Fourth Quarter Market Commentary - SEI
Quarterly Market Commentary Fourth Quarter 2015
The fourth quarter witnessed an escalation in geopolitical strains, deepened distress in the oil patch and longanticipated follow through by the U.S. Federal Open Market Committee. Higher-risk fixed-income market segments decoupled, and higher-quality segments came under pressure. Global equity markets mounted a steep advance during the fourth quarter despite a setback in December.
Economic Backdrop The fourth quarter began with a combination of mixed economic reports and accommodative central bank policies that proved enough to support a recovery from third-quarter losses. A spate of attacks by religious extremists spanned four continents from late October through early December, emboldening the West’s involvement in a coalition targeting Islamic State in Iraq and Syria. Deteriorating conditions for U.S. energy companies raised concerns among high-yield bond investors, resulting in a sharp selloff that likely discouraged equity investors and kept a lid on performance as the year drew to a close. Major central bank policies commenced a long-awaited divergence late in the quarter. The U.S. Federal Open Market Committee (FOMC) raised the federal funds rate in mid-December for the first time since 2006, leaving behind a nearzero-interest-rate stance that had been in place since late 2008. The Bank of England’s Monetary Policy Committee made no changes and the European Central Bank (ECB) indicated a willingness to expand its quantitative-easing program if necessary. The Bank of Japan expanded it asset-purchase program by lengthening the average maturity of purchased Japanese government bonds and increasing purchases of broad equity-market exchange-traded funds. Reports on the U.S. manufacturing sector highlighted slowing activity in December, and initial services-sector data indicated that December’s growth was set to be the weakest of the year. Industrial production dropped in November by the most in over three years, while retail sales (excluding autos and gas) advanced by more than expected. A surge in November permits precipitated a significant advance in housing starts as new homes under construction reached a sixyear peak. New home sales continued to increase in November, while sales of existing homes tumbled. Core consumer and producer prices (which exclude food and energy) climbed during November, as consumer spending increased by considerably more than anticipated. Payrolls and personal incomes rose by more than expected but by less than in October. The unemployment rate remained unchanged at 5% and average-hourly earnings expanded by 0.2%. U.S. economic growth settled at a seasonally-adjusted annualized rate of 2% during the third quarter, down from the secondquarter rate by almost half. U.K. retail sales volumes exceeded their year-ago levels in December, but by less than expected and at the expenses of soft projections for January. This followed November’s 11-month peak in retail sales, which was attributable to broadbased improvements, although online sales contributed most. Manufacturing data indicated slower growth in December; orders and output advanced, but by less than during November. Inflation pressures remained effectively non-existent through November; consumer prices were flat, while producer prices extended significant year-over-year declines. The unemployed claimant count widened in November for the fourth consecutive month. The unemployment rate declined to 5.2% for the August-October period, while 2.4% annualized average earnings growth represented a seven-month trough. Third-quarter gross domestic product’s (GDP) final reading was revised down to 0.4%, and 2.1% year over year, below the second-quarter pace. Eurozone manufacturing data for December indicated that growth had accelerated to its fastest pace in more than 18 months. Services sector data moderated, but remained firmly in growth territory. Industrial production advanced by considerably more than expected during October, more than offsetting the prior month’s decline. Retail sales, however, continued to edge lower in October. Consumer prices fell in November after rising in October, but were positive year over year. Core prices (which exclude energy, food, alcohol and tobacco) also fell after delivering the largest year-over-year advance since 2013 in October; core prices remained considerably higher than the broad price measure. The unemployment rate dropped to 10.7% in October, reaching the lowest rate since 2012. GDP strengthened by 0.3% in the third quarter and 1.6% year over year. Government spending, private consumption and inventories climbed, but a negative trade balance prevented greater expansion. © 2016 SEI
