Yield in the Time of Cholera

John E. Coyne, III, Vice Chairman, Brinker Capital

I recently reread the Gabriel Garcia Marquez novel from the 80s, Love in the Time of Cholera, and as I found myself being warped back to that decade, it naturally led made me reflect on the current municipal bond market! I’ll explain.

Because romance is nowhere near as risky as this market is today, it is easy to see how we can fall in love with the exciting, attractive yields in the after-tax world (around 8.5% on the long end). Nevertheless, there is something to be said for stability and safety in a time of incredible uncertainty especially with continuing interest-rate increases and, even more unnerving, a frightening credit risk landscape.

The rising-rate environment of the late 70s and early 80s played havoc on both the value and purchasing power of bonds held by individual investors. So whether for income or safety of principal, the holder was punished. And the credit markets were not nearly as challenged as today. Rates topped out in 1983, and we began the 30-year bond rally that has recently unraveled. I would imagine that during that extended period, an argument can be made that a passive-laddered approach might have been acceptable as opposed to active management—particularly in the bygone days of credit insurers like MBIA and AMBAC.

Well, not today. If investors want to navigate the treacherous credit markets while capturing these currently attractive yields they need a steady, experienced guide to help manage their portfolio. Advisors should be working with their municipal managers to craft strategies that can balance out their needs for income, safety and maintaining purchasing power.  Now that can make for a wonderful romance.

There’s a Reason It’s Cheap

Jeff Raupp, CFA, Senior Investment Manager

A few years ago when I was down the shore in New Jersey with my family, I decided it was time for my then nine- and six-year-old children to try one of my favorite childhood pastimes—boogie boarding. For those unfamiliar, a boogie board is a (very) poor-man’s version of a surf board; basically a short board that helps you ride waves either on your stomach or, if you’re really good, your knees. So we went to the store to buy a pair of boards and found a pretty wide price range— $10 for the 26-inch, all-foam board to $100+ for the 42-inch poly-something-or-other board with the hard-slick bottom. Being a bit of a value investor, and not knowing how much the kids would like riding waves, I went with something much closer to the bottom end of that range. To make a long story short, three hours later I found myself with a broken board (who knew a foam board couldn’t handle a 200+ lb dad demonstrating?), a broken ego, and a trip back to the store to purchase a new pair of boards—this time closer to the middle of the price range. A good lesson for the kids, but definitely a reinforced lesson for me, is often when something is cheap there’s a very good reason why.

I’m reminded of this lesson when I look at global equity valuations, particularly those in Europe. Forward P/E ratios (stock price divided by the next 12 months of projected earnings) in most of the major Eurozone countries fall in the 10- to 12-times range, which is relatively cheap from a historical perspective. Compared to the U.S. at 14½ and other developed countries like Japan and Australia at close to 14, the region seems pretty attractive. Tack onto that that the Eurozone has just emerged from its longest recession ever, and the idea that markets are forward-looking, it would seem like a great opportunity to rotate assets into cheap markets as their economies are improving. And we’re seeing some of that in the third quarter, as the Europe-heavy MSCI EAFE index has outpaced the S&P 500 by about 3% quarter-to-date.

But, similar to low-priced boogie boards, buyers of European equities need to be aware of the risks that come with your “bargain” purchase. This past Tuesday, German finance minister, Wolfgang Schauble, admitted that there would need to be another Greek bailout next year even though they’ve been bailed out twice in the last four years and restructured (defaulted on) 25% of their debt in 2012. All told, about $500 billion has gone to support an economy with a 2013 GDP of about $250 billion, and it hasn’t been enough. And by the way, youth unemployment is approaching 60%, and 2013 has seen multiple protests and strikes over austerity measures.

Beyond Greece, Portugal and Ireland are running national debts of over 120% of GDP and could need additional bailout money. Italy is operating with a divided government and a national debt of over 130% of GDP, and the Netherlands and Spain are still on the downward side of the housing bubble. Germany has been Europe’s economic powerhouse and has played an integral role in containing the debt issues on Europe’s southern periphery. But they’ve been grudging financiers, so much so that German chancellor Angela Merkel has gone to great lengths to avoid the topic of additional bailouts ahead of upcoming German elections.

