Mary's Defensive Market Moves

07/23/2004 12:00 am EST


Mary Farrell is the brilliant chief investment strategist for UBS Wealth Management USA. Her quarterly market reviews, nearly 40 pages long, is an all-encompassing wealth of investment information. Here are excerpts from her recently completed 2nd quarter report.

"In our last Quarterly Market Outlook in April, we provided key signposts to look for as investors anticipated rising interest rates. Specifically, what we were waiting for - sustained job growth, higher inflation, a Fed rate hike, robust corporate profits, and increased geopolitical risk - has occurred over the past three months.

  • Sustainable job creation. After losing 2.7 million jobs from March 2001 to August 2003, the U.S. economy has retraced more than half those job losses in the last 10 months, with an increase of over 1.5 million jobs.
  • Higher inflation. Headline CPI has jumped from a year-over-year change in March 2004 of 1.7% to 3.0% as of May 2004.
  • A fed rate hike. The Fed raised the federal funds rate 25 basis points at the June 30 FOMC meeting.
  • Corporate profits. First quarter 2004 S&P 500 profits came in far above consensus at $15.87—registering a 26% year-over-year gain, and a noteworthy eight percentage points higher than consensus expectations at the end of quarter.
  • Geopolitical risk. As the handover of formal sovereignty approached, violence escalated in Iraq.

"How have financial markets reacted? The S&P 500 gained 3% in the first six months of 2004, but it was hardly a steady rise (see chart 2). During the first three months of the year, financial markets waited with bated breath for labor market reports (weekly jobless claims, monthly employment situation) to confirm the economy had moved from the recovery stage of the cycle to self-sustained expansion. Once confirmed, markets quickly turned to fears of escalating inflation and sharply rising oil prices, reacting from ‘data release to data release’.

"We’ve previously discussed the five I’s, or the five most important risk factors concerning markets: Inflation, interest rates, increased prices at the pump, Iraq, and incumbent or challenger (election 2004) were the chief concerns of financial markets during the first half of the year, and continue to be uncertainties going forward. Importantly, all five are interrelated: Inflation should drive interest rates; Iraq unrest is a part of the oil pricing story, which feeds directly into commodity inflation; geopolitics are front and center in election 2004, the winner of which could impact policy that may, in turn, affect Iraq, energy pricing, inflation, and, ultimately, interest rates.

  • Regarding interest rates, our ‘peak’ concern is that the onset of the tightening cycle could end the rally in stocks that began in March 2003. However, our take is that the average stock market gain in years with rising bond yield is a robust 12.3%. With Fed tightening to remain at a measured pace and CPI inflation to moderate the average stock market gain in years with rising bond yield is a robust 12.3%. With Fed tightening to remain at a measured. pace and CPI inflation to moderate around 2.5% by year-end 2004, according to UBS forecasts, rising rates are unlikely to have a significant negative impact on equity market returns.

  • Regarding inflation, our chief concern is that the Fed’s ‘looser for longer’ policy has left it behind the curve, and could lead to higher than desired levels of inflation, leading to a more aggressive and less measured tightening cycle. For now, we’d note that UBS chief US economist Maury Harris believes core inflation will moderate over the remainder of the year, after rising by 1.7% year over year through May. To date in 2004, the Fed's preferred inflation gauge, the PCE deflator, has risen 2.3% annualized, far above the Fed's forecast of 1.25% for the year. If inflation moderates, the Fed is likely to be able to maintain a ‘measured’ approach in raising rates; if not, then Fed policy may be more aggressive. Upcoming inflation data releases will be key.

  • Regarding Iraq, our chief concern is that global terrorist attacks could raise the equity risk premium, capping stock valuations and raising energy An earlier than expected transfer of power has opened a new page in the Iraq storybook, however increasing violence from insurgents is unlikely to abate soon. Geopolitical risk is the hardest to quantify or anticipate and remains the key wild card in market valuations.

  • Regarding the election, a close election would likely offer no guidance to policy initiatives until markets, on average, tend to exhibit normal returns in the months leading up to an election. Gridlock on Capital Hill is actually a historical positive for the markets.

  • Finally, regarding rising energy costs, our peak fear is that these costs could take a toll on the consumer, weakening the economic recovery. For now, UBS energy analysts forecast oil at $35.60 by year-end 2004, $28.00 by 2005, and $25.00 by 2006. WTI spot oil prices peaked at $42.35 on June 1, but are down 12.5% as of June 30. While energy prices should continue to moderate through 2004 and 2005, increased levels of global demand will keep prices high relative to recent historical norms, and upside surprises could result from terror-related supply disruptions.

"We are entering the fifth Fed tightening cycle since 1982. In each of the prior four cycles, stocks outperformed bonds in both the subsequent six- and 12-month periods. Rising rates, in and of themselves, are not an absolute negative for equities, since the cause of rising rates is typically an economic expansion, which boosts corporate profits, a positive for stocks. With the aggregate market likely to remain range-bound between 1,050-1,250, the importance of sector and stock selection is paramount to overall portfolio performance.

