Fiduciary Trust International


Q3 Perspective: Volatility May Be the New Norm in an Interconnected World

September 2011

The world is indeed flat—everything matters and affects everything else. Tom Friedman, the award-winning New York Times columnist, recently reminded us of this in his national best-selling book. The flaws in the Maastricht Treaty, the arrangement that brought us the euro, came back to haunt us this summer. No surprise. Without political union, Europe-wide economic policymaking is a hope and a prayer at best. The European Central Bank (ECB), which one would think would have paid close attention to the Fed’s crisis prevention efforts in 2008, blissfully ignored the deepening dismay of bond investors and talked of fighting inflation. The policymaking disarray across Europe is stark: high-debt Euro countries that need to grow out of debt—Italy, Greece and France—are considering repressive tax increases to raise revenue.

Policymaking Disarray Resulted in Unstable European Interest Rates

The ECB, apparently ignoring the Federal Reserve’s well-thumbed playbook, isn’t considering aggressively buying its weaker members’ bonds in order to provide liquidity and keep interest rates low and steady. The Italian 10-year bond reacted to the uncertainty like a thinly traded small-cap equity, with its yield jumping from 4.64% on June 3 to 6.19% on August 4 and then falling back to 5.34% on September 8 (CHART 1). It is hard to run a company or a nation when costs are so volatile.


Confidence in Europe Has Faltered

While European banks should have been pushed hard to raise capital after 2008, it was only during the summer’s interbank funding scare that there was serious talk of requiring them to do so. U.S. banks are much healthier. And, the "Man in the Strasse" is voting his narrow self-interest, shown by Angela Merkel’s party’s string of losses in local elections. The disarray has affected confidence and therefore European growth.

The U.S. Recovery: Slow and Frustrating, but Motoring on

The most casual observer cannot miss all the signs of weakness in Europe and of course, here at home. In the U.S., the recovery motored on. Yes, it is slow going and frustrating, the term du jour, because we are throwing up our own barriers to recovery. The litigation underway against mortgage servicing firms is slowing the clearing out of foreclosed houses, which is so critical to restoring confidence. And there are politics.

But do these mean another recession is about to engulf businesses, clip earnings and bring equity markets down? We do not think so. The "bad" signs—low measures of consumer sentiment, little job growth, residential loan delinquencies—get the media attention. These are flashing amber in our view.

Americans’ view of the future is pessimistic. Seventy-three percent of the 1,000 people questioned in late August told NBC/Wall Street Journal pollsters that they saw the country headed in the "wrong" direction.

Despite Rampant Pessimism, Some Positive Signals Persist

Less or hardly discussed at all, are the "good" signs of a recovery that are underway. Consider that since last year:

  • Corporate profits are up. Profits of companies in the S&P 500 are up by 15.45% versus second quarter 2010.
  • Industrial production is higher. Production is up by 3.7% through the 12 months ended July 31.
  • Lending has increased. The growth of bank loans and commercial paper (the way many corporations fund daily operations) is up by 15.5% over the 12 months ended August 17.
  • Durable goods orders are up. Orders for durable goods are up by 9.5% through the 12 months ended July 31.

In addition, factory orders have remained positive. Although they slowed at the latest release, order levels indicate that manufacturing is expanding.

Americans Are Spending

Although Americans are telling pollsters one thing, they are acting with their wallets as the upward march of retail sales shows (CHART 2). This behavior is important because so much of U.S. economic activity, approximately 70%, is consumption.



Home Prices Are Modestly Increasing

Lastly, home prices are not "collapsing" as some claim. They have actually been showing a modest increase (CHART 3).


Proactive Steps by the Federal Reserve Are Vital

Very important to the recovery is that the Federal Reserve continues to be as vigilant and proactive as it can be to enable the U.S. to create jobs, increase incomes and expand investment for the long term. Their controversial zero interest rate policy, now extended to May 2013, and intense discussion about further moves to lower long-term interest rates are evidence. Clearly inflation is not a near-term issue; longer term, however, is another matter.

