Issue 29: 2015

Investment outlook

The Big Top World

Even with a circus of conflicting trends, the outlook remains encouraging.

Photograph by Andy Ryan

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The world is sending us conflicting signals as the rebalancing of growth continues, extending a cycle that is still in its early stages. We would characterize this phase, to slightly alter the lyrics from Journey’s classic 1983 song “Faithfully,” as “circus [markets] under the big top world, we all need [growth] to make us smile.”

A lot has happened since September of last year. Economic data have been mixed, volatility has increased, currencies and rates have been diverging, European quantitative easing has started, the speed of dollar strengthening (and euro weakening) has accelerated, energy prices have remained under pressure, and now U.S. monetary policy is preparing to normalize.

In all of this we see a “big top world” that is undergoing several trend reversals, and there are many reasons why we are more encouraged than worried about these recent events.

Don’t fear the turning point

The most noisy and complex environments for investors or asset allocators are those that include major reversals of trends. Economists and strategists call them turning points. Some turning points are cyclical; some are rare, especially those when an entire decade or two of catalysts is reversed and an entirely new trend is born. We are experiencing one of those rare ones, and we have been calling it the rebalancing of world growth. Past examples include the emerging markets crisis in the 1990s, the NASDAQ bubble, the housing credit cycle in the United States and, finally, the debt problems in Europe. More recently, new circus acts have entered the big top world, including the commodity producers, the high-deficit countries within the emerging markets, the energy sector, the European financial balance sheets, and the massive restructuring in China, which is one of the world’s fastest-growing and least transparent economies.

We see several trend reversals, and there are many reasons why we are encouraged.

This year, two new and opposing catalysts are on a high-wire act: There’s the economic growth backdrop that is improving and the strengthening dollar that has high velocity behind it. These clashing trends are causing a major dispersion between central bank policies in Europe and Japan when compared with those in the United States. Similar differences exist within emerging markets. These differences are causing pressur eacross areas of the world outside of the Eurozone and the United States that have traditionally been viewed as “safe havens.” Switzerland and Denmark are experiencing upward pressure on their currencies, which has also created a negative-yield backdrop. Furthermore, pressure is building to show resolve in U.S. monetary policy by signaling to the market that ultra-accommodative policy is coming to an end, and equal but opposite pressure is on the European Central Bank to stop deflation in its tracks with an increasingly easy policy.

And the impact on portfolios?

With these major turning points comes a wave of borrowing in a cheap currency with ultralow rates (from the yen initially, to the dollar during and after the credit crisis, and now to the euro) and significant shifts in portfolios. When financial institutions gather high-quality long-dated bonds to shore up balance sheets and boost capital, the supply of bonds is strained and rates drop. This creates a lack of yield for investors in an asset class usually designed to provide cash flow and a level of principal protection.


Mis Imagenes/Getty Images

 

The further the yields drop, the less the cash flows. Then a shift begins, and along with it the search for yield outside fixed income investments. Investors switch their allocations to bond proxies in the equity markets — higher-yielding equities, sectors such as utilities and telecommunications, real estate investment trusts (REITs) and master limited partnerships (MLPs). In addition, some increase weightings in high-yield bonds and emerging markets debt help to make up for the gap from general fixed income. And still others add cash, lower fixed income and boost equity exposure at the same time to protect against a “correction” or to have liquidity ready if a correction ensues.

This is still occurring, and it is one of the catalysts driving the value of the dollar. As borrowers of our formerly cheap currency pay back their loans at record low rates, the scramble for dollars occurs, and the dollar’s strength increases. We expect this to slow down but continue well into the future. On the flip side is the euro. The euro’s weakness has been rapid, and its rates have been historically low. This is tonic for borrowing to shift from dollars to euros. It causes volatility and further complicates asset allocation for investors who are searching for cash flow.

A strong dollar is a plus

In our view, the strength in the dollar is a plus for world growth. The issue is the speed of its strengthening, which is forcing some profit-taking in risk assets. We believe this is temporary since the effect on earnings per share (EPS) should not be as negative as forecasters believe. The strength of the dollar should keep U.S. interest rate policy and inflation moderate, and the weakness in the euro and the fall in oil prices are growth-friendly for struggling areas.

