European Secession Votes and Market Implications: Scotland

Stuart P. Quint, CFA, Senior Investment Manager and International Strategist

This first blog in a two-part series will examine the Scottish secession vote coming in September and the potential implications for financial markets. The second blog will delve into the Catalan vote in November.

“There is the real possibility of one or several national divorces being initiated in Western Europe in 2014,” opines Nicholas Siegel, program officer at the Transatlantic Academy, a U.S.-European think-tank based in Washington.[1]

Secession votes will be held in the UK in September over the future of Scotland and in Spain in November over the future of Catalunya. It appears unlikely that either will result in a real separation of the regions from these nations. However, financial markets should still monitor the progress of these votes. Markets appear to discount a rejection of secession. If voters in one of these regions were to vote for secession, that could trigger near-term volatility. Regardless, these votes highlight fragility in the fabric of the European Union that warrants monitoring.

Voters in Scotland will elect whether to remain a part of the United Kingdom or to secede and claim independence. A “Yes” vote would lead to binding negotiations between the Scottish and UK Governments for eventual secession. Recent polls suggest pro-independence voters will not succeed as a plurality of voters leans against independence.[2]

In the event of a vote for independence, complications both for the UK and Scotland could ensue. The size of the economy and population of Scotland is less than 10% of the UK; yet, these statistics conceal a few hurdles. Much of the energy produced within the UK falls within Scottish jurisdiction. Many UK financial services companies are based in Scotland (though the majority of their revenues derive from outside Scotland). Moreover, the Bank of England has stated that Scotland would have to use its own currency instead of the British Pound Sterling.

The costs of independence could bring with them financial turmoil at least for an independent Scotland. However, the UK itself might not go unscathed as the British Pound Sterling is a reserve currency that could lose support. Major corporations, such as Standard Life, could relocate from Scotland back to the UK

Even a “No” vote, though, does not necessarily put an end to the matter. A narrow vote could give way to a second future vote and have repercussions for future votes on the UK remaining in the EU and general elections in 2015. A “No” vote that fails to win overwhelmingly could potentially accelerate the timing of the referendum for whether the UK remains in the EU.

In terms of financial markets, the closest recent comparable is Canada, which experienced two failed referenda regarding the secession of Quebec in 1980 and 1995. In both instances, markets did not underperform global markets leading into and post the referenda. Although markets shrugged off the referenda, over time many large Canadian corporations relocated their headquarters out of Quebec.

[1] “Is Secession the Answer? The Case of Catalonia, Flanders, and Scotland”, December 2, 2013 retrieved on http://knowledge.wharton.upenn.edu/article/secession-answer-case-catalonia-flanders-scotland/ .

[2] Lukyano Mnyanda, “Scots Anti-Independence Camp Gains in Poll amid Pound Doubts”, August 13, 2014, Bloomberg News.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

An End to Complacency

Joe Preisser, Portfolio Specialist, Brinker Capital

Volatility abruptly made an entrance onto the global stage, shoving aside the complacency that has reigned over the world’s equity markets this year as they have marched steadily from record high to record high. Asset prices were driven sharply lower last week, as gathering concerns that the Federal Reserve Bank of the United States may be closer than anticipated to raising interest rates, combined with increasing worries about the possibility of deflation in the Eurozone, and a default by the nation of Argentina, to weigh heavily on investor sentiment. The selling seen across equity markets last Thursday was particularly emphatic, with declining stocks listed on the NYSE outpacing those advancing by a ratio of 10:1, and the Chicago Board Options Exchange Volatility Index (VIX), which measures expected market volatility, climbing 25% to its highest point in four months, all combining to erase the entirety of the gains in the Dow Jones Industrial Average for the year.

The looming specter of the termination of the Federal Reserve’s bond-buying program, which is scheduled for October, is beginning to cast its shadow over the marketplace as this impending reality, coupled with fears that the Central Bank will be forced to raise interest rates earlier than expected, has served to raise concerns. Evidence of this could be found last Wednesday, where, on a day that saw a report of Gross Domestic Product in the United States that far exceeded expectations, growing last quarter at an annualized pace of 4%, vs. the 2.1% contraction seen during the first three months of the year, and a policy statement from the Federal Reserve which relayed that, “short-term rates will stay low for a considerable time after the asset purchase program ends” (Wall Street Journal) equity markets could only muster a tepid response. It was the dissenting voice of Philadelphia Fed President, Charles Plosser who opined that, “the guidance on interest rates wasn’t appropriate given the considerable economic progress officials had already witnessed” (Wall Street Journal), which seemed to resonate the loudest among investors, giving them pause that this may be a signal of deeper differences beginning to emerge within the Federal Open Market Committee. Concern was further heightened on Thursday morning of last week, when a report of the Employment Cost Index revealed an unexpected increase to 0.7% for the second quarter vs. a 0.3% rise for the first quarter (New York Times), which stoked nascent fears of inflation, bolstering the case for the possibility of a more rapid increase in rates.

