investment outlook great expectations: inflation · investment outlook 2 february 2011 great...

E. William Stone, CFA, CMT

Chief Investment Strategist

Rebekah M. McCahan

Investment Strategist

Fred H. Senft, Jr., CFA

Director of Research

Nicholas M. Srmag

Fixed Income Analyst

Paul J. White, PhD, CAIA Senior Investment Strategist

February 2011

Great Expectations: Inflation “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

—John Maynard Keynes

Executive Summary

This month we focus on inflation. Inflation is a source of concern for most investors because it influences buying power in real terms. In our view, inflation can be divided into two types:

expected inflation; and unexpected inflation

The expected component of inflation does not qualify as risk; only the unexpected component should be considered as risk. Expected inflation gets priced into the market without shock, while unexpected inflation acts as a source of volatility to the markets.

To hedge inflation an investor purchases inflation insurance, which may or may not be cheap or effective. Our studies lead us to the following views.

Gold is an inflation hedge over the very long term. Commodities are an inflation hedge with non-inflation exposures. TIPS are an inflation hedge. Private real estate is an ineffective inflation hedge.

This month’s Investment Outlook will focus on our inflation watch indicators, expected versus unexpected inflation, and the above-mentioned inflation hedges, with attention paid to the unintended exposures that accompany those hedges. Unintended exposures in a hedge position may, in fact, expose an investor’s portfolios to additional, unforeseen risks. That is the danger in adding a hedge position that is not pure.

While we have devoted much of our February Investment Outlook to other assets used in hedging inflation risks, we would be remiss not to discuss stocks and bonds in this regard as well. Though high inflation historically has led to poor short-term stock performance, equities historically have provided the highest real return across stocks, bonds, and cash. Stocks adapt to inflation because earnings eventually rise with the level of inflation and offset at least some of the negative impact of inflation. Bonds paying a fixed coupon are unable to adapt to unexpected inflation and suffer badly in comparison.

Our current recommended allocation attempts to balance the relative attractiveness of stocks and other risk assets, given the transition to expansion that we expect in the global economy. We remain vigilant in monitoring asset valuations and the various factors affecting our views on the sustainability of the economic recovery. There continue to be a number of sources of volatility and downside risk, including European sovereign debt, emerging market inflation, employment, and other geopolitical risks.

PNC’s six asset allocation models are shown on the back page of this outlook.

John Maynard Keynes (1883–

1946) was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments. While Keynes’s views fell relatively out of favor starting in the 1970s with the U.S. economic struggles and the rise of the Monetarists like Milton Friedman, the Great Recession has inspired a renaissance for his ideas.

pnc.com

Great Expectations: Inflation

InvestmentOutlook

Investment Outlook

2 February 2011

Great Expectations Inflation is a source of concern for most investors because it influences buying power in real terms. Higher inflation can lower an investor’s purchasing power; for that

reason, the convention that lower inflation is a positive for equities typically holds. Inflation is usually measured by the consumer price index (CPI). The CPI is a price index calculated as the current cost of a fixed basket of goods divided by the cost of the basket in the base period.

Chart 1 shows inflation as measured by the CPI.1 Inflation had three strong spikes–in 1974, 1979, and 1980. The values exceeded 10%. This period is strongly associated with soaring energy prices and recessions. Here, both expected and unexpected inflation are shown. The conventions of expected and unexpected inflation are constructs.

Expected inflation is the idea that an investor expects inflation to remain constant year over year. Unexpected inflation is the change in the inflation rate year over year.

Although there isn’t a strict definition for unexpected inflation, this separation reflects the idea that an investor is

biased neither higher nor lower with regard to next year’s value. Neither optimism nor pessimism enters into a neutral point of view. The timeframe is important to consider because we want to examine the effect of inflation over longer periods, that is, years. These longer time periods are associated with investing, financial planning, retirement, and the like. Inflation can be sampled on a shorter timescale, but higher-frequency observations do not add to the message here.

The change itself in year-over-year inflation can occur over very short periods. To that end, it would be practical to follow inflation proxies in the market. Market indicators would have the advantage of immediacy versus the lag time associated with publishing CPI numbers. A dramatic change in these values might alert an investor to large values in unexpected inflation. Obviously, the negative scenario is one of positive spikes in inflation.

At PNC, we use several inflation watch indicators2 to monitor the onset of inflation: core inflation (inflation excluding food and energy) (Chart 2, page 3); market expectations for future inflation (Chart 3, page 3); commodity prices (Chart 4, page 3); import prices (Chart 5, page 3); labor costs (because this is what fed the wage/price spiral of the 1970s) (Chart 6, page 3); and the timeliness of the unwinding of central bank policy actions (Chart 7, page 3).

1 Some people use the GDP deflator as a metric for inflation. CPI has known quality

adjustment and substitution biases. The choice does not affect our conclusions here. 2 These indicators were introduced in the July 2009 PNC Investment Outlook—Hold ‘em or Fold ‘em.