We Expect Continued Volatility to Be the Norm in the Near Term

What a volatile spring and summer! After the April 29 high, U.S. stocks, using the S&P 500 as the gauge, were volatile, but did little until July 22 when Congress took up the debt ceiling debate. That acrimonious display, which took place alongside divisive discussions about supporting recovery among the Euro zone nations, slammed investor confidence. Markets had to digest the real possibility that policymakers here and in Europe would stick a wrench into the economic recovery gears by preventing the U.S. Treasury from borrowing to fund the myriad recession-fighting initiatives.

In Europe, the leading banks are still far behind their U.S. peers at repairing the balance sheet damage from their profligate lending before 2008. When the bond markets signaled that Greek default was likely at the same time that German political opinion swung against further bailouts, these banks faced the real possibility that they would have to curtail lending—just when the Euro zone economies need credit the most. The S&P fell 16.8% over the twelve trading days ending August 2 as investors calibrated the possible impacts to future growth, sales and earnings.

The debate settled, and Standard and Poor’s downgrade of U.S. government debt on August 5th proved not to be the Armageddon event some feared. In fact, the centrally important 10-year U.S. Treasury bond rose 4.9% in price over the next 10 days. Stocks gained 7.6% in the same period.

To us, the core message is that the probability of more vulnerable markets has risen. Minor policy mistakes may now have more severe impacts. The rhetoric of the presidential campaigners will affect the outlook. Yet, with expectations so low a slight "less-bad" economic report, a credible policy initiative from the administration, or a similarly important move by the Europeans or Chinese could trigger a meaningful global equity rally. After all, second quarter net income among S&P 500 companies was up 15.4% versus the second quarter last year, and is projected to show an 8.4% advance when the third quarter reports are in by mid-November.

Lower Corporate Profit Margins May Lie Ahead

What concerns us, as financial commentator and columnist Andrew Smithers points out, is that corporate profit margins are at historic highs using data back to 1925. Another related measure is that corporate compensation as a percentage of corporate GDP is at a post-WWII low. A healthy job market is essential to recovery, and it is difficult to foresee one unless wage earners start to claim a larger piece of the corporate pie. Strategas Research Partners notes that this ratio is reversing,1 which in our view is important for consumption’s growth. Companies do consume a lot, but wage earners buy and use a great deal more.

Although subtle today, when wages rise profits inevitably will be pinched. This is an important shift and is in our view a sign that lower corporate profit margins lie ahead. Equity markets are highly sensitive thermometers of the rate of change of profits. When profit growth slows, stock prices may retreat. Although we believe the impact of lower profit margins on earnings remains a ways off, we are watchful, especially as we approach 2013.

1. Reference: Strategas Research Partners, Economics Viewpoint.

We Are Reducing Portfolio Risk Exposure in Light of Many Cross Currents

In response to these many perplexing cross currents we have sought to manage risk across client accounts by building cash balances to levels that we believe will help protect accounts should the irresolution and unresolved debate continue. We have also used the uncertain period to examine the bottom-up investment case for the equities and business sector exposures we hold.

In our view, what offered opportunity a year or more ago in some cases no longer does. U.S. companies, especially banks for instance, are further along at fixing the problems bred in the boom years-often holding too much unrecoverable debt-than their foreign peers and therefore we believe they offer value to today’s buyer. The careful husbanding of cash by most non-financial firms as the U.S. began to slip into recession in 2007 places American companies in an enviable position. They are able to buy future growth at today’s cheap prices, raise their cash dividends and repurchase their own shares, making what clients hold more valuable. The fact that so many of the large U.S. companies we hold have repositioned their operations toward high-growth emerging markets adds to their attractiveness in our view.

Another change is our increasing focus upon the age of this economic recovery, no matter how weak it may have been and continues to be. We are expressing our caution with less exposure to companies that we believe are highly sensitive to the ebb and flow of the business cycle.

