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Market View

Lord Abbett investment professionals address investor concerns regarding the recent market volatility and its impact on key asset classes.

China’s devaluation of the yuan on August 11, coming on the heels of dramatic price declines in global commodity markets, sparked volatility in financial markets worldwide. The volatility is clearly being driven by concerns about Chinese growth and stability.

China: The Current Environment
These concerns stem in part from the transition that China has undertaken in recent years to shift its economy from one that is export-based to one that relies more on domestic consumption. China’s rapid growth over the past few decades has been driven largely by exports. Tracking this growth, however, has always been difficult, given the lack of transparency in the economy. 

This has made monitoring the progress of this transition from an export model to a consumer model difficult. Declines in commodity prices that began earlier this year provided one clue that the shift to the less commodity-intensive domestic consumption model was indeed occurring. But questions remained about the willingness of the Chinese population to reduce their savings rate and adopt a consumption-oriented lifestyle. Personal savings rates are high by necessity, given the country’s lack of “safety net” programs, such as social security, retirement plans, and health insurance.   

The August 11th devaluation, therefore, caught markets by surprise, while also providing some much-needed clarity. It suggested that the transition to a consumer-oriented economy may not be occurring as smoothly as expected, making a return to the export model necessary.

This has sparked concerns about the impact of these events on global economic growth, resulting in the current market turmoil. Policymakers, however, have begun to undertake measures to address these problems. China cut interest rates and initiated new fiscal stimulus. The European Central Bank has indicated a willingness to step up its monetary stimulus if deflation becomes a greater threat. The U.S. Federal Reserve also may decide to leave interest rates unchanged next month; New York Federal Reserve president William Dudley has indicated that recent events have made the case for a rate hike in September “less compelling.”

Ultimately, the upshot of the yuan devaluation is that China’s economy may be struggling more than expected, leading some investors to suppose that there is a greater possibility of a global recession. Combine this with the lack of transparency in China and numerous other uncertainties, and the result is the current market turmoil.

With all those factors in play, Lord Abbett has received numerous questions from investors and investment professionals. In this special edition of Market View, we asked experts from across the spectrum of our investment disciplines to respond to some of the most common queries. Addressing these questions are Brian Foerster, U.S. Equity Strategist; Harold Sharon, International Equity Strategist; Tim Paulson, Investment Strategist, Fixed Income; Steve Hillebrecht, Fixed Income Product Strategist; Brian Arsenault, Investment Strategist, Leveraged Credit; and Dan Solender, Director of Municipal Bonds. 

U.S. Equity
by Brian Foerster

Why have U.S. equities fallen so sharply and so quickly?
In addition to the devaluation, there also is growing concern that a debt-fueled credit crisis could emerge around China’s property market, which grew too aggressively over the past decade. Last, many natural resource-rich emerging market countries that depend on Chinese demand sold off significantly as well.  

All of these concerns sparked a massive sell-off in the highly speculative Shanghai Composite, which caused it to fall 43% from its peak.1 That said, the Chinese market is still up 32% over the past 12 months.2 These concerns have rippled through global equity markets as investors reassess their expectations for global growth rates.  

Is this a time to sell and get conservative?
We have no idea when the markets will stabilize or whether there will be more selling pressure in the near term. However, we do believe that the U.S. economy has a number of positives going for it. First, it is more insulated than other developed and emerging-market countries in that it has a very small, direct export exposure to China. Remember, approximately 70% of the U.S. economy is from domestic consumer demand.3

Second, U.S. earnings have been extremely resilient throughout the recovery. The headline for the most recent earnings season was that earnings were flat; however, excluding energy stocks from the S&P 500® Index, earnings were up nearly 6% and, excluding the negative effects of the euro devaluation, earnings were even higher. Over time, low commodity costs will turn from a negative to a positive for corporate earnings. Finally, we think the probability of an aggressive Fed rate-increase program is even less likely today than it was two weeks ago. The Fed may raise rates by 0.25% once or twice, but it will be hard pressed to raise rates meaningfully. Historically, that type of environment has been positive for equities.

What are your thoughts on valuations of U.S. stocks?
In short, they just fell from being a little above their historical averages to right in line with historical averages. On balance, price-to-earnings (P/E) ratios are a terrible predictor of stock market direction. I’ve often noted that the P/E in 1994 was the same as it was in 2007 (roughly 18 times earnings). Was that a helpful predictor of future market performance? No. Nevertheless, when asked this question, we prefer to point investors to a discussion on corporate earnings. As of now, both Standard & Poor’s and FactSet are forecasting earnings growth north of 10% for the next year. We think that would be great, but it may be on the high side. But even if earnings come in at their historical average of 6.5% and the P/E stays where it is, that would equate to a return north of 8% in the market over the next year.

