Separating volatility from risk is key as we look to 2012
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Mike Avery
Ryan Caldwell
Co-Portfolio Managers
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Ivy Asset Strategy Fund – January 2012
Challenging 2011 prompts cautious growth outlook
The Ivy Asset Strategy Fund closed a challenging 2011 with an ongoing focus on opportunities in equities, particularly in U.S. companies. Co-portfolio managers Mike Avery and Ryan Caldwell review the events that supported the emphasis on equities markets and offer an outlook for 2012.
The background for equities
Despite a “double-dip” scare early in the year, recession did not return to the U.S. in 2011 and we do not expect one in 2012. The Federal Reserve has indicated it will keep interest rates at current levels next year, so money will remain very cheap. And it’s hard to have a recession when the cyclical sectors of the economy, such as housing and auto production, have yet to fully recover.
In addition, U.S. corporate balance sheets appear to be in very good shape because of actions companies took after the 2008 credit crisis to reduce costs and raise cash. As a result, we think companies are likely to maintain high margins next year. We also think the U.S. is likely to continue to be considered a “safe haven” investment option, as was shown in late 2011 despite a credit rating downgrade by Standard & Poor’s in August.
In our view, equities are inexpensive whether analyzed by forward price/earnings ratio or the equity risk premium (ERP). The ERP is the concept that investors should be compensated for taking additional risk, and it can be used to compare how equities are priced relative to bonds. Our current calculation of the ERP suggests that equities have not been this inexpensive relative to bonds since the late 1970s, and that conclusion is one important factor for the Fund favoring equities over long-duration, fixed-income securities.
Separating volatility and risk
While equities markets have been volatile this year, we think it’s important to separate volatility and risk — the concepts are not interchangeable. It can be very difficult to accurately assess and price risk, but we believe equities markets are focused appropriately on pricing risk now. The correlation among various global equities markets has increased to historically high levels, indicating that markets believe all risk is systemic or common across the asset class, and generally is not specific to location or market capitalization.
But we do not think risk is as clearly priced in the fixed income markets, with the exception of municipal and high yield securities. Volatility in fixed income markets overall has been lower and the returns have been solid, leading many investors to move to those securities. We continue to think that extreme risk aversion has driven up the price of assets that are perceived to be safe and has driven down the price of assets that may participate in future growth.
In the intermediate to longer term, we do not see fixed income as a safe haven and anticipate much higher volatility and much more risk than what the market is assigning now with
U.S. interest rates at historic lows. In our view, many investors are taking on risk simply to avoid that volatility. When fixed income investors perceive that U.S. inflationary pressures are building, leading to a future rise in interest rates, we think they will be forced to move out of fixed income or risk leaving their money tied up in investments paying comparatively low yields. If this reallocation occurs, we think equities are likely to benefit, particularly in relation to fixed income investments.
Next steps in Europe
The European equities in the Fund are focused on companies with a combination of products or services that are geared to the emerging middle class globally, and on those with a cost advantage. We expect to continue this approach in the near term.
In looking back at 2011, we had expected Europe’s leaders to find a solution to the region’s sovereign debt crisis. The problem is well understood, given the near impossibility of having monetary union without fiscal union. Recent actions by the European Central Bank amount to aggressive monetary easing, and we expect such efforts will continue in order to bring down the cost of capital for the European Union (EU) countries that are struggling with their debt loads.
We think a credible fiscal union of some type is required to allow the transfer of capital from the stronger EU members to the weaker, less competitive ones. Nevertheless, from an investor’s perspective, we think that recent actions by EU leaders are likely to be interpreted positively and have been reflected in equities prices.
The future of the euro currency also has been in question as a result of the sovereign debt crisis, but we do not expect any major changes in the single-currency union in the near term. It’s important to remember that Germany is a major beneficiary of the eurozone because 40 percent of its economy is export based. Germany is in an export boom, which has added jobs. Companies there have benefitted from spreading their supply chains around the eurozone, reducing labor costs and becoming very productive and competitive. But that situation would change without the euro currency.
