Financial asset prices are a reflection of the current environment as well as future expectations, but often, rising or falling prices feed back into the shaping of expectations themselves. Rising prices often cause more buyer optimism and cause those less positive on the economy to capitulate. Pricing also feeds back into fundamentals as higher financial asset pricing lowers corporate cost of capital and increases business and consumer confidence, which furthers economic improvement and induces further market improvement.
This feedback loop is one of the reasons financial markets form “trends” or “market momentum.” However, one cannot extrapolate any trend in perpetuity; history has demonstrated that eventually the pendulum that swings between fear and greed reverses course, sometimes very suddenly. We believe the potential for a shift to greater investor pessimism is too high relative to where we project further potential credit market improvement; therefore, we have reduced credit risk across our multisector portfolios.
The Citigroup Economic Surprise index measures the magnitude in which the market consensus underestimates or overestimates actual U.S. economic strength. Through the fourth quarter, the U.S. economy consistently outperformed broad expectations as demonstrated by this index. As a result, many economists raised their expectations and investor appetite for market risk grew.
However, the degree to which economists have underestimated economic strength has diminished steadily since January. Although economic data remains firm, the decline of this index and others like it combined with the current pricing of risk assets in the context of our long-term trend growth expectations leads us to believe that much of the recent optimism is already reflected in the markets. There is potential for the rally in equities and credit spreads to continue to feed itself, but the preponderance of risk in today’s environment gives us pause in participating in what could prove to be a greater fool’s game.
Among the risks that give us concern is a worsening of the European sovereign debt crisis. Although the European Central Bank, International Monetary Fund and the European Commission have gone to extraordinary lengths to prevent an immediate collapse, they have done so through liquidity measures that do not resolve long-term solvency issues. Additionally, austerity measures designed to reduce the debt-to-GDP ratios in the peripheral countries have had an unintentional and powerful effect in reducing mostly just the denominator of the ratio. Europe is in a recession and will be for some time. This is undoubtedly negative for global growth and has the potential to be very bad.
Domestically we remain modestly optimistic with a base case projection for 1.75% to 2.25% gross domestic product growth. We feel we are likely to avoid a recession, but by a lesser margin than the 2.3% projection of the Bloomberg economist survey from March 4. While encouraged by recent data, transfer payments are slated to decline, the savings rate remains unsustainably low, and real incomes are stagnant. Additionally, higher gasoline prices and uncertainty surrounding the extension of Bush tax cuts will likely add headwinds to consumption. We expect revelations of these economic challenges to create volatility and perhaps investment opportunities.
Credit risk was increased across the multisector portfolios in the fourth quarter and that incremental allocation provided additional benchmark outperformance. We feel it is the right time to protect those gains and reduce our exposure to credit spreads. We have reduced our exposure to high yield and moved higher in quality within investment grade. Together, these moves reduce our sensitivity to widening credit spreads by roughly one quarter. Although we remain overweight spread product, our position is modest giving us the confidence and capacity to redeploy capital into risk sectors when the pendulum inevitably swings the other way.
Christopher Zeppieri is vice president and portfolio manager multisector portfolios at Hartford Investment Management Co., Hartford, Conn.