How are Lord Abbett’s equity portfolios reacting to the sharp volatility in the equity markets?
Our portfolio managers have seen many corrections and bear markets, and the general consensus across the teams has been to stick to their processes and look for opportunities in oversold stocks. In particular, the indiscriminant selling of large, high-quality companies in recent trading sessions provided opportunities to buy or add to existing positions. Good active managers can often take advantage of market dislocations, particularly when individual stocks with strong fundamentals are oversold.

Brian Foerster is a Lord Abbett Equity Strategist.

International Equities
by Harold Sharon

What is the extent of the global equity market downturn?
Within the international equity markets, emerging markets are the worst performers, particularly Asia and Latin America, continuing the poor performance that many have exhibited over the last 12 months. Given that some of the largest emerging-market funds are exchange-traded funds (ETFs) and index funds, the large redemptions have hit many of the smaller markets quite hard. This phenomenon may also explain the underperformance of large-cap developed-market stocks versus small-cap developed-market stocks during this month. The MSCI EAFE Index is down 9.5% (through August 24, 2015) for the month to date in August, while MSCI EAFE Small Cap is down only 7.1%.4 MSCI Emerging Markets Index is down 14.3% month to date. 

 

Table 1. In International Stocks, Emerging Markets Have Suffered Most
Performance of select markets from recent peaks, through August 24, 2015

Source:  Bloomberg. For illustrative purposes only. 

 

What does this broad downturn mean for the global economy?
While the environment continues to be volatile, one would have to believe there is a full-blown global recession in the cards to justify some of the valuation levels we see in the international equity markets. But currently we do not see this.

While Europe and Japan have greater economic exposure to China than the United States, recent manufacturing and gross domestic product (GDP) indicators are still showing growth, although in some instances they are less robust than expected. The major central banks—European Central Bank, Bank of Japan, and now the People’s Bank of China—are all easing, putting the international markets in a very different position than the U.S. market. 

What we can’t quantify yet is whether there will be a severe knock-on effect to consumer spending and investment around the world, given these market gyrations. If that occurs, growth could be harder to come by. But that could spur further fiscal stimulus, reform policies, or monetary accommodation overseas.

The devaluation of the yuan is a reflection of the tensions created within monetary policy when fixing exchange rates and trying to control liquidity domestically. In this situation, maintaining a fixed exchange rate is difficult when capital starts to flow out. Thus, we think there will be additional weakening of the yuan in the coming years, and clearly there will be heightened risk in emerging markets in general.

In this environment, where are the opportunities likely to be?
Recent research trips abroad have increased our confidence that there are some strong secular investment themes that have staying power in the current environment, and we are focusing on further opportunities in those areas. Some examples would be stocks that are likely to benefit from the lower-for-longer interest rate environment, which includes many quality, low-volatility, high-dividend stocks, and small-cap growth stocks.

We are seeking companies that predominantly sell into Europe and the United States and have a substantial yuan cost base. That’s a theme we’re considering pursuing.

We also believe that changes in Japanese corporate governance and balance sheet restructuring are just beginning, and should benefit profitability and investment returns in the medium term. We do, however, need to modulate this if the pace of yuan devaluation picks up, as this could impact Japanese competitiveness negatively and possibly even derail the embryonic détente between China and Japan.

It’s these longer-term strategies that look attractive to us given the setback in valuations over the last few weeks.

Harold Sharon is a Lord Abbett International Equity Strategist.

Investment-Grade Bonds
by Tim Paulson and Steve Hillebrecht

Clearly, market volatility is being driven by concerns about Chinese growth and stability. As Andrew O’Brien, Lord Abbett Partner & Portfolio Manager, notes, the Chinese are taking the right steps to stimulate growth and encourage stability. Although it is not immediately obvious that these efforts will be completely successful, they have many resources, understand the problems, and have enormous flexibility in addressing them.

O’Brien also notes that spreads on many U.S. fixed-income categories have widened a lot recently, including securities that have only the most tangential connection to China. In many cases, these spreads seem too wide, given a fundamental picture that’s actually pretty respectable in most parts of the market.

How are U.S. fixed-income portfolios performing right now?
Note that investment-grade spreads have widened throughout the year, mainly due to record supply of new securities in the market rather than any significant credit issues. Widening spreads across credit-quality categories could create opportunities to add to positions in companies with exposure to the U.S. economy, which should be insulated from China growth concerns.

Can you tell us more about riskier assets?
We have had an "up-in-quality" bias for quite some time as we didn't feel we were getting appropriately compensated for some of the risks in other asset classes. We believe that high-grade corporate debt, along with other high-grade assets that are attractive but less vulnerable to the international drama currently playing out, is a compelling opportunity right now.