If the eurozone were to break apart and Germany were to return to the deutsche mark, economists and currency strategists estimate the mark would show significant appreciation against the U.S. dollar and most major currencies. Germany’s exports would be likely to decline because its costs no longer would be competitive, and its unemployment rate probably would increase over time.
So we conclude that it’s in nobody’s best interest for the euro to fall apart or for countries to exit the currency union. We do see an intermediate to longer term risk if the debtor countries — especially Spain and Italy — cannot achieve the austerity required to manage their debt. We expect total debt around the world to increase in 2012 — sovereign, corporate and private. Central banks and governments have been easing steadily since mid-2011 in response to slow economic growth. The world is desperate for growth and governments are acting desperately to generate that growth, thereby proliferating what we see as a very big credit cycle.
As economies reaccelerate, which we expect around the second half of 2012, we think the year could provide a positive growth surprise, especially relative to some economists’ forecasts for U.S. gross domestic product (GDP) growth at only 1 to 2 percent. That range looks a little low to us. We may see central banks start to tighten liquidity in the future as growth accelerates, especially in the U.S. and China — the world’s largest economies.
China’s economic future
China’s economy has been the target of a “hard landing” scare, but we see no evidence of a hard landing on the horizon. After the onset of the 2008 credit crisis, China began a very aggressive fiscal stimulus program and it worked — in fact, it worked too well. China’s 2009 GDP growth exceeded 10 percent, which is a level that the government knew was not sustainable. In 2010, China began increasing interest rates and tightening lending requirements as part of a concerted effort to slow its growth. Over the course of 2010 and 2011, that effort succeeded in slowing the Chinese economy. China now is gradually easing monetary and fiscal policy, but the full benefit of those actions won’t be seen until the second or third quarter of 2012.
Perhaps more significantly, it appears that inflation in China peaked several months ago. November inflation was below 5 percent, December is forecast around 4 percent, and inflation is expected to stay around 4 percent at least through early 2012. Declining inflation should give China the leeway to continue its monetary easing, which we think will lead to an environment that is friendly to equities.
To reiterate, the information we have learned through our research and travels to China does not support fears of a hard economic landing. In fact, across Asia, we think there are markets that could grow faster with more infrastructure and more fixed asset investment in place, and this includes parts of western China.
Cautious outlook for growth
The aggressive policy intervention across the globe may have positive effects on economic growth. We estimate U.S. fourth-quarter 2011 GDP growth at 3 to 4 percent, and think 2 to 3 percent growth is likely in 2012. As a result of the 2008 credit crisis, policy makers moved aggressively to avoid a deflationary spiral that could have led to an economic depression. But we do not see an indication of widespread deflation in any of the economic statistics. We do see inflation in the global economy, however, and believe there is a risk that the aggressive monetary easing could cause mispricing in the long term. With an aggressive monetary policy and currency risk, we expect to maintain a gold position as a means to manage that risk.
These factors overall eventually will present a new challenge in identifying the next “safe haven” investment. In pursuing this challenge, we will stay true to our mandate by researching all markets and asset classes, identifying what we feel are the best investment opportunities, managing risk, and ultimately doing what is in the best interest of our shareholders.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Jan. 3, 2012, and are subject to change due to market conditions or other factors.
Risk Factors: As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. These and other risks are more fully described in the Fund’s prospectus. The Fund may allocate from 0-100 percent of its assets between stocks, bonds and short-term instruments, across domestic and foreign securities, therefore, the Fund may invest up to 100 percent of its assets in foreign securities. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The Fund may focus its investments in certain regions or industries, thereby increasing its potential vulnerability to market volatility. The Fund may use short-selling or derivatives to hedge various instruments, for risk management purposes or to increase investment income or gain in the Fund. These techniques involve additional risk, as short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss for the Fund, and the value of investments in derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative’s value is derived. Investing in physical commodities, such as gold, exposes the Fund to other risk considerations such as potentially severe price fluctuations over short periods of time and storage costs that exceed the custodial and/or brokerage costs associated with the Fund’s other holdings. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/ dealers.
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