"A rising rate environment has typically benefited defensive sectors. We believe investors should consider the level of risk in addition to the absolute expected return. Incorporating risk, as defined here by the standard deviation of sector returns for the past 60 months, we calculated a level of risk-adjusted expected return for each sector. Consumer staples seem the most attractive, along with consumer discretionary, financials, materials, and tech, on a risk-adjusted basis. Selected stocks assigned "buy" recommendations by UBS in the five most attractive sectors by risk-adjusted expected return are listed below:

Consumer Staples

Sysco (SYY NYSE)
Pepsico (PEP NYSE)
Wal-Mart (WMT NYSE)
Gillette (G NYSE)
Procter & Gamble (PG NYSE)

Consumer Discretionary

Centex (CTX NYSE)
Kohl's (KSS NYSE)

McDonald's (MCD NYSE)


Fannie Mae (FNM NYSE)
Freddie Mac
American Intl Group (AIG NYSE)
ACE Limited (ACE NYSE)
Merrill Lynch (MER NYSE)


Bowater (BOW NYSE)
Weyerhaeuser (WY NYSE)

Air Prod. & Chem.
Newmont Mining

Information Technology:

Texas Instruments
Linear Technology (LLTC NADSAQ)
First Data (FDC NYSE)

"The Fed has initiated a tightening cycle that will now likely extend well into 2005. Just how well braced is the bond market for such a cycle? The bond market’s favorable reaction to the June rate hike suggests that a shift in monetary policy was already fully discounted. Yields had risen sharply well ahead of the June rate hike, with the short/intermediate sector once again bearing the brunt of this re-pricing. Against this backdrop, bonds appear much better braced for the policy shift than they were just three months ago. Bonds also appear much better braced for Fed tightening than they were back in 1994, which was the most aggressive tightening campaign in recent memory and also marks the worst single-year performance for bonds in a generation. What made the 1994 tightening cycle so acute was not only the magnitude of the rate hikes, but also how complacent forward curves were in pricing for the impact of a policy shift. This time around, market participants have been much more aggressive in responding to the threat of a protracted cycle. But while bonds are much better positioned for the beginning of the tightening cycle than they were back in 1994, or even just three months ago, it remains our view that yields are biased higher as the Fed continues the process of raising rates.

"While bonds are arguably much better positioned for a shift in monetary policy than they were either three months ago (or just prior to the 1994 cycle) as evidenced by the post-meeting rally, the notion that yields already fully reflect the full impact from a tightening cycle strikes us as wishful thinking. Keep in mind that a tightening cycle, regardless of how measured it may ultimately turn out to be, is never an entirely benign affair. And with the target funds rate still at least 225 basis points below what many consider to be a neutral policy stance, the current cycle is apt to be an extended one, in our view. Of course, bond yields could well peak out before the end of the tightening cycle: this is exactly what happened back in 1994. However, as we see it, it is difficult to imagine a scenario where yields crest just as the tightening cycle begins. The recent mini-rally following the FOMC meeting and weaker than expected jobs report is symptomatic of a bond market struggling with assessing the aggressiveness of future Fed policy, not the direction of that policy. So, while yields had risen sharply in anticipation of a policy shift, bondholders remain in harm’s way as the Fed embarks on a tightening cycle that is likely to extend well into 2005. Against this still-threatening backdrop, we recommend:

  • Retain a duration underweight.
  • Continue to overweight spread product (non-treasuries).
  • Stick with premium paper.
  • Selective floating rate debt; with the Fed now poised to begin the process of raising rates, floating rate debt now offers a more attractive return profile over the balance of the next six-12 months.

"In conclusion, we expect stock prices to be relatively stronger this tightening cycle. Additionally, greater stability of dividends, lack of alternatives to replace income, lower fund durations and the projected ‘measured’ pace of future Fed rate hikes relative to past cycles should provide these funds with better performance than previous tightening cycles. The greatest risk to these funds is rates rising faster, and by a greater amount, than anticipated. Among municipal funds, we point investors to two (on which we maintain a neutral rating) for the stability of their dividends and sizeable cushions of undistributed net investment income (cushions) BlackRock Investment Quality Municipal (BKN NYSE) and BlackRock Municipal Income Trust (BFK NYSE). Among taxable funds, we continue to find attractive leveraged taxable funds that have hedged their leverage either in part or in full such as Evergreen Income Advantage Fund (EAD AMEX), Pioneer High Income Trust (PHH NYSE), Nicholas Applegate Convertible and Income Fund (NCV NYSE). Non-leveraged favorites are Putnam Master Intermediate (PIM NYSE), Putnam Premier Income (PPT NYSE), and Managed High Income (MHY NYSE)."

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