Negative sentiment weighed heavily on equity markets outside of the U.S. as well last week, as the possibility of deflationary pressures taking hold across the nations of Europe’s Monetary Union, combined with ongoing concerns over the situation in Ukraine and the second default in thirteen years by Argentina on its debt to unsettle market participants. According to the Wall Street Journal, “Euro-zone inflation increased at an annual rate of just 0.4% in July, having risen by 0.5% the month before. In July 2013 the rate was 1.6%” While a fall in prices certainly can be beneficial to consumers, it is when a negative spiral occurs, as a result of a steep decline, to the point where consumption is constrained, that it becomes problematic. Once these forces begin to take hold, it can be quite difficult to reverse them, which explains the concern it is currently generating among investors. The continued uncertainty around the fallout from the latest round of sanctions imposed on Russia, as a result of the ongoing conflict in Ukraine, further undermined confidence in stocks listed across the Continent and contributed to the selling pressure.

Into this myriad of challenges facing the global marketplace came news of a default by Argentina, after the country missed a $539 interest payment, marking the second time in thirteen years they have failed to honor portions of their sovereign debt obligations. The head of research at Banctrust & Co. was quoted by Bloomberg News, “the full consequences of default are not predictable, but they certainly are not positive. The economy, already headed for its first annual contraction since 2002 with inflation estimated at 40 percent, will suffer in a default scenario as Argentines scrambling for dollars cause the peso to weaken and activity to slump.”

With all of the uncertainty currently swirling in these, “dog days of summer,” it is possible that the declines we have seen of late may be emblematic of an increase in volatility in the weeks to come as we move ever closer to the fall, and the terminus of the Fed’s asset purchases.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Monthly Market and Economic Outlook: July 2014

Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital

Equity markets continued to grind higher in the second quarter despite continued tapering by the Federal Reserve, a negative GDP print, and rising geopolitical tensions. All asset classes have delivered positive returns in the first half of the year, led by long-term U.S. Treasury bonds. There has been a lack of volatility across all asset classes; the CBOE Volatility Index (VIX) fell to its lowest level since February 2007.

Year to date the U.S. equity markets are slightly ahead of international markets. All S&P sectors are positive year to date, led by utilities and energy. Mid cap value has been the best performing style, helped by the double-digit performance of REITs. U.S. large caps have outperformed small caps, but after experiencing a drop of more than -9%, small caps rebounded nicely in June. Value leads growth across all market capitalizations.

Despite concerns surrounding the impact of Fed tapering on emerging economies, emerging market equities outperformed developed markets in the second quarter, and have gained more than 6% so far this year, putting the asset class ahead of developed international equities. Small cap emerging markets and frontier markets have had even stronger performance. The dispersion of performance within emerging markets has been high, with India, Indonesia and Argentina among the top performers, and China, Mexico and Chile among the laggards. On the developed side, performance from Japan has been disappointing but a decent rebound in June bumped it into positive territory for the year-to-date period.

Despite a consensus call for higher interest rates in 2014, U.S. Treasury yields moved lower. The 10-year Treasury Note is currently trading at 2.6% (as of 7/7/14), still below the 3.0% level where it started the year. While sluggish economic growth and geopolitical risks could be keeping a ceiling on U.S. rates, technical factors are also to blame. The supply of Treasuries has been lower due to the decline in the budget deficit, and the Fed remains a large purchaser, even with tapering in effect. At the same time demand has increased from both institutions that need to rebalance back to fixed income after experiencing strong equity markets returns, and investors seeking relative value with extremely low interest rates in Japan and Europe.

With the decline in interest rates and investor risk appetite for credit still strong, the fixed income asset class has delivered solid returns so far this year. Both investment grade and high yield credit spreads continue to grind tighter. Emerging market bonds, both sovereign and corporate, have also experienced a nice rebound after a tough 2013. Municipal bonds benefited from a positive technical backdrop with strong demand for tax-free income being met with a lack of new issuance.

We approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds, with a number of factors supporting the economy and markets over the intermediate term.

• Global monetary policy remains accommodative: Even with quantitative easing slated to end in the fall, U.S. short-term interest rates should remain near-zero until 2015 if inflation remains contained. The ECB and the Bank of Japan are continuing their monetary easing programs.
• Global growth stable: We expect a rebound in U.S. growth in the second quarter after the polar vortex helped to contribute to a decline in economic output in the first quarter. Outside of the U.S., growth has not been very robust, but it is still positive.
• Labor market progress: The recovery in the labor market has been slow, but we have continued to add jobs. The unemployment rate has fallen to 6.1%.
• U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash. M&A deal activity has picked up this year. Corporate profits remain at high levels and margins have been resilient.
• Less Drag from Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year. Fiscal drag will not have a major impact on growth in 2014, and the budget deficit has also declined significantly.

Risks facing the economy and markets remain, including:

• Fed Tapering/Tightening: If the Fed continues at the current pace, quantitative easing will end in the fall. Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, this withdrawal is more gradual and the economy appears to be on more solid footing this time. Should inflation pick up, market participants will shift quickly to concern over the timing of the Fed’s first interest rate hike. Despite the recent uptick in the CPI, the core Personal Consumption Expenditure Price Index (PCE), the Fed’s preferred inflation measure, is up only +1.5% over the last 12 months.
• Election Year: While we noted there has been some progress in Washington, we could see market volatility pick up later this year in response to the mid-term elections.
• Geopolitical Risks: The events surrounding Iraq, as well as Russia/Ukraine are further evidence that geopolitical risks cannot be ignored.

Risk assets should continue to perform if we experience the expected pickup in economic growth; however, we could see increased volatility and a shallow correction as markets digest the end of the Federal Reserve’s quantitative easing program. Economic data, especially inflation data, will be watched closely for signs that could lead the Fed to tighten monetary policy earlier than expected. Equity market valuations look elevated, but not overly rich relative to history, and maybe even reasonable when considering the level of interest rates and inflation. Investor sentiment remains overly optimistic, but the market trend remains positive. In addition, credit conditions still provide a positive backdrop for the markets.

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Asset Class	Outlook	Favored Sub-Asset Classes
U.S. Equity	+	Large cap bias, dividend growers
Intl Equity	+	Emerging and Frontier markets, small cap
Fixed Income	–	Global high yield credit, short duration
Absolute Return	+	Closed-end funds, event driven
Real Assets	+/-	MLPs, natural resources equities
Private Equity	+	Diversified

 

Source: Brinker Capital

Brinker Capital, Inc., a Registered Investment Advisor. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Past performance is not a guarantee of similar future results. An investor cannot invest directly in an index.

Reach Out in Good Times and Bad

Sue Bergin, President, S Bergin Communications

It’s no secret that clients like to hear from their advisors. In fact, failure to communicate is one of the top five reasons why clients become dissatisfied with their advisor. According to a Spectrum study, 40% of clients said they consider leaving when the advisor makes them do all the work (make all the calls).[1]

A recent study by Pershing, however, shows that advisors do make the calls—when they have bad news. Here are some of the key findings when it came to communication choices.

• 58% of the advisors contacted clients during market downturns, yet only 39% reached out to discuss market gains.
• 68% of advisors reached out to clients when personal investments declined, while only 53% initiated contact with the client in instances when personal investments increased in value.[2]

How News is Delivered
The telephone is the most frequently used communication vehicle for both good and bad investment performance news. A quarter of the advisors surveyed used email and face-to-face meetings to communicate market losses, while 58% of the advisors picked up the phone. The only type of communication that happened more frequently in person than any other message was in the area of education. 52% of advisors said that they scheduled face-to-face meetings to educate clients while 48% did so over the telephone.

“No News is Good News” Applies Better to Weather than Client Relationships
Communication work is fundamentally about two things: trust and relationships. Good communication can strengthen relationships and deepen trust while poor communication can have the opposite effect. The “no news is good news” approach many advisors seem to take is problematic for a few reasons. It robs the advisor of the opportunity to score relationship-building points. It also increases the risk of clients feeling neglected. Finally, it makes it more difficult for the advisor to identify opportunities proactively because they become somewhat out-of-touch with what is happening in their clients’ lives.

[1] http://www.onwallstreet.com/gallery/ows/client-switching-advisor-top-five-reasons-2681390-1.html

[2] The Second Annual Study of Advisory Success: A New Age of Client Communications and Client Expectations, Pershing.

