Calvert Investments: Cathy Roy, chief investment officer, fixed income, Natalie Trunow, chief investment officer, equities, and Steve Van Order, fixed-income strategist met to discuss the key investment themes they see shaping the markets in 2014.
•Janet Yellen's assumption of the Fed helm doesn't signal any significant change in policy this year or into 2015.
•Rates will inevitably rise, but that won't necessarily produce negative returns in 2014.
•As long as the Fed intends to maintain a zero-interest-rate policy (ZIRP) through 2016, this puts a natural cap on how high the 10-year Treasury rate (which influences other interest rates) will go.
•Financials could benefit from changes in the yield curve and increases in interest rates.
•A rising rate environment will continue to be favorable for our short duration/high-yield blend strategy.
•A potential credit event with a political aspect to it could roil the markets. That event could be Argentina, where last's week's peso slide contributed to a selloff in emerging markets.
•Small-caps have come out of a multi-year period of underperformance to outperform last year, and there is still more room for good relative performance in this asset class.
So, we start 2014 with new leadership at the Federal Reserve (Fed). Janet Yellen has taken the helm from Ben Bernanke, who leaves a strong, and arguably, highly successful imprint on the post. How do you think the change in Fed leadership could impact markets in 2014 (and beyond)?
Cathy Roy: We don't think there will be any big change in policies this year or in 2015. Yellen's nomination was a deliberate choice; she's drinking the same Kool-Aid he (Ben Bernanke) did. Forward-looking guidance will still be the name of the game, so we're not really expecting much change in interest rates. That said, there could be some volatility around the three-to seven-year part of the yield curve as investors anticipate an earlier demise of the zero-interest-rate policy than expected, but we see that as a good opportunity for Calvert's fixed-income funds in terms of our active trading.
Natalie Trunow: I think folks put too much emphasis on the chairperson. Because Fed policy is made by committee, there's quite a bit of continuation of policy.
Steve Van Order: I agree. And the vacancies on the Federal Open Market Committee (FOMC) will get filled without too much of an issue—and will get filled with the right people to keep Fed policy on track.
Natalie Trunow: What I thought last year and still believe, is that we will not have a major deviation from the Fed's current course. They will continue to manage the volatility around interest rates as much as the interest-rate levels, in that any sharp changes or moves to the upside will likely negatively impact mortgage rates and the housing market, one of the major drivers of this economic recovery. The housing market in turn is a major driver of Fed policy (through the unemployment rate, impact on the economy and inflation numbers), so I'm pretty sure they will continue to monitor that closely, and through their actions try to maintain a steady pace of change. I think we've already seen that in the telegraphing that went on around tapering last year and it will continue; anytime there is an overreaction or major move in the marketplace, the Fed will try to correct it, most likely through their language, if not actions.
Cathy Roy: Yes and the Fed knows that the housing component has been such a strong driver of the recovery and will continue to be, and that they can't afford to let rates rise.
Do you think U.S. lawmakers are ready to set aside partisan differences in 2014 and take real and lasting action to support a continued economic recovery?
Natalie Trunow: I think Congress knows that their constituents are unhappy about the level of political infighting in Washington which is clearly to the detriment of the country's well-being. I do think and hope that the political climate and the functionality in Washington will improve over time.
Cathy Roy: Economic policy uncertainty is in a downtrend (that's a good thing). And, because it's a mid-term election year; practical reelection concerns could temper lawmakers' extreme stonewalling techniques.
Steve Van Order: Economic policy uncertainty in the U.S. and in Europe has been trending down since 2011, which along with central bank guidance, has steadily lowered the general level of volatility in the financial markets. The Fed has forecast that key measures of the U.S. economic capacity, such as the output gap and unemployment rate, will approach normal by the end of 2016. This year, 2014, is supposed to be a step in that direction. Private-sector forecasters have largely accepted the Fed's forecast. We call this phenomenon the "normalization expectation." As such, if the Fed is incorrect, markets may react with some volatility.
Natalie Trunow: The way we look at it is similar to the approach credit agencies take when evaluating sovereign credit. Policy uncertainty will matter less and less as the economy recovers and expands. The diminished decision-making ability of our lawmakers was more critical when the U.S. economy was in much worse shape than it is today. As the economy recovers, the political landscape won't matter as much.
What wild cards could surface to potentially derail the global economic recovery?
Cathy Roy: Well we saw last week that in China, manufacturing slowed to a six-month low, so that's something we need to keep a close eye on. Any global slowing could cause investors concern. Natalie and I have both been very focused on housing as a driver of growth. We both agree that a move up in interest rates—that wasn't immediately tempered by Fed actions—could mean a drag on housing growth. But some positive surprises might be around the corner as well. One could come from immigration reform, which could be positive for housing if it happened right away, and another from something like a pick-up in natural gas exports.
Natalie Trunow: An unexpected spike in interest rates, which could be precipitated by many things, like a selloff of bond holdings by retail investors who have accumulated as much as $1.3 trillion in debt mutual funds over the past few years. A quick rotation out of these assets could be felt in the marketplace. This could cause a negative impact to the housing market, which could potentially have a slowing effect on the overall economy.
