“Investor requests for redemption, however, in addition to the general reduction of liquidity in the fixed income markets, have made it impracticable for [Third Avenue’s Focused Credit Fund] going forward to create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.” – David Barse, CEO of Third Avenue Management, December 9th, 2015
Volatility remained high during the fourth quarter. Global central banks were the center of attention as divergent policies weighed on investors. Geopolitical tensions continued to remain in the foreground as incidents of terrorism around the globe raised persistent concerns. The rout in commodities showed no signs of slowing down. Additionally, cracks in global financing markets widened further amidst an illiquid trading environment. Despite these concerns, equity markets generally finished the quarter in the black, thanks in large part to one strong month of performance.
The US economy maintained some positive momentum. Third quarter GDP estimates revealed that the economy grew at a rate of 2% following a 3.9% increase in Q21. Many market participants took confidence in the fact that consumer spending and domestic demand remain healthy. Nevertheless, concerns about growing inventories worked to temper some optimism surrounding the Q3 report as said inventory buildup could weigh on future growth.
Following a mixed third quarter, the labor market rebounded. The November jobs report showed that the economy added 211,000 jobs, a figure that bested expectations. Furthermore, the prior two months were revised upward to 298,000 in October and 145,000 in September, respectively2. The October and November results were particularly encouraging after the disappointment and uncertainty engendered by data released in Q3 (please see Massey Quick’s Third Quarter Newsletter). The unemployment rate in the US clocked in at 5%, the lowest level since April 20083.
These generally positive data points set the stage for the US Federal Reserve’s much-anticipated December meeting. Odds of a rate hike had been rising steadily over the course of the fourth quarter as most market participants assumed that the Fed would increase interest rates in the absence of any truly alarming economic data. The Fed largely matched the market’s expectations by announcing an increase of the Federal Funds rate from 0% to a range of 0.25%-0.50%, its first such increase in a decade. In her press conference following the announcement, Fed Chairwoman Janet Yellen emphasized the sustained improvement of the US economy while also stressing the Fed’s desire to engage only in “gradual” rate increases to avoid derailing the domestic recovery. Based on trading action surrounding the announcement, uncertainty still remains as the Fed engages in its first tightening cycle after years of low rates.
On the micro front, earnings results continued to be mixed. According to data from JP Morgan, approximately 74% of S&P 500 companies beat earnings per share estimates; however, 56% of the same cohort missed sales estimates (data as of 11/11/15 & excludes the Energy sector). The lackluster fundamental results observed throughout 2015 continue to raise questions about the future return potential of domestic equities following a multi-year rally from the depths of the recession. Margin pressures as a result of continued strength in the dollar remained a common refrain for large cap and multi-national companies. The dollar appreciated +2.4% in the fourth quarter and rallied by +9.3% in 20154.
Merger and acquisition activity continued to feature prominently in the headlines as several additional large-scale transactions came across the tape in Q4. Notable examples include Pfizer’s proposed $160B merger with Allergan and AB InBev’s agreement to buy SABMiller for $120B. These two deals were among the largest announced in a year that was already characterized by a busy M&A calendar. 2015 represented a record year for M&A activity with a total deal volume of close to $5 trillion, a figure that handily exceeded the previous record set in 20075.
With Eurozone inflation continuing to fall below expectations, all eyes were fixed on the European Central Bank with most market participants expecting significant further action to be announced in December. However, markets were largely disappointed when ECB President Mario Draghi announced a less-than-anticipated cut to the ECB’s already negative deposit rate while simultaneously extending QE measures into 2017. Risk assets slumped sharply lower and the euro knee-jerked higher in the immediate aftermath of the announcement. Perhaps in an effort to appease markets, subsequent remarks from Draghi reiterated that the ECB stood ready to supply additional easing to spur economic growth.