The views expressed are those of Brinker Capital and are for informational purposes only.

Monthly Market and Economic Outlook: June 2014

Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital

The global equity markets continued to climb higher in May. In the U.S. the S&P 500 Index hit another all-time high, gaining more than 3% for the month. The technology and telecom sectors were the top performing sectors in May, but all sectors were positive except for utilities. In a reversal of March and April, growth outpaced value across all market capitalizations, but large caps remained ahead of small caps. In the real assets space, REITs and natural resources equities continued to post solid gains despite low inflation.

International developed equity markets were slightly behind U.S. markets in May, but emerging market equities outperformed. After a weak start to the year, emerging market equities are now up +3.5% year to date through May, even with China down more than -3%. The dispersion in the performance of emerging market equities remains wide. Indian equities rallied strongly in May, gaining more than 9%, after the election of a new prime minister and his pro-business BJP party.

Despite a consensus call for higher interest rates in 2014, U.S. Treasury yields have continued to fall. The yield on the 10-year Treasury note ended the month at 2.5%, still above its recent low of 1.7% in May 2013, but well below the 3.0% level where it started the year. While lower than expected economic growth and geopolitical risks could be keeping a ceiling on U.S. rates, technical factors are also to blame. The supply of Treasuries has been lower due to the decline in the budget deficit, and the Fed remains a large purchaser, even with tapering in effect. At the same time demand has increased from both institutions that need to rebalance back to fixed income after such a strong equity market in 2013 and investors seeking relative value with extremely low interest rates in Japan and Europe.

As interest rates have declined, fixed income has performed in line with equities so far this year. All fixed income sectors were positive again in May. Municipal bonds and investment grade credit have been the top performing fixed income sectors so far this year. Both investment grade and high yield credit spreads continue to grind tighter. Within the U.S. credit sector fundamentals are solid and the supply/demand dynamic is favorable, but valuations are elevated. Emerging market bonds have also experienced a nice rebound after a tough 2013. Municipal bonds benefited from a positive technical backdrop with strong demand for tax-free income being met with a dearth of issuance.

We approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds, with a number of factors supporting the economy and markets over the intermediate term.

• Global monetary policy remains accommodative: Even with the Fed tapering asset purchases, short-term interest rates should remain near-zero until 2015 if inflation remains low. The ECB announced additional easing measures, and the Bank of Japan continues its aggressive monetary easing program.
• Global growth stable: U.S. economic growth has been slow but steady. Economic growth declined in the first quarter, but we expect it to turn positive again in the second quarter. Outside of the U.S. growth has not been very robust, but it is still positive.
• Labor market progress: The recovery in the labor market has been slow, but we have continued to add jobs. The unemployment rate has fallen to 6.3%. Unemployment claims have hit cycle lows.
• Inflation tame: With core CPI running below the Fed’s target at +1.8% and inflation expectations contained, the Fed retains flexibility to remain accommodative.
• U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be used for acquisitions, capital expenditures, hiring, or returned to shareholders. M&A deal activity has picked up this year. Corporate profits remain at high levels and margins have been resilient.
• Less drag from Washington: After serving as a major uncertainty over the last few years, there has been some movement in Washington. Fiscal drag will not have a major impact on growth this year. The deficit has also shown improvement in the short-term.

Risks facing the economy and markets remain, including:

• Fed Tapering/Tightening: If the Fed continues at the current pace, quantitative easing should end in the fourth quarter. Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, this withdrawal is more gradual and the economy appears to be on more solid footing this time. The new Fed chairperson also adds to the uncertainty. Should economic growth and inflation pick up, market participants will shift quickly to concern over the timing of the Fed’s first interest rate hike.
• Emerging markets: Slower growth could continue to weigh on emerging markets. While growth in China is slowing, there is not yet evidence of a hard landing.
• Election year: While we noted there has been some progress in Washington, we could see market volatility pick up later this year in response to the mid-term elections.
• Geopolitical risks: The events surrounding Russia and Ukraine are further evidence that geopolitical risks cannot be ignored.

Risk assets should continue to perform if real growth continues to recover; however, we could see volatility as markets digest the continued withdrawal of stimulus by the Federal Reserve. Economic data will be watched closely for signs that could lead to tighter monetary policy earlier than expected. Equity market valuations are fair, but are not overly rich relative to history, and may even be reasonable when considering the level of interest rates and inflation. Investor sentiment remains elevated but is not at extreme levels. Credit conditions still provide a positive backdrop for the markets.