Chart 1

Expected and Unexpected Inflation

(shaded areas are recession periods)

Source: Bureau of Labor Statistics, Bloomberg L.P., PNC

Great Expectations

Chart 1Expected and Unexpected Inflation(shaded areas are recession periods)

-10

-5

0

5

10

15

Per

cent

1970

1975

1980

1985

1990

1995

2000

2010

2005

InflationUnexpected Inflation


3

Chart 5

Import Prices Excluding Petroleum


Chart 2

Headline and Core CPI


Chart 4

DJ-UBS Commodity Index

Source: Dow Jones, UBS, Bloomberg L.P., PNC

Chart 6

Average Hourly Earnings


Chart 7

M2

Source: Federal Reserve, Bloomberg L.P., PNC

Chart 3

5-Year 5-Year-Forward TIPS Spreads


Chart 2Headline and Core CPI

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

1/08

4/08

7/08

10/0

8

1/09

4/09

7/09

10/0

9

1/10

4/10

7/10

10/1

0

Year

-ove

r-Ye

ar P

erce

ntag

e C

hang

e Total

Core: Total Excluding Food & Energy

Chart 5Import Prices Excluding Petroleum

1/08

5/08

9/08

1/09

5/09

9/09

1/10

5/10

9/10

114

116

115

111

113

112

109

110

106

108

107

2000

= 1

00

Chart 35-Year 5-Year-Forward TIPS Spreads

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1/08

4/08

7/08

10/0

8

1/09

4/09

7/09

10/0

9

1/10

4/10

7/10

10/1

0

1/11

Per

cent

Chart 4DJ-UBS Commodity Index

1/08

5/08

9/08

1/09

5/09

9/09

1/10

5/10

9/10

1/11

100

120

140

160

180

200

220

240

260

Inde

x 1/

2/19

91 =

100

Chart 6Average Hourly Earnings

1/08

5/08

9/08

1/09

5/09

9/09

1/10

5/10

9/10

1.5

2.0

2.5

3.0

3.5

4.0

Year

-ove

r-Ye

ar P

erce

ntag

e C

hang

e

Chart 7M2

0

2

4

6

8

10

12

1/08

4/08

7/08

10/0

8

1/09

4/09

7/09

10/0

9

1/10

4/10

7/10

10/1

0

1/11

Year

-ove

r-Ye

ar P

erce

ntag

e C

hang

e

Investment Outlook

4 February 2011

Inflation is wealth entropy. It detracts from value in most circumstances and is a hurdle to real purchasing power. In deciding what to spend or in estimating the final value of an investment, inflation must be accounted for. In that sense, it is straightforward enough to plan for expected inflation. It may be high or low, but expected inflation fits into financial planning, for better or for worse. Unexpected inflation is typically for the worse. Even if one is a debtor (where inflation reduces one’s debt in real terms), unexpected inflation is a cost in terms of volatility.

Chart 8 shows the growth of one dollar invested in each of the S&P 500® and the Barclays Aggregate bond index from 1989 to 2009. The values of each are presented

in both nominal and real terms. The real value is the compound annual growth with inflation taken out. The difference is higher than most people think. For the S&P 500, the end value of about 700% in nominal terms becomes about 450% in real terms. The corresponding figures for the Barclays Aggregate are 470% in nominal terms versus 270% in real terms. The difference of nominal versus real becomes even clearer over longer periods. The period from 1989 to 2009 was not the one of the highest inflation; that would be the mid-70s, a time when inflation peaked somewhere near 10% a year. Regardless of the period chosen, it is clear that inflation plays a destructive role in terms of purchasing power.

Unexpected inflation is a shock to financial planning. It might be a negative or positive value. Both are not favored, but clearly a large positive spike is the less desired of the two outcomes. What is examined here is a way to hedge the unexpected positive shocks in inflation.

It is the PNC view that inflation should be moderate over the near term. However, given the diversity of the client base, we recognize that portfolios of different investors have different sensitivities to sharp increases in inflation. To that end, the discussion here centers on methods to hedge unexpected inflation in those specific portfolios.

Since one cannot accurately predict the short-term movement of stocks or infallibly forecast the future, we primarily focus on what is knowable. When determining a recommended asset allocation for our clients, we focus on their:

goals;risk tolerance; income needs; investment holding period; and personal situation.

In addition, when the Investment Policy Committee considers PNC’s general recommended allocations, it concentrates on the intrinsic valuation of possible investments and weighs the estimated risk versus reward.

Hedging: Expecting the Unexpected Separating inflation into expected and unexpected components might seem academic at first glance. However, inflation itself is not observable, meaning one can’t go into the market and identify something on the exchange that is distinctly inflation. The separation of something that is already invisible seems strange, but it is precisely the

Chart 8

S&P 500 and Barclays Aggregate Bond Index

Source: Standard & Poor’s, Barclays Capital, Bureau of Labor Statistics, Bloomberg L.P., PNC

Chart 8S&P 500 and Barclays Aggregate Bond Index

0

100

200

300

400

500

600

700

800

900

12/8

9

8/91

4/93

12/9

4

12/9

9

12/0

4

8/96

8/01

8/06

4/08

12/0

9

4/03

4/98

S&P 500S&P 500 Inflation AdjustedBarclays AggregateBond IndexBarclays AggregateInflation Adjusted

Per

cent

Hedging: Expecting the Unexpected


unexpected versus the expected that drives changes in the market. Consider an unexpected rate change from the Federal Open Market Committee as an analogy. In this case, unexpected refers to a rate change between regularly scheduled meetings. On October 8, 2008, the federal funds rate was lowered to 1.5% at an unscheduled meeting and the S&P 500 swung more than 5% between the high and the low price on that day. Unexpected inflation is also a source of volatility.