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Market Impact Fixed-income markets produced interesting results during the fourth quarter; the performance of traditional higher-risk market segments decoupled, and the highest-quality segments came under pressure. Foreign-currency-denominated (external) emerging-market debt was the quarter’s best performer despite giving back more than half of its advance during December. U.S. dollar-hedged (which seeks to reduce U.S. dollar-related volatility) global sovereign securities had modest gains during the quarter, trailed with positive performance only by dollar-hedged global non-government debt. Local emerging-market debt was nominally negative during the quarter, having suffered considerable losses in December. U.S. mortgage-backed securities were slightly negative during the quarter, while U.S. asset-backed securities and U.S. investment-grade corporate fixed income sustained steeper losses. U.S. Treasury Inflation-Protected Securities had more significant losses, trailed on the downside by unhedged global non-government debt, U.S. Treasurys and then unhedged global sovereign securities. U.S. high-yield bonds had the worst performance, with the quarter’s entire loss essentially attributable to December performance, stemming from energy sector weakness. Global equity markets, as reflected by the components of the MSCI AC World Index (Net), mounted a steep advance during the fourth quarter despite a setback in December; however, full-year 2015 performance was negative. Regionally, Asia Pacific delivered the fourth quarter’s most outsized returns; Indonesia and New Zealand were the top two performers, while Australia, Japan and Malaysia followed closely behind. Several European countries also had strong returns, led by Belgium, Hungary and Finland. The U.S. had a strong quarter, while the U.K. was modestly positive. Latin America struggled, as did much of the peripheral Europe, with Greece and Poland delivering the poorest performances. Global sectors were positive outside of energy, which had a comparably small decline relative to its full-year performance. Information technology was the fourth quarter’s top performing sector, followed by healthcare, industrials and the consumer sectors. Index Data for Fourth Quarter The Dow Jones Industrial Average Index returned 7.70%. The S&P 500 Index rose7.04%. The NASDAQ Composite Index returned 8.71%. The MSCI AC World Index (Net), used to gauge global equity performance, advanced by 5.03%. The Barclays Global Aggregate Index, which represents global bond markets, fell by 0.92%. The Chicago Board Options Exchange Volatility Index, a measure of implied volatility in the S&P 500 Index that is also known as the “fear index”, decreased in the quarter as a whole, moving from 24.50 to 18.21. WTI Cushing crude oil prices, a key indicator of movements in the oil market, moved from $45.09 a barrel at the end of September to $37.04 on the last day in December. The U.S. dollar strengthened against the euro, sterling and yen during the quarter. The U.S. dollar ended December at $1.09 against the euro, $1.47 versus sterling and at 120.3 yen. Portfolio Review U.S. equities rebounded during the fourth quarter, led by large companies in an environment that favored growth strategies. Large-cap positioning was challenged due to stock selection within consumer discretionary, healthcare, materials and industrials, with the poorest results driven by selection in the latter two sectors within value strategies. Small-cap positioning also struggled as adverse selection in healthcare, industrials and technology outweighed strong selection in consumer discretionary. A slight overweight to energy also detracted. Overseas results kept pace with international equity markets; stock selection was positive but regional allocation detracted. The strongest results were produced in Europe, while Japan and the broader Pacific region made considerable contributions despite an underweight that detracted from overall performance. Off-benchmark exposures, specifically to Korea and Canada, were negative. Within emerging-market equities, positive results were driven primarily by stock selection. Emerging Asia positions were the top contributors, but Europe, the Middle East, Africa and Latin America were also additive. An overweight to the information technology sector in both developed and emerging markets was a key source of outperformance. Core fixed income benefitted from non-government sector performance during the quarter. A slightly short-duration posture was additive as U.S. Treasury yields increased in anticipation of the FOMC rate hike, and a yield-curve-flattening bias was supported by the comparably greater increase in short-term Treasury yields than long-term rates. Overweights to corporate bonds, particularly financials, and non-agency mortgages contributed, while overweights to asset-backed securities and commercial mortgage-backed securities detracted. An underweight to agency mortgages also weighed on performance. The high-yield market suffered its second consecutive quarter of material losses and ended the year in negative territory for the first time since 2008. The energy sector was down nearly 13% for the quarter, but other sectors ― retail, telecommunications, media and healthcare ― also exhibited signs of weakness. Underweights and selection within basic materials and services, along with an overweight and selection within technology and electronics, contributed. Selection within retail, healthcare and (an underweight to) financial services detracted. Emerging-market debt had a © 2016 SEI