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Asset Class	Outlook	Favored Sub-Asset Classes
U.S. Equity	+	Large cap bias, dividend growers
Intl Equity	+	Frontier markets, small cap
Fixed Income	–	Global high-yield credit, short duration
Absolute Return	+	Closed-end funds, event driven
Real Assets	+/-	MLPs, natural resources equities
Private Equity	+	Diversified approach

Source: Brinker Capital

 Brinker Capital, Inc., a Registered Investment Advisor. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Past performance is not a guarantee of similar future results. An investor cannot invest directly in an index.

Volatility: Why it Matters

Ryan Dressel, Investment Analyst, Brinker Capital

Have you ever noticed how many commercials on TV use blind comparison tests to prove that their products are better than their competitors? Soft drinks, washing detergents, tablets, air fresheners, fast food chains, and even web sites all use this marketing tool on a fairly regular basis. One reason companies do this is to try to change your perception about their product. It’s human nature to associate a good or bad feeling about a product, brand, or company based on personal experiences. If you got sick from food at a restaurant for example, chances are you won’t return to that restaurant again, even if it changes the staff, menu, and décor. A blind comparison test is an attempt to convince you that a product isn’t as bad as you might think.

How can this be applied to your investments? You’ll hear dozens of mutual fund companies advertise that they are beating an index, benchmark, or peer group (such as Lipper) over a specific time frame. You could also open the Wall Street Journal and read about a mutual fund manager boasting smart decisions with regard to short-term news, such as the S&P 500 rising or falling in any given week. If you try to interpret headline news or those T.V. commercials without any context, there’s a good chance you could misjudge your portfolio and even worse, make an irrational decision! What you will rarely hear on T.V. or read in the papers is an advertisement for a portfolio that provides steady and consistent returns by managing volatility.

Why does volatility matter? To demonstrate the value of volatility, we’ll do a blind comparison using two hypothetical portfolios (you saw that coming right?). Both Portfolio A and Portfolio B started with an initial investment of $100,000 and have a sum of returns of 65% over a 10-year time period. The portfolios have the following annual returns over that time frame:

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Portfolio A	+2%	+13%	+5%	+20%	7%	4%	-7%	-1%	+16%	+6%
Portfolio B	+6%	+25%	-10%	+36%	-15%	+11%	-25%	-7%	+33%	+11%

Which portfolio would you predict to have a higher balance at the end of the 10-year time frame? Looking at the returns we can observe a few things that jump out. Portfolio B managed to achieve extremely high gains in years 2, 4 and 9. Conversely, it also had a couple of really bad years in year 5, and year 7. It also finished the last two years with a combined +44%. Looking at Portfolio A, we can see that it never topped 20% in a given year, and never lost more than 7% in a year. It also finished seven out of the 10 years with a return of +7% or less.

If you chose Portfolio A, you would be correct!

As demonstrated in the charts above and below, Portfolio A has a much lower level of volatility. Through the power of compounding, this allowed Portfolio A to finish with a higher balance despite the fact that both portfolios have identical sum of returns. In reality, this is typically achieved by constructing a well-diversified portfolio using a wide array of asset classes. This is also a good reminder of how fixed income and absolute return strategies are beneficial to your portfolio in any market environment.

If these were actual investment products, there is no doubt that you would hear Portfolio B being advertised as an outperformer during a time frame that captures those years of strong performance. In the end however, the only thing that matters is the balance of your portfolio and that you are on track towards achieving your investment goals. Be sure to review your portfolio in the right context, especially during times of market “noise.”

Source: The data used and shown above is hypothetical in nature and shown for illustrative purposes. Not intended as investment advice.

The views expressed are those of Brinker Capital and are for informational purposes only. Holdings are subject to change.

Monthly Market and Economic Outlook: April 2014

Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital

The full quarter returns masked the volatility risk assets experienced during the first three months of the year. Markets were able to shrug off geopolitical risks stemming from Russia and the Ukraine, fears of slowing economic growth in the U.S. and China, and a transition in Federal Reserve leadership. In a reversal of what we experienced in 2013, fixed income, commodities and REITs led global equities.

The U.S. equity market recovered from the mild drawdown in January to end the quarter with a modest gain. S&P sector performance was all over the map, with utilities (+10.1%) and healthcare (+5.8%) outperforming and consumer discretionary (-2.9%) and industrials (+0.1%) lagging. U.S. equity market leadership shifted in March. The higher growth-momentum stocks that were top performers in 2013, particularly biotech and internet companies, sold off meaningfully while value-oriented and dividend-paying companies posted gains. Leadership by market capitalization also shifted as small caps fell behind large caps.

