29 Apr

Ever-Changing Tides

As investment professionals, one of our challenges is composing communiques that remain relevant for more than five minutes. Information and opinions are disseminated continuously in our connected world, and what seems like a timely or insightful thought can be outdated or proven inaccurate by the time the intended recipient receives the message. With that said, we remain committed to communicating our thoughts and convictions.

During the first calendar quarter of 2014, U.S. equity market averages eked out positive returns of 1.8% for the S&P 500 Index and 0.8% for the technology-centric NASDAQ. This marked the fifth consecutive quarter of positive returns. The last time this occurred was from Q3 2006 through Q3 2007; however, it is not uncommon. During the past 50 years, the S&P 500 Index has experienced eight periods of at least five consecutive quarters of positive returns, with the longest streak lasting 11 quarters in the early 1960s.

At EPIQ, we attempt to avoid the practice of data mining convenient facts that support our thesis. We prefer to stress traditional measures of value to assess the risk/reward relationship that a security or sector presents at any given time.

Currently, we continue with a constructive outlook for equity investors over the next year or two, but are more guarded in our enthusiasm. Valuations as a whole have discounted much of 2014 earnings expectations, and we have seen an increase in financial leverage.

If equity investments are cause for concern, a safe harbor in the bond market is unlikely. Fixed income is far more challenging as the risk/reward relationship remains poorly skewed. During the past five years, bonds with the lowest credit profiles have produced extraordinary returns. Defaults have declined and issuers whose debt once traded at steep discounts to par now may command a premium. It is not uncommon for companies rated CCC (one rating level above default) to yield 3-4 percent for bonds coming due in a few years. The rewards appear modest and the sector is priced for perfection. In addition, new issues are coming to market with less bond-holder protection than a few years ago.

For bond investors to earn 4 percent in a solid investment-grade credit, they need to loan their money for 10 years and hope (pray) that interest rates do not rise materially. This might work, but the potential downside makes it challenging to justify the risk in today's environment.

Macro issues will always confront the capital markets, and we are encouraged by the lack of catastrophic events in the recent past. Consumer and investor confidence continue to inch higher, and federal, state, and local governments are no longer facing extreme budgetary issues. Monetary policy from the Federal Reserve is moving in the right direction even if it has a long way to go before we return to what many investors would regard as "normal."

Last summer when interest rates spiked, we opined that the market was overreacting to potential rate hikes (http://www.epiqpartnersllc.com/blog/item/51-perspective). We continue to hold our outlook and anticipate that the Fed's activity of reducing bond and mortgage purchases will continue at the communicated pace. By the end of 2014, we suspect that the Fed will be out of the business of buying bonds in the open market and will begin to focus its energy on raising the overnight lending rate from near 0% to something greater than 0%. The market is currently projecting a rate of .5% one year from now and 1.5% in two years.

If this materializes, it would be great news for most investors and citizens of the United States. Slowly raising rates would suggest an economy (and society) that has recovered from the global malaise of just a few years ago. New issues, such as rampant inflation, that could have been as bad as (or worse than) the original problem have not materialized to date.

The key words here are "to date." One issue that does concern us is the composition of U.S. debt. Much of the Treasury's debt is short-term. If interest rates rise materially, so will the government's borrowing cost. That will require more expenditures to service existing debt, making fewer funds available for tangible services. This is not a new concern for the market, and we feel properly positioned with our current investments for an increase in inflation.

Thank you for taking the time to read this.  Feel free to contact EPIQ to extend the conversation.


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