Despite continued macroeconomic headwinds, the third quarter was very much a “risk on” period as riskier assets appreciated significantly thanks to global central bank intervention. The fiscal cliff in the US, the banking crisis in Europe, and a slowdown in China forced the Federal Reserve and the ECB to deliver additional easing measures during the quarter.
Estimates for GDP growth continued to be revised downward during the quarter despite a surprisingly strong jobs number in the beginning of August. While median estimates called for an increase of only 100,000 workers in July, employment increased by 163,000 following an upward revision for June’s data. This data combined with improvements in housing, auto sales, and personal debt levels created cautious optimism that the consumer remains on a path to recovery.
Corporate balance sheets remain strong with low debt levels and high cash balances but optimism for top line growth is muted in anticipation of third quarter earnings announcements. The lack of progress around the fiscal cliff is concerning and it appears as if nothing will be done prior to the elections. Both parties had their respective conventions during the quarter and speculation around who will prove victorious in the election varies by the minute. We continue to believe that the fiscal situation here in the US is the most troubling of factors as a $16 trillion national debt level requires bipartisan agreement at a time when that seems very unlikely. We are optimistic that the fiscal cliff will be postponed until after the election so some form of a “Grand Bargain” can be implemented to curtail the fiscal issues of this country. Lastly, and most importantly, the long awaited announcement of QE3 by Fed Chairman Bernanke on September 13th proves that central banks will take whatever actions are necessary to flood the system with liquidity and stem any possibility of a double dip recession. The Fed extended the pledge of very low interest rates through 2015, agreed to keep stimulus accommodative for some time, and pledged to purchase $40 billion of mortgage backed securities (MBS) per month in addition to the extension of the current Operation Twist program. While many were expecting the announcement of QE3, it was clear that the magnitude of the announcement had not yet been discounted in capital markets as risk assets appreciated substantially on the news immediately following the announcement. Whether or not this money actually makes its way in to the economy is to be determined as the first two QE programs have yet to have that affect.
There was plenty of activity in the EU during the quarter. Spain unveiled a new austerity package while Moody’s downgraded the debt of Italy and thirteen Italian banks. Citigroup stated that there was a 90% chance that Greece would exit the EU in the next year and possibly in the next few months. To counter these concerns, Mario Draghi reiterated his promise to do “whatever it takes” to support the euro. On September 6th, he announced that the ECB is prepared to make “outright monetary transactions” in the secondary bond market to “address severe distortions in government bond markets.” While there will be conditions tied to the program, the goal is to support the troubling near term financial situations in Spain and Italy, the third and fourth largest economies in the Eurozone. There would be no limits on the size of the bond purchases which will focus primarily on shorter duration instruments and the ECB will not have a preferred creditor status. Markets reacted very positively on the news as the sovereign debt of European peripheral countries rose for the duration of the quarter. The ECB’s announcement is evidence that they are willing to take action to maintain the euro. Patience, however, is warranted as the devil still lies in the details.
As growth around the globe has slowed, China, one of the world’s biggest trade-based economies, is feeling the pain. The Shanghai Composite Index reached its lowest point since late 2008, and manufacturing contracted for a second month for the first time since 2009. GDP growth in China slowed to 7.6% versus a +10% average for the previous decade. The Chinese implemented two stimulus packages during the quarter via government spending programs with the hope of spurring growth.
The accommodative monetary policy out of the Federal Reserve Bank and European Central bank drove equity markets higher across the globe during the third quarter. Most equity markets finished up anywhere between 5-8% for the quarter and up over 10% on a year-to-date basis. After the announcement of QE3 on September 13th, both the S&P 500 and the Dow Jones Industrial Average reached five-year highs before retreating marginally at month end due to some discouraging news out of Europe.
The following chart summarizes various equity market indices in the third quarter:
While large cap US equities were the clear winners during the first six months of the year, the third quarter experienced strong performance for riskier equities such as small cap, growth, international, and emerging markets. Bottom Line: While we remain bullish on large cap high-dividend-paying equities, we have begun to reduce exposure to this sub asset class in favor of smaller capitalization, growth oriented, and emerging market equities. While the major risks are clear and there is likely to be some short term volatility, equities remain attractive for the long term investor.