Gold3

Gold was covered in PNC’s November 2010 Investment Outlook: Road Trip to Eldorado. The publication examined several investment aspects of gold, including its ability to act as an inflation hedge. Gold was not an effective inflation hedge over short or even sometimes multiple-decade investment holding periods. We will not revisit details of the argument against inflation hedging. Instead, we want to examine whether gold is an adequate hedge against unexpected inflation, which we defined as the change in the year-over-year inflation rate.

To examine the possibility that gold is a hedge against inflation, we performed a numerical analysis using linear regression. Linear regression is a way to look for dependencies of certain variables contained inside another variable, in our case, the returns of gold. The idea is that the returns from gold are derived, in part, from inflation. We know from previous work that gold is an inflation hedge over the very long term. By very long term, we mean literally decades. Our test in this work is to see whether investors should consider gold as a hedge for unexpected inflation over the very long term, as well. Recall that a steep rise in unexpected inflation can have adverse effects on financial planning.

Assume for the moment that the returns of gold are driven solely by expected and unexpected inflation. We can then model the effect with linear regression. In linear regression, we can see how large a variable’s dependence is, namely, the size of the regression coefficient; but more importantly, we can see whether the variable is essential to the regression at all (this is commonly known as statistical significance). Basically, we want to know what is important to the model and what is not.

The results of the regression are displayed in Table 1. We believe what is shown here confirms our earlier result that gold is an inflation hedge in the long run, because the t-statistic is 2 or higher in absolute value. This result does not surprise us. The result for unexpected inflation shows that gold is not an effective hedge, neither long nor

short term. What is also interesting is how little of the variation in gold prices is explained by either component of inflation. The R-squared is about 10%. If only 10% of the return is captured by inflation, that means another 90% of it is not accounted for. This can take the form of simple supply/ demand dynamics, asset bubbles, and so on. A hedge is most effective when it is pure;

3 The November 2009 Investment Outlook: Time to Use the Philosopher’s Stone? discusses in more detail PNC’s view on gold as an investment.

linear regression—

shows the relationship between variables by fitting a line to a group of data points. (See Chart 9, page 6 for an example.)

Table 1 Linear Regression Results for Gold against Inflation and Unexpected Inflation

dloG

%61 tpecretnI

88.1 tpecretnI tatS-T

Inflation Coefficient -5.01

T-Stat Inflation Coefficient -2.00

Unexpected Inflation Coefficient -1.91

T-Stat Unexpected Inflation Coefficient -0.85

Adjusted R-Squared 10%

Source: Bloomberg L.P., PNC

t-statistic—tells whether a variable is statistically significant or just noise.

R-squared—a value between 0% and 100%; 100% is a perfect linear fit.

5

Table 1Linear Regression Results for Gold againstInflation and Unexpected Inflation

Investment Outlook

6 February 2011

in other words, when much of the price variation of the hedge is explained by the price variation of the risk that one is looking to hedge.

It is our view that gold is not an effective hedge against unexpected inflation. This does not preclude the possibility that the price of gold may rise when inflation spikes higher, but it does say that the price of gold and the rate of inflation do not have a high probability of moving together.

Commodities4

Gold is not the only commodity. Contained within the S&P GSCI™ are anywhere between 25 and 35 different commodities depending upon the year. Collections of individual commodities may form complexes, such as the soybean complex, and these may be part of larger constituents, such as the energy portions of the GSCI. Of all the various commodity indexes, we chose the GSCI because it is based on world production values of the commodities.5

The GSCI is a commodity index with a long history and well-documented methodology of composition. The analysis that we perform here might not be possible with another commodity index. Leveraging the longer history of the GSCI, we can plot the GSCI versus unexpected inflation (Chart 9).

Immediately apparent is the linear relationship between the two. The R-squared is around 50% and the F-value is about 34 with a p-value much less than 0.00001. Disregarding the various statistics, the human eye tells us that this is a good fit. On the surface, the GSCI appears like a good candidate for hedging unexpected inflation. As unexpected inflation spikes, the positive linear relationship between the GSCI and unexpected inflation suggests that they should move in concert.

We think it is fair to analyze the GSCI in much the same way as gold, because they are both commodities.

However, it is important to keep in mind that the GSCI is a collection of different commodities. It is possible that a commodity, like crude oil, does not share the same inflation dependency as another commodity, say lean hogs. The claim has been made that the GSCI is heavily weighted toward the energy commodities (crude oil, gasoline, and heating oil). Performing a separate analysis on each commodity might shed more light on this. To this end, we can examine them individually to determine whether the inflation hedging properties are consistent across the commodity index constituents. We keep in mind that buying individual sets of commodities comes at a cost to diversification and that the exercise serves to shine light on a well-known fact that not all commodities behave alike.

The analysis looks at complexes first and then breaks them down into the constituents. From the results of the regression, we see that the results are non-uniform. The green numbers in the Unexpected Inflation T-Stat column are the important ones. Copper, cattle, and heating oil seem to be the ones that provide explicit hedging for unexpected inflation. At the complex level, this occurs for 4 Our October 2009 white paper, Natural Resources and Real Return: Gamma from Managed Futures, discusses commodities in greater detail.

5 Standard & Poor’s Goldman Sachs Commodity Index Handbook.

Chart 9

GSCI Versus Unexpected Inflation


F-value—value to determine whether regression is statistically valid.

