Equities have endured another setback recently led by the outsized decline in momentum moving the broader indices to a flat line through the first three and one half months of 2014. This has come on the heels of significant stock market gyrations earlier this year — a 5.8% equity pullback to begin the year followed by a rally of more than 7%. This latest move lower is a rebalancing event in our view. Asset allocators are rebalancing portfolios off of the large gains from last year. This is evident in flows into bonds and profit taking in the high-momentum stocks and a movement into more value-oriented stocks.
This is natural in our opinion and we would rebalance as well and continue to diversify across the board with a preference for large cap U.S. companies that offer an attractive dividend, good value, double-digit earnings growth, and are beneficiaries of our mega trend themes. With information readily available across all economic geographies, asset classes, sectors, industry groups and the geopolitical landscape, wary investors are poring over every data point. As we travel through this year and into 2015, everyone — even the hills and their eyes — will be watching every economic statistic, every move by and word from central bankers, every corporate earnings release and every comment about “shadow banking” in China, not to mention any uprisings that occur in countries with emerging markets.
This scrutiny is typical of mid-cycle periods, particularly those that unfold after an outsized gain in the equity markets. In addition, the psychological adjustment is still a major part of the investor mind-set given the destruction of wealth during the credit crisis. As a result, many capital allocators have been conditioned to look for the next black swan, stress event, negative surprise or contagion episode. Adding to these fears have been economic data points in the United States and China that have elevated concerns about overall global growth. And now we have a geopolitical event in Ukraine creating further agitation.
Even though a majority of strategists have a positive outlook on the economy and financial markets, the broad investment community remains skeptical. This skepticism should allow markets to grind higher — likely in the low-double-digit percentages — through this year and next, and keep valuations in the equity markets from getting too far ahead of themselves. Furthermore, given the relative attractiveness of global equities versus global fixed income, the capital allocation tradeoff is still very favorable for equities. Therefore, we expect investment flows to continue moving from more conservative assets into equities.
With Information readily available, wary investors are poring over every data point.
As the growth curve around the globe continues to rebalance between emerging and developed markets, investment capital will likely seek areas where there is a stark mismatch between supply and demand in five broad thematic categories: the Earth, the markets, people, government and policy, and innovation.
In this regard, return on investments should be higher in investment solutions, companies and managers that benefit from the build-out of energy infrastructure, the rise of the emerging markets middle-class consumer, the massive change in the demographic wave, and the continuous development of disruptive technologies and innovation. In the medium term, successful capital allocation may be more about selectivity, active management and thematic investing than a large-scale movement up in the broader equity indexes, in our opinion.
Will the hills have eyes and ears for the positive scenarios that could unfold? We think so.
Equities: We remain confident that the uptick in financial stress caused by recent emerging market turmoil will not lead to a downturn in global economic activity. Thus, we remain overweight equities. Global reflationary efforts, led by the United States and Japan, still favor stocks over bonds, as valuations remain attractive on a relative basis. Our base case is for the S&P 500 to finish 2014 in the 1950–2000 range.
- U.S. equities: We continue to expect the U.S. economy to lead global growth and U.S. equities to outperform other asset classes, and thus remain overweight U.S. markets. Within domestic equities, we remain overweight large caps due to their greater exposure to global growth. We are also overweight small caps and mid caps.
- International equities: We remain slightly overweight international-developed equities based on our view that the improving global economic backdrop should provide enough of a tailwind to maintain modest growth in Europe, in addition to Japan continuing aggressive steps to end deflation. In the short term, the events unfolding in Ukraine could pressure certain markets in Europe, such as Germany. We have, as a result, moved to market weight in Europe. The euro is too strong, and the European Central Bank has been reluctant to address its deflationary implications.
- Emerging markets: We remain underweight in emerging market equities as the drawdown of asset purchases by the Federal Reserve and rising interest rates will likely continue to have a negative impact on several emerging markets, especially those where elections are making needed structural reforms difficult. We therefore remain very selective in emerging markets — with a preference for Mexico, South Korea and Poland — and are committed to owning what the emerging markets consumer needs and buys.
Skepticism should allow markets to grind higher through this year and next.
Fixed income: We remain underweight fixed income overall, but we are still finding selective opportunities. We recommend that investors reduce the duration in long-duration portfolios to protect against a rising interest-rate environment. Within fixed income, we continue to prefer credit over Treasuries, with an emphasis on corporate bonds, municipals (for example, general obligations and tax-backed bonds of state and local governments, as well as revenue bonds issued by utilities, transportation, higher education and healthcare systems), residential mortgage-backed securities, commercial mortgage-backed securities, and certain non-U.S., non-euro and non-yen sovereign bonds for their yield and currency advantages.
Commodities: We are underweight commodities. The tangible asset class is likely to face “tapering” headwinds as it has a high correlation to financial liquidity conditions. Stronger global growth should keep industrial metals outperforming gold.
Hedge funds: We remain slightly underweight hedge funds based on our view that directional asset classes should perform better as the U.S. economy gains momentum, but opportunities exist in global long/short, event-driven and relative value strategies.
Currencies: Our macro view implies that the dollar has ended its downtrend against other major (rich country) currencies and even has the potential to rise substantially against the euro and yen. Selected emerging market currencies (yuan, Korean won, Taiwan dollar) are most likely to prove exceptions.
Private equity: We remain neutral private equity.
Real estate: We remain overweight real estate as the housing recovery continues to gain momentum.
Investing involves risk. There is always the potential of losing money when you invest in securities.
Projections made may not come to pass due to market conditions and fluctuations.
Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.
Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.
OTHER IMPORTANT INFORMATION
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.
Stocks of small and mid cap companies pose special risks, including possible illiquidity and greater price volatility, than stocks of larger, more established companies.
Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.
For investments in MBS and CMBS, generally, when interest rates decline, prepayments accelerate beyond the initial pricing assumptions, which could cause the average life and expected maturity of the securities to shorten. Conversely, when interest rates rise, prepayments slow down beyond the initial pricing assumptions and could cause the average life and expected maturity of the securities to extend and the market value to decline. Mortgage-backed securities are subject to credit risk and the risk that the mortgages will be prepaid, so that portfolio management may be faced with replenishing the portfolio in a possibly disadvantageous interest rate environment.
International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.
Trading in commodities, such as gold, is speculative and can be extremely volatile. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest-rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Tangible assets can fluctuate with supply and demand, such as commodities, which are liquid investments, unlike most other tangible investments.
Energy and natural resources stocks have been volatile. They may be affected by rising interest rates and inflation, and can also be affected by factors such as natural events (for example, earthquakes or fires) and international politics.
Alternative investments are intended for qualified and suitable investors only. Alternative investments are speculative and involve a high degree of risk. Alternative investments such as derivatives, hedge funds, private equity funds and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity and your tolerance for risk.
Real Estate Investment Trusts (“REITs”) involve a significant degree of risk and should be regarded as speculative. They are only made available to qualified investors under the terms of a private offering memorandum. Holdings in a REIT may be highly leveraged and, therefore, more sensitive to adverse business or financial developments. REITs are long term and unlikely to produce a realized return for investors for a number of years. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties, such as rental defaults.
Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.
The Standard & Poor’s (S&P) 500 index tracks the performance of 500 widely held, large capitalization U.S. stocks.