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positive fourth quarter supported by external debt as most local currencies weakened relative to the U.S. dollar. Several currencies, however, strengthened meaningfully, including the Indonesian rupiah; an overweight to Indonesia was the quarter’s top contributor. An underweight to South Africa also benefitted relative performance amid currency weakness, while an underweight to Malaysian debt detracted. In Latin America, an overweight to Argentina contributed, while an overweight to Brazil was the most notable drag on performance. Manager Positioning and Opportunities SEI’s portfolio managers rely on investment-manager selection and portfolio construction in an effort to deliver diversified sources of excess return for our portfolios. Our positioning anticipates the late stages of a market expansion and we expect increased volatility as markets try to balance encouraging U.S. economic data with continued emerging-market pressures and a weak commodity sector. We continue to support our deep value managers who have the most exposure to troubled parts of the market. Valuations and the risk-reward profile are becoming more attractive in these spaces, but the timing of a rebound is uncertain as the catalyst remains unclear. Longer term, we look to slowly build exposure to stability as the expansion matures. Our base case favors quality growth until concerns are resolved by either a risk-on (healing of energy) or risk-off (emerging-market contagion) environment. We retain a rather constructive view on international developed equity markets like the eurozone and Japan as fundamentals remain attractive and ongoing policy support is likely creating a more supportive macro-economic backdrop, although plenty of risks remain. Nevertheless, we remain pro-cyclically positioned and favor higher-quality, more-profitable companies. After a significant drop in emergingmarket equity prices and a strong negative news flow, the asset class appears more tempting. We believe it is time to consider exposure to the asset class, especially for long-term investors, but it is necessary to differentiate between regions and countries as the risks and opportunities are quite diverse. The duration posture within investment-grade fixed income remains slightly short to neutral since interest rates remain within a relatively narrow range, with a continued yield-curve-flattening bias. Credit spreads narrowed during the fourth quarter and we have been adding risk selectively. An underweight to the industrial corporate sector has been reduced, but we are slightly underweight corporate bonds despite a continued overweight to financials. We also maintained an underweight to agency mortgages. Within high yield, default rates remain below historical averages but have been trending higher and could approach or exceed those levels in the next year if market stress spreads. However, the volume of upcoming maturities through 2017 appears to be manageable based on new issue figures from the past few years. We maintain a slightly more defensive posture via bank loan and cash allocations, and remain underweight the energy sector as well as metals and mining (excluding steel), a subsector of basic materials. We will be selective in new purchases given ongoing volatility and will continue to assess bank loan opportunities especially when valuations appear attractive versus BB-rated bonds. Positioning within emerging markets remains underweight external debt and overweight corporate bonds. The largest external debt positions are within Indonesia, Brazil, Venezuela, Mexico, Turkey, and Argentina. An underweight to local-currency debt also remains, with significant overweights in India, Indonesia and Russia. The biggest currency overweights are in countries that stand to benefit from the decline in commodity prices, such as India, while the most significant underweights are in low-yielding Asian currencies (Thai baht, Malaysian ringgit). Our View The volatility of the past year and the pain felt in certain asset classes reminds us more of the 2011 experience than the calamitous tumult of 2008. We believe that the proper course is to maintain exposure to risk assets and continue buying selectively on the dips. We still like the odds of equities outperforming fixed income. The much-anticipated “lift-off” move that raised the federal funds rate is more akin to launching a hot-air balloon than a rocket. Our base case for 2016 is for more of the same: we expect yields to move slowly higher, much closer to the market’s expectations than those expressed by the FOMC members. The first few hikes in the federal funds rate ordinarily are taken in stride by the equity market — and for good reason. The Fed has no desire to lean hard against the economic expansion. ECB President Mario Draghi claims that the central bank stands ready to do more, if necessary, but it all comes down to how the eurozone economy does in the coming months. Measures of economic activity and monetary indicators are improving, and Draghi has some grounds to claim that his policies are showing signs of success. We expect further recovery in 2016 given the impact of monetary easing and the big decline in the value of the euro against the U.S. dollar over the past 18 months. However, we expect the ECB to do what it must to push inflation closer to its target rate. We think this will entail a further expansion of the central bank’s quantitative-easing program. Although our conviction level is not as high as it was this time last year, we still view an additional decline in the euro toward parity against the U.S. dollar as more likely than not.