Our Emphasis Remains on Global Growth, Steady Earnings and Strong Dividends

In sum, portfolios will be reflecting an emphasis on companies that we believe 1) can benefit from global growth, particularly from the emerging markets; 2) are steady earners through the thick and thin of a business cycle; 3) that demonstrate the capability to increase dividends. Although arriving in dribs and drabs, dividends have been, and, in our view, will continue to be, a major source of investment return. Indeed, today the dividend yield on the Dow Industrials is 2.74% while a typical money fund provides less than 0.5%, to be generous, and the 10-year Treasury bond is yielding 1.9%. This is indeed a rare period.

September and October are often treacherous months for equity investors, and there is little reason to think this fall will break the trend. As we said, it will only take some "less-bad" data and a demonstration of will and resolve by the administration, Congress and their European counterparts to turn the tide away from pessimism and bring into stark focus how little opportunity there is in zero-earning cash. The Fed cannot carry all the water, and everyone knows this, in spite of what they might say. Equity and bond markets sense small changes in outlook early. Being ready to reinvest has the potential to be quite rewarding. In the meantime, amidst such uncertainty, we believe a higher cash allocation is comforting. 


Risk Aversion Drove Treasury Yields to Historic Lows

Much has happened since last quarter that caused investors to avoid risk: the ugly, eleventh-hour agreement to lift the U.S. debt ceiling, the domestic and global economic slow down, the volatile and declining equity markets, the Euro zone debt woes, the credit downgrade of U.S. Treasury debt, and the Federal Reserve’s pledge to keep the funds rate at 0.25% through mid-2013. These events precipitated a flight to quality that pushed the 10-year U.S. Treasury yield below 2% for the first time in history, and caused the 30-year Treasury yield to revisit the lows reached in January 2009.

Bond Sector Returns Closely Correlated to Perceived Risk

Over the quarter, bond sectors performed in line with their level of perceived risk. Since the end of June, yields on intermediate-term U.S. Treasury bonds declined by nearly 0.60%, while yields on high-grade municipal bonds fell by about 0.40%. Investment-grade corporate bond yields were roughly unchanged, and rates on high-yield bonds bucked the trend and rose by 1.10%.1

Total returns over the quarter illustrate investors’ preference for safety, quality and liquidity.




Municipal Bond Yields Followed Treasury Yields Lower

Compared to Treasuries, the municipal bond market experienced modest declines in yields during the period. Municipal bonds benefitted from a continuation of subdued supply, favorable reinvestment flows and muted headline risk. In fact, the sector’s modest rate decline brings 10-year municipal bond yields to their most attractive valuations relative to Treasuries since April of 2009. Looking ahead, we expect the low interest rate environment to persist as a result of actions by the Federal Reserve.

Seeking Opportunity in a Volatile and Low Rate Environment

Against this low interest rate backdrop, there is a temptation to chase yield by meaningfully extending maturities and lowering credit standards. We have avoided this impulse because in general, we believe the risk reward trade-off is unfavorable.

We expect new issue supply to rebound in the third quarter. This modestly heavier volume could provide a window to purchase securities at what we believe will be slightly more attractive valuations over coming months, especially in states and sectors that have experienced a dearth of supply in recent weeks. Also, since yields on short maturity bonds have remained low, we are seeking to take advantage of the steepness of the yield curve by modestly moving out to intermediate maturities as the yield pick up is significant.

We are also directing our efforts on issue selection—bonds with clear and solid sources of repayment that are being offered at what we believe to be attractive valuations. These include essential service revenue bonds, state (as opposed to local level) entities that have reasonably well-funded pension costs, and government-backed housing debt. We are also focusing on higher coupon callable bonds that are trading at premiums in the municipal area, as well as select issues in the corporate debt sector.

With diligence, we believe we are able to find value on a selective basis in all of these spaces. Our goal is capital protection, and with discipline we continue to seek to identify and act upon good opportunities for our portfolios while remaining vigilant in the management of both credit and interest rate risk.