International developed equities lagged the U.S. markets for the quarter; however, emerging market equities were also the beneficiary of a shift in investor sentiment in March. The asset class gained more than 5% in the final week to end the quarter relatively flat (-0.4%). Performance has been very mixed, with a strong rebound in Latin America, but with Russia and China still weak. This variation in performance and fundamentals argues for active management in the asset class. Valuations in emerging markets have become more attractive relative to developed markets, but risks remain which call into question the sustainability of the rally.

After posting a negative return in 2013, fixed income rallied in the first quarter. The yield on the 10-year U.S. Treasury note fell 35 basis points to end the quarter at 2.69% as fears of higher growth and inflation did not materialize. After the initial decline from the 3% level in January, the 10-year note spent the remainder of the quarter within a tight range. All fixed income sectors were positive for the quarter, with credit leading. Both investment-grade and high-yield credit spreads continued to grind tighter throughout the quarter. Within the U.S. credit sector, fundamentals are solid and the supply/demand dynamic is favorable, but valuations are elevated, especially in the investment grade space. We favor an actively managed best ideas strategy in high yield today, rather than broad market exposure.

While we believe that the long-term bias is for interest rates to move higher, the move will be protracted. Fixed income still plays an important role in portfolios as protection against equity market volatility. Our fixed income positioning in portfolios—which includes an emphasis on yield-advantaged, shorter-duration and low-volatility absolute return strategies—is designed to successfully navigate a rising or stable interest rate environment.

We approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we begin the second quarter, with a number of factors supporting the economy and markets over the intermediate term.

• Global monetary policy remains accommodative: Even with the Fed tapering asset purchases, short-term interest rates should remain near zero until 2015. In addition, the ECB stands ready to provide support if necessary, and the Bank of Japan continues its aggressive monetary easing program.
• Global growth stable: U.S. economic growth has been slow and steady. While the weather appears to have had a negative impact on growth during the first quarter, we still see pent-up demand in cyclical sectors like housing and capital goods. Outside of the U.S. growth has not been very robust, but it is still positive.
• Labor market progress: The recovery in the labor market has been slow, but we have continued to add jobs. The unemployment rate has fallen to 6.7%.
• Inflation tame: With the CPI increasing just +1.1% over the last 12 months and core CPI running at +1.6%, inflation is below the Fed’s 2% target. Inflation expectations are also tame, providing the Fed flexibility to remain accommodative.
• U.S. companies remain in solid shape: U.S. companies have solid balance sheets with cash that could be reinvested, used for acquisitions, or returned to shareholders. Corporate profits remain at high levels, and margins have been resilient.
• Less drag from Washington: After serving as a major uncertainty over the last few years, there has been some movement in Washington. Fiscal drag will not have a major impact on growth this year. Congress agreed to both a budget and the extension of the debt ceiling. The deficit has also shown improvement in the short term.
• Equity fund flows turned positive: Continued inflows would provide further support to the equity markets.

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

• Fed tapering/tightening: If the Fed continues at its current pace, quantitative easing should end in the fourth quarter. Historically, risk assets have reacted negatively when monetary stimulus has been withdrawn; however, this withdrawal is more gradual, and the economy appears to be on more solid footing this time. Should economic growth and inflation pick up, market participants may become more concerned about the timing of the Fed’s first interest rate hike.
• Significantly higher interest rates: Rates moving significantly higher from current levels could stifle the economic recovery. Should mortgage rates move higher, it could jeopardize the recovery in the housing market.
• Emerging markets: Slower growth and capital outflows could continue to weigh on emerging markets. While growth in China is slowing, there is not yet evidence of a hard landing.
• Geopolitical Risks: The events surrounding Russia and Ukraine are further evidence that geopolitical risks cannot be ignored.

Risk assets should continue to perform if real growth continues to recover; however, we could see volatility as markets digest the continued withdrawal of stimulus by the Federal Reserve. Economic data will be watched closely for signs that could lead to tighter monetary policy earlier than expected. Valuations have certainly moved higher, but are not overly rich relative to history, and may even be reasonable when considering the level of interest rates and inflation. Credit conditions still provide a positive backdrop for the markets.