Sometimes that bargain purchase works out. You get the right product on sale or you’re able to buy cheap markets when the negatives have already been baked into the price. But make sure you’re considering all the angles, or you could quickly end up back at the store.

Labor Market: Myths vs. Reality

The following excerpt has been provided by Mr. Neil Dutta, Head of Economics at Renaissance Macro Research.

Myth #1: America is a nation of part-timers
Here is what is true: Over the last four months, part-time employment has expanded by 8.9% at an annual rate while full-time employment has risen at just a 0.5% annual rate. What is not true is that rising part-time work represents a new structural phenomenon in the U.S. labor market.

Consider the following points: part-time employment represents one-fifth of total household employment. A quick inspection of this series screams cyclical NOT structural. That is, the series rises during recessions and falls as the recovery gains traction. The Household Survey is notoriously volatile, so it makes sense to analyze longer-term trends. Over the last year, all of the increase in part-time employment has been for non-economic reasons (child care, vacation, schooling, training, etc.)

Why has this subject generated so much attention? Simple. The Affordable Care Act (ACA). However, there is little survey evidence that firms plan to materially alter worker hours because of the health law. A survey of firms across the New York Fed District found that only 12% of respondents refrained from hiring or shifted full-time workers into part-time; that compares to 7% that made minimal changes to their workforce. So, the ACA is having marginal impact, but it is overwhelmed by business cycle dynamics.

Myth #2: Job gains are all low wage
Earlier this month USA Today ran with the following headline, “Many new jobs are part-time and low-paying”. This is a true statement. Many of the jobs being created are low-paying and that may or may not be something to worry about. What is not true, however, is that this is a new development and unique only to this recovery.

The two sectors that get the most attention are retail trade and leisure & hospitality. So, we went back five economic cycles and looked at the composition of employment growth from the payroll trough to peak. Here is what we found: retail trade and leisure & hospitality employment, typically accounts for one-fourth of the job creation. In this cycle, 28.2% of the new jobs are in these categories. That compares to 28.4% in the 2003-07 recover, 23.4% in the 90s, 28.5% in the 80s, and 23.7% in the 70s.

More broadly, the narrative misses the fact the wages typically lag in employment recoveries. While the labor market continues to recover in a relative sense, there is still plenty of slack. What is important is that these unemployed workers here value. Otherwise, they would not be able to exert downward pressure on the wages of those working and the newly employed. That tells us the labor stack is cyclical not structural. As the labor recovery ensues and the slack is absorbed, wages will begin to rise. When growth bears fret about low-wage work, a more apt translation at this stage is: it is still early in the jobs recovery.

The views expressed above are those of Neil Dutta and are not intended as investment advice.

The Next Chairman of The Federal Reserve Is…

Andrew Rosenberger, CFA, Senior Investment Manager, Brinker Capital

In the study of various sciences such as physics, biology, or even economics, we often create models to help us better understand the world around us.  These models often start out simple and usually only account for a few variables at a time.  For example, when solving a physics problem, we may assume that friction doesn’t influence the movement of an object.  That may be an okay assumption if you were calculating the movement of an ice skater along the ice, but ignoring friction could have a devastating impact when discussing vehicle safety or sending a spaceship to the moon.  So too is the case with investments.  As investors, we often create models to try and explain the economic world around us.  For example, to explain the price of a stock or asset class, we may look to the future earnings power and discount rates to calculate a fair value.  But too often these models fail.  Just as many came to believe in the efficient market hypothesis theory, the 2008 financial crisis proved to be a wake-up call that the world of sociology and investor behavior is more complicated than even the most sophisticated models of today.

Since the failure of many traditional valuation models, many investors have shifted from a bottom-up-only view of the world to one that incorporates a more top-down approach.  Thanks in part to massive amounts of liquidity in the form of Quantitative Easing, Fed-watching has become a main source of the new top-down approach.  Unfortunately, leadership at the Federal Reserve remains in question and a seat change may be afoot again.  During an interview on June 18 with Charlie Rose, President Obama stated, “He’s [Ben Bernanke] already stayed a lot longer than he wanted, or he was supposed to.” The statement was a clear signal that new leadership will begin February 1 of next year.

