Facing extreme market volatility and uncertainty, we’re showing longer-term patience and perspective

 

 

 

In the spring of 2008 the vast majority of individual country leading indicators were contracting, whereas the most recent readings have the vast majority expanding. Then, as now, select country and select banking sector credit default swaps (CDS) “insurance prices” were rising. However, so far, the average of all sovereigns has not changed much, and the banking sector contagion has been more contained. Capital reserves for most global banks are in better shape now than they were in 2008. Federal Loan Officer Surveys showed continued tightening in 2008 versus the steady easing trends over past months. The U.S. dollar has spiked higher, but unlike in 2008, when almost all currencies declined relative to the dollar, the weakness is focused in the euro.

 

Unlike in 2008, when the Fund was fully exposed to foreign currencies, we have been hedging off roughly half of the euro, the pounds sterling (GBP), the Canadian dollar (CAD), and the South African rand (ZAR), and have had a 25 percent hedge on the Brazilian real (BRL), which we might take to 50 percent. More specifically, we have less than 1 percent exposure to continental Europe, but we do have a few stocks listed in the United Kingdom. We would have been better positioned if we’d had those fully hedged. We have generally left the Asian currencies unhedged because they have been supported by stronger domestic conditions; however, we may put on partial hedges there, too. We will leave the Hong Kong dollar (HKD) unhedged, as we think it will go higher. Between U.S.-based investments, foreign investments and USD-based American Depository Receipts (ADRs), more than two thirds of the Fund is in USD-based assets, about 15 percent exposed to global currencies.

 

So, like in 2008, the USD rally has caused global resource indices quoted back into USD to temporarily underperform U.S.-based resource indices by several percentage points, which had a small and temporary impact on the fund. Post 2008, many companies have been restructured, taken over or been able to refinance and pay down debt, reducing their balance-sheet risk. Corporate bond yields are currently flat to down in contrast to the increase throughout 2008. Then, as now, China was looking to slow its growth and domestic inflation pressures. The Chinese property slowdown has been part of the reason for an underperformance off the highs in the basic materials sector. However, China is also now much more aware of its growing role on the world stage. While it is serious about arresting housing inflation, Chinese leaders have already expressed awareness of the risks of over-tightening. Then, as now, the resources sector has been the whipping boy for renewed recession scare, but in contrast to 2008, neither the average CDS prices for metals nor the energy sectors have come unglued.

 

 

Like most investors, investment managers and advisors are being worn down by pervasive market volatility. Nonetheless, our refrain remains to “hang tough” in fast- moving, volatile markets, underreacting often works better than overreacting. The market is not wrong to claim there are near-term headwinds, and this has given momentum traders an excuse to shoot first, ask questions later. However, we continue to view the long-term opportunity in emerging markets, leading international equities and resources as attractive, driven by margin discipline and challenges to supply as well as demand growth. We believe select, rather stark short-term declines, particularly in resources, are over-discounting economic pull-back risks.

 

Even with the negative Euro headlines, we still remain leery about losing our investment positions in the context of our expectation for moderate global expansion and resumed bull market activity post consolidation/pullbacks. In recent weeks we nonetheless raised 3 to 5 percent cash and layered in an additional approximate 7 percent hedge using listed futures of the resource-heavy Canadian stock. More recently, we have added roughly the same using S&P 500 Index (SPX) minis. A good number of stocks in various sectors around the world are holding up quite well, reflecting decent prospects, which suggests a decent-sized pullback is more likely than a renewed, broad-based bear market. We are prepared to hold this position for a few months and may even add to it, but we may reduce it if markets stabilize. We expect we will be fully invested for the fourth quarter.

 

What has been particularly challenging is that the biggest pullbacks in recent months have been in areas that arguably have the best long-term franchise value. The BRIC countries (Brazil, Russia, India and China), led by China, appear the strongest, but their stock markets have been laggards. Copper, iron ore and metallurgical coal have been the leaders coming out of last year’s lows. However, investors with a short-term perspective have been leaning on these stocks. One justification has been the suggested super profits punitive taxation Australia is considering imposing. Companies like Rio Tinto (2.2% of fund holdings as of May 15, 2010), have seen their shares under pressure to levels that price in a go-forward 30 to 40 percent decline in metals prices. The industry is rapidly responding by shelving or reducing go-forward capital investment. The more investment in additional supply gets delayed, the less likely we will see a meaningful sustained decline in metals prices. We also suspect active public discussion about potentially hurting the very investments that have helped bring prosperity to the country. In the end we expect some tax increase, but not the full measure proposed. Metallurgical coal producers have also been affected by China construction concerns, including several of the Fund’s holdings. The companies acknowledge a slightly softer market in China, but the accident in Russia’s biggest met coal mine (no exposure in the Fund) will serve to tighten supply, too. We don’t like the pullback in coal shares, but we do like the outlook for current and future cash generation.

 

 

The Gulf of Mexico is the source of 20 percent of U.S. oil production and more than 10 percent of U.S. natural gas. The world needs to continue to pursue the more-difficult-to find and harder-to-produce oil because there just isn’t enough of the easily accessible oil. At the end of the quarter, the Fund had substantial exposure to three world-class services companies; Halliburton (3.8% of fund holdings as of May 15, 2010), Cameron (2.5% of fund holdings as of May 15, 2010) and TransOcean (0.0% of fund holdings as of May 15, 2010). It did not hold BP, the rig operator, nor junior partner Anadarko. We believe Halliburton and Cameron will ultimately be less impacted than the market first factored in and the steadying of the shares seems to support this. However, the pace of offshore drilling worldwide will be slowed. Ahead of the spill, we had transferred some holdings to Seadrill for more international exposure; we subsequently transferred more and progressively sold down and ultimately out of TransOcean and another oil services firm, Noble (1.0% of fund holdings as of May 15, 2010), at prices that were more of a give back of prior gains than meaningful losses. These shares, along with BP, are quickly approaching deep value, but they may be value traps for a while.

