Tony Soslow, CFA, Senior Portfolio Manager
The markets turned volatile again last week as developments in China and the energy markets have added stress to both high yield bond markets and equities. As of December 15th, large cap U.S. Equity indices have narrowly entered negative territory year to date (before dividends) while broad measures of riskier parts of the markets such as small caps, junk bonds and international equities are down approximately 3-8% for 2015. Thus far this year, many of our strategies remain positive year-to-date and our Navigator Tactical Fixed Income Strategy currently holds U.S. Treasury-like securities.
Energy’s abrupt decline has disrupted many capital markets worldwide. Last Friday, oil declined to $35.62/barrel – its lowest level in 6 years, and natural gas plunged to a 14 year low as the warmest weather on record has sapped demand in the face of high OPEC production. While energy’s weakness has historically provided a dividend to consumers in the form of lower prices at the gas pump (gasoline at $2.12/gallon is 62 cents cheaper than the prior year), much of the debt financed energy sector expansion over the last few years is now threatened. Like leveraged U.S. energy companies, the declines in energy and commodities in general are having an outsized impact on the currencies of oil exporters like Brazil and Russia.
Separately, the lead-up to a likely increase in interest rates by the Fed has blunted China’s efforts to rekindle its economic growth. In response last week, China devalued the yuan, removed its dollar peg and transitioned its controlled value to a basket of currencies. The surprising fall of yuan to a 4.5-year low at 6.45 to the dollar is providing additional stress to the equity markets as U.S. exporter competitiveness is further harmed.
Low Quality and Liquidity
While generally stable credit conditions and low default rates have kept high grade corporate and mortgage securities yield spreads to U.S. Treasuries near historic median levels – the decline in energy and commodity prices has caused havoc in the lower quality segment of high yield market. Option adjusted spreads on CAA and unrated bonds have spiked up one or more standard deviations past historical levels. Declining prices and higher volatility typically elevates uncertainty and with it widens bid-ask spreads. This weak price discovery has become most pronounced in the lowest quality areas of the fixed income market and valuing portfolio assets has become quite difficult. In response, Third Avenue Asset Management – in an effort to treat redeeming and non-redeeming shareholders equally – halted redemptions on their high yield Third Avenue Focused Credit Fund. As investors were fleeing at a faster rate than the fund could responsibly sell assets, prices of the unsold remaining fund assets would be jeopardized. Rather than sell at distressed prices, the firm halted redemptions to liquidate the fund in an orderly manner over the next year. We believe troubles with this fund are not new and not indicative of the high yield asset class in general, but rather limited to the small sub-set of unrated or lowest rated securities. The fund, which at one point was $2.5 billion, had shrunk to $785 million through redemptions and loss on investments. The fund had the most exposure to illiquid assets of any fund in its class, with 85% of its holdings in distressed debt.
Earlier in July, we wrote an article in ETF.com about the liquidity risk in high yield debt. As we believed then, and continue to believe, the real liquidity risk in high yield debt is within traditional mutual funds, not ETFs.
Oversold Meets Seasonally Opportune
Recent market selling pressure has led to a fairly significant oversold condition. On Monday, 632 issues or nearly 20% of all stocks hit new 52-week lows, the most since August. Going back to 1962, rarely have nearly 20% of issues been at 52-week lows when the S&P 500 was so close to a 52-week high. On a technical basis, the S&P 500 did find and hold support around the 2000 area on the S&P 500. That level marks a consolidation zone following the August decline and also represents the 50% retracement of the advance off of the September lows.
Historically, December has been a strong month and many investors come to expect the “Santa Claus Rally.” Seasonally, the typical December trading pattern shows weakness early (likely coincident with tax-selling) and a low around the 10th trading day of the month. Subsequently, stocks traditionally rally into year-end. The 10th trading day of the month was Monday and the market has responded by holding support and rebounding.