1. June 30, 2011 through September 7, 2011.



  • Our tactical allocation recommendation for equities has moved below our long-term target due to our outlook for heightened volatility in the shorter term.
  • We are focusing on equities with above-market dividends and a history of dividend increases, and are recommending reduced holdings in companies with cyclically sensitive earnings streams.
  • We are slightly reducing our target allocation to emerging markets.
  • While we expect higher long-term growth opportunities in these markets, we believe that excessive volatility will be a factor in the near term.


  • Our tactical recommendation for fixed income allocation remains unchanged and below our long-term target due to the acutely low level of interest rates.
  • We are maintaining overweight allocation recommendations across taxable fixed income asset classes to increase diversification within portfolios.
  • We continue to be constructive on corporate credit fundamentals and are overweight both investment-grade and speculative-grade debt on a tactical basis.
  • Our allocation to the U.S. government-guaranteed bond category remains overweight due to the favorable yield spreads and muted price volatility available on mortgage-backed securities.


  • Our cash allocation recommendation has increased significantly on a short-term tactical basis due to current high levels of uncertainty and elevated anxiety about sustained recovery in the Euro zone.
  • We anticipate recommending redeployment of cash when we perceive conditions becoming more favorable.








With lower than expected GDP growth in the U.S. and the Federal Reserve’s promise to keep interest rates low through mid-2013, investors are facing uncertainty and heightened volatility in the markets. Our Fiduciary Trust Forum members discuss their approach to finding investment opportunities in the face of this more challenging market environment.


Penny Knuff, Managing Director, San Mateo, CA

Xavier Martinez, Managing Director, Miami, FL

Joe Portillo, Managing Director, Los Angeles, CA

Robert Bridges, Managing Director, New York, NY

1. What can investors expect given the weaker than expected growth outlook?

Joe: Clearly, the economic data that we have been seeing points toward moderate, below-trend growth in the near term for developed economies. Lower growth, coupled with the debt problems in the U.S. and Europe, has shaken investor confidence. We therefore believe investors can expect higher levels of volatility to be the new norm for the foreseeable future.

Rob: One thing we can say is that the U.S. economy in particular has historically proven to be more resilient than naysayers expect. I tend to think there’s a grain of truth in the humorous quote, "The market has predicted nine out of the last five recessions." In our view the pessimism about the market in general should not be confused with the outlook on individual companies and their prospects for this year and next year.

2. How is this more volatile environment changing the way you are managing portfolios?

Rob: We have been seeking to use volatility to our favor to buy some high quality companies on sale. Companies that fit this bill include high-quality, dividend-paying companies where we feel we can get paid to ride out a rough patch. We also have been selectively selling weaker holdings to raise a little bit more cash to be in the position to take advantage of future opportunities.

Xavier: In an environment where you have low growth and low interest rates, a good dividend stream becomes very important. Consider that over the past 80 years, dividends have represented nearly half of the total return delivered by the S&P 500.

Penny: We are also attracted to companies with successful business models and therefore, higher returns on equity. Many of these companies have the ability to push price increases through to their customers—and, at a time when revenue growth may be slowing, they are still able to maintain or increase their profit margins.

Joe: These companies are hitting a "sweet spot" because they are producing things that consumers seem to want to buy and use regardless of the economic environment —such as smartphones, tablets and social media-related services. Consider that 550,000 smartphones based on the Android operating system are being activated per day-that’s phenomenal growth.

3. Which sectors are you particularly interested in?

Rob: We are focusing on technology, particularly areas that relate to mobility, cloud computing, network enhancement and social media. As Joe mentioned, despite the perceived poor economic environment, consumers are now viewing these products and services as necessities.

Joe: Consumer staples--companies that offer daily necessities--have performed well year-to-date, and we expect this sector to remain generally attractive until the market perceives a stronger economic footing.

