How to strike the right balance in high yield bonds
Strong 2016 performance and a sharp rally in credit spreads have prompted some investors to take a cautious view of high yield bonds.
Our previous Outlook was titled “Central banks remain key to market sentiment,” but the U.S. elections proved to be the key to market sentiment in the fourth quarter and heading into 2017. To be clear, central bank accommodation remains a pillar for global markets and the economy. But the election of President Donald Trump and Republican control of the U.S. Congress have changed the game. Investors now envision acceleration in gross domestic product growth bolstered by cuts in personal and corporate income taxes, less constrictive regulation and the potential for infrastructure investment. Thus, fiscal stimulus appears to be forthcoming for the world’s largest economy.
In China, the second-largest economy, the debt-led stimulus begun in late 2015 continues into this year with stabilizing infrastructure growth, improving consumption and a property market that had softened but appears to be turning around on low inventories and better demand. Commodity prices and inflation have reacted, with the producer price index accelerating to a recent high of 5.5% growth year over year and consumer prices held down only by the volatile food category.
We believe China’s growth will continue during the next few quarters with the knock-on effect of continued stronger global trade. The trick, as always, is to foresee the next batch of policy change as the Communist Party and the People’s Bank of China deal with accelerating inflation and the continuing buildup of debt.
During the last few months, we’ve reacted to changes in the outlook for global growth by increasing the Fund’s overall equity exposure. We added to holdings in the financials sector in the U.S. and Europe, where we believe value still exists. We also increased weightings in industrials and materials, although we are picking our spots carefully in subsectors where valuations have not been pushed too far too fast. We expect the rise in U.S. interest rates to continue (though not uninterrupted) and eventually put pressure on rates in Europe and potentially Japan.
We reduced the Fund’s weighting in health care, a difficult sector in 2016, and shifted the composition a bit from pharmaceuticals and biotechnology into services. In particular, we acquired stock in a large-capitalization hospital
that had temporarily come under pressure after the U.S. elections, providing an entry point with what we believe was an attractive free cash flow yield. We also have reduced the Fund’s information technology weighting, although it remains overweight versus the benchmark S&P 500 Index. We have focused on areas that we believe will benefit from global mobile proliferation, online commerce and the Cloud business model.
The Fund benefitted recently from positions added last year in materials – global mining and paper. We have added exposure in Japan, where we’ve found value in telecommunications and an automobile original equipment manufacturer (OEM) with exposure to India and other attractive Asian markets. Both companies carried free cash flow yields above 10%. We kept several auto components companies in the portfolio despite their detraction from performance last year.
Those companies recently benefitted from stabilization in OEM volumes and greater investor appreciation of the value of their exposure to important new technologies — active safety, electric power and other content features becoming more common on the average car sold. Two names in the Fund have exposure to high-end tires where higher rubber prices threaten margins, but we believe a recovery in mining foreshadows improvement in what is by far their highestmargin business within the category. All sell at reasonable valuations relative to our forecast of their market opportunities.
The largest equity weighting remains in the U.S., where value doesn’t necessarily abound, but where the relative attractiveness of the economy is supported by the fiscal outlook, especially the potential for lower corporate taxes.
The Fund’s fixed income exposure, on the other hand, is skewed toward emerging markets and Latin America in particular. We favor local sovereign debt issues where real rates are high, key metrics are stable to improving and currencies are arguably undervalued – offsetting the Fund’s outsized U.S. dollar exposure in equities. The Trump victory hurt the value of the Fund’s Mexican peso holdings, but we like the risk/ reward outlook now despite the potential risks of a renegotiation of the North American Free Trade Agreement and given the Fund’s Mexican debt yields of around 7.5%. The Brazilian real continues to claw back from depressed levels versus the dollar, and the Fund’s Brazilian debt yield is more than 10%.
The Fund had held long-duration U.S. Treasuries since the third quarter of 2015, but we began trading them in the middle of last year and into the fourth quarter for Treasury Inflation Protected Securities to round out our bond exposure.
Gold remains a part of the portfolio, though below the 8% allocation reached during 2016. While stronger economic growth and higher interest rates provide headwinds for prices, gold is trading near its marginal cost of production at a time when the global economy continues to build up debt to create growth. It’s difficult to forecast exactly when the market will shift its focus from stronger growth to increasing leverage. But the scares we’ve witnessed since the 2008 global financial crisis, the most recent of which were related to the devaluation of the Chinese yuan, could reemerge when growth next slows. Given that, we view gold as an important diversifying element in offsetting equity risk and dampening volatility.
India in November 2016 instituted a historic demonetization drive under Prime Minister Narendra Modi. Before this plan was introduced, India’s central bank under the new leadership of Urjit Patel had already begun to focus monetary policy measures toward both growth and inflation. This was in contrast to the central bank’s previous policy under Raghuram Rajan in which inflation was the primary focus. The market’s interpretation was that monetary easing would be more likely in the future. Contrary to widespread expectations, the Reserve Bank of India (RBI) decided not to cut interest rates in December, citing sustained strength in food prices and volatility in oil prices as risks to its inflation target. The RBI also suggested that the effects of the demonetization campaign were transitory and uncertain, and were not a consideration in its monetary policy stance.
This backdrop resulted in increased financial market volatility in India during the fourth quarter. Banks were one of the weakest sectors there during the final months of the year on the expectation that loan growth would remain a challenge. The Fund owns a position in one of the largest private sector banks in India and it was not immune to the weakness.
From a long-term perspective, we believe the potential in India is undeniable. Most market participants have realized that the playbook for India will be different from China. However, in the next 15 years, India is likely to have more people connected to the internet than any other country. In China, we witnessed e-commerce grow 600% between 2010 and 2014. Amazon wants to make India its second-biggest market after the U.S. Alibaba, the e-commerce giant in China, is also making substantial investments in companies such as in India’s Paytm, a mobile wallet/e-commerce company. Two- thirds of Indians are younger than 35 years old and their phones give them access to the internet in vast numbers. Technology clearly will play a transformational role in the development of India. Many global companies have done their homework and are looking to unlock this potential.
Much work has to be done in terms of infrastructure and regulatory hurdles. As such, we established early positions in a large engineering and construction firm, the largest consumer products company and have exposure to the growing automotive market through the Japanese auto OEM mentioned earlier in this commentary. We believe there is truth to Amara’s Law, coined by American researcher and scientist Roy Amara, a past president of The Institute for the Future: “We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.”
Past performance is no guarantee of future results.The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through February 2017, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Diversification does not guarantee a gain or protect against loss in a declining market. It is a method to reduce risk.
Top 10 Equity Holdings as a percent of net assets as of 12/31/2016: JPMorgan Chase & Co., 2.23%; Kraft Heinz Co., 2.15%; Halliburton Co., 2.04%; Citigroup Inc., 1.87%; Microsoft Corp., 1.81%; EOG Resources, Inc., 1.53%; Pfizer, Inc., 1.49%; Coca-Cola Co., 1.44%; Lockheed Martin Corp., 1.36%; AIA Group Ltd., 1.35%.
The S&P 500 Index is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. It is not possible to invest directly in an index.
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