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Fiscal Stimulus? Check Your Portfolio’s Inflation Beta

By Vadim Zlotnikov With negative interest rates unlikely to ignite global growth, the debate will soon shift to expansionary fiscal policy. Investors should consider how a potential inflation recovery could impact their portfolios. In the aftermath of the global financial crisis, central banks have boosted liquidity, which has helped markets return to normal and supported asset prices. But end demand hasn’t fully recovered yet, and nominal economic growth is still subdued. As a result, investors are losing confidence in monetary policy as a tool to stimulate growth. We see this as a key source of potential downside for risk assets. A closer look at three key transmission mechanisms sheds light on why quantitative easing (QE) has become less effective over time: QE encourages risk taking . By reducing the supply of financial assets, QE was expected to lower the risk premium investors demanded. But current estimates of the 10-year US Treasury term premium are now negative. That’s a 50-year low, and it suggests there’s limited potential for further declines. Meanwhile, equity valuations have risen above their historical averages and housing prices have regained their pre-crisis highs in most regions. Sure, valuations could expand further, but upside potential appears more limited, and further gains could trigger concerns about asset-price bubbles. Wealth effects haven’t led to more spending . Higher asset valuations have helped reduce household leverage, but households have been reluctant to spend more – despite growing wages and cheap energy. One likely reason: rising asset prices mostly benefit higher-net-worth households, which tend to save more. And even though households have reduced their leverage from post-crisis highs ( Display 1 ), it’s still higher compared to history. Corporations have reacted to tepid end demand by returning cash to shareholders, instead of exploiting higher stock prices and low rates to fund investment. Click to enlarge Currency depreciation is less likely to continue . As currencies have weakened in response to lower interest rates, they’ve been very effective at driving corporate profit margins and equity returns across regions. But if QE becomes less effective at pushing down long-term interest rates, it will also likely be less effective at driving currencies. Supportive Environment for Fiscal Stimulus The deleveraging cycle appears likely to last if consumer and business sentiment don’t improve. We think governments can break this cycle, even though they’re highly leveraged, too. Central bank asset purchase programs are in place, so governments could finance spending initiatives by expanding the money supply. And given low rates, the interest expense burden should be fairly small. In general, it’s hard to gauge how effective fiscal stimulus can be. Academic studies estimate that fiscal spending multipliers on GDP average less than one in a normal interest rate environment. In other words, for every fiscal dollar spent, GDP gets a boost of less than a dollar. But recent research suggests multipliers may be much higher today. When growth is strong and there’s no slack in the economy, public spending raises inflation and interest rates, crowding out private spending. But when output is below potential, like today, and there’s spare economic capacity, increased public spending can have a more direct impact on real economic growth, with a much larger fiscal multiplier ( Display 2 ). Click to enlarge Also, when monetary policy is constrained by zero interest rates, fiscal stimulus raises inflation expectations, causing real interest rates to decline. This decline raises overall demand substantially, which further heightens inflation expectations and depresses real interest rates. This process can help break the deflationary dynamics of zero interest rates. US growth has been strengthening and core inflation has been accelerating, but the settings in Europe and Japan point to the potential for fiscal stimulus to be more effective than normal. Underinvestment Has Created Fiscal Spending Targets Infrastructure spending could be a prime target for that fiscal stimulus, because many developed economies have arguably underinvested in this area. A McKinsey study estimates that in the US and some European countries, spending would need to increase by 0.5-1% to meet infrastructure needs. Fiscal spending directed towards the right infrastructure projects may have a positive structural impact on growth in addition to cyclical benefits. In Japan, given the country’s elevated infrastructure spending, measures to improve consumption (such as the postponement of the consumption tax), labor-force participation (such as elder care and child care), wages and capital spending (including corporate tax incentives) may be more appropriate. Up Next: Helicopter Money? We expect the risk-on, risk-off environment to last for a while – investors and policymakers still don’t have a coherent framework for stimulating economic growth. Monetary policy, including negative interest rates, has failed to bring sustainable growth. We expect to see more discussion of the potential for helicopter money (central banks printing money and funneling it to consumers to stoke demand), or simply tighter integration of monetary and fiscal policy. If this is done in scale, it would likely recharge inflation. But there are political hurdles in large-scale fiscal stimulus, so we expect these initiatives to be delayed until 2017-2018. And they’ll be implemented only if there’s more evidence that monetary policy is becoming less effective. Long-Term Investors: Check Your Portfolio’s Inflation Sensitivity Still, investors with long-term horizons (three to 10 years or longer) have some things to think about – if they’re willing and able to tolerate short-term volatility. We think it makes sense to consider increasing portfolio tilts toward assets that would benefit from an environment of reflation – in other words, inflation recovering to normal trend levels. This means potentially increasing their portfolios’ inflation sensitivity – also known as the inflation beta. Some ideas would be allocating to real assets, such as commodities, and emerging-market-related assets in equity, credit and currency. Value equities in Europe and Japan would be other ideas to consider. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Vadim Zlotnikov, Chief Market Strategist; Co-Head – Multi-Asset Solutions; Chief Investment Officer – Systematic and Index Strategies

Are Buy-Write Funds Good Buys?