Importantly, the Federal Reserve meets today and it is widely expected to increase the Fed Funds rate by 0.25%. In our opinion, the Fed missed the opportunity to initiate rate normalization earlier this year. Now confronted with weaker earnings, low inflation and a deteriorating high yield market, the Fed seems to have painted themselves into a corner. The initiation of normalization/tightening policies to combat mildly improving labor markets appears divergent from the easing policies of our important trading partners – Europe, Japan and China. Although we anticipate the Fed will follow through with their telegraphed rate hike from a credibility perspective, the factors cited above will likely restrict their ability to meaningfully raise rates in 2016.
Our Unwavering Commitments
Despite increases in market volatility, we remain committed to the disciplined application of our investment processes. During this year and throughout our history, we believe this commitment has given us a disciplined rudder to navigate difficult markets and transition to more liquid and safer securities when appropriate. Our Tactical Fixed Income Strategy has done just that and most of our other strategies currently hold what we view to be the highest quality equity and fixed income securities. Most importantly, we remain committed to providing you with the tools and communication you need to advise your clients on how they should pursue return and avoid undue risk. As such, this may be a great time to re-connect with your Clark Investment Consultant to review individual client objectives for income and retirement.
Market Cycle Returns
Although we acknowledge that disruptions in the high yield market often portend difficult periods in the economy and/or equity markets, we believe the intermediate and long term outlook for high quality U.S. and International equity returns remains favorable and exceeds the returns present from currently low yielding fixed income securities. Given current levels of low interest rates and likely long term equity growth rates, we believe broad classes of equities are priced fairly — with high current relative earnings yields — and should deliver returns similar to their long term historical averages. The likely change in Fed policy does not dissuade us as we believe intermediate term future policy is intended to just remove the now-unnecessary extraordinary accommodative policies initiated during the 2008-2009 recession. Equities remain the beneficiaries of moderate economic growth, fair prices, low inflation and continuing low levels of interest rates.
Looking forward to 2016
As always, thank you again for partnering with Clark Capital. We look forward to serving you and your clients in 2016. Please mark your calendars and register here for our 2016 Market Outlook Webinar, which will be held on Thursday, January 7th at 4pm Eastern and is eligible for one hour of CFP® CE credit.
The opinions expressed are those of the Clark Capital Management Group Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. There is no guarantee of the future performance of any Clark Capital investment portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. For educational use only. This information is not intended to serve as investment advice. This material is not intended to be relied upon as a forecast or research. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Past performance does not guarantee future results.
Clark Capital Management Group, Inc. is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Clark Capital’s advisory services can be found in its Form ADV which is available upon request.
The S&P 500 measures the performance of the 500 leading companies in leading industries of the U.S. economy, capturing 75% of U.S. equities.
The Dow Jones Industrial Average is a stock market index that shows how 30 large publicly owned companies based in the U.S. have traded during a standard trading session in the stock market.
The NASDAQ Index is a market-weighted index of all common stocks listed on the NASDAQ exchange.
The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performers of developed markets outside the U.S. and Canada.
The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance.
The MSCI World Index ex. U.S. is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance excluding the U.S.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The MSCI All Country Europe is a free float-adjusted market capitalization index that is designed to measure the performance of European equity markets.
The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index.
The Russell 3000® Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.
The VIX Index is a forward looking index of market risk which shows expectation of volatility over the coming 30 days.
Barclays U.S. Government/Credit Bond Index measures the performance of U.S. dollar denominated U.S. Treasuries and government-related and investment grade U.S. corporate securities that have a remaining maturity of greater than one year.
The Barclays U.S. Aggregate Bond Index covers the U.S. investment-grade fixed-rate bond market, including government and credit securities, agency mortgage pass-through securities, asset-backed securities and commercial mortgage-based securities. To qualify for inclusion, a bond or security must have at least one year to final maturity, and be rated investment grade Baa3 or better, dollar denominated, non-convertible, fixed rate and publicly issued.
The Barclays U.S. Corporate High-Yield Index covers the dollar-denominated, non-investment grade, fixed rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
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