October 21, 2015

The Fed: Data-Dependent or Date-Dependent?

Income Opportunity Strategy 3Q 2015 Review

Market Commentary

Commentary about heightened “uncertainty” seems to be much more prevalent than it is useful, as we can’t remember a time when the investing outlook was ever certain. However, the big story of the third quarter may be exactly that – increasing uncertainty. The VIX volatility index, often a proxy for “uncertainty,” spiked during the quarter, hitting its highest level since the summer of 2011, a time when many investors feared that too much debt among European countries could lead to a second collapse of the global financial system. Corporate bond spreads, an indicator of credit risk, increased while the S&P 500 notched a 7% decline from start to finish.

People blame the volatility on a number of things including a potential slowdown in China, gridlock in Washington and a collapse in the commodities complex, among other things. While all of these issues likely contributed to the rising volatility, we think there is no more salient issue than the market’s concern about the Fed shifting from a commitment to “data dependence” to a stance of possible “date dependence.”

In January of 2012, the Federal Open Market Committee (FOMC) released a policy statement regarding its longer-run goals and monetary policy, noting that, “The committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures (PCE), is most consistent over the longer run with the Federal Reserve’s statutory mandate.” At the time of the statement, the core PCE index, which excludes the volatile food and energy categories, was indeed rising at 2%. Since that time however, the core PCE index has fallen steadily to its current rate of 1.3%.

Meanwhile, the other part of the Fed’s dual mandate is to promote maximum employment. Estimates of “normal” unemployment from the FOMC’s September 2015 Summary of Economic Projections ranged between 4.7% and 5.8% with a median value of 4.9%. The most recent rate of unemployment was 5.1%. Not only is that unemployment rate higher than the committee’s median estimate for maximum employment, but the labor force participation rate of 62.4% continued to fall to its lowest level since 1977, suggesting lots of potential workers are opting to remain on the sidelines in the face of lackluster wage growth.

Despite the fact that the economy appears to be moving in the opposite direction of the Fed’s stated targets, Fed chair Janet Yellen said in a speech last month that, “It will likely be appropriate to raise the target range of the federal-funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2% objective.” The markets are suggesting that hiking rates this year is the wrong policy action. The 10-year inflation breakeven rate, which measures market-implied expectations for annualized inflation over the coming decade, plummeted to 1.4%, the lowest level since we were exiting the financial crisis in 2009.

Investors’ reduced clarity around the Fed’s stance, along with the prospect that the Fed could raise interest rates and reduce liquidity in a fragile economy appear to be the primary causes of increasing volatility. Short rates did not reach 1% for 20 years after the Great Depression, so the market likely wonders why the Fed appears to be in a hurry to get there just six years after a collapse of similar magnitude.

Strategy Highlights

During the third quarter of 2015, Income Opportunity Strategy returned -13.66%, net of fees.1 In comparison, the Strategy’s unmanaged benchmarks, the BofA Merrill Lynch US High Yield Master II Index and the S&P500 returned -4.90% and -6.44%, respectively.

We initiated three positions and eliminated fourteen during the quarter, ending the quarter with 50 holdings.

Top Contributors

  • All three top contributors were a result of the Income Opportunity Strategy’s timely selling of its shares. Gamestop Corp. was down -3.24% over the quarter but the Strategy showed an increase of 10.43% as a result of selling. Likewise, Seagate Technology was down -4.69% for the quarter but the Strategy realized a gain of 10.71% due to selling. In addition, the Herbalife LTD 2.0 8/19 convertible returned 3.23% as a result of selling versus the convertible’s decline of -0.26% over the whole period. The Strategy has now exited all three of these positions.

Top Detractors

  • Abengoa Yield PLC ended the third quarter down -46.23%, despite its second quarter performance. During the third quarter, the company announced strong Q2 operational results and declared a dividend of $0.40 per share (9.67% annualized yield), which is an increase of 17.6% over Q1. Over the period, the CFO resigned, becoming the second abrupt management change in four months.
  • Triangle Capital Corp. declined -27.18% over the quarter. Triangle disappointed in the second quarter, announcing EPS of $0.49, a penny shy of the $0.50 estimate and five cents shy of the dividend. Lower-than-expected loan originations appeared to drive the miss. Over the period, the company declared a steady dividend of $0.54 per share and another $0.05 “special” dividend (13.4% annualized yield).
  • Fortress Transportation and Infrastructure Investors LLC was down 28.45% during the quarter. The company announced weak second quarter EPS of $0.02 versus the consensus estimate of $0.11 but declared a $0.15 partial stub dividend (9.35% annualized yield) and said they expect to meet or exceed a 10% annual dividend growth rate. At the end of the third quarter, John Levin wrote a public letter to Fortress CEO Wes Edens calling for a meeting to discuss possible resolutions to alleviate the conflict of interest between Fortress and the shareholders of entities that Fortress manages.

1For important information about Income Opportunity Strategy performance, please click on the Income Opportunity Composite Performance Disclosure. Past performance is no guarantee of future results.

Contact LMM to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

©2015 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.

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