Following October’s huge rally, global equity markets ended the month of November mostly unchanged. Long-term US dollar interest rates, after rising in the first week of November, declined back below 3% to end the month nearly unchanged as well. In contrast with the calm in those markets, short-term dollar interest rates have climbed sharply and the dollar resumed strengthening ahead of the Fed’s highly anticipated rate hike, which we expect to be executed following the FOMC’s meeting on December 16th. We were well positioned to take advantage of these developments—we have hedged our foreign currency exposure across half of our international equity allocation, and have focused our fixed income holdings on the long end of the interest rate curve.
We’ve received a number of questions from advisors on this aspect of our portfolio—why would we want to hold long duration fixed income in front of a Fed rate-hike cycle? It is true that the present value of longer duration bonds are more sensitive to interest rate movements and that long-term rates typically rise concurrently with short-term rates. However, at the start of a typical tightening cycle, there is relatively high and increasing inflation, narrowing credit spreads, and strong and accelerating GDP growth. Currently none of those conditions exist. We therefore expect long-term interest rates to fall as tighter monetary conditions from the Fed help strengthen deflationary forces in the global economy.
A large portion of the deflationary forces that have plagued the global economy in recent years have been driven by the deceleration of Chinese growth and it’s shift away from natural resource consumption. We have long argued that this is a necessary component of China’s modernization and integration with the developed world. Chinese policymakers achieved another victory in this respect last week when the IMF formally announced its inclusion of the RMB in its Special Drawing Rights basket—blessing it as an international reserve currency. While the RMB’s rise to prominence in international finance will be slow and gradual, a more immediate effect is that the PBOC has relinquished some control over its exchange rate. This may lead to a weaker RMB in the next few years, as Chinese policymakers struggle with slowing growth, a shrinking labor force, and a large debt overhang.
Our equity positions are limited to developed market countries and our fixed income positions are limited to dollar denominated holdings. Overall, our GTA portfolio holds 46% dollar denominated fixed income, 13% US equities, 28% international equities, 5% alternatives, and 8% cash and equivalents. We favor developed international equities and are avoiding emerging market equities and commodities. We hold a limited amount of foreign currency exposure, and have a small tactical cash position to manage current market volatility.
Our fixed income exposure is limited to dollar denominated securities. We hold positions in long-duration US treasuries, investment grade corporate bonds, high yield bonds, preferred stock, and dollar denominated emerging market debt, which has outperformed local currency debt by more than 12% YTD. This gives us broad exposure to fixed income while avoiding foreign currencies and targeting the long end of the curve.
We have recently increased the overall credit quality of our US corporate bonds by exchanging half of our high yield position for investment grade bonds. While we still feel that high yield bonds offer good value, as a result of their underperformance in 2015, there is a risk that funds managers will liquidate their positions before year-end, which could increase volatility.
We favor European and Japanese equities to US equities, and continue to hold a portion of each in hedged-currency form, which have outperformed US equities by 7% and 11% respectively.
Our US equity exposure is limited to low volatility equities, which we have recently added to, giving us broad exposure to US equities while minimizing drawdown risk by focusing on conservative sectors and companies.
We expect the ECB’s quantitative easing program to continue to drive European equity outperformance. Our European equity exposure is split evenly between hedged and unhedged with respect to the euro in order to minimize the impact of currency volatility.
We have maintained our exposure to Japanese equities, which are supported by the Bank of Japan’s aggressive monetary policy, expansionary fiscal policy, and favorable regulatory environment. In order to minimize the impact of currency volatility, we have split our exposure between hedged and unhedged positions.
We hold a position in mortgage REITs. We expect that the Fed will not be able to increase short-term interest rates to the extent that markets expect, which will ease funding conditions for mortgage REITs, which borrow heavily in short-term markets.
We continue to avoid commodities, which are down more than 30% YTD. Our portfolios have benefited greatly by avoiding commodities through 2015 and minimizing exposure to commodity producers through careful sector selection.
*Emerging Markets allocation overlaps with regional allocations
^Excluding GTA’s 59% fixed income, alternative, and cash positions
**Individual account allocations may differ slightly from model allocations.
Past performance is no guarantee of future results. The material contained herein as well as any attachments is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies, opportunities and, on occasion, summary reviews on various portfolio performances. Returns can vary dramatically in separately managed accounts as such factors as point of entry, style range and varying execution costs at different broker/dealers can play a role. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts are inherently limited and should not be relied upon as an indicator of future results. There is no guarantee that these investment strategies will work under all market conditions, and each advisor should evaluate their ability to invest client funds for the long-term, especially during periods of downturn in the market.
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