Volatility has picked up across asset classes with the Federal Reserve’s announcement that it will begin reducing stimulus as the economy gains a foothold. While this is GOOD NEWS, as it is dependent on real economic recovery, the result has been bad news for asset prices, with deleveraging across the board.
Some of the most popular trades this year (junk bonds, REITs, MLPs, etc.) have been hit hard. There have been games being played by non-fundamental players using leverage to enhance returns from yielding instruments, both stocks and bonds. Increased volatility, increased bond yields and change in momentum for these names causes these funds to unwind positions and when they do, it is abrupt and indiscriminate. Excitingly, the good and bad stocks go down together, offering great opportunities for bottom-up fundamental managers like us to improve the quality of our portfolios, reducing risk and increasing potential upside in the process.
While seemingly a shock, at the end of the day a move to 3% or even 4% yields on 10-year U.S. government bond won’t slow down investing decisions or drastically reduce U.S. growth because it will be driven by an improving economy and increased confidence. What it will do is punish those players in the market who have been layering on risk without an appreciation for the underlying fundamentals of the businesses, and in the process distorting market signals and valuations. Score one for the good guys.
While we still have some macro concerns globally (mainly China), fundamentals in the U.S. remain solid and we don’t believe an increase in rates will derail the recovery. Our exposures remain the same: Core total return names supplemented with U.S. cyclical recovery plays (transports, aerospace, etc.), along with ample liquidity to react quickly if fundamentals worsen.