Tag Archives: income

Macro Themes And The Implications: Time To Pay Attention To U.S. High Yield Bonds

By Dr. Chenjiazi Zhong Key Macro Themes and the Implications Low inflation : Inflation is low but it does not mean inflation is zero. The slow growth in global economy keeps inflation subdued even as CPI slowly rises. Global policy divergence : Fed continues to normalize slowly as other central banks pursue stimulus policies. Investors should expect yields to rise modestly. Supply-side weakness : Across developed countries, the low productivity and growth in labor force will ultimately cap longer-dated yields. Strength in U.S. economy : U.S. economy remains resilient; recession risks are being overpriced for 2016, which indicates a good environment for high yield bond. Gradual recovery in Europe : The expansion in Europe is on track; monetary policy is a key factor that will support EU stocks and credit markets. Japan – beyond Abenomics : The economic risk in Japan is becoming more binary; the asset returns will be more geared to fiscal response. Emerging markets rebalancing : The stats of emerging markets implies that the environment is stabilizing and the valuations are undemanding. The short-term risks exist but investors can expect the conditions will improve in 2016. China in transition : That China is shifting from resources to services will continue to weigh on global trade. U.S. High Yield Bonds In an environment of full valuation, fragile investor sentiment, favorable relative valuations of credit over equity, slow but positive growth with limited recession risk that is priced in, high yield credit that offers equity-like returns is an attractive proxy for stocks. U.S. High yield credit spreads widened the most since 2011. U.S. high yield bonds offer lower volatility than equities due to their coupon income. In down markets, a larger coupon for high yield bonds helps to offset market declines; in up markets, high yield bonds usually correlate to rising equities. Moreover, high yield bonds are generally not impacted by modest rise in interest rates; spreads are more a reflection of market expectations for future default rates rather than expectations for higher interest rates. Furthermore, high yield bonds managers charge lower fees as compared to the hedge funds specializing in distressed debt. Despite U.S. high yield bonds offer equity-like return, investors need to adjust or discount the asset class for its potential for downside losses, liquidity constraints, sector risks, and other realities: The high yield bonds market is characterized by asymmetric risk whereby the potential for downside losses outweighs upside capital appreciation. Asymmetric risk exposure is a situation in which the potential gains and losses on an investment are uneven. The high yield bonds are traded over the counter, which highly depends on dealer capital. Additionally, the majority of high yield bonds do not trade on a daily basis, which means there may be a significant difference between trade prices and broker quotes. Independent fundamental analysis is paramount. The market generally anticipates upgrades and downgrades long before the actual rating changes. The difficulty in estimating defaults is defaults are not correlated to the severity of recessions. For instance, the 2008-2009 period was not the worst for defaults but it was dramatic to other asset classes. The key to long-term success in investing in high yield bonds is managing credit risk, avoiding dangerous concentrations and minimizing defaults in the portfolio. In addition, in harvesting carry across extended credit markets, security selectivity becomes even more crucial . Investors shall stay engaged, know the securities; do not be afraid of sentiment. The increase in volatility is creating numerous opportunities for fundamental, bottom-up investors. With more movement in the market, there is a wider range of possible outcomes, some of them lost, but some of them gained. While the downside increases, so does the upside. As with any investment, the riskier it is, the greater the possible return is. Furthermore, a contrarian stance, backed by a comprehensive understanding of companies’ long-term fundamental prospects, will provide a strong foundation to withstand as well as profit from a world of rising volatility.