Chart 9GSCI Versus Unexpected Inflation

y = 7.0996x + 0.0712R2 = 0.4791

-60

-40

-20

0

20

40

60

80

Inflation Rate Year-over-Year Percentage Change

GSCI Excess Returns

Linear (GSCI Excess Returns)

-0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08

Per

cent


energy, non-energy, livestock, and industrial metals. Although this does not hold cross-sectionally, the weightings of the index, specifically toward energy, ensure that the GSCI provides this hedging property.

The GSCI also provides hedging for inflation. As we said before, gold does give some hedging property over the long term. This is followed by hogs and cattle. It is interesting to note that energy is not as strong in this category. The R-squared values of some of these categories are relatively high as well. These are the red numbers in the Adjusted R-Squared column. This gives some reassurance that commodities contain a significant inflation and unexpected inflation component of returns.

However, there are other drivers of the returns, which makes commodities an impure hedge and subject to additional risks. To the extent that an investor can diversify the additional idiosyncratic risks, PNC recommends a diversified basket of commodities to perform the inflation hedging.

TIPS6

Treasury Inflation-Protected Securities (TIPS) provide pure hedging to inflation, both expected and unexpected. In the October 2009 white paper Private Real Estate: Inflation Hedging?, we outlined a mathematical argument based on cointegration for why we believe TIPS make a good inflation hedge. In this case, TIPS hedged both components of inflation, expected and unexpected. TIPS were constructed around the CPI to adjust the principal repayment based on those changes.

6 Our June 2009 white paper, Neither Fish Nor Fowl: A TIPS Primer, discusses TIPs in

greater detail.

Table 2

Linear Regression Results for Various Commodities against Inflation and Unexpected Inflation

noitalfnI tatS-T Unexpected Inflation Adjusted

Intercept Intercept Coefficient T-Stat Coefficient T-Stat R-Squared

GSCI -16% -1.62 7.25 2.41 12.15 4.54 44%

Non-Energy -8% -1.14 2.88 1.42 5.07 2.81 21%

Energy -19% -0.94 10.15 1.58 18.70 3.79 36%

Livestock -24% -2.79 8.28 3.17 6.80 2.92 24%

Agriculture -6% -0.62 0.90 0.33 3.34 1.37 4%

Industrial Metals 7% 0.36 1.99 0.33 14.01 2.59 29%

Precious Metals 16% 1.98 -5.10 -2.06 -2.00 -0.91 11%

Heating Oil -11% -0.58 7.69 1.23 18.02 3.75 37%

Cattle -24% -2.79 8.28 3.17 6.80 2.92 24%

Hog -31% -2.29 9.33 2.28 6.67 1.83 11%

Wheat -12% -0.81 2.28 0.53 2.43 0.63 -6%

Corn -16% -1.24 3.44 0.86 3.79 1.06 -3%

Soybeans 13% 0.96 -3.12 -0.77 2.15 0.59 6%

Sugar 22% 1.22 -5.89 -1.09 4.49 0.93 19%

Coffee -7% -0.26 3.01 0.37 2.41 0.34 -7%

Cotton -1% -0.04 0.60 0.12 3.63 0.81 -3%

Gold 16% 1.88 -5.01 -2.00 -1.91 -0.85 10%

Silver 16% 1.27 -5.28 -1.38 -1.74 -0.51 2%

Copper 18% 0.79 0.54 0.08 15.57 2.56 32%


7

Table 2Linear Regression Results for Various Commodities against Inflation and Unexpected Inflation

Investment Outlook

8 February 2011

TIPS, although a purer hedge to inflation than other investments, are still regulated by basic supply/demand forces in the market. If there is a great demand for that type of security in the market, the price will rise. TIPS can become expensive like any other type of insurance. The closer in time that protection is bought to an oncoming market event, the more expensive it will likely be.

Private Real Estate

Private real estate was shown in our October 2009 white paper, Private Real Estate: Inflation Hedging?, not to have good hedging ability for inflation. Calling an investment in private real estate an inflation hedge may not be accurate. Private real estate probably does have some exposure to inflation, but that is not the only exposure it might have. What must not be neglected when discussing its use as a hedge are its other components, which in the short run might drive returns sharply negative, as has been true recently, and which in the long run may still dominate any hedging efficacy it might have against inflation. Private real estate does have exposure to inflation, but this exposure can be overwhelmed by asset bubble behavior. This is the difference between using a pure investment hedge and an impure investment hedge such as private real estate.

Unexpected Inflation Hedges = TIPS and Commodities

TIPS and commodities form a hedge to unexpected inflation spikes. We have outlined arguments that support this in a number of publications. It may give you added confidence in our conclusion to know that our finding is corroborated by another author.7 Using a different mathematical technique, the author found good inflation hedging properties of TIPS, commodities, timber, and farmland. While the PNC platform does not currently allow for farmland investment, there is a timber option available. However, the illiquidity of the investment in timber, as well as other idiosyncratic risks, discourage us from considering it as an equivalent investment to TIPS or commodities.

Our recommendation for clients with acute inflation sensitivity is to consider the portfolio constructed in our June 2009 white paper, Alternative Investments in Non-Institutional Sized Accounts, as a way to guard against that particular risk. As with any investment, this should be measured against the knowable aspects of a client’s situation as listed in the bullets on page 4.

It is the view of the PNC Economics team, detailed in the January 2011 PNC Economic Outlook, that inflation will remain contained in 2011, with annualized changes forecasted to be 2.0% in the first quarter, 1.3% in the second, 1.7% in the third, and 1.8% in the fourth.