This article first appeared in the May issue of Wealth Management Magazine and online at WealthManagement.com Equity markets stalled in 2015 after a relentless six-year rise from the depths of the Great Recession. Last year’s stagnant market, even with its bearish tilt, was a perfect set-up for buy-write plays. A buy-write is an option strategy featuring a stock purchase (that’s the “buy” part) along with the sale (a “write”) of a related option. Typically, these are call options. Deemed “covered calls,” they offset the otherwise unlimited liability associated with selling options through ownership of the underlying stock. The object of the strategy is income production. The premium earned for selling the options is retained if the contracts remain unexercised-a likely occurrence in a flat-to-bearish market. That’s not to say there’s no risk. If the market value of the stock spikes, pushing the options into the money, shares may be called away at the strike price, leaving the writer with just the premium and perhaps a bit more. What’s at risk is the upside potential of the stock, a sort of opportunity cost. Should the value of the underlying stock decline instead, the call premium provides a modicum of downside protection. A number of exchange traded funds engage exclusively in buy-writes. Most use call options. A couple, though, feature puts. Selling puts rewards investors in a stagnant or rising market if the underlying stock’s market price exceeds the put’s strike price; a downtrending market is anathema to this particular variation on the strategy. It’s worth a look at these ETFs to see how successful they’ve been in providing income and limiting risk. The PowerShares S&P 500 BuyWrite Portfolio (NYSEARCA: PBP ) writes at-the-money calls on its portfolio of S&P 500 securities. Launched in 2007, PBP is well established with $308 million in assets and an average daily volume of 109,000 shares. Over the past two years, PBP’s maximum drawdown was significantly less than the biggest hit taken by the SPDR S&P 500 ETF (NYSEARCA: SPY ) , a proxy for the blue chip index. Drawdowns represent peak-to-trough losses sustained before new price peaks are attained (see Table 1). Another metric of downside risk, Value at Risk (VaR), typifies the expected loss within a given timeframe. Essentially, VaR depicts a worst-case scenario. Based on the past two years’ returns and within a 95 percent confidence level, PBP can be expected to lose 1.12 percent on a bad day. Compared to SPY, with a daily VaR of 1.44 percent, PBP appears less risky than holding the index portfolio outright. A final comparative metric, M-squared (M 2 ), depicts the fund’s risk-adjusted return. Simply put, M-squared estimates what the fund would return if it took on the same level of risk as its SPY benchmark. PBP would have earned 3.82 percent-86 basis points more than its actual total return-if it was as volatile as SPY. If the M-squared return was lower than the fund’s actual return, the PBP portfolio would be more risky than the benchmark. So what about income? PBP boasts a dividend yield more than twice as high as SPY’s. Still, the buy-write fund’s total return is just a third of the level of the index fund-testimony to the effect of having assets called away as the market rose prior to leveling off. Click to enlarge Another ETF based on the S&P 500, the Horizons S&P 500 Covered Call ETF (NYSEARCA: HSPX ) , pursues a more aggressive call-writing strategy. HSPX sells out-of-the-money options, which, all else equal, typically produce less income. The fund, however, writes more calls than PBP-up to 100 percent of each stock position. This affords more equity upside. But there’s a trade-off for this-namely bigger drawdowns and a higher VaR compared to PBP. Despite the risk disparity, both funds earned the same M-squared return over the past two years. Chart 1 depicts the day-to-day performance of the buy-writes versus the SPY benchmark. Click to enlarge First Trust Advisors runs two actively managed buy-write portfolios, one geared to maximize income, the other designed to minimize volatility. The First Trust High Income ETF (NASDAQ: FTHI ) relies on a universe of large-cap stocks paying high dividends to underlie its call writing and rewards its investors with an attractive total return and dividend yield. The cost for this is higher risk, reflected in all three metrics: drawdown, VaR and M-squared. A sibling fund, the First Trust Low Beta ETF (NASDAQ: FTLB ) writes calls on the same portfolio as FTHI, but also buys put options to reduce volatility. The put premiums create a drag on performance, reducing both total