Superforecasting For Active Investors

By Sammy Suzuki In a fiercely competitive world, active managers are constantly looking for ways to advance their performance edge. One good place to focus on is how to become better forecasters. If just looking at averages, the active management industry has a spotty record. But some active investors manage to beat the market consistently, suggesting that they possess some degree of skill. If you can identify them or become one of them, the payoff is large. The question is, what separates skilled investors from unskilled ones? Many people will answer that question by pointing to credentials or other markers: the manager seems especially smart, acts more authoritatively than others, shows more conviction or appears on TV more frequently. The problem is that none of these factors is necessarily correlated with increased predictive capabilities. In fact, some of them have a mildly negative relationship to it. In a world engulfed in random noise, performance itself is a fairly unreliable measure of skill in the short run. So what, then, are the traits common to the most skillful investors? A Teachable Moment We have some thoughts on the matter, largely drawn from the insightful research conducted by Philip Tetlock, professor at the Wharton School of the University of Pennsylvania and co-author of Superforecasting: The Art and Science of Prediction. The book is based on the findings from the Good Judgment Project, a multiyear study in which Tetlock and his colleagues asked thousands of crowdsourced participants to predict the likelihood of a slew of future political and economic events. As the book’s title suggests, “superforecasters” do, in fact, walk among us. Despite their lack of professional expertise, a small group of participants in the study significantly out-predicted both their fellow volunteers and teams of top professional researchers. And, over time, their advantage not only persisted, but grew. Most important, Tetlock found that good analytical judgment relies on a set of discrete approaches that can be taught and learned. With that in mind, we offer a framework for investors looking to improve. It’s About HOW You Think How forecasters think matters more than what they think, according to Tetlock’s research. In fact, how a person approaches a research question is the single biggest element distinguishing a great forecaster from a mediocre one. Predictive research is about focusing on the information that is most likely to raise the odds of being right: if you know x, your odds improve by y%. Superforecasters think in terms of probabilities; break complex questions down into smaller, more tractable components; separate the known from the unknowns and search for comparables to guide their view. Professional investors and research analysts gather reams of data to build their forecasting models, a lot of which has little proven predictive value. Our research shows, for example, that there is little correlation between a country’s GDP growth and how well its stock market performs. Good investment forecasting is akin to meditating in the middle of Times Square. It requires learning how to isolate the few relevant “signals” from a cacophony of irrelevant market “noise.” That’s not something most of us are taught how to do in our formal education. In areas such as math, science or engineering, the relationship between general laws and what you observe is much tighter. Stay Actively Open Minded In reality, the range of possible outcomes of any event is wider than most people can imagine. Outcomes usually look obvious after the fact, but they frequently surprise when they happen. Tetlock’s work suggests that a forecaster who considers many different theories and perspectives tends to be more accurate than a forecaster who subscribes to one grand idea or agenda. Being open minded also means accepting the (very real) possibility of overconfidence. Superforecasters also have a healthy appetite for information, a willingness to revisit and update their predictions as new evidence warrants and the ability to synthesize material from sources with very different outlooks on the world. Maintain Humility It takes a certain kind of person to have both the humility to accept that they may be overconfident in their assumptions and predictive powers and the conviction necessary to manage an investment portfolio. It also takes a certain type of person to learn from their mistakes without over-learning. The best forecasters were less interested in whether they were right or wrong than in why they were right or wrong. Using Tetlock’s words, superforecasters also tend to be in perpetual beta mode. Like software developers working on an untested app, these people rigorously analyze their past performances to figure out how to avoid repeating mistakes or over-interpreting successes. In the age of information overload, the active investor’s edge increasingly lies in knowing what information matters and how to process that information. If you can identify skill – whether you are looking to hire a portfolio manager or you are a portfolio manager aspiring to improve – we believe that this superforecasting framework can give you a better shot at beating the market. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Sammy Suzuki, CFA – Portfolio Manager—Strategic Core Equities

A Distinctly Canadian View Of Emerging Markets

Figuring out whether developed equity markets will outperform emerging market stocks has been no easy task, even if the choices couldn’t be any starker. By now, we are all familiar with the potential benefits of emerging markets: They have grown at a faster pace than developed economies, their population is younger , and they will soon be expected to aspire to consume many of the things people in the developed world take for granted. Sounds pretty good, right? Not so fast. These seeming positives have been in place for many years, and yet emerging markets have pretty consistently underperformed most developed markets since 2011. A combination of falling commodity prices, heightened political risk, slower (but still relatively brisk) economic growth, rampant corruption, a stalled reform agenda and limited earnings growth have all weighed on performance to one degree or another across the emerging world over this time period. So while emerging markets appear inexpensive, they are not unambiguously cheap. For Canadian investors, it’s even less clear if emerging markets will prove to be a winning destination for investment capital. As I’ll show, the loonie has tended to move with EM currencies, correlations between EM and Canadian equities have been high, and the sector composition was reasonably similar for a long time. That said, some of these factors are changing and even boosting the allure of holding EM equities in a portfolio. Currency Since the January lows, emerging market stocks have posted sizeable returns in US dollars, but the results are much less impressive in Canadian dollar terms, thanks to strength in the loonie. Some of the same factors lifting emerging market stocks, bonds and currencies also support the Canadian dollar and Canadian stocks: a rebound in commodity prices, a more patient Federal Reserve and less dire news about the global economy, especially out of China. This result shouldn’t seem all that surprising; the Canadian dollar has closely tracked emerging market currencies since 2010 (see the chart below). Consequently, Canadian investors don’t get as much of a boost to performance from appreciating EM currencies when risk appetites are growing and the global economy is accelerating, because the Canadian dollar is typically rising too. That said, EM currencies could potentially appreciate against the loonie given how far they’ve fallen. Click to enlarge Correlation Assets that exhibit a high positive correlation have more muted diversification benefits. If emerging market currencies and the Canadian dollar tend to appreciate together, then what about the correlation between EM and Canadian stocks? Here again, there’s another tight fit and another reason for Canadians to be apprehensive about the diversification benefits of owning emerging market equities. Looking at the chart below, Canadian equities have been much more positively correlated to EM equities since 2005 than to US or other international developed stock markets (represented by MSCI EAFE). That said, we should note that the high positive correlation of EM and Canadian equities have declined in recent years, boosting the diversification benefit. Click to enlarge Composition One reason correlations were this high – and the diversification benefits for Canadian investors this low – may have something to do with the similarity of industry exposures: the energy, materials and financials sectors made up more than half of the market cap of both Canadian and emerging market stocks. In the past five years, however, something interesting has happened. Thanks to the initial public offerings of many high-tech companies, the information technology sector has grown to more than a fifth of the emerging market equity index (see the chart below), whereas it’s less than 3% of the MSCI Canada index. As a result, EM may begin to deviate more from Canadian equities because of shifting sector exposures. The expansion of the tech sector is both a sign of, and offers investors exposure to, the convergence of emerging markets to developed economies. Click to enlarge Although not without risks, we’re warming up to emerging market equities and continue to believe in the possibility of improved investment returns based on better demography, faster growth and pent-up consumer demand. For Canadian investors, we see room for EM currency appreciation versus the loonie and better portfolio diversification benefits over time than has historically been the case. Source: BlackRock Investment Institute and Bloomberg. This post originally appeared on the BlackRock Blog.