7 George A. Martin, “The Long Horizon Benefits of Traditional and New Real Assets in

the Institutional Portfolio,” The Journal of Alternative Investments, Vol. 13, No. 1

(Summer 2010): 6-29.

Chart 10

Private Real Estate Performance and Inflation

(rolling 1-year returns of NCREIF and CPI)

Source: NCREIF, Bureau of Labor Statistics, Bloomberg L.P., PNC

Chart 10Private Real Estate Performance and Inflation(rolling 1-year returns of NCREIF and CPI)

12/7

8

9/81

6/84

3/87

12/8

9

9/92

6/95

2/98

11/0

0

8/03

5/06

2/09

30

25

20

15

10

5

0

-5

-10

-15

-20

-25

Year

-ove

r-Ye

ar P

erce

ntag

e C

hang

e

NCREIF CPI Bubble Bubble


9

Themes for 2011 UpdateState of the States Revisited

In light of continued headlines describing the deterioration of state budgets and painting a grim picture for holders of municipal debt, we want to comment again on the issue that we added as a theme for 2011 in last month’s Investment Outlook—Escape 2011: Outlook Part II. The main culprit of states’ fiscal problems continues to be faltering revenues, with at least 46 states facing budget shortfalls in fiscal 2011. Most recently, municipal market phobias have arisen from budget deficit issues in the state of Illinois, as well as a significant increase in the cost of borrowing for issuers of new debt. This has prompted many investors to question whether the states will be able to adequately service their future debt burdens. When paired with a small number of highly publicized municipal bankruptcies, these issues make the municipal market appear to be quite a dangerous place. In reality, however, we believe this market environment may provide an opportunity for investors.

While the list of potential problems is a concern, municipalities still enjoy a number of advantages that corporations and others do not. It is these advantages that we believe should provide investors with adequate comfort that the vast majority of municipalities will meet their obligations, despite ever-increasing headline risk.

Below are some less-sensational facts about the municipal market that should help to quell many investors’ concerns.

Because of balanced budget requirements, most states can not run budget deficits for significant periods. This heightens the immediacy with which states must address any budget shortfalls, including coverage of existing general obligation debt. States are required to bring their budgets in line by decreasing expenditures, increasing taxes, or both. The recent income tax increase by the Illinois General Assembly is an example. Illinois also illustrates that states are different from corporations in that few if any corporations could pass along a price increase the size of Illinois’s tax increase.

As a result of balanced budget requirements, the municipal bond market enjoys much lower default rates than similarly rated investment-grade corporate bonds. For example, Moody’s cites the average five-year historical cumulative default rate for investment-grade municipal debt as 0.03% compared with 0.97% for corporate issuers. In fact, between 1970 and 2009 there have been only 54 Moody’s-rated municipal defaults. Only three of these carried a general obligation pledge. Further, of the recent municipal defaults, most came the way of defunct non-essential service revenue bond projects, rather than municipalities that carry the benefits of a full faith and credit backing. Amidst continued difficult operating conditions, only six municipal entities sought Chapter 9 protection in 2010.

The states have not had to endure the recent and current economy on their own. Federal stimulus has helped states not only in closing budget gaps, but it can be argued that federal aid is stimulative to the economy because it prevents states from making additional spending cuts, tax hikes, or both. Of the $160 billion state budget shortfall projected for fiscal 2011, at least $59 billion will automatically be covered by Uncle Sam as part of the American Recovery and Reinvestment Act of 2009. While we do not expect future federal bailouts, the Federal Reserve maintains the ability to purchase short-term municipal debt to provide liquidity to municipalities in the event of extreme market dislocation.

Themes for 2011 Update

Investment Outlook

10 February 2011

Contrary to the inferences of recent headlines, third-quarter 2010 marked the third consecutive quarter that state tax receipts have increased on a year-over-year basis, according to The Rockefeller Institute of Government. In addition, third-quarter 2010 marked the fourth consecutive quarter that current receipts exceeded expenditures for state and local governments (Chart 11). The breadth of states showing improvement was equally impressive, with 42 states reporting increases in tax collections. In terms of absolute dollars, California and New York experienced the largest personal income tax collection increases. Although still below prerecession values, this presents a positive sign for both state budgets and municipal investors. The emergence of the Build America Bonds program had two significant positive effects for the municipal market, especially near the end of 2010.

° The program allowed states to come to market at a low cost in a time when liquidity was scarce.

° It can be argued that because the program offered taxable issuance, it helped backstop the municipal market from additional pressures by keeping tax-exempt supply low.

Although the program expired in 2010, a panel to discuss tax issues headed by Treasury Secretary Timothy Geithner does allow for the possibility of a program extension, especially if market conditions worsen further.

While Chapter 9 of the U.S. Bankruptcy Code specifically governs the debt service agreements of municipalities, the 50 states are actually classified as sovereign entities. Therefore, U.S. Bankruptcy Code does not apply to the states. Stated differently, in the hypothetical situation in which a state considers bankruptcy, there is currently no legal mechanism in place that would allow for such an action. Prior to the advent of U.S. Bankruptcy laws, the last time a state defaulted was in the early 1840s.