return and dividend yield, but pay off with lower drawdowns and VaR compared to FTHI. Yet another actively managed portfolio, the AdvisorShares STAR Global Buy-Write ETF (NYSEARCA: VEGA ) , is even more expansive. A fund of funds, VEGA is presently made up of equity sector ETFs and bond ETFs in addition to broad-based ETFs like SPY and the iShares MSCI EAFE ETF (NYSEARCA: EFA ). The extensive call-writing base hasn’t produced capacious returns or dividend yields, though. A fund [1] that writes puts rather than calls is a standout, but not in a good way. The ALPS US Equity High Volatility Put Write ETF (NYSEARCA: HVPW ) selectively sells out-of-the-money puts on high-volatility large-cap stocks, aiming to maximize income. HVPW succeeds on that front. Its dividend yield is high, but volatility torpedoes the fund on a total return basis. HVPW, in fact, is the only ETF surveyed that produced a negative total return over the past two years. One other ETF requires special attention. Rather than being focused on the large-cap stocks populating the S&P 500, the Recon Capital NASDAQ 100 Covered Call ETF (NASDAQ: QYLD ) buys the stocks populating the Nasdaq-100 Index, a compendium of the largest nonfinancial issues listed on the Nasdaq marketplace. As you can see in Table 2 and Chart 2, QYLD shows the dramatic trade-off between total return and dividend yield. Compared to the PowerShares QQQ ETF (NASDAQ: QQQ ) , a portfolio that tracks the Nasdaq-100, QYLD produces a much bigger dividend yield, but a significantly lower total return. The risk metrics of the QYLD fund show the benefit derived from call writing. Click to enlarge Click to enlarge The Bottom Line Call-writing funds more often than not compensate for their relatively low returns with high dividends, making up for losses incurred over the past two years. Most of the funds, too, mute market volatility, providing higher risk-adjusted returns. Put writing, though, has been a vexation. The hefty premiums received for put sales just couldn’t cover the capital losses incurred as the options were assigned. Investors looking for high levels of current income and hedged exposure to the equity market might very well find call writing funds attractive alternatives in a flat-to-slightly bearish market. If, however, an investor or advisor believes stocks are poised for another sustained upward surge, less costly and mechanically simpler exposures are more suitable. [1] Another ETF, the ALPS Enhanced Put Write Strategy ETF (NYSEARCA: PUTX ) also pursues a put-write strategy, but was only launched in 2015, making it too young to include in our two-year study.

6 Mutual Funds To Buy As Russell 2000 Outperforms

Over the past one-month period, the major U.S. benchmarks witnessed a positive trend that helped most of them to register gains. Among these, the Russell 2000, which tracks the performance of small-cap stocks, clearly emerged as the top performer in the last one month. While the Dow, the S&P 500 and the Nasdaq gained 2.6%, 2.7% and 2.6%, respectively, in the past one month, the Russell 2000 increased 6.5% during the same period. In line with the performance of the small-cap index, the small-cap mutual funds also registered healthy returns – higher than the large- and mid-cap ones. Small-cap mutual funds posted an average return of 6% in the last one month, while the large- and mid-cap funds registered average gains of 3.3% and 4.4%, respectively. Moreover, small-cap funds have gained 2.4% in the year-to-date frame, beating their large-cap counterparts, which gained only 1.7%. Against this backdrop, investing in small-cap funds may prove to be a profitable strategy for risk lovers. Factors Boosting Small-Cap Funds Oil Rally Despite the disappointment in the Doha meeting, crude prices continued their rally, which emerged as one of the major reasons for the impressive performance by the U.S. benchmarks. Though the much-vaunted meeting of the major oil producing countries in Doha on production freeze failed to produce favorable results, its impact on crude was lesser than expected. Continuing decline in the U.S. rig count and oil production helped oil prices to post gains for the third straight week. Recently, Baker Hughes (NYSE: BHI ) reported that U.S. oil rig count posted its fifth straight weekly drop, declining from 351 to 343. Meanwhile, the U.S. Energy Information Administration (EIA) reported that domestic crude output fell by 24,000 barrels per day (bpd) to 8.953 million bpd for the week ended April 15. U.S. crude output declined for the sixth consecutive week. Encouraging Economic Data Moreover, some of the encouraging economic