© 2016 SEI
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Further afield, we would argue that investors have begun to factor in the impact of a sluggish Chinese economy. We see the weakening of the renminbi as a good news/bad news development. On the positive side of the ledger, it should improve the competitiveness of the industrial economy, but it shifts the pressure onto China’s neighbors. We could see a round of competitive devaluations in the region in 2016. If China can build on the tentative signs of recovery we are seeing, we believe it would be a net positive for those neighboring countries (Australia, Korea, Japan) that export commodities and semi-finished manufactured goods. In particular, we maintain a positive stance toward the Japanese equity market. Weak commodity prices are a net positive for the country’s consumers and businesses, and although the currency has appreciated in recent months on a tradeweighted basis, it remains at a far more competitive level than in 2012, before the advent of Abenomics. Corporate earnings are still trending upward and stock valuations remain the most attractive of any major region. Finally, Abenomics reform efforts continue apace and should get an additional tailwind as the recently concluded Trans-Pacific Partnership agreement is put into place over the next few years. In some ways, the outlook seems more worrisome now than at the beginning of 2015. The damage in commodities, emerging-market debt and equity, and high-yield securities suggest a sharp deterioration in global economic fundamentals. We also concede that stock-market valuations remain problematic. The current forward multiple on the S&P 500 Index is close to its high for this cycle and above the reading in mid-2007, just months before the onset of the bear market. While the multiples may be similar, the economic fundamentals are far different. Treasury bond yields, for example, were spiking in July 2007, while they remain stuck at less than half those levels today. Oil was spiking on its way to a July 2008 peak almost four times current levels. Even if bond yields rise in sympathy with short rates, they would need to climb dramatically for stock prices to fall in significant fashion. Additionally, until central banks begin to pursue tighter money policies that raise interest rates to much higher levels and cause the yield curve to invert (short-term interest rates move above longer-term rates) we will give risk assets the benefit of the doubt. Although the U.S. has embarked upon a rising interest-rate phase, even Fed policy remains quite easy by the yardstick of previous cycles. As risk rises and dispersion increases, the benefits of active management increase. Our equity investment managers maintain a pro-cyclical outlook, yet are mindful of headwinds such as rising interest rates, U.S. dollar strength, peak profit margins and low earnings growth. Fixed-income managers still seek to minimize the impact of commodity-related exposure (particularly in high yield), while emphasizing emerging-markets debt in Latin America and Africa and sharply increasing exposure to local-currency debt.
© 2016 SEI
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Benchmark Descriptions The Dow Jones Industrial Average is a widely followed market indicator based on a price-weighted average of 30 bluechip New York Stock Exchange stocks that are selected by editors of The Wall Street Journal. The S&P 500 Index is a capitalization-weighted index made up of 500 widely held U.S. large-cap companies. The NASDAQ Composite Index is a market value-weighted index of all common stocks listed on the National Association of Securities Dealers Automated Quotations (NASDAQ) system. The MSCI All Country World Index is a market capitalization-weighted index composed of over 2,000 companies, representing the market structure of 48 developed and emerging-market countries in North and South America, Europe, Africa and the Pacific Rim. The Index is calculated with net dividends reinvested in U.S. dollars. The Barclays Global Aggregate Bond Index is a market capitalization-weighted benchmark, tracks the performance of investment-grade fixed- income securities denominated in 13 currencies. The Index reflects reinvestment of all distributions and changes in market prices. The Chicago Board Options Exchange Volatility Index (VIX) tracks the expected volatility in the S&P 500 Index over the next 30 days. A higher number indicates greater volatility. The BofA Merrill Lynch US High Yield Constrained Index measures the performance of a representative basket of high-yield bonds.