However, another area that we expect to do well is luxury goods. This may seem counterintuitive at first, but we have to remember that the U.S. and Europe are not the whole game here. The new millionaires being minted in Asia and other developing economies are showing an incredible demand for branded luxury goods. It’s not a surprise that the Hong Kong stock market has seen the listing of some high-profile luxury goods companies and that more listings of such companies appear to be in the cards.

Xavier: Even in the U.S., the high-end consumer seems to be willing to buy. We believe these companies can weather a choppy economic environment quite well because their brands have high intrinsic value to their customers and their customers tend to have high enough levels of disposable income to continue to afford them.

4. With the price of oil falling, what is your outlook for energy?

Penny: Consumers do cut back on energy consumption during an uncertain economic environment, but there are limits to how much they can cut as they still need to drive their cars and turn on their lights at home.

Currently, energy prices have softened a bit as a weaker economic environment is getting factored into demand forecasts. This provides a bit of a break to the consumer, especially in emerging markets. Even on the back of somewhat softer oil prices, we expect the energy service companies to continue to do well as their profit margins expand and the industry’s pricing power is recognized. Right now we are seeing some high-potential companies that we believe are trading relatively cheaply.

5. Will there be any clear winners as corporations continue to operate with a cost-savings mindset?

Xavier: We believe that companies that help other companies "do more with less" should continue to thrive. In the technology area, companies whose products either simplify computer networks or make application deployment easier fall into this category.

Rob: Outsourcing technology is a trend that we expect will gain strength. Companies are beginning to lease space or run applications on computer networks maintained by others, as opposed to owning their own technology infrastructure assets. The costs drop for the end-user, while the provider of these services lowers its overall costs due to the larger scale of its operations.

Joe: Businesses are finding that e-commerce is helping them streamline their overall operations, and areas like data warehousing are becoming more important. Specialized data warehousing appliances are being purchased by many companies to help them consolidate and analyze data so they can quickly adapt to consumers’ changing needs. In an environment where every point of market share is important, companies that can analyze data quickly in order to be proactive have a big leg up on the competition.

6. How are you adjusting portfolios in light of reduced government spending?

Joe: We are constantly looking at companies’ business models and customer bases. We evaluate how exposed a particular company is to government spending and contracts. In an environment like this where government spending is going to be under pressure, we consider whether a particular company-even one with leading edge products-may be overexposed to the government sector.

7. With emerging markets showing weakness, what is your view?

Penny: Things are slowing in emerging market economies, but we anticipate that they will be successful in orchestrating a soft landing. Lower commodity prices can help mitigate the threat of inflation, helping these countries to grow at a slightly subdued but very healthy growth rate, especially vis-à-vis the developed markets.

Joe: In recent months many developing and emerging markets have sold off in sympathy with developed markets in the U.S. and Europe. The valuations of some emerging market stocks have slipped to the point where they are trading at multiples lower than U.S. stocks. So they are actually cheaper compared to some developed market stocks, while being exposed to markets that have higher growth potential.

Xavier: We anticipate higher growth over the long term as these countries continue to build infrastructure--roads, bridges, high-speed rail--to meet the needs of their citizens. They are also developing products and services, including everything from autos to fast-food restaurants to financial services, to cater to their new rising middle-class consumers.

Rob: As we’ve seen though, these markets do suffer knee-jerk reactions to bad news coming from the developed markets and this can lead to some dramatic swings. Over the longer term, however, we believe markets in developing and emerging economies will benefit from increasingly attractive internal growth dynamics that will win out in the long run.

This communication is intended to provide general information. The information and opinions stated are as of September 19, 2011 unless otherwise indicated, and do not represent a complete analysis of every material fact concerning any industry, security or investment. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment advice or as a recommendation of any particular security, strategy or investment product.


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 MackinPulsifer_3370.JPGMackin Pulsifer
Vice Chairman and Chief Investment Officer

RonSanchez_2293_web.jpgRonald Sanchez
Director of Fixed Income Strategies

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Q3 Perspective: Volatility May Be the New Norm in an Interconnected World

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