Global markets have begun 2016 just as they finished 2015: with volatility elevated across all asset classes. Many trends remain intact, but there are several new developments that bear close attention.
One important new trend is the decline in US treasury yields. Despite elevated volatility, weak global growth, and rising disinflationary forces last year, mid- to long-duration treasury yields ended the year mostly unchanged and shortduration yields ended higher. At the time, we argued that this was due to significant selling of US treasuries by foreign central banks, and that those effects would prove to be transitory. Our conviction has been rewarded so far this year, with treasury yields falling significantly. Our portfolios have benefitted from targeting the long end of the treasury curve with our largest US treasury allocation since 2009.
A second, and arguably more important, new development is the sudden weakness in the US dollar, especially against other developed market currencies. Typically during an equity market selloff the dollar is supported by its safe-haven status, allowing it to strengthen. The fact that this has not been the case suggests that investors are fearful that the US growth advantage which has propelled the dollar higher may not be sustained, which would lead to more accommodative Fed policy than was previously expected.
The common factor driving both of these developments is a rapid change in market expectations of future Federal Reserve policy. At year-end the Fed was projecting four interest rate hikes in 2016 and markets were expecting between two and three. Those expectations have quickly declined—at the start of the year markets were priced for a 50% chance of a rate hike at the March FOMC meeting, currently markets expect only a 30% of a rate hike at all this year.
We have been well positioned to capture the effects of this shift in expectations. In addition to our large allocation to long-duration US treasuries, we have unhedged most of our foreign equity exposure to benefit from a weakening dollar, and we have also added exposure to gold which has benefitted from a weakening US dollar, expectations of easier Fed policy, and increased political uncertainty as the US Presidential race gets underway.
Our equity positions are limited to developed market countries and our fixed income positions are focused on high quality, dollar denominated holdings. Overall, our GTA portfolio holds 51% fixed income, 13% US equities, 28% international equities, 5% alternatives, and 3% cash. We have large allocations to US treasuries and US investment grade corporate bonds which have served us well in recent weeks. We favor developed international equities and are avoiding emerging market equities. We have also taken a position in gold, which has benefitted from increased market uncertainty.
Our fixed income holdings favor high quality, long-duration exposure. We hold positions in long-duration US treasuries, investment grade corporate bonds, preferred stock, and dollar denominated emerging market debt. This gives us broad exposure to fixed income while avoiding low quality holdings and targeting the long end of the yield curve.
We have recently sold our position in high yield bonds in favor of investment grade US corporate bonds and long duration US treasuries. Although we still think high yield bonds offer good relative value, the lower quality portion of the market has become increasingly illiquid. This illiquidity has led to forced selling in the higher quality portion, as managers have been forced to sell whatever they can to keep up with withdrawals. As a result of this dynamic, we have liquidated our position.
Our US equity exposure is limited to low volatility equities, giving us broad exposure while minimizing drawdown risk by focusing on conservative sectors and companies. This increases our relative exposure to non-cyclical sectors and has served us well—outperforming the S&P 500 by 5.6% since we added the position in November.
Markets have begun to recognize the likelihood of more dovish Fed policy. As a result, the dollar has weakened somewhat. In anticipation of further weakness in the dollar, as well as elevated market volatility, we have sold our position in currency-hedged European equities in favor of low volatility international developed market equities.
We have maintained our exposure to Japanese equities, which despite their recent downturn 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 have initiated a position in Canadian equities. We expect a weaker US dollar to provide some relief to commodity producers, and Canadian equities and the Canadian dollar are a conservative way to participate.
We have sold our position in mortgage REITs. Many of the mortgage-backed securities owned by mortgage REITS are somewhat illiquid, and have unfortunately struggled with the same dynamic as high yield bonds described above.
We have initiated a position in gold. A weaker dollar and easier Fed policy, along with elevated volatility, should support gold. Additionally, as an asset with low correlations to most others, it should lower overall portfolio volatility.
*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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