Additional focus recently centered on the municipal credit default swap (CDS) market as investors watched Illinois 5-year CDS spreads rise to record highs, which some alluded to as a sign of an imminent default. In its simplest form, a CDS can be used as a gauge of credit risk in individual credits or the market as a whole. For a number of reasons, however, it’s difficult to use a municipal CDS as a perfect proxy for default probability. Unlike other asset classes, there is no alternative way for municipal investors to express a short position on the underlying assets other than a CDS, so spreads generally tend to be biased upward. Furthermore, a CDS is used for a number of reasons other than default speculation—including hedging certain exposures, taking a directional view on credit, and exposing relative value among different credits. Finally, the CDS market is young and, therefore, rather illiquid, which can also place an upward bias on spreads. In fact, at the end of 2010, net notional CDS outstanding was approximately 0.01% of the $2.8 trillion municipal market. Given these facts, however, we do expect further standardization and use of the municipal CDS market in the future. That being said, we track CDS spreads as an additional market barometer in what has traditionally been known as a less-than-transparent market. Even with imperfect pricing, Illinois CDS spreads have decreased more than 20% since

Chart 11

U.S. State and Local Government Fiscal Position

(current receipts less current expenditures)

Source: Bureau of Economic Analysis, PNC

Chart 11U.S. State and Local Government Fiscal Position(current receipts less current expenditures)

1Q80

3Q82

1Q85

3Q87

1Q90

3Q92

1Q95

3Q97

1Q00

3Q02

1Q05

3Q07

1Q10

80

Bill

ions

of D

olla

rs

60

40

20

0

-20

-40

-60

-80

-100


11

the increase in the state income tax, indicating a fairly significant decrease in credit risk.

Like many facets of the economy, state and local finances are improving, though we believe they are still not out of the woods and one must be careful not to extrapolate the general onto all specific state and local municipalities. Our view is that the situation for state and local governments is better than some of the alarmists might suggest. In addition, the combination of worries about the fiscal position of municipalities and the resultant volatility have made valuations on municipal bonds relative to taxables much more attractive again (Chart 12).

While we would expect continued increased volatility due to the structural changes in the municipal bond market and worries about general fiscal health, we believe this should provide interesting investment opportunities for the keen investor. For client portfolios that use individual tax-exempt securities, we continue to recommend using only general obligation or essential service revenue bonds, such as sewer and water bonds. This municipal market may also provide significant opportunities for municipal bond managers to add value via good credit research and taking advantage of the more differentiated returns with monoline bond insurance much less a factor now.

PNC Current Recommendations Our current recommended allocations continue to reflect the more positive tone, while being mindful of the continued downside risks inherent in the market and economic outlook:

a baseline allocation of stocks relative to bonds; a baseline allocation to international relative to domestic stocks; an allocation to emerging markets within the international component; a preference for high-quality stocks; a tactical allocation to leveraged loans within the bond allocation; a tactical allocation to dividend-focused stocks within the U.S. large-cap stock allocation; and an allocation to alternative investments for qualified investors.

Baseline Allocation of Stocks Relative to Bonds

Since one cannot accurately determine the short-term movement of stocks, we argue that investors should focus on what is knowable and controllable. The one thing an investor can truly control is asset allocation. PNC’s six baseline asset allocation models are shown on the back page of this outlook.

Preference for High-Quality Stocks

Any relapse to stressed capital markets or to another credit crunch from a financial crisis poses a higher threat to lower-quality and highly leveraged companies. Companies with weak balance sheets and less-robust business models have a much higher risk to their survival. While this risk had seemingly receded as the world economies stabilized, it has come back into focus with economic fears surrounding

Chart 12

Municipal Ratios

(municipal yields relative to Treasury yields)


Chart 12Municipal Ratios(municipal yields relative to Treasury yields)

1/10

2/10

3/10

4/10

5/10

6/10

7/10

8/10

9/10

10/1

0

11/1

0

12/1

0

1/11

1.4

1.2

1.0

0.8

0.6

Rat

io

10-Year Ratio 5-Year Ratio

PNC Current Recommendations

Investment Outlook

12 February 2011

the sovereign debt woes in Europe. We favor a preference for high-quality stocks as a method of risk control against the possibility that the rebound may not be sustainable.

Allocation to Leveraged Loans within Bonds8

We believe an allocation to leveraged loans within the bond portion of a portfolio should help defend against higher interest rates. Since leveraged loans are adjustable-rate instruments tied to short-term interest rates (typically 3-month LIBOR), we believe holders should benefit from the rising rates (Chart 13). If longer-term interest rates rise, the shorter duration of leveraged loans should result in significantly better performance relative to longer-duration fixed income, such as the Barclays Capital U.S. Aggregate Index. As both the taxable and tax-exempt bond markets stumbled in late-2010, this allocation continued to provide positive results even in a rising rate environment.

In summary, this allocation could be characterized as lowering the portfolios’ interest rate risk while raising the credit risk and correlation with equities. It accomplishes this without a large impact on portfolio income.

Allocation to Dividend-Focused Stocks9

The allocation to dividend-focused large-cap U.S. equities is 10% of the large-cap U.S. allocation taken from the large-cap value category. Companies continue to have large and growing corporate cash holdings (Chart 14). Also, the payout ratio for the S&P 500 remains low (Chart 15). Corporations in general have a significant stash of

8 The March 2010 Investment Outlook, Shakespeare for Primates, provides details

about leveraged loans. 9 The October 2010 Investment Outlook, Iceland: Lessons from the Front Line of the

Financial Meltdown, provides details about the dividend focus recommendation.