Source: Zeorehedge.com via Paddy Power

Over the past month, the search for a new Fed Chairman has narrowed to an apparently short list of two candidates: Larry Summers and the current Vice Chairman of the Federal Reserve, Janet Yellen.  While many influential members of the economic community were quick to vocally support Yellen, the pendulum of consensus now appears to be forming around Larry Summers.  In fact, the nomination has garnered so much momentum in the financial community, that Paddy Power, a United Kingdom-based gambling site, is taking wagers on the outcome.  The current odds are fascinating, with Larry Summers a 1:2 favorite over Janet Yellen, with 2:1 (against) odds.  Amazingly, as charted by Zero Hedge, in less than a month’s time, Summers has moved from having an outside chance to being the favorite.  If you’re skeptical of foreign-based online gambling websites, even reputable sources such as Bloomberg put the odds of a Summers nomination at 60%[1].

What does this mean for investors?  Whereas the investing community largely expects a Yellen nomination to represent a continuation of the current monetary policy as directed under Chairman Bernanke, a Summers nomination is far more uncertain.  However, I’ll quote from one of our trusted research providers, 13D Research:

We have read everything that Summers has written in recent years and we suspect his views coincide very closely with that of President Obama. What makes this all so interesting is that Summers is a vocal supporter of fiscal expansion. It is highly possible that if he is nominated and confirmed by the Senate that he will push for a form of Overt Monetary Finance…Today’s Financial Times carries an article on Summers that quoted remarks he made about the effectiveness of quantitative easing at a conference last April. “QE in my view is less efficacious for the real economy than most people suppose…If QE won’t have a large effect on demand, it will not have a large effect on inflation either.” Summers also gave a highly optimistic outlook for the U.S. economy. “I think the market is underestimating the pace at which the Fed will alter its current course and the consequences of that for interest rates.” This means a radical change in the markets’ expectations. The article also emphasized the following: “People who have discussed policy with him say Mr. Summers regards fiscal policy as a more effective tool than monetary policy.” What has been lacking at the Fed is a strong personality and intellectual leadership. Summers is brash, intelligent and self-confident, traits which may enable him to take charge of the FOMC. A regime change of this order of magnitude would be a game changer of the highest order, impacting inflation, economic growth, wages, gold, and the U.S. dollar….

The jury is still out as to who will ultimately be the next Fed Chairman and what their policies will be.  Similarly, given that Summers represents a shift away from the status quo, his recent surge in garnering the nomination may partially be why markets have decided to take a breather.  After all, markets prefer predictability and quantitative easing has been a major tailwind for investor confidence.  Thus, we wouldn’t be surprised to see higher market volatility as investors adjust their models and conceptual frameworks to reflect the possibility of a new Federal Reserve paradigm led by Larry Summers.

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[1] Bloomberg, http://www.bloomberg.com/news/2013-08-12/the-fed-race-heats-up.html

Monthly Market and Economic Outlook: August 2013

@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital

The U.S. equity markets hit new all-time highs in July after investors digested the Fed’s plans to taper asset purchases.  The S&P 500 Index gained over 5% during the month while the small cap Russell 2000 Index gained 7%. So far 2013 has been a stellar year for U.S. equities with gains of 20%. Second quarter earnings have been decent with 69% of S&P 500 companies beating estimates (as of 8/5)[1]; however, revenue growth remains weak at just +1.3% year over year. We will need to see stronger top-line growth for margins to be sustainable at current high levels.

Developed international equity markets also participated in July’s rally, helped by a weaker U.S. dollar. The MSCI EAFE Index gained just over 4% for the month in local terms and gained over 5% in USD terms. Japan’s easing policies have been celebrated by investors, driving Japanese equity markets 17% higher so far in 2013. Emerging markets were able to eke out a gain of just 1% in July as Brazil and India continued to struggle in the face of slowing growth and weaker currencies.