Disclosures This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of SEI Funds. There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results. Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company (SEI). Neither SEI nor its subsidiaries are affiliated with your financial advisor. © 2016 SEI
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The fourth quarter witnessed an escalation in geopolitical strains, deepened distress in the oil patch and longanticipated follow through by the U.S. Federal Open Market Committee. Higher-risk fixed-income market segments decoupled, and higher-quality segments came under pressure. Global equity markets mounted a steep advance during the fourth quarter despite a setback in December.
Economic Backdrop The fourth quarter began with a combination of mixed economic reports and accommodative central bank policies that proved enough to support a recovery from third-quarter losses. A spate of attacks by religious extremists spanned four continents from late October through early December, emboldening the West’s involvement in a coalition targeting Islamic State in Iraq and Syria. Deteriorating conditions for U.S. energy companies raised concerns among high-yield bond investors, resulting in a sharp selloff that likely discouraged equity investors and kept a lid on performance as the year drew to a close. Major central bank policies commenced a long-awaited divergence late in the quarter. The U.S. Federal Open Market Committee (FOMC) raised the federal funds rate in mid-December for the first time since 2006, leaving behind a nearzero-interest-rate stance that had been in place since late 2008. The Bank of England’s Monetary Policy Committee made no changes and the European Central Bank (ECB) indicated a willingness to expand its quantitative-easing program if necessary. The Bank of Japan expanded it asset-purchase program by lengthening the average maturity of purchased Japanese government bonds and increasing purchases of broad equity-market exchange-traded funds. Reports on the U.S. manufacturing sector highlighted slowing activity in December, and initial services-sector data indicated that December’s growth was set to be the weakest of the year. Industrial production dropped in November by the most in over three years, while retail sales (excluding autos and gas) advanced by more than expected. A surge in November permits precipitated a significant advance in housing starts as new homes under construction reached a sixyear peak. New home sales continued to increase in November, while sales of existing homes tumbled. Core consumer and producer prices (which exclude food and energy) climbed during November, as consumer spending increased by considerably more than anticipated. Payrolls and personal incomes rose by more than expected but by less than in October. The unemployment rate remained unchanged at 5% and average-hourly earnings expanded by 0.2%. U.S. economic growth settled at a seasonally-adjusted annualized rate of 2% during the third quarter, down from the secondquarter rate by almost half. U.K. retail sales volumes exceeded their year-ago levels in December, but by less than expected and at the expenses of soft projections for January. This followed November’s 11-month peak in retail sales, which was attributable to broadbased improvements, although online sales contributed most. Manufacturing data indicated slower growth in December; orders and output advanced, but by less than during November. Inflation pressures remained effectively non-existent through November; consumer prices were flat, while producer prices extended significant year-over-year declines. The unemployed claimant count widened in November for the fourth consecutive month. The unemployment rate declined to 5.2% for the August-October period, while 2.4% annualized average earnings growth represented a seven-month trough. Third-quarter gross domestic product’s (GDP) final reading was revised down to 0.4%, and 2.1% year over year, below the second-quarter pace. Eurozone manufacturing data for December indicated that growth had accelerated to its fastest pace in more than 18 months. Services sector data moderated, but remained firmly in growth territory. Industrial production advanced by considerably more than expected during October, more than offsetting the prior month’s decline. Retail sales, however, continued to edge lower in October. Consumer prices fell in November after rising in October, but were positive year over year. Core prices (which exclude energy, food, alcohol and tobacco) also fell after delivering the largest year-over-year advance since 2013 in October; core prices remained considerably higher than the broad price measure. The unemployment rate dropped to 10.7% in October, reaching the lowest rate since 2012. GDP strengthened by 0.3% in the third quarter and 1.6% year over year. Government spending, private consumption and inventories climbed, but a negative trade balance prevented greater expansion. © 2016 SEI
1