Fixed Income Markets
Europe remained the focus for global debt markets. The news out of the ECB was promising but fears of Greek and Spanish exits have not dissipated. The better performing investments in the fixed income universe were high yield and emerging market debt as investors were adding risk to their fixed income portfolios. The “Bernanke Put” has created a temporary floor for fixed income securities and investors continue to search for yield. The announcement by the Federal Reserve that interest rates will remain low for some time reduces the duration risk in fixed income portfolios for the time being. Bottom Line: Traditional fixed income will serve as a source of liquidity and a means of dampening overall portfolio volatility but return expectations remain muted. Portfolios with allocations to fixed income should have some combination of actively managed high quality “so I can sleep at night” capital as well as alpha drivers via more opportunistic credit strategies. Actively managed fixed income is the best option in this space as monetary policy is highly unpredictable and inflation risks are only increasing. The following chart summarizes performance for various fixed income indices in the third quarter:
Alternative Managers entered the quarter with relatively low net exposures as global risks remained front and center. However, the accommodative global central bank policies postponed imminent market turmoil and exposures inched up for the quarter. More importantly, the “risk on” mentality of investors delivered the long awaited “pop” in the long portfolio for many alternative managers and returns were much higher during the quarter. Contrary to recent market rallies, the hedge fund universe participated in a greater percentage of the upside in August and September as the underappreciated long ideas held by many of our managers surpassed market averages and a more differentiated earnings season rewarded fundamental shorts. The following chart summarizes performance for various hedge fund indices in the third quarter:
Contrary to the previous quarter, the long/short equity managers were the best performing group within the universe as their long portfolios and higher net exposures drove performance higher. Within the credit space, the managers with allocations to the RMBS and distressed markets continued to appreciate. Multi-strategy managers also delivered strong returns as their allocations across all markets proved beneficial. Long positions in gold (+11%) and silver (+26%) contributed positively to hedge fund performance during the quarter as inflation concerns were elevated.
The attractive risk/reward opportunities that managers had been building earlier this year have started to pay off for investors. Their ability to adjust exposures and allocate capital quickly makes them more able to capitalize when markets finally reward value. Bottom Line: Alternative strategies remain a core component for client portfolios. Hedge fund structures allow managers to adjust exposures and exploit inefficiencies in reaction to exogenous events. During the quarter, we continued initiating investments in the long/short non-agency RMBS and distressed universe as we continue to believe that the opportunity sets are ripe for returns.
Real estate and private equity opportunities remain very attractive as the liquidity premium of the pre-2008 era has resurfaced. Investors that can withstand the illiquidity will be rewarded with higher returns going forward. With traditional lending avenues under continued regulatory pressure, private sources of capital are invaluable. We have been very active in working to identify opportunities in the commercial real estate, long term distressed, middle market lending, and secondary private equity markets.
Conclusion and Outlook
Macroeconomic risks are clear but markets have rallied on accommodative central bank policies as evidenced in equity market returns and historically low yields across debt markets. Yield chasing is especially excessive and money printing has only made this worse. We remain cautiously optimistic and continue to believe that asset allocation is the most important component to investment performance. Our managers remain nimble and poised to capitalize on market opportunities. A disciplined approached to portfolio construction, manager selection, and periodic rebalancing will deliver the most attractive long term return profile to investors.
This letter is being furnished on a confidential basis to the recipient for discussion purposes only and is not intended as investment advice. This letter is not to be transmitted in whole or in part without the prior consent of Massey, Quick & Co. LLC (Massey Quick). Massey Quick makes no express or implied representation or warranty with respect to the accuracy or completeness of this letter. Massey Quick has no obligation to inform the recipient when the information herein is no longer current. This letter does not constitute an offer to buy or sell, or a solicitation of an offer to buy or sell any securities or interests of any entities, or to provide investment advisory services.
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.
This letter is based upon information Massey Quick believes to be reliable. However, the information set forth herein does not purport to be complete and is subject to change.
Certain information contained herein may constitute “forward‐looking statements,” which can be identified by the use of forward‐looking terminology such as “may, “ “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue” or “believe” or the negatives thereof or other variations thereon or other comparable terminology. No representation or warranty is made as to such forward‐looking statements. The use of this letter in certain jurisdictions may be restricted by law. Prospective recipients of this letter should inform themselves as to the legal requirements and consequences of such use within the countries of their citizenship, residence, domicile and place of business.