We expect equities to outperform fixed income, albeit at a slower pace and with slightly more volatility than in recent years.

We believe this is a normal pullback and not an extended correction. Big corrections occur when excessive overvaluation is present (not the case), EPS rolls over as recession looms (not the case), the interest rate curve becomes inverted (not the case) and oil prices are excessively high (not the case). The midcycle under the big top world is still on track.

In short, we would be buyers on a pullback. For the full year, we are maintaining our estimate of 2200 for the S&P 500, and we are looking for a 2.5% yield at the top end on 10-year Treasuries.

Portfolio considerations and investment themes

We continue to expect equities to outperform fixed income, albeit at a slower pace and with slightly more volatility than in recent years. We expect non-U.S. developed equities to outperform the United States on a hedged basis, as the relative increase in growth versus expectations is more pronounced overseas. Also, valuations outside the United States are more favorable. We would continue to emphasize our get-paid-to-wait equity strategy and continue to lower the overall beta in portfolios by allocating to lower-volatility investments. Specifically, we are still slightly overweight U.S. and European equities, and slightly more underweight emerging markets.

We remain overweight financials, information technology, healthcare and energy; and remain neutral materials and industrials, and the consumer sector. We would underweight utilities and telecommunications.

For asset classes, we are underweight fixed income and commodities. We’re neutral hedge funds, private equity and real estate. We continue to emphasize the manufacturing renaissance, cybersecurity, personalized medicine, obesity, the emerging markets middle-class consumer, long-term North American energy and the natural resource revolution.

IMPORTANT INFORMATION

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

Equities 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.

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.

Technology stocks may be more volatile than stocks in other sectors.

Master Limited Partnerships (MLPs) are limited partnerships or limited liability companies that are taxed as partnerships and whose interests (limited partnership units or limited liability company units) are traded on securities exchanges like shares of common stock. Currently, most MLPs operate in the energy, natural resources or real estate sectors. Investments in MLP interests are subject to the risks generally applicable to companies in the energy and natural resources sectors,including commodity pricing risk, supply-and-demand risk, depletion risk and exploration risk.

Fixed Income Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.

Investments in high-yield bonds (sometimes referred to as “junk bonds”) offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer’s ability to make principal and interest payments.

Treasury bills are less volatile than longer-term fixed-income securities and are guaranteed as to timely payment of principal and interest by the U.S. government.

International Investing 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.

Commodities 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.

Alternative Investments 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.

Other Nonfinancial assets, such as closely held businesses, real estate, oil, gas and mineral properties, and timber, farm and ranch land, are complex in nature and involve risks, including total loss of value. Special risk considerations include natural events (for example, earthquakes or fires), complex tax considerations and lack of liquidity. Nonfinancial assets are not suitable for all investors.

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.

The Standard & Poor’s (S&P) 500 index tracks the performance of 500 widely held, large capitalization U.S. stocks.

The world is sending us conflicting signals as the rebalancing of growth continues, extending a cycle that is still in its early stages. We would characterize this phase, to slightly alter the lyrics from Journey’s classic 1983 song “Faithfully,” as “circus [markets] under the big top world, we all need [growth] to make us smile.”

A lot has happened since September of last year. Economic data have been mixed, volatility has increased, currencies and rates have been diverging, European quantitative easing has started, the speed of dollar strengthening (and euro weakening) has accelerated, energy prices have remained under pressure, and now U.S. monetary policy is preparing to normalize.

In all of this we see a “big top world” that is undergoing several trend reversals, and there are many reasons why we are more encouraged than worried about these recent events.

Don’t fear the turning point

The most noisy and complex environments for investors or asset allocators are those that include major reversals of trends. Economists and strategists call them turning points. Some turning points are cyclical; some are rare, especially those when an entire decade or two of catalysts is reversed and an entirely new trend is born. We are experiencing one of those rare ones, and we have been calling it the rebalancing of world growth. Past examples include the emerging markets crisis in the 1990s, the NASDAQ bubble, the housing credit cycle in the United States and, finally, the debt problems