 

In addition, favoring oil, the Fund had smaller holdings in companies that plan to develop offshore oil fields. Unfortunately these plans will be slowed, impacting share progress. We partially sold down positions to augment holdings in companies that may be earlier participants in the next round of advances. In aggregate, we estimate this cost the Fund a couple of basis points in both absolute and relative performance.

 

On a brighter note, equipment provided by premium companies should command superior margins, and the hurdle for new companies considering entering the offshore services industry likely has become insurmountable. This should be good for franchise value and is one reason we are holding Cameron.

 

One potential and less obvious implication is that onshore production will be valued more over time, benefiting companies like Occidental (2.5% of fund holdings as of May 15, 2010). This holding is valued attractively and performing very well at the operational level, but trading lower short-term due to macro issues. Tar sands in Canada could also be assessed higher over time, and we are adding to our oil-sands holdings. Oil was climbing to the higher end in April, but is now closer to the lower-end. It might slip a little lower, but in the past when the near month futures price has traded much lower than the second and third month prices, as is now the case, oil has tended to bottom and rise within the next one to two months. The U.S.-based West Texas Intermediate price is also reflecting higher inventories, causing these often-quoted prices to trail global prices. We expect prices to firm at these lower levels and then rise again, and we would not be surprised to see new rally highs into early next year.

 

 

We believe natural gas is making an important rolling bottom, quietly rising from nearly decade-long lows. Gulf supply constraints, less drilling to hold acreage and a shift in drilling to chase more oil and liquids will be part of the mix in making the turn. Elevated temperatures in some Atlantic Ocean currents may drive increased hurricane activity. This is an under-owned sector and a long-term upturn could create attractive new investment opportunities for several years. We have highlighted a softer way to first invest, through producers that have big infrastructure assets too. El Paso (3.0% of fund holdings as of May 15, 2010) and Williams (2.1% of fund holdings as of May 15, 2010) are good examples. El Paso was one company in 2008 that was under financial duress as it tried to secure funding for projects that it had committed to. Now the company has its funding in place and is proceeding with value-creating projects while at the same time making good progress in its exploration business. The shares of these companies were advancing to new recovery highs just a few weeks ago and we would expect them to resume that trend once macro noise clears.

 

 

The recent events in Europe and a near-term moderation in the growth rate in China have investors questioning future demand for resources. Further deterioration of global CDS rates, a widening of credit spreads, a broadening of currency pressures and hostile policy language from China are all triggers that could get us more defensive. On the other hand, interest rates hikes will be pushed out, and a turn down in CDS rates, an upturn in Chinese equities or more supportive Chinese policy, or simply continued operational success could turn the shares higher again. Sometimes a simple exhaustion of the selling and new opportunistic buying is all it takes.

 

Volatility in resources remains extreme. In addition to the primary broad macro headlines and equity market selloff, an unforeseeable disaster in the Gulf, a larger selloff in basic materials, and now somewhat too early steps to get deeper into the energy trade have all impacted Fund performance. It is hard to offer compelling “must buy now” catalysts in the context of “sell in May, buy later in the year,” but energy stocks and gold can often bottom earlier. Stocks have already come down, we still like the diversified approach, and valuations are attractive enough with a number of companies likely to deliver double- digit free cash flow for us to maintain holdings and judiciously add more in the context of balanced portfolios.

 

In prior periods resources have demonstrated a pattern of early stock market recovery gains, a shake-out pullback and then a more sustained uptrend over continued economic expansion. As long-term investors in resources, we expect the natural consequence of economic skittishness and policy mistakes will be an underinvestment in supply. While the immediate trend has been negative, these are amongst the reasons in a normalized economic period we would still expect commodity prices and resource shares to trend meaningfully higher. Some more patience may be necessary short-term, but the multi-year potential should be worth it.

 

Ivy Funds is an exceptional combination of investment managers that offers global reach and capabilities to advisors and their clients. Ivy seeks to enable its fund shareholders to remain comfortably committed to their long-term goals. We are:

 

Proven: We’re part of an organization whose roots date to 1937, with an investment style emphasizing participation in positive markets and, especially, seeking to manage risk.

 

Focused: We do our own work, believe in our own research and act on our own ideas. Our steady approach is guided by a belief in fundamentals over fads.

 

Constant: We say what we mean, and do what we say. What we value most, and remember every day, is the trust that we have earned, and must continue to earn, from our shareholders.

 

The Ivy Funds are managed by Ivy Investment Management Company and distributed by its subsidiary, Ivy Funds Distributor, Inc.

 

Past performance is not a guarantee of future results. The opinions expressed are those of the Fund 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 May 12, 2010, and are subject to change due to market conditions or other factors.

 

Consider all factors. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification. 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. Investing in natural resources can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments; and the cost assumed by natural resource companies in complying with environmental and safety regulations. 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. 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 with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These and other risks are more fully describe in the fund’s prospectus.