Chart 13

3-Month LIBOR

Source: British Bankers’ Association, Bloomberg L.P., PNC

Chart 14

Corporations’ Total Liquid Assets


Source: Federal Reserve, FactSet Research Systems, PNC

Chart 15

S&P 500 Payout Ratio


Source: Standard & Poor’s, First Call, FactSet Research Systems, PNC

Chart 15S&P 500 Payout Ratio(shaded areas are recession periods)

Per

cent

65

60

55

50

45

40

35

30

25

1961

1964

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

Chart 14Corporations’ Total Liquid Assets(shaded areas are recession periods)

Bill

ions

of D

olla

rs

2,000

1,800

1,600

1,400

1,200

1,000

800

600

400

200

0

1980

1985

1990

1995

2000

2005

2010

Chart 133-Month LIBOR

Per

cent

0.24

0.29

0.34

0.39

0.44

0.49

0.54

0.59

1/10

2/10

3/10

4/10

5/10

6/10

7/10

8/10

9/10

10/1

0

11/1

0

12/1

0

1/11


13

liquidity and level of earnings that give them flexibility to support the current dividends and likely increase them.

While dividend stocks have lagged their more aggressive counterparts in the recent strong market environment, we believe the focus on return of capital is likely to remain with investors for some time as the financial crisis remains an overriding memory. We believe dividend stocks remain attractive for investors seeking a growing income stream and those attempting to lock in a larger amount of their potential total return from stocks with dividends. In addition, the recent extension of the Bush tax cuts with the lower dividend tax rate now removes another impediment for investors. Dividend-focus stocks currently remain one of the better risk/reward opportunities within our opportunity set, in our opinion.

Allocation to Alternative Investments

Alternative asset classes should also be considered for qualified investors, we believe, because they may provide an effective risk management tool for portfolios. The argument is that if alternative and traditional investments are put on even footing with regard to expected returns, then solely by virtue of the two investments being different, the risk of the overall portfolio is reduced without altering the portfolio’s expected return. The risks may not be less, but they are in some ways different, so we believe this diversification should help manage overall portfolio risk.

Every action (or even inaction) involves risk, and we firmly believe that investors should think about risk when they consider alternative investments. However, our research suggests that adding carefully selected alternative investments to a diversified portfolio of traditional investments may materially reduce the overall risk (as defined by the volatility of returns) of that portfolio without affecting expected returns. We believe that alternative investments should be considered as a tool for managing portfolio risk, not for adding risk to increase returns.

As an example of the possible value alternatives, in particular hedge funds, can bring to a portfolio in the current environment, one can look at the correlation between the S&P 500 and the HFRX™ Macro Index (Chart 16). Obviously, low correlation with stocks at times when they are falling would be a distinct positive in terms of reducing the downside. While at times these two very different assets move nearly in unison, the hedge funds do have exposure to other factors than solely stocks and also might adapt to the environment by changing exposures.

Given the current market environment, which includes a large number of factors (such as low returns on cash and occasional spikes in macroeconomic concerns) that could continue to result in increased volatility, we believe alternative investments are worthy of consideration.10

10 For more details, see our October 2009 Investment Outlook, Alternative Medicine,

and our August 2009 white paper The Science of Alternative Investments.

Chart 16

HFRX Macro Index and S&P 500 Correlations

Source: HFR Asset Management, LLC; Bloomberg L.P.; PNC

Chart 16HFRX Macro Index and S&P 500 Correlations

30-D

ay R

ollin

g C

orre

latio

ns

1.0

0.5

0.0

-0.5

-1.0

2007

2008

2009

2010

2011

Latest: 0.8712

Low: -0.9407

High: 0.9721

Investment Outlook

14 February 2011

Great Expectations in the Financial Markets While we have devoted much of this outlook to other assets used in hedging inflation risks, we would be remiss not to discuss stocks and bonds in this regard as well. Studies have shown that high inflation historically has led to poor short-term stock performance.11 However, in one of the most comprehensive studies of long-term global stock market performance, Dimson, Marsh, and Staunton12 found that equities provided the highest real return across the stock, bond, and cash returns of 16 countries and 101 years of data.

Though it is an extreme example, the German hyperinflation episode of the early 1920s can also serve as an interesting example of stock behavior. As one might expect, all fixed cash flow assets (bonds, pensions, and so on) suffered horribly during this period while real assets, stocks and many businesses fared much better.13

In fact, when looking at some of the data during the episode, one can see the performance of stocks during inflationary episodes, as well as some of reasons behind what we monitor in the PNC Inflation Watch Indicators (Table 3).

It is logical that businesses and stocks adapt to inflation because earnings and future dividends eventually start to rise with the level of inflation and offset at least some of the negative impact

11 Jeremy J. Siegel, Stocks for the Long Run (New York, McGraw Hill, 2002). 12 Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton, NJ: Princeton University Press, 2002). 13 Adam Fergusson, When Money Dies: The Nightmare of the Weimar Collapse

(William Kimber & Co. Ltd., London, 1975).