Source: Brinker Capital

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high-conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Data points above compiled from FactSet, Standard & Poor’s, MSCI, and Barclays. The views expressed are those of Brinker Capital and are for informational purposes only. Holdings subject to change.

Monthly Market and Economic Outlook: February 2014

Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital

After such a strong move higher in 2013, U.S. equity markets took a breather in January as the S&P 500 Index fell -3.5%. Volatility returned to the markets as concerns over the impact of Fed tapering and emerging economies weighed on investors. Investor sentiment, a contrarian indicator, had also climbed to extreme optimism levels, leaving the equity markets ripe for a short-term pullback.

In U.S. equity markets, the utilities (+3%) and healthcare (+1%) sectors delivered gains, while energy and consumer discretionary each declined -6%. Mid caps led both small and large caps in January, helped by the strong performance of REITs. Fourth quarter 2013 earnings season has been decent so far. Of the one-third of S&P 500 companies reporting, 73% have beat expectations.

U.S. equity markets led international markets in January, helped by a stronger currency. Performance within developed markets was mixed, with peripheral Europe outperforming (Ireland, Italy, Spain, Portugal), while Australia, France and Germany lagged.

Emerging markets equities significantly lagged developed markets in January, as the impact of Fed tapering, slower economic growth and higher inflation weighed on their economies. Countries with large current account deficits have seen their currencies weaken significantly. Latin America saw significant declines, with Argentina down -24%, Chile down -12% and Brazil down -11%. Asia fared slightly better, with the region down less than -5%. Emerging Europe was dragged lower with double-digit losses in Turkey.

Fixed income had a solid month of performance as interest rates fell across the yield curve. The 10-year Treasury note is now trading around 2.6%, 40 basis points lower than where it started the year. The Barclays Aggregate Index gained +1.5% in January, its best monthly return since July 2011. All major sectors were in positive territory for the month; however, higher-quality corporates led high yield. Municipal bonds edged out taxable bonds and continue to benefit from improving fundamentals.

We believe that the bias is for interest rates to move higher, but it will likely be choppy. Rising longer-term interest rates in the context of stronger economic growth and low inflation is a satisfactory outcome. Despite rising rates, fixed income still plays a role in portfolios, as a hedge to equity-oriented assets if we see weaker economic growth or major macro risks as experienced in January. Our fixed income positioning in portfolios, which includes an emphasis on yield advantaged, shorter duration and low volatility absolute return strategies, is designed to successfully navigate a rising or stable interest rate environment.

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 2014, with a number of factors supporting the economy and markets over the intermediate term.

• Monetary policy remains accommodative: Even with the Fed beginning to taper asset purchases, short-term interest rates should remain near zero until 2015. In addition, the ECB stands ready to provide support, and the Bank of Japan has embraced an aggressive monetary easing program in an attempt to boost growth and inflation.
• Global growth strengthening: U.S. economic growth has been slow and steady, but momentum picked up in the second half of 2013. Outside of the U.S., growth has not been very robust, but it is still positive.
• Labor market progress: The recovery in the labor market has been slow, but stable. Monthly payroll gains have averaged more than 200,000, and the unemployment rate has fallen to 7%.
• Inflation tame: With the CPI increasing +1.5% over the last 12 months, inflation in the U.S. is running below the Fed’s target.
• Increase in Household Net Worth: Household net worth rose to a new high in the third quarter, helped by both financial and real estate assets. Rising net worth is a positive for consumer confidence and future consumption.
• U.S. companies remain in solid shape: U.S. companies have solid balance sheets with cash that could be reinvested, returned to shareholders, or used for acquisitions. Corporate profits remain at high levels and margins have been resilient.
• Equity fund flows turned positive: Equity mutual funds have experienced inflows over the last three months while fixed income funds have experienced significant outflows, a reversal of the pattern of the last five years. Continued inflows would provide further support to the equity markets.
• Some movement on fiscal policy: After serving as a major uncertainty over the last few years, there seems to be some movement in Washington. Fiscal drag will not have a major impact on growth next year. All parties in Washington were able to agree on a two-year budget agreement, averting another government shutdown. However, the debt ceiling still needs to be addressed.

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

• Fed Tapering: The Fed will begin reducing the amount of their asset purchases in January, and if they taper an additional $10 billion at each meeting, QE should end in the fall. Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, the economy appears to be on more solid footing this time and the withdrawal is more gradual. The reaction of emerging markets to Fed tapering is cause for concern and will contribute to higher market volatility.
• Significantly higher interest rates: Rates moving significantly higher from current levels could stifle the economic recovery. Should mortgage rates move higher, it could jeopardize the recovery in the housing market.