While interest rate volatility overwhelmed the second quarter, the fixed income markets stabilized in July. After moving sharply higher in May and June, the 10-year U.S. Treasury rose only nine basis points during the month and at 2.64% (as of 8/5), remains at levels we experienced as recently as 2011. The Barclays Aggregate Index was relatively flat for the month. Small losses in Treasuries and agency mortgage-backed securities were offset by gains in credit. The high yield sector had a nice rebound in July as credit spreads tightened, gaining 1.9%.

With growth still sluggish and inflation low, we expect interest rates to remain relatively range-bound over the near term; however, the low end of the range has shifted higher.  Volatility in the bond market should continue as the Fed begins to taper asset purchases.  Negative technical factors, like continued outflows from fixed income funds, could weigh on the asset class. Our portfolios remain positioned in defense of rising interest rates with a shorter duration, an emphasis on spread product, and a healthy allocation to low volatility absolute return strategies.

The pace of U.S. economic growth has continued to be modest, but attractive relative to growth in the rest of the developed world. U.S. GDP growth in the first half of the year has been below expectations; however, there are signs that growth has been picking up in the second quarter, including an increase in both the manufacturing and non-manufacturing purchasing manager’s indices (PMIs) and a decline in unemployment claims.  The improvement in the labor markets has been slow but steady.  Should the Fed follow through with their plans to reduce monetary policy accommodation, it will do so in the context of an improving economy, which should be a positive for equity markets.

We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we move into the second half of the year.  A number of factors should continue to support the economy and markets for the remainder of the year:

• Monetary policy remains accommodative: The Fed remains accommodative (even with the eventual end of asset purchases, short-term interest rates will remain low for the foreseeable future), the ECB has pledged to support the euro, and now the Bank of Japan is embracing an aggressive monetary easing program in an attempt to boost growth and inflation.
• Fiscal policy uncertainty has waned: After resolutions on the fiscal cliff, debt ceiling and sequester, the uncertainty surrounding fiscal policy has faded.  The U.S. budget deficit has improved markedly, helped by stronger revenues.  Fiscal drag will be much less of an issue in 2014.
• Labor market steadily improving: The recovery in the labor market has been slow, but steady.
• Housing market improvement: The improvement in home prices, typically a consumer’s largest asset, boosts net worth and as a result, consumer confidence.  However, a significant move higher in mortgage rates could jeopardize the recovery.
• U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be reinvested or returned to shareholders. Corporate profits remain at high levels and margins have been resilient.

However, risks facing the economy and markets remain, including:

• Fed mismanages exit: If the economy has not yet reached escape velocity when the Fed begins to scale back its asset purchases, risk assets could react negatively as they have in the past when monetary stimulus has been withdrawn.
• Significantly higher interest rates: Rates moving significantly higher from here could stifle the economic recovery.
• Europe: While the economic situation appears to be bottoming, the risk of policy error in Europe still exists.  The region has still not addressed its debt and growth problems; however, it seems leaders have realized that austerity alone will not solve its problems.
• China: A hard landing in China would have a major impact on global growth.

We continue to seek high conviction opportunities and strategies within asset classes for our client portfolios.  Some areas of opportunity currently include:

• Domestic Equity: favor U.S. over international, financial healing (housing, autos), dividend growers
• International Equity: frontier markets, Japan, micro-cap
• Fixed Income: non-Agency mortgage-backed securities, short duration, emerging market corporates, global high yield and distressed
• Real Assets: REIT Preferreds
• Absolute Return: relative value, long/short credit, closed-end funds
• Private Equity: company specific opportunities

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[1] Strategas Research Partners

An Ode to Barnes & Noble

Dan Williams, CFP, Investment Analyst , Brinker Capital

On July 8, 2013 the CEO of Barnes & Noble, William Lynch, abruptly resigned. His rise and fall were tied largely in part to his belief that the future of B&N was in its NOOK digital reader. Lynch also felt that being a brick-and-mortar business would overcome the technology headwind of competing with Google, Amazon, and Apple on their turf, the tablet space. In fairness, he is likely right that people do derive a lot of benefit from being able to physically visit their book store. Still the struggle for B&N, and Borders prior to their demise, seems to be compensation for this social benefit. Now the debate is whether the physical book stores can survive in the Amazon age. In my biased opinion, I believe the answer is yes.