Table 3

German Hyperinflation Components

(change)

namreG kramhcstueD elaselohW

kcotS .S.U susreV ecirP yenoM

Year CPI Wages Supply Index Dollar FX Prices

1919 60% 80% 60% 230% -82% 40%

1920 105 105 90 80 -36 120

1921 70 80 70 140 -62 170

1922 3500 2700 1000 4100 -97 1100

Source: ISI, Gerhard Bry, Bresciani-Turroni, PNC

Table 4

Baseline Asset Allocation with Alternative Assets

noitavreserP Conservative Moderate Balanced Growth Aggressive

Strategic Allocation %0.07 %0.06 %0.05 %0.04 %0.03 %0.51 skcotS

0.51 0.03 0.54 0.06 0.03 sdnoB

0.0 0.0 0.0 0.0 0.55 hsaC

0.03 0.52 0.02 0.51 0.01 evitanretlA

%0.001 %0.001 %0.001 %0.001 %0.001 %0.001 latoTAlternative Assets

0.71 0.41 0.8 5.7 5.2 sdnuF egdeH

0.4 0.3 0.2 0.0 0.0 ytiuqE etavirP

Private Real Estate 0.0 0.0 2.0 3.0 4.0

Natural Resources/Real Return 7.5 7.5 8.0 5.0 5.0

Total Alternative Assets 0.0% 10.0% 15.0% 20.0% 25.0% 30.0%

Source: PNC

Table 3German Hyperinflation Components(change)

Table 4Baseline Asset Allocation with Alternative Assets

Great Expectations in the Financial Markets


15

of inflation. Bonds paying a fixed coupon are unable to adapt to unexpected inflation and suffer badly in comparison.

As we have noted in the past, we believe that alternative investments can be used to reduce some risks (likely including inflation risk) because they are exposed to some different risks than are traditional investments. As illustrated in this outlook, commodities and TIPS have the most direct inflation hedging ability. Hedge funds, private equity, private real estate, and stocks probably all share some exposures that should help guard against inflation in the long term, though there are other major factors at work there as well. Table 4 on page 14 shows our recommended asset allocation including alternative investments for qualified investors, which reflects our current recommended allocations to many of the asset classes discussed in this publication. For more information regarding these allocations please see our August 2009 white paper The Science of Alternative Investments.

PNC currently recommends a baseline allocation in our asset allocations in terms of stocks versus bonds and cash, but we also recommend the following tactical allocations.

In order to reduce interest-rate risk within portfolios, we recommend leveraged loans within the bond allocation. This is an expression of our baseline view that the recovery should continue, which will likely push interest rates higher. We believe dividend-focused stocks within the U.S. large-cap stock allocation should effectively lower some volatility in the portfolio while providing the opportunity to add some income and risk-adjusted performance in this environment.

Our current recommended allocation attempts to balance the relative attractiveness of stocks and other risk assets, given the transition to expansion that we expect in the global economy, with the continued downside risks to our forecast. We remain vigilant in monitoring asset valuations and the various factors affecting our views on the sustainability of the economic recovery. There remain various sources of volatility and downside risk, including European sovereign debt, emerging market, inflation, employment, and other geopolitical risks.

Investment Outlook

Asset Allocation Recommendations

The PNC Financial Services Group, Inc. (“PNC”) provides investment and wealth management, fiduciary services, FDIC-insured banking products and services and lending and borrowing of funds

through its subsidiary, PNC Bank, National Association, which is a Member FDIC, and provides certain fiduciary and agency services through PNC Delaware Trust Company. This report is furnished

for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation or

particular needs of any specific person. Use of this report is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client’s individual account

circumstances. Persons reading this report should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies

discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in this report was obtained from sources

deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in this report and the opinions expressed herein are subject

to change without notice. Past performance is no guarantee of future results. Neither the information in this report nor any opinion expressed herein constitutes an offer to buy or sell, nor a

recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by

PNC affiliates. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC,

the Federal Reserve Board, or any government agency. Securities involve investment risks, including possible loss of principal.

©2011 The PNC Financial Services Group, Inc. All rights reserved.

50% Growth

50% Value85% Large-Cap

10% Mid-Cap

5% Small-Cap

20% International

80% Domestic

Equity Allocation

Fixed Income Allocation

CCaappiittaalliizzaattiioonn:: BBaasseelliinnee SSttyyllee:: BBaasseelliinnee

PPlluuss DDiivviiddeenndd FFooccuuss WWiitthhiinn LLaarrggee--CCaapp

GGlloobbaall PPoossiittiioonniinngg:: BBaasseelliinnee

CCrreeddiitt PPoossiittiioonniinngg:: CCoorree pplluuss LLeevveerraaggeedd LLooaannss

(Baseline is 85/10/5) (Baseline is 50/50)

(Baseline is 80/20)

(Baseline is 100% Core)

0

20

40

60

80

100 100%55%

25%

20%

Pre

se

rva

tio

n

Co

ns

erv

ati

ve

Mo

de

rate

Ba

lan

ced

Gro

wth

Ag

gre

ss

ive

100%20%

80%

35%

65%

50%

50%

65%

35%

55%

30%

15%

0

20

40

60

80

100

Pre

se

rva

tio

n

Co

ns

erv

ati

ve

Mo

de

rate

Ba

lan

ced

Gro

wth

Ag

gre

ss

ive

100%20%

80%

35%

65%

50%

50%

65%

35%

55%

30%

15%

Bonds100%

Stocks

Current Tactical

Baseline

As of market close, Monday, January 24, 2011:

For qualified investors, we recommend an allotment to alternative assets of 20% of a balanced allocation to

complement the traditional allocation.

Cash

90%

10%

Core

High-Yield

11980.521290.84

DJIA

0.154%

90-DAY T-BILL

3.408%

10-YEAR T-NOTES&P 500®

investment outlook great expectations: inflation · investment outlook 2 february 2011 great...

Documents