  The price-to-earnings ratio on international stocks, as measured by the MSCI EAFE Index, was at 20.3x on December 31, 2009, similar to the U.S. market.  Should price-to-earnings ratios contract, this could offset the strong earnings growth.  Furthermore, high unemployment, the removal of government stimulus, and potentially higher interest rates could dampen economic growth and corporate earnings.  Many are also concerned about the massive rally we experienced last year.  Rarely have we seen stocks return so much in such a short time period.  According to J.P. Morgan, however, the average bull market return is 176%.  The S&P 500 Index gained 65% from the March 2009 lows, indicating there is still room for this bull market to continue. Although history can be useful, the strength of the economy will most likely have the biggest impact on the direction and magnitude of stock returns going forward.

 

• Emerging markets experienced even better returns than the developed markets in 2009 and are trading at reasonable valuations compared to the developed markets (see chart below).  Valuations are above their long-term averages, but most of this can be explained by the significant improvements that have occurred within these economies.  For example, today many emerging market’s sovereign debt is rated investment grade, where this was rare 10 to 20 years ago.  Additionally, these countries continue to have much higher GDP growth than the developed markets, and if this can be sustained, emerging markets should produce attractive returns.

 

• Private equity is attractive today due to low valuations and a decrease in the amount of capital flowing into this area.  This creates compelling opportunities for investors with capital to commit.  Private equity often posts some of its highest returns in vintage years that include recessions.  The risks, though, are a weak economy, unavailability of credit, and a poor exit market.
• Hedged equity mandates, or unconstrained active management, could perform well with a return to fundamentals, which were lacking in the 2008 market decline and 2009 market rally, as well as more normalized volatility.  Investors wishing to participate in the equity markets over the long-term, but skeptical that the rally will continue over the near term, may want to increase their exposure to hedged equity, as these mandates seek to provide equity-like returns, but with less volatility and lower drawdowns.

Global Fixed Income and Credit

• Yields on U.S. Treasuries remain at historical lows and at risk of price declines should interest rates rise.  The implied inflation rate (the difference between the 10-year Treasury yield and the 10-year TIPS yield), however, stood at 2.4% at the beginning of 2010, indicating TIPS should outperform nominal Treasuries in even a modest inflationary environment.  Consequently, nominal Treasuries are unattractive due to their low yields, and although unlikely to generate high returns, TIPS should be considered to provide inflation protection.
• Investment grade corporate bond spreads over Treasuries contracted from unprecedented heights reached in the midst of the credit crisis in late 2008 to still elevated, yet more reasonable levels (see chart below).  Had the 2008 crisis not occurred, we would be commenting on the attractive yield spreads for investment grade corporate debt, as the spreads are near historic highs (exempting the 2008 spike).  Investment grade bonds are at low risk of default, and with attractive yields, still offer compelling relative returns within the fixed income portfolio.

• High yield bonds experienced a similar path as investment grade corporate bonds in 2008 and 2009.  The difference was that yield spreads were even wider and the potential losses even greater, in part due to rising default rates in 2009.  Today, high yield spreads are slightly above long-term averages (see chart below) and offer adequate compensation based on expected default rates, which are anticiapted to decline in 2010.  Like investment grade corporate bonds, high yield no longer offers the compelling opportunities of a year ago, but still provide attractive yields compared to Treasuries.

 

• One area with compelling return potential is lower rated commercial mortgage backed securities (CMBS).  The story is similar to late 2007/early 2008 when agency (Freddie Mac and Fannie Mae) residential mortgage backed securities (RMBS) were initially supported by government programs, while non-agency RMBS were not initially supported.  The spread difference was wide and once non-agency RMBS began to be supported by government programs (e.g., Public-Private Investment Program), the spread narrowed and non-agency RMBS prices rallied.  Today AAA-rated CMBS are supported by government sponsored programs, while lower quality CMBS are not.  The risk/return profile is comparable to bank loans and high yield bonds at the beginning of 2009.  BB-rated CMBS yields are similar to those of high yield bonds a year ago (see chart below).  Just as there was fear in the credit markets in late 2008 and early 2009, sentiment today is similarly negative for commercial real estate.  These wide spreads reflect this fear and investors who believe the commercial real estate market is close to bottoming and are willing to invest in CMBS could realize returns similar to those realized in the corporate bond market in 2009.

 

Real Assets

• Real assets include real estate, timber, energy, commodities, and other natural resources.  These assets should be considered as inflation protection strategies, as well as providing diversification to the portfolio.  Many of these investments are expected to provide equity-like returns over the long-term, but can only be accessed through partnerships with limited liquidity.  Therefore, investors must understand the illiquidity inherent in these strategies and be willing to forgo liquidity for enhanced diversification and potentially higher returns.
• REITs are a way to gain real estate exposure via the public markets.  The recapitalization of REITs in 2009 provided stability and improved their balance sheets.  Like the stock market, REITs rallied and provided investors with equity-like returns in 2009.  Valuations today, however, are not compelling, with price-to-funds from operations and price-to-NAV well above long-term averages.  Furthermore, REIT yields averaged a 1% point premium above 10-year Treasuries since 1992, but as of December 31, 2009, REIT yields were only 0.6% points above 10-year Treasury yields.
• With commercial real estate trading at depressed prices, core real estate investments are not attractive.  Rather, investors should focus on distressed and value-added opportunities in private real estate.

Although we focused much of our analysis on the public markets, investors can implement these strategies in a variety of ways, depending on their risk tolerance and liquidity needs.  For example, investors seeking credit exposures can hire traditional long-only managers, with full liquidity, either through dedicated strategies or broad-based fixed income strategies with a concentration in credit.  Likewise, investors can invest in credit-based hedge funds, which are semi-liquid, allowing the manager more flexibility than a long-only manager.  Another approach would be to focus on distressed investments through private partnerships, which have limited liquidity. 

 

 

Conclusion

In early 2009, investors were seeking an end to falling equity prices and widening credit spreads, and a return to a sense of normalcy.  Once the economy began to stabilize and thoughts of a depression dissipated, the equity and credit markets rallied.  Investors who did not panic and flee to cash and Treasuries, but rather, sought the attractive valuations in the equity and credit markets were handsomely rewarded in 2009.  The opportunities in 2010 are not nearly as compelling as they were a year ago and economic headwinds present challenges.  Investors should review their risk appetite and consider how to best structure their portfolios to meet their long-term investment objectives.  Part of this process may include taking a contrarian stance and seeking attractive risk-adjusted returns by investing in distressed and unloved areas of the market.