Market Impact Fixed-income markets produced interesting results during the fourth quarter; the performance of traditional higher-risk market segments decoupled, and the highest-quality segments came under pressure. Foreign-currency-denominated (external) emerging-market debt was the quarter’s best performer despite giving back more than half of its advance during December. U.S. dollar-hedged (which seeks to reduce U.S. dollar-related volatility) global sovereign securities had modest gains during the quarter, trailed with positive performance only by dollar-hedged global non-government debt. Local emerging-market debt was nominally negative during the quarter, having suffered considerable losses in December. U.S. mortgage-backed securities were slightly negative during the quarter, while U.S. asset-backed securities and U.S. investment-grade corporate fixed income sustained steeper losses. U.S. Treasury Inflation-Protected Securities had more significant losses, trailed on the downside by unhedged global non-government debt, U.S. Treasurys and then unhedged global sovereign securities. U.S. high-yield bonds had the worst performance, with the quarter’s entire loss essentially attributable to December performance, stemming from energy sector weakness. Global equity markets, as reflected by the components of the MSCI AC World Index (Net), mounted a steep advance during the fourth quarter despite a setback in December; however, full-year 2015 performance was negative. Regionally, Asia Pacific delivered the fourth quarter’s most outsized returns; Indonesia and New Zealand were the top two performers, while Australia, Japan and Malaysia followed closely behind. Several European countries also had strong returns, led by Belgium, Hungary and Finland. The U.S. had a strong quarter, while the U.K. was modestly positive. Latin America struggled, as did much of the peripheral Europe, with Greece and Poland delivering the poorest performances. Global sectors were positive outside of energy, which had a comparably small decline relative to its full-year performance. Information technology was the fourth quarter’s top performing sector, followed by healthcare, industrials and the consumer sectors. Index Data for Fourth Quarter The Dow Jones Industrial Average Index returned 7.70%. The S&P 500 Index rose7.04%. The NASDAQ Composite Index returned 8.71%. The MSCI AC World Index (Net), used to gauge global equity performance, advanced by 5.03%. The Barclays Global Aggregate Index, which represents global bond markets, fell by 0.92%. The Chicago Board Options Exchange Volatility Index, a measure of implied volatility in the S&P 500 Index that is also known as the “fear index”, decreased in the quarter as a whole, moving from 24.50 to 18.21. WTI Cushing crude oil prices, a key indicator of movements in the oil market, moved from $45.09 a barrel at the end of September to $37.04 on the last day in December. The U.S. dollar strengthened against the euro, sterling and yen during the quarter. The U.S. dollar ended December at $1.09 against the euro, $1.47 versus sterling and at 120.3 yen. Portfolio Review U.S. equities rebounded during the fourth quarter, led by large companies in an environment that favored growth strategies. Large-cap positioning was challenged due to stock selection within consumer discretionary, healthcare, materials and industrials, with the poorest results driven by selection in the latter two sectors within value strategies. Small-cap positioning also struggled as adverse selection in healthcare, industrials and technology outweighed strong selection in consumer discretionary. A slight overweight to energy also detracted. Overseas results kept pace with international equity markets; stock selection was positive but regional allocation detracted. The strongest results were produced in Europe, while Japan and the broader Pacific region made considerable contributions despite an underweight that detracted from overall performance. Off-benchmark exposures, specifically to Korea and Canada, were negative. Within emerging-market equities, positive results were driven primarily by stock selection. Emerging Asia positions were the top contributors, but Europe, the Middle East, Africa and Latin America were also additive. An overweight to the information technology sector in both developed and emerging markets was a key source of outperformance. Core fixed income benefitted from non-government sector performance during the quarter. A slightly short-duration posture was additive as U.S. Treasury yields increased in anticipation of the FOMC rate hike, and a yield-curve-flattening bias was supported by the comparably greater increase in short-term Treasury yields than long-term rates. Overweights to corporate bonds, particularly financials, and non-agency mortgages contributed, while overweights to asset-backed securities and commercial mortgage-backed securities detracted. An underweight to agency mortgages also weighed on performance. The high-yield market suffered its second consecutive quarter of material losses and ended the year in negative territory for the first time since 2008. The energy sector was down nearly 13% for the quarter, but other sectors ― retail, telecommunications, media and healthcare ― also exhibited signs of weakness. Underweights and selection within basic materials and services, along with an overweight and selection within technology and electronics, contributed. Selection within retail, healthcare and (an underweight to) financial services detracted. Emerging-market debt had a © 2016 SEI
2