Elsewhere around Europe, the migrant refugee crisis that began in the third quarter continued to engender worries of growing instability. Additionally, November saw a tragic terrorist attack in Paris claim more than 100 lives as confrontations with ISIS in the Middle East once again came to the foreground. Tensions surrounding Russia remained high, particularly following Turkey’s shooting down of a Russian warplane in late November. The incident highlighted geopolitical instability as a result of the continued conflict in Syria wherein several major world superpowers find themselves on different sides of the aisle.
Perhaps somewhat surprisingly, the aforementioned tensions in the Middle East did not have their usual positive impact on the price of oil. Instead, crude oil continued to test new multi-year lows. Production data continued to reveal only a modest slowing despite persistent oversupply conditions. Furthermore, OPEC once again opted to maintain production in an effort to drive out competition, a decision that yielded further downside in oil prices. WTI crude prices collapsed from $45.09/barrel to $37.04/barrel during the fourth quarter. For the year, oil prices declined by -30.5%6.
After roiling markets for several months, China appeared to stabilize. Policy makers in China demonstrated additional willingness to remain accommodative (via policy rate and reserve ratio adjustments) in an effort to assuage fears of lagging growth. China also featured prominently among headlines following the IMF’s decision at the end of November to include the yuan as a world reserve currency. While many market participants are optimistic that the announcements signal the likelihood of further Chinese financial reform, the longer-term impact remains to be seen.
The myriad macroeconomic factors mentioned above had a tangible impact on risk asset volatility in the third quarter with equities seesawing between gains and losses to wind down the year. After a tough third quarter, the S&P 500 (including dividends) roared back to gain +8.4% in October. This monthly result was largely responsible for keeping the index in the black for the year following a subsequent small gain of +0.3% in November and a loss of -1.6% in December. All sectors within the index yielded gains for the fourth quarter with many of the biggest losers from Q3 posting gains. On an individual basis, Materials (+9.7%), Technology (+9.2%) and Healthcare (+9.2%) led the way.
International markets were not immune to the swings in investor sentiment and generally experienced similar levels of volatility. However, as was the case with the US, strong October results helped to keep many indices in the black for Q4. For reference, the MSCI AC Europe index gained +2.3% in the fourth quarter. The AC Asia Index fared better posting gains of +6.5%. After struggling for the majority of the year, emerging markets (as measured by the MSCI EM index) managed to post gains of +0.7% for the quarter. Generally, lower levels of China angst likely helped to facilitate the region’s performance. Nevertheless, this positive quarter could hardly counteract the carnage the emerging market complex saw in 2015; for the year, the MSCI EM was down close to -15%.
Bottom Line: We still continue to view equities as an attractive source of long-term growth in portfolios. We believe that volatility creates opportunities and are monitoring exposures closely. Opportunistic rebalancing activity may be appropriate in market segments that see significant selling activity.
Global bonds (as measured by the Barclays Global Aggregate Index) struggled in the fourth quarter. Within broader fixed income markets, high yield bonds represented a noteworthy loser during a volatile fourth quarter with the Barclays Global High Yield index declining -0.9% to close the year down -2.7%. This decline marked only the third time in the last twenty years that the index finished the year in the red (previous instances were 1998 & 2008). There is no doubt that the energy sector continued to weigh heavily on the high-yield market; however, stress spread to other sectors throughout Q4. It is worth highlighting that riskier CCC bonds saw more substantial spread widening than their BB counterparts. For context, CCC spreads ramped from 1292 basis points to 1653 basis points while BB spreads actually tightened from 458 basis points to 424 basis points in the fourth quarter7.
Trading liquidity in fixed income markets remained poor as the absence of large bank dealer desks continued to result in non-fundamental price movements in debt instruments. It was not uncommon to see bond prices gapping down on no fundamental news simply because there was no counterparty to absorb selling pressure in the market. Price movements and trading illiquidity led to the suspension of redemptions by a daily-liquidity mutual fund managed by Third Avenue alongside the liquidations of a few select credit hedge funds. These “gates” on capital withdrawals harkened back to similar circumstances in 2008 and worked to engender further uncertainty.