data had a positive impact on investor sentiment. The ISM manufacturing index increased from 49.5% in February to 51.8% in March, surpassing the consensus estimate of 50.8%. The ISM Services Index increased from 53.4% in February to 54.5% in March, witnessing its highest level in the last three months. Meanwhile, better-than-expected jobs addition, rise in wages and falling initial claims point to continued improvement in the labor market. While the U.S. economy generated 215,000 jobs in March and average hourly earnings increased 0.3% last month to $25.39, initial claims for the week ending April 16 continued to decrease to reach a record low since 1973. Separately, the Consumer Confidence Index advanced to 96.2 in March from 92.2 in February and was also higher than the consensus estimate of 94.9. Meanwhile, each of the 12 districts indicated moderate growth in economic activity, according to the Fed’s Beige Book. These positive economic data indicate that the U.S. economy is on a path of recovery. 6 Small-Cap Funds to Buy Though small-cap funds are believed to have a higher level of volatility compared to their large- and mid-cap counterparts, they show greater growth potential when markets see an uptrend and continued domestic economic improvement. This is because small-cap stocks are closely tied to the domestic economy and have less international exposure, making them safer bets than their large- and mid-cap counterparts in a sluggish global growth environment. Hence, risk-loving investors can pick these funds to gain from the current encouraging environment. In this scenario, we highlight two mutual funds from each of the three small-cap categories – growth, blend and value – that either have a Zacks Mutual Fund Rank #1 (Strong Buy) or #2 (Buy). We expect these funds to outperform their peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but also on the likely future success of the fund. Besides having impressive one-month returns, these funds also have strong three-year annualized returns. The minimum initial investment is within $5000. Also, these funds have a low expense ratio and carry no sales load. Small-Cap Growth – One-month return of 6.9% Ivy Small Cap Growth Fund (MUTF: WSCYX ) invests a large chunk of its assets in common stocks of companies having market capitalization similar to those included in the Russell 2000 Growth Index. Currently, WSCYX carries a Zacks Mutual Fund Rank #2. The product has one-month and three-year annualized returns of 8% and 9.4%, respectively. Annual expense ratio of 1.30% is lower than the category average of 1.31%. Oppenheimer Discovery Fund (MUTF: ODIYX ) primarily focuses on acquiring common stocks of domestic companies having impressive growth prospects. Currently, ODIYX carries a Zacks Mutual Fund Rank #1. The product has one-month and three-year annualized returns of 7.2% and 9%, respectively. Annual expense ratio of 0.86% is lower than the category average of 1.31%. Small-Cap Blend – One-month return of 5.6% Fidelity Stock Selector Small Cap Fund (MUTF: FDSCX ) invests the lion’s share of its assets in common stocks of companies with market capitalization within the universe of the Russell 2000 Index or the S&P SmallCap 600 Index. Currently, FDSCX carries a Zacks Mutual Fund Rank #1. The product has one-month and three-year annualized returns of 5.5% and 8.3%, respectively. Annual expense ratio of 0.76% is lower than the category average of 1.22%. USAA Small Cap Stock Fund (MUTF: USCAX ) invests most of its assets in equity securities of domestic small-cap companies. Currently, USCAX carries a Zacks Mutual Fund Rank #2. The product has one-month and three-year annualized returns of 5.9% and 7.8%, respectively. Annual expense ratio of 1.15% is lower than the category average of 1.22%. Small-Cap Value – One-month return of 5.5% American Century Small Cap Value Fund (MUTF: ASVIX ) invests heavily in securities of companies having market capitalization identical to those listed in the S&P Small Cap 600 Index or the Russell 2000 Index. Currently, ASVIX carries a Zacks Mutual Fund Rank #2. The product has one-month and three-year annualized returns of 7.4% and 8.4%, respectively. Annual expense ratio of 1.24% is lower than the category average of 1.31%. CornerCap Small-Cap Value Fund (MUTF: CSCVX ) invests a major portion of its assets in equity securities of small-cap companies located in the U.S. Currently, CSCVX carries a Zacks Mutual Fund Rank #1. The product has one-month and three-year annualized returns of 7% and 13%, respectively. Annual expense ratio of 1.30% is lower than the category average of 1.31%. Original Post