positive fourth quarter supported by external debt as most local currencies weakened relative to the U.S. dollar. Several currencies, however, strengthened meaningfully, including the Indonesian rupiah; an overweight to Indonesia was the quarter’s top contributor. An underweight to South Africa also benefitted relative performance amid currency weakness, while an underweight to Malaysian debt detracted. In Latin America, an overweight to Argentina contributed, while an overweight to Brazil was the most notable drag on performance. Manager Positioning and Opportunities SEI’s portfolio managers rely on investment-manager selection and portfolio construction in an effort to deliver diversified sources of excess return for our portfolios. Our positioning anticipates the late stages of a market expansion and we expect increased volatility as markets try to balance encouraging U.S. economic data with continued emerging-market pressures and a weak commodity sector. We continue to support our deep value managers who have the most exposure to troubled parts of the market. Valuations and the risk-reward profile are becoming more attractive in these spaces, but the timing of a rebound is uncertain as the catalyst remains unclear. Longer term, we look to slowly build exposure to stability as the expansion matures. Our base case favors quality growth until concerns are resolved by either a risk-on (healing of energy) or risk-off (emerging-market contagion) environment. We retain a rather constructive view on international developed equity markets like the eurozone and Japan as fundamentals remain attractive and ongoing policy support is likely creating a more supportive macro-economic backdrop, although plenty of risks remain. Nevertheless, we remain pro-cyclically positioned and favor higher-quality, more-profitable companies. After a significant drop in emergingmarket equity prices and a strong negative news flow, the asset class appears more tempting. We believe it is time to consider exposure to the asset class, especially for long-term investors, but it is necessary to differentiate between regions and countries as the risks and opportunities are quite diverse. The duration posture within investment-grade fixed income remains slightly short to neutral since interest rates remain within a relatively narrow range, with a continued yield-curve-flattening bias. Credit spreads narrowed during the fourth quarter and we have been adding risk selectively. An underweight to the industrial corporate sector has been reduced, but we are slightly underweight corporate bonds despite a continued overweight to financials. We also maintained an underweight to agency mortgages. Within high yield, default rates remain below historical averages but have been trending higher and could approach or exceed those levels in the next year if market stress spreads. However, the volume of upcoming maturities through 2017 appears to be manageable based on new issue figures from the past few years. We maintain a slightly more defensive posture via bank loan and cash allocations, and remain underweight the energy sector as well as metals and mining (excluding steel), a subsector of basic materials. We will be selective in new purchases given ongoing volatility and will continue to assess bank loan opportunities especially when valuations appear attractive versus BB-rated bonds. Positioning within emerging markets remains underweight external debt and overweight corporate bonds. The largest external debt positions are within Indonesia, Brazil, Venezuela, Mexico, Turkey, and Argentina. An underweight to local-currency debt also remains, with significant overweights in India, Indonesia and Russia. The biggest currency overweights are in countries that stand to benefit from the decline in commodity prices, such as India, while the most significant underweights are in low-yielding Asian currencies (Thai baht, Malaysian ringgit). Our View The volatility of the past year and the pain felt in certain asset classes reminds us more of the 2011 experience than the calamitous tumult of 2008. We believe that the proper course is to maintain exposure to risk assets and continue buying selectively on the dips. We still like the odds of equities outperforming fixed income. The much-anticipated “lift-off” move that raised the federal funds rate is more akin to launching a hot-air balloon than a rocket. Our base case for 2016 is for more of the same: we expect yields to move slowly higher, much closer to the market’s expectations than those expressed by the FOMC members. The first few hikes in the federal funds rate ordinarily are taken in stride by the equity market — and for good reason. The Fed has no desire to lean hard against the economic expansion. ECB President Mario Draghi claims that the central bank stands ready to do more, if necessary, but it all comes down to how the eurozone economy does in the coming months. Measures of economic activity and monetary indicators are improving, and Draghi has some grounds to claim that his policies are showing signs of success. We expect further recovery in 2016 given the impact of monetary easing and the big decline in the value of the euro against the U.S. dollar over the past 18 months. However, we expect the ECB to do what it must to push inflation closer to its target rate. We think this will entail a further expansion of the central bank’s quantitative-easing program. Although our conviction level is not as high as it was this time last year, we still view an additional decline in the euro toward parity against the U.S. dollar as more likely than not.