To say that I am a regular at my local B&N is an understatement. Over my career, I have studied for various FINRA licenses, the CFP designation, and all three levels of the CFA exams. The vast majority of this studying was done at my local B&N. On the rare occasions when I did not have anything to study for, I could not help but continue to go to B&N as it had become such a part of my life. This amounts to a total of about ten years of trips to my local B&N, usually multiple times per week. During this time, I have witnessed a lot of life from my table in the crowded B&N café.  From college interviews, job interviews, dates, people doing quasi-library research (most often on vacation destinations) and people who are clearly looking at books to purchase—of course, not at B&N, but later at a discount from Amazon.com. You can see them all at B&N. And for the most part, these people did not purchase anything from B&N outside of the food items in the cafe. It was fairly typical for me to spend three to four hours on a Saturday studying but only purchase an iced tea and a sandwich. Often, I would grab a new book off the shelf to read, and often I would end up reading a whole book without ever taking it out of the store. It is clear the store was being used less as a place for B&N to sell books and more like a community center or an improved library.

This social benefit of this institution is echoed by Lydia DePillis in her July 10, 2013 Washington Post article “Barnes & Noble’s troubles don’t show why bookstores are doomed. They show how they’ll survive” when she notes:

“Here’s the thing: Bookstores, more so than movie rental and record stores, are oases in the middle of cities (and even in suburban malls). We go there to kill time, expose ourselves to new stuff, look for a gift without something specific in mind, and maybe pick up something on impulse while we’re there. Even Borders’ disorganized warehouses left holes in the urban fabric when they disappeared, and Barnes and Nobles would do the same–they’re a kind of public good, at a time when the public is getting less good at supporting libraries.”

However, the free-rider problem is also a known challenge as Lauren Hazard Owen in her July 9, 2013 paidContent.org article “Barnes & Noble throws out its CEO, but that won’t save the company” writes:

“While everyone likes the idea of a neighborhood bookstore, that doesn’t translate into business success. While Barnes & Noble is, in fact, the only neighborhood in a lot of areas, consumers who advocate shopping local may still think of it as a big box store, and they’re not likely to show the same loyalty to it as they might to the charming indie bookstore on Main Street. Instead, they’ll keep doing what they do now: Go in to the store to browse and for the AC, then go home and order books on Amazon.”

The clear lesson here is that providing service to society is only good business if you can be compensated for supplying it. I, however, also know that providing something that people want is a great place to start a business. Ultimately, I think that in ten years we will still have Barnes & Noble at least in some tangible form. First, as I noted above, the café part of B&N works. People who are enjoying their time here are drinking a coffee while doing it. In many ways it is an improvement on the Starbucks experience by having this attachment to the book store. Second, Amazon clearly benefits from B&N existing as an uncompensated partner in many of their transactions. Third, publishers and authors don’t want to be left with an Amazon-only world as book stores represent their physical retail outposts to host book-signings, book-release frenzies, and the like. Fourth, our society seems to value physical book stores (even though they will try to free-ride if they can) as something beyond a retail space.

When you have this many interested parties wanting something to exist, I expect it to exist. Maybe B&N survives through a business model with a leaner book store and larger café business model. Maybe Amazon buys B&N and accepts that they will barely break even on the physical book store, but their overall profit will be improved for having B&N around. Maybe B&N, in name, does go away, but Starbucks opens a book store/coffee house location type, recognizing it as part of their positive social image campaign to improve the Starbucks experience—or maybe just the hubris that they can make it work. Some publishers may even band together to create some physical retail super store to replace B&N or cut some deals with to keep them around. The hard part is that it seems best for all parties involved to have someone else step up.

I could be delusional and perhaps thinking with my heart rather than my head as many a beloved business have been washed away by the waves of retail climate change. With that said, as long as there is a B&N,  you can find me sitting there drinking an iced tea blend known locally as “The Dan” (told you I was a regular), reading a book I am perpetually thinking of buying but never do, and watching yet another awkward college interview.

Security mentioned is shown for illustrative purposes and is not owned by Brinker Capital