What’s your current approach to portfolio risk?
We don't believe we are dealing with larger systemic risks, as the Chinese central bank has a lot of tools at its disposal to stimulate the domestic economy and stabilize markets. Given that spreads are widening across the board, credit sectors tied to the U.S. economy and consumer look attractive. Within corporates, we believe it is important to differentiate among corporate securities, separating issues tied to global growth and commodity prices from those companies leveraged to the U.S. economy and U.S. consumer spending.

What’s the key takeaway here?
We aren't trying to predict the direction of the market, or the timing of a potential rebound. Instead, we have been carefully rotating among fixed-income sectors, moving to parts of the market that display attractive relative value. Whether markets are calm or wracked with turmoil, we employ a disciplined, rigorous approach to identifying attractively valued securities. 

Tim Paulson is a Lord Abbett Investment Strategist, Fixed Income.
Steve Hillebrecht is a LordAbbett Fixed Income Product Strategist.
 

High-Yield Bonds
by Brian Arsenault

How has the U.S. leveraged credit sector fared amid the turmoil?
Take a look at Chart 1, below, which displays U.S. high-yield sector returns for the week of August 17-21—when the effects of China’s market rout began to have a significant impact on investments worldwide—and year-to-date through August 21. The weakness in high-yield returns for the week was mostly driven by a meltdown in the metals, mining, and energy group, no surprise given the plunge in commodity prices that went hand-in-hand with rising fear of a significant economic slowdown in China. Of course, these groups have experienced weakness throughout 2015, but the selling accelerated amid global volatility.

What about other sectors?
The encouraging news here is that most other sectors only posted modest declines last week. In fact there are many segments within U.S. high-yield that have posted positive year-to-date returns in the 4–6% range. 

What about specific credit-quality segments within high-yield?
On a ratings basis, issues in the 'CCC' category led the market lower, which was not surprising given the preponderance of coal, metals, and lower-quality energy companies with that designation.

Do you see opportunities in out-of-favor sectors?
Many of the names that have seen significant selling are not likely to come back. Long term trends in the U.S. coal industry, for example, are highly unfavorable. Energy companies that need crude oil prices to remain around the $70 per barrel level to break even also may find the deck stacked against them.

 

Chart 1. How Has U.S. High-Yield Fared in a Volatile Environment?
Total return for indicated high yield segments for the week of August 17–21, 2015, and year-to-date through August 21, 2015

Source: J.P. Morgan. For illustrative purposes only.

 

Brian Arsenault is a Lord Abbett Investment Strategist, Leveraged Credit.

Municipal Bonds
by Daniel Solender

Amid the volatility in financial markets, the U.S. municipal bond sector has held up relatively well. Through August 25, the Barclays Municipal Bond Index, a broad gauge of the muni sector, was up 0.33% for the month of August and 1.18% year to date, according to Barclays data. The attractive tax-free income offered by muni bonds holds particular appeal for investors in a time of market turmoil.

In a recent Market View, we surveyed the state of the muni market in the wake of a default by Puerto Rico on some of its municipal obligations on August 3. We believe our observations remain relevant in the current market environment. To summarize:

What’s the state of state and local finances?
While Puerto Rico faces continuing challenges, the news for the state and local governments that issue muni securities is generally positive. According to the U.S. Census Bureau, revenues of state and local governments have been steadily increasing since their post-financial–crisis low point in the first quarter of 2010, and reached a multiyear high in the first quarter of 2015.

What about muni-bond default rates?
Based on data compiled by Moody’s, municipal bonds have featured far lower default rates than similarly rated corporate debt issues across the ratings spectrum. Muni-bond issuers have not deviated from their history of very low default rates. In fact, many issuers have seen their debt upgraded, and states such as California have improved their finances and credit quality materially in recent years.

What has been the effect on the high-yield muni market?
Puerto Rico bonds have suffered steep price declines. What may be surprising to some is that the rest of the high-yield market hasn’t suffered as a result; with Puerto Rico debt excluded, the Barclays High Yield Municipal Bond Index is actually up 3.25% year to date through August 25.

Do muni bonds still offer good value for investors?
Recent tax-equivalent yields across the ratings spectrum were significantly higher than yields on similarly rated taxable categories, according to Barclays. As the market continues to digest developments in China, Puerto Rico, and elsewhere, munis continue to offer appealing relative value versus other fixed-income categories.

Dan Solender is Lord Abbett’s Director of Municipal Bonds.

 

1 Bloomberg.
2 Bloomberg.
3 Bureau of Economic Analysis. 
4 Bloomberg. 

 

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