Jay Pelosky, an old friend and Principal at J2Z Advisory, LLC, an investment strategy consultancy and former head of Morgan Stanley global asset allocation research. He is it comes to all things macro and is an expert in emerging markets. Jay can often be seen on Bloomberg and CNBC. I wanted to share his latest piece, originally posted at Minyanville:
Investing is, in large part, deciding when, where, and how to take risk and get paid for it.
The post 2008 risk-taking environment has been uncertain at best, an environment mirrored in 2012. Government intervention, asset price fluctuation, and sub-par global economic growth have combined to shrink trading volumes and increase volatility across assets. Within a long-term portfolio, tactical decision-making has assumed greater importance. Taken together, these effects have led investors on a search for the Holy Grail of investing: high single digit returns with low volatility.
While there is no halftime in investing, we approach the second half of 2012 and investing conditions look ugly.
Europe remains a mess, emerging markets suffer stagflation, commodity investors question the super cycle, equities soar then swoon, and bond yields shrink in safe havens while rising in ever-wider parts of Europe. US financial assets: the dollar, Treasuries and equities, have remained safe havens leading to significant outperformance. Through May, US equities have outperformed the rest of the world by roughly 800 bps and emerging market equities by 500 bps.
Here is how I see the second half playing out.
European outcomes remain polarized between closer integration and dissolution. Greece is effectively discounted with very little private sector money involved; its risk now resides in an exit from the euro and what that might mean for Spanish euros, Italian euros and the rest of Europe. Spain is likely to need a bailout soon while Germany continues to resist spending more money. Germany remains Europe’s lead actor and what it desires is a weak currency within a large trading bloc, suggesting that at some point it will do as the others wish. Market pressures have risen sharply; ECB and perhaps IMF action could be imminent. One thing is certain: The longer the brinkmanship between the ECB and Europe’s politicians lasts, the weaker European growth will be — not only in 2012, but in 2013 and beyond.
A principal question for investors is whether US equity performance is sustainable in the second half. I have my doubts. The main US equity risk for 2012 remains earnings driven. With second half S&P earnings forecast to grow 12% y/y and 2013 earnings forecast to grow another 10% there is more than ample room for earnings disappointments. Investors and analysts tend to focus their thinking toward the out year once June and Q2 earnings come through. Earnings have been key to maintaining equity price levels – that support will be called into question in the second half.
US equity risk is not so much relative as it is absolute. The US should continue to outperform the rest of the world, driven by the Rebirth of Middle America theme. But it is absolute performance that is now in question and it is domestic based risk, not European risk, which is key. European risk has been heavily discounted; domestic risk has not. May’s job report and the subsequent 2.5% daily decline in the S&P illustrate the point. Risk heavy financial asset prices around the world have sold off aggressively, are oversold and due for a bounce. Decisive action in Europe, even if imperfect, could well stimulate an equity rally. That rally should be sold as domestic driven downside risk remains and equity market leadership is lacking.
While earnings risk is the principal domestic concern, domestic politics offers further cause for concern with the battle of the fiscal cliff coming to your newspaper, TV, radio and maybe even smartphone app soon enough. There are growing reports that fiscal cliff uncertainty has already begun to impact CEO and CFO spending plans for 2013. Temperature taking across the aisle suggests little appetite for any deal prior to January 2013 and a new political alignment.
These risks should support ProShares Ultra 7-10 Year Treasury (UST), while weak growth implies a continuation of Operation Twist (though with limited effect), and Europe becomes ever more of a global capital no-go zone. For those who question how low US yields can go, note that the German 10-year bund yields 1.27% and the PowerShares DB Japan Gov Bond ETN (JGBL) yields 85 bp. The UST outlook is critical to investing in the second half because long dated Treasuries are the trip wire to the portfolio strategy one should consider embracing.
This strategy seeks to attain the Holy Grail of high single digit returns for 2012 with low volatility.
How can one execute the strategy? Well, it helps if one is up 2-3% ytd through May. If so, then the investment strategy is to use risk asset rallies to sharply cut equity risk and take risk in higher yielding instruments, effectively building a portfolio yield of 6-8%. The 3% ytd return, coupled with 3-4% of coupon clipping through the remaining seven months of the year should generate total returns in the high single digits with low volatility.
To return 7% in a zero cash world where 10 yr. UST yield 1.5% is no small feat; to do so with low volatility is even more difficult. As returns contract, volatility is assuming ever-greater importance in the big money world of pensions, sovereign wealth funds and reserve managers. Hedge fund managers face business risk if down two years running and sharply underperforming the S&P. The return profile suggested by this strategy should ensure capital stays in the portfolio and presents a solid case for new money investors exiting those funds that fail to adopt such a strategy.
What are some of the instruments to build this high yielding portfolio? US high yield corporate bonds should be a core holding. Corporates are in the best shape relative to consumers and governments. High yield will trade with equity to an extent, one limited by yield and the enhanced search for yield (see 2012 and The Global Search for Yield) driven by the business risk noted above. In other words, high yield should continue to generate a bid given the yield on offer. High yield’s recent sell off ensures one is not top ticking.
Other areas to consider include mortgage and other REITS, USD emerging market debt, and high dividend yielding emerging market stocks.
What are the risks to this strategy? Underperformance in the case of a sharp upward move in equities is the main risk. Resolution in Europe, a sharp US growth recovery, earnings beats, and an outbreak of political wisdom in Washington could all trigger a major move higher. The solution? Use a small amount of the income generated by the portfolio to buy upside calls on the S&P. In the interim, once can sleep soundly, knowing that cash is coming into the portfolio, that continued safe haven buying, slow growth and quiescent inflation will protect the UST tripwire position while an extended refi cycle in US high yield will, in turn, protect the principal area where one has decided to take risk and get paid for it.