Risk assets should continue to perform if real growth continues to recover; however, we could see volatility as markets digest the slow withdrawal of stimulus by the Federal Reserve. Valuations have certainly moved higher, but are not overly rich relative to history. There are even pockets of attractive valuations, such as emerging markets. We are not surprised that we have experienced a pull-back in equity markets to start the year as investor sentiment was elevated and it had been an extended period of time since we last experienced a correction. However, we expect it to be more short-term in nature and maintain a positive view on equities for the year.

We feel that our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high-conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Asset Class Returns

Data points above compiled from FactSet, Standard & Poor’s, MSCI, and Barclays. Asset Class Returns data compiled from FactSet and Red Rocks Capital. The views expressed are those of Brinker Capital and are for informational purposes only. Holdings subject to change

Investment Insights Podcast – February 7, 2014

Bill Miller, Chief Investment Officer

On this week’s podcast (recorded February 6, 2014):

• What we like: Stability in emerging market currencies; European Central Bank fighting deflation

• What we don’t like: Hypersensitivity to growth metrics

• What we are doing about it: Letting natural hedging between asset classes manage volatility; remaining neutral in other portfolios; looking for a good employment number

Click the play icon below to launch the audio recording.

The views expressed are those of Brinker Capital and are for informational purposes only. Holdings are subject to change.

What is Investment Risk?

Jeff Raupp, CFA, Senior Investment Manager

One of the go-to formulas of horror movies is to try to avert the audience’s (and character’s) attention away from the real risk. Someone hears a noise in a (supposedly) empty room, they walk in and see an open window. The unfortunate character starts focusing on why the window would be open, maybe even leans out the window and starts looking around. At some point, the character is satisfied that the open window is no longer a threat (whew!), closes the window, turns around, and BAM! You find out the real risk came in through the window and was hiding in the room. Now, the settings and characters change (why don’t we try having a group of sharks caught in a tornado?), but the formula remains the same.

Similarly, investors can sometimes get caught focusing on certain risks, while it’s often the ones they’re not focused in on that cost them the most.

One of the most widely used ways that investors look at risk is the standard deviation of an investment. Harry Markowitz won the Nobel Prize largely on his work on Modern Portfolio Theory (MPT), which defines risk as standard deviation. The standard deviation gives you a basic measure of how volatile the return stream of an investment has been (or is expected to be), and is extremely useful in getting an understanding of what to expect in a normal environment.

MPT took the concept of risk further in recognizing that the correlation of investments in a portfolio is also important, that the combination of investments with a low or negative correlation to one another can create an outcome where you can get a higher level of return for a given level of volatility. This enabled investors to create an “optimized portfolio,” which was the best possible mix of investments to maximize your return for a given level of risk.

The problem with this is that we don’t live in a normalized world, where return distributions are symmetrical and correlations between investments remain constant. 2007 and 2008 were shining examples of that. Quantitative strategies that had been effective in a “normal” environment collapsed when price moves that they had viewed as “once in a million year events” started occurring with regularity. Optimize all you want, but if you owned an investment vehicle backed by Lehman Brothers you probably didn’t have a good outcome, even if you were on the right side of the trade.  And not many people factored in the possibility of their money market fund breaking the buck, as happened to the Reserve Fund.

So, what’s the solution? Diversification. Inevitably you’ll find your investments adversely affected by some kind of risk; however, with proper diversification just part of your portfolio will be affected rather than the entire thing. But while the MPT concept of diversification starts you in the right direction, it doesn’t check all the nooks and crannies where danger might be lurking.

Thinking about how asset classes would react under different scenarios or events helps you to better protect your portfolio. Entering 2007 most investors would have thought commodities were good hedges against a stock market decline. Commodities had done very well in 2000-2002 when the tech bubble burst, and touted a negative correlation to stocks over most trailing periods, a huge consideration when optimizing a portfolio using MPT. But when a deep recession caused consumption and production to plummet, commodity prices dropped right along with stocks, leaving many investors scratching their heads. The credit crisis did that to nearly all asset classes with any level of risk associated with it, leaving the only winners investors in high quality bonds and a relatively obscure (at the time) strategy called managed futures.

The lesson is clear. There are times when “normal” becomes abnormal and the way asset classes interact with one another changes. So while checking the open window in the empty room might be the right thing to do 99% of the time, it pays to be on the look-out for the monster in the closet.