Spring 2015 Investment Advisory Group Commentary

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As economies across the globe move into or out of quantitative easing, the ripple effects are coming ashore for investors.

IFP ResearchThe primary investment related themes of the recent Independence Financial Advisors Investment Advisory Group meeting center on protecting assets from the eventual slowing of U.S. equity markets while potentially gaining exposure to new opportunities outside of the U.S. Depending on each investor's risk profile and investment horizon, each theme may play more or less significant a role.

Nothing is Cheap Right Now – Including Money

We know that “Manage Expectations” often connotes a directive to lower expectations.  In the case of investing, a global equity opportunity is intersecting with a potential U.S. equity correction.  Hence, manage expectations and perhaps, consider a degree of reallocation.

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Positioning equity investments to hedge a U.S. market correction does not include panic moves.  While we are in a period of “volatility uncertainty,” economists from inside the Beltway to Wall Street have been deliberating not “if” but “when” and the markets have been subtly responding, which is not entirely unhealthy.   The “when” factor depends significantly on when the Federal Reserve actually moves up on interest rates.  Interest rate-related market movement would ideally be in response to concrete guidance from the Fed as opposed to the speculative leaps some investors have made.

Global equities in both developed and non-developed markets are on track for continued growth, keeping in mind some areas are still more vulnerable than others.  Where the U.S. has ended Quantitative Easing (QE), Japan is still in deeply in a QE cycle and the European Central Bank (ECB) recently initiated its own version.  The ripple effects of this include an already strengthening dollar against the Euro.  There will be winners and losers, depending on which side of which currency investors sit.   Countries that import commodities stand to gain, while profits will be squeezed in countries that rely heavily on exporting commodity products.  If QE positively impacts Europe’s equities, there may be compelling new investments across the pond; however, it’s important to keep in mind the flipside of the currency coin in estimating potential returns. 

A U.S. market correction may also present buying opportunities.  U.S. companies whose revenues may be negatively impacted by currency and rising rates may be in the trough just temporarily; depending on one’s investment horizon, buying the dips could be worth exploring in longer-term outlooks.

Dig Deeper for Diversification

With so many investment variables in flux and “volatility uncertainty”, the traditional stock/bond 60/40 diversification ratio may be challenged.  Equities and bonds are bucking historical investment trends by having high valuations in tandem.  It may be prudent to consider that they may follow congruent paths of decreasing value as well.  Blending strategies, including alternative strategies, is a more complex but potentially effective way to deflect some risk and spread exposure across the board.  Alternative strategies require scrutiny in the areas of both cost and strategy selection.

Combining active and passive approaches including smart beta funds, a relatively new hybrid approach to fund management, adds yet another arrow in the investor’s quiver.  Smart beta funds aim to hit a risk versus exposure sweet spot by blending the lower costs of a passive fund with the potential upside of active selection.  Funds are selected based on what is known as a “rules-based approach” – looking at current value, size, momentum, volatility or dividend yield. 

Possessing patience and perhaps even thick skin is imperative when blending multiple strategies since each strategy will outperform at different times.  On the other hand, many investors take comfort in blending strategies because they feel they have more balanced exposure to downside risk at any given time.

Don’t Throw Fixed Income Completely Under the Bus

Speaking of diversification, is there a more evolved strategy to employing bonds in the current environment?  Yes.  Duration, the measure of a bond’s sensitivity to a 1 percent change in interest rates,  is more at risk of increasing in the next 12 to 18 months given the anticipation of an upward tick in interest rates.  Fixed income credit risk is also trending upward, albeit slowly.  For managers who can balance active fixed income opportunities globally while providing some stability with high-quality, longer duration issues such as U.S. Treasuries, the fixed income market presents compelling if more complex opportunities.

Beware of Wolf in Sheep’s Clothing - High Yield Debt

High yield and floating rate debt markets need to be closely monitored.  While not everyone agrees on the “if” or “when” of any collapse in the high yield or floating rate debt markets, it is our view that investors should keep an eye on a potential increase in default rates as well as increased activity in the credit default swap markets. 

The more cautionary outlook is surprisingly not comforted by low default rates which were at near six year lows at 2.1% at the close of 2014[1] and still well below the average of 4.4% since 1993[2].  We believe that ultra-low interest rates have allowed companies to refinance debt rather than default.  As this ultimately pushes liquidity to its brink, the default rate is expected to increase.  Oil companies in particular, who are hurting from the plummet in pricing, have been deeply drilling into refinancing their debt.  Some are forecasting an eventual explosion, or more aptly, implosion when these forces all converge at a point beyond their reasonable limits.

Others disagree.  Energy sector issues aside, the J.P. Morgan High Yield Index has the projected 2015 default rate average at 4.3%[3] - still a benign default environment combined with favorable crediting rates for those with a more positive interpretation. 

Conclusion

The conclusion upon which everyone agreed was that monitoring and diversification are the keys to making the most of opportunities while weathering the challenges of the next 12-18 months.  The sophistication level of monitoring and asset allocation may be what is changing the most right now.  There are geopolitical, economic and natural forces in play that can prompt erratic reactions from the investment media and markets.  Our guidance is to maintain an informed perspective and position for now that may enable asset protection and still provide some yield while the current volatility and uncertainty work themselves out.

[1] “Moody's Expects Low Default Rate in 2015”, Vipal Monga, wsj.com
[2] “High-Yield Default Rate Down to 1.7%, Should Stay Low – Moody’s”, Michael Aneriro, Barrons.com, October 23, 2014
[3] “The High Yield Default Outlook”, SeekingAlpha.com, March 6, 2015

This information is for educational purposes only. This information does not constitute investment advice. Please consult with your financial advisor before taking any action. For planning advice contact Independence Financial Partners.

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