by Neil Azous, Chief Investment Officer
Our outlook for the broad market and the closed-end fund universe is the most uneven it has been this year.
Regarding the closed-end fund universe, because of this mixed outlook for the broad market, solely relying on opportunistic trading, or only focusing on how wide a fund’s discount is trading at, is a risky approach to this specialized market.
More than ever, tactical asset allocation (TAA) is required to improve the risk-adjusted returns of passive closed-end fund investing or opportunistic trading.
In that spirit, we are placing greater emphasis on specific regions. Additionally, it is prudent to add a concentration to the sector(s) with the strongest profile and hold none-to-little exposure with the weakest outlook.
Stocks vs. Bonds
The returns in risky assets, such as equities and lower-rated corporate bonds, since the US Presidential Election have been substantial. Our internal models show that a significant amount of future returns have been pulled forward, such as future earnings growth due to fiscal policy changes and animal spirits, and a reduction in geopolitical risk from the defeat of more radical candidates in European elections.
Market returns after these “overheating” episodes tend to be much lower than normal. Therefore, fixed income offers attractive total returns in this environment.
At the same time, volatility across asset classes is now at an absolute and relatively low level. While market returns tend to be positive during these periods, the total return is well below average.
As a result, we see limited upside in domestic equity assets over the intermediate-term and would prefer to be more defensively setup to capture a higher amount of income rather than capital appreciation. Conversely, we do not see any major catalyst – either known or unknown – to drive market prices substantially lower.
US equity closed-end funds do not offer a compelling risk/reward. One key reason for this weaker outlook is that fund managers rely heavily on the equity market perpetually rising to pay out a high distribution through capital gains.
Over the last two months, US equity closed-end funds have seen their discounts tighten and in some cases now offer a less compelling value relative to owning ETF’s that utilize similar strategies, due to the relative risk of potential discount widening should the equity market experience a selloff and investors become fearful.
As a reminder, retail investors are the largest holders of closed-end funds. Hence, the discounts of these funds are strongly driven by the human emotions fear and greed. When volatility across asset classes, especially equity volatility (i.e. the VIX), is persistently low, investors become greedy and push closed-end fund discounts beyond what is rational.
Conversely, there is scope for emerging markets and European risk assets to build on their impressive relative outperformance this year. Valuations of these assets relative to the US are at a decade wide. Also, discounts in international equity closed-end funds are coming from a wider starting point, or have narrowed at a slower pace than US funds.
While the speed and degree of the outperformance over the last several months may slow in the short-term, we do not see investor appetite for European or emerging market equities abating in the medium-term. The list of reasons to be long – stronger economic activity, less geopolitical risk, contained inflationary pressures, attractive financing conditions, corporate re-leveraging, undervaluation, etc. – is growing by the day, and investors have only just started to act.
In fixed income, we believe that the future tightening path of the Federal Reserve has been well discounted.
The Fed seems intent on raising interest rates by 25 bps two more times this year and then letting the size of its balance sheet run down later this year or in the early parts of next year.
We think if the Fed does raise interest rates two more times that there is a very reasonable probability that they will be done hiking for this cycle.
If that is the case, it leaves limited downside for one’s principal investment.
For the last 12 months, due to their limited interest rate exposure, leveraged loans have been an investor favorite.
The sensational demand to be long the top of the capital structure ended up driving closed-end fund discounts to historically very expensive levels.
That said, of late, and due to minor profit taking, now that the path of future Federal Reserve interest rate policy is largely discounted, leveraged loan closed-end funds have seen their discounts widen, albeit incrementally.
Still, there is no easy money to be made still in this sector.
Tax-exempt municipal bond closed-end fund valuations remain the cheapest on a relative basis to all other major asset classes that we track. This highlights the general disdain for government bonds and any fixed income assets with a high degree of interest rate sensitivity.
In light of all of this, municipal bond closed-end funds with 5.5% pre-tax distribution yields are set up to capture this profile moving forward. Given their wide relative discounts in the closed-end fund universe, it makes the opportunity that much more appealing.
High yield spreads remain extraordinarily tight by most historical measures.
The short-term credit cycle appears to have hit a cyclical peak, and the stress of more at-risk borrowers has increased. Lending, in general, has tightened up. Ultimately, as lenders tighten credit conditions, more creditworthy borrowers could face stress. We do not know the timing of when the “credit cycle” will end as they don’t ring a bell at the top, but we’re confident that when it’s truly over, our internal models will alert us.
This argues for reduced weightings in spread product where possible and is especially true for closed-end funds in the high-yield sector where a fair amount trade at premiums to their Net Asset Value (NAV).
Finally, a larger cash position than normal is prudent until there is further stabilization in crude oil prices and “finality” regarding the path of Federal Reserve policy.
Why? Because we think there will be numerous opportunities throughout the rest of the year to deploy excess cash during market “disturbances.”
Additionally, in early March, a confluence of rare market moving events collided at once, and it reoccurred in early May. These are examples of these disturbances.
Crude oil prices dropped by ~12%. The probabilities for an interest rate hike at the March FOMC meeting went from pricing in no hike to fully pricing a hike in 48 hours following surprise communications from various Board members. There was a rapid rise in real yields.
The result in March was a substantial spread widening in higher yielding asset classes. In closed-end funds, we witnessed a true outlier event where every asset class we track – both bond and stock – experienced multiple standard deviation losses on the same day.
The fallout in May was more isolated to sectors with a high correlation to crude oil – high yield, MLP’s, etc. – and interest rate sensitive equities.
These rare events show why tactical asset allocation (TAA) should be part of a closed-end fund investment process, which is a critical component of our approach.
In both cases, being in the right regions or asset classes, with the commensurate overweight/underweight exposure, would have provided an opportunity to deploy cash when others may not have been able to.
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