Steve Van Order: A credit event with a political aspect to it; that could be Argentina, that could be Puerto Rico, or the eurozone. The idea of a credit event with a political component always lurks. And when those develop, they develop fairly quickly, and they tend to surprise markets and you at least get a temporary bout of volatility. I'm not saying it's going to happen, but it is definitely something to watch out for.
Cathy Roy: In the eurozone, Draghi (the European Central Bank president) is still very accommodative and we really don't know how all this will unwind and when. We could be surprised if and when other central bankers come out with pronouncements ahead of our Fed.
Natalie Trunow: A perennial concern is the Middle East of course. If there is a conflict, this could be big for the equity markets. For example, it's unclear what kind of impact a preemptive strike by Israel against Iran could have on the global economy; but we know that investor sentiment will be impacted negatively.
Interest rates are always front and center in the investor's mind, and even more so now that rising rates appear to be a given. Where will we be with interest rates in 2014?
Cathy Roy: We know rates are going to be rising, it is inevitable, but we don't think it's going to be something that's will necessarily produce negative returns in 2014. And, as long as the Fed intends to maintain a zero-interest-rate policy through 2016, this puts a natural cap on how high the 10-year Treasury rate (which influences other interest rates) will go.
Natalie Trunow: I'm in the same camp. I do think the general trend and direction for rates is up. The rates will go up over time and the volatility around the trend will be managed by the Fed to the best of its ability. Orderly increases are something I expect. This path would be healthier for the economy. I don't expect a big jump anytime soon.
Steve Van Order: A rising rate environment will continue to be favorable for our short duration/high-yield blend strategy which, when complemented by a constructive view on the economy, can do a fixed-income investor well.
Which sectors of the market have your attention right now and how could they be impacted (positively or negatively) over the coming year?
Natalie Trunow: We've had some good results coming out of sectors that have not really participated in this recovery to date; energy and industrials in particular have shown some interesting results of late, and they could take over some of the leadership in the marketplace, or at least recover in relative terms. Financials and telecom have done better and I think there are still some interesting opportunities there. To the extent that energy and industrials take the lead and perform better than the rest of the market, it will be negative for the ESG-driven (environmental, social and governance) strategies where those sectors are underrepresented. These strategies are quite well exposed to financials and telecoms however.
Cathy Roy: One of our favorite spots continues to be at the short end of the (yield) curve, especially in asset-backed securities, high yield in general, and in the investment-grade banking sector in particular; we continue to be overweight in banking. As long as the Fed is so accommodative and the idea of "too big to fail" persists, banks will continue to benefit from a lot of cash on their balance sheets, low borrowing rates and the ability to go out the yield curve to pick up yield. We've been avoiding U.S. agencies and utilities, and we've been underweighted in sovereigns, although we might see some opportunities to benefit from some improvement in Europe.
Natalie Trunow: In a rising interest rate environment and, more importantly, in an environment of rising expectations for interest rate levels, dividend-yielding securities are very much at risk, especially given current valuations for the group. We saw signs of what could be on the horizon for high-dividend-yielding stocks in the spring and early summer of 2013. We see this as an area of potential risk. As we anticipated, U.S. small-caps have come out of a multi-year period of underperformance to outperform last year, and we believe there is still room for good relative performance in these names.
I also think emerging markets could be an interesting investment opportunity given the drastic underperformance in that part of the market of late. Having said that, I would watch China's real GDP growth levels which are somewhat alarming. China has to continually grow GDP to keep things at a steady-state level and avoid social unrest. That's a challenge for them right now amid significantly reduced demand for their products now that developed-world consumers have come to their senses and the frothy part of demand of the bubble period is gone. Part of that demand may not come back for a long time, possibly a decade or more.
Natalie Trunow: On the equity side, I think financials is the sector that benefits from changes in the yield curve and increases in interest rates, so exposure to the sector, U.S. financials in particular, could be beneficial, especially now that a lot of the excesses and issues in the sector have been cleared up. Financials are well-represented in Calvert's core fund lineup. I also think high-dividend-yielding stocks will be hurt by an increase in rates over time, so I would perhaps lighten up on those and get an exposure to core funds instead. As we mentioned earlier, small caps and emerging markets could provide interesting investment opportunities in a diversified global portfolio.
I do not expect 30%-type returns this year, but I think we will continue to have decent returns that will be driven by corporate earnings and improving GDP growth. Most sectors had positive earnings surprises in the fourth quarter of 2013.
Cathy Roy: Defaults are down towards historic lows and our expectation for 2014 is for that to continue and that's also very supportive of high yield and credit in general. There will be surprises here and there though, and that's why we think security selection will be a big driver of attribution this year. That's where Calvert's ESG story comes in nicely.
This commentary represents the opinions of its authors as of 1/23/14 and may change based on market and other conditions. The authors' opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.
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