© 2016 SEI
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Further afield, we would argue that investors have begun to factor in the impact of a sluggish Chinese economy. We see the weakening of the renminbi as a good news/bad news development. On the positive side of the ledger, it should improve the competitiveness of the industrial economy, but it shifts the pressure onto China’s neighbors. We could see a round of competitive devaluations in the region in 2016. If China can build on the tentative signs of recovery we are seeing, we believe it would be a net positive for those neighboring countries (Australia, Korea, Japan) that export commodities and semi-finished manufactured goods. In particular, we maintain a positive stance toward the Japanese equity market. Weak commodity prices are a net positive for the country’s consumers and businesses, and although the currency has appreciated in recent months on a tradeweighted basis, it remains at a far more competitive level than in 2012, before the advent of Abenomics. Corporate earnings are still trending upward and stock valuations remain the most attractive of any major region. Finally, Abenomics reform efforts continue apace and should get an additional tailwind as the recently concluded Trans-Pacific Partnership agreement is put into place over the next few years. In some ways, the outlook seems more worrisome now than at the beginning of 2015. The damage in commodities, emerging-market debt and equity, and high-yield securities suggest a sharp deterioration in global economic fundamentals. We also concede that stock-market valuations remain problematic. The current forward multiple on the S&P 500 Index is close to its high for this cycle and above the reading in mid-2007, just months before the onset of the bear market. While the multiples may be similar, the economic fundamentals are far different. Treasury bond yields, for example, were spiking in July 2007, while they remain stuck at less than half those levels today. Oil was spiking on its way to a July 2008 peak almost four times current levels. Even if bond yields rise in sympathy with short rates, they would need to climb dramatically for stock prices to fall in significant fashion. Additionally, until central banks begin to pursue tighter money policies that raise interest rates to much higher levels and cause the yield curve to invert (short-term interest rates move above longer-term rates) we will give risk assets the benefit of the doubt. Although the U.S. has embarked upon a rising interest-rate phase, even Fed policy remains quite easy by the yardstick of previous cycles. As risk rises and dispersion increases, the benefits of active management increase. Our equity investment managers maintain a pro-cyclical outlook, yet are mindful of headwinds such as rising interest rates, U.S. dollar strength, peak profit margins and low earnings growth. Fixed-income managers still seek to minimize the impact of commodity-related exposure (particularly in high yield), while emphasizing emerging-markets debt in Latin America and Africa and sharply increasing exposure to local-currency debt.
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Benchmark Descriptions The Dow Jones Industrial Average is a widely followed market indicator based on a price-weighted average of 30 bluechip New York Stock Exchange stocks that are selected by editors of The Wall Street Journal. The S&P 500 Index is a capitalization-weighted index made up of 500 widely held U.S. large-cap companies. The NASDAQ Composite Index is a market value-weighted index of all common stocks listed on the National Association of Securities Dealers Automated Quotations (NASDAQ) system. The MSCI All Country World Index is a market capitalization-weighted index composed of over 2,000 companies, representing the market structure of 48 developed and emerging-market countries in North and South America, Europe, Africa and the Pacific Rim. The Index is calculated with net dividends reinvested in U.S. dollars. The Barclays Global Aggregate Bond Index is a market capitalization-weighted benchmark, tracks the performance of investment-grade fixed- income securities denominated in 13 currencies. The Index reflects reinvestment of all distributions and changes in market prices. The Chicago Board Options Exchange Volatility Index (VIX) tracks the expected volatility in the S&P 500 Index over the next 30 days. A higher number indicates greater volatility. The BofA Merrill Lynch US High Yield Constrained Index measures the performance of a representative basket of high-yield bonds.
Disclosures This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of SEI Funds. There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results. Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company (SEI). Neither SEI nor its subsidiaries are affiliated with your financial advisor. © 2016 SEI
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