Bottom Line: We continue to approach credit markets with caution. Recent price action has highlighted the dangers inherent in a lower-liquidity trading environment. As we remarked in last quarter’s newsletter, bonds are often considered a leading indicator for equities and potential cracks in the market for credit instruments are worth monitoring closely.
Based on preliminary index results, hedge funds were able to post positive results in Q4 with the HFN Hedge Fund Aggregate Index gaining +0.6%. However, there was a significant dispersion of returns among underlying strategies with results largely following the trends set by traditional asset classes. Equity-oriented funds generally fared well: the HFN Equity Hedge Index yielded gains of +2.5%. In contrast, credit-oriented managers struggled with the mark-to-market price movements described above likely weighing heavily on certain strategies. The HFN Distressed Index was a noteworthy negative performer (decline of -3.6% for the quarter) as this segment of the debt market continued to feel pressure from limited liquidity and declining commodity prices. Macro funds (flat to modestly down in Q4) also yielded mixed results in a volatile trading environment as several popular positions (e.g. long European equities, short the euro) saw volatility into the end of the year. As was the case in the previous quarter, exposure to “crowded” hedge fund positions once again represented a potential pain point for many funds as widespread portfolio de-risking may have facilitated price declines.
Bottom Line: Several high-profile hedge funds struggled in 2015 and there was certainly a wide variety of results among sub-strategies for the year. We are sympathetic to investor frustration with hedge fund performance. However, we maintain our position that increasing levels of volatility and market inefficiencies in illiquid assets create attractive opportunities.
Conclusion and Outlook
Our focus remains grounded in a dedicated, disciplined asset allocation framework for each client portfolio. We continue to believe that portfolio diversification across asset classes facilitates a broad opportunity set for delivering returns in an environment of increasing uncertainty.
1 Source: Bureau of Economic Analysis
2 Source: Bureau of Labor Statistics
4 Source: Bloomberg
5 Source: Dealogic via CNBC (http://www.cnbc.com/2015/12/23/the-biggest-merger-deals-of-2015.html?slide=1)
6 Source: Bloomberg
7 Source: Bank of America Merrill Lynch; St. Louis Federal Reserve
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Massey, Quick & Co., LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Massey, Quick & Co., LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Massey, Quick & Co., LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. If you are a Massey, Quick & Co., LLC client, please remember to contact Massey, Quick & Co., LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of the Massey, Quick & Co., LLC’s current written disclosure statement discussing our advisory services and fees is available upon request.
This presentation and the accompanying discussion include forward-looking statements. All statements that are not historical facts are forward-looking statements, including any statements that relate to future market conditions, results, operations, strategies or other future conditions or developments and any statements regarding objectives, opportunities, positioning or prospects. Forward-looking statements are necessarily based upon speculation, expectations, estimates and assumptions that are inherently unreliable and subject to significant business, economic and competitive uncertainties and contingencies. Forward-looking statements are not a promise or guaranty about future events.
Historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings correspond directly to any comparative indices
Indices included in this report are for purposes of comparing your returns to the returns on a broad-based index of securities most comparable to the types of securities held in your account(s). Although your account(s) invest in securities that are generally similar in type to the related indices, the particular issuers, industry segments, geographic regions, and weighting of investments in your account do not necessarily track the index. The indices assume reinvestment of dividends and do not reflect deduction of any fees or expenses.
Please Note: (1) performance results do not reflect the impact of taxes; (2) It should not be assumed that account holdings will correspond directly to any comparative benchmark index; and, (3) comparative indices may be more or less volatile than your account holdings.
Please note: Indices are frequently updated and the returns on any given day may differ from those presented in this document.
Index data is supplied from various sources and is believed to be accurate but Massey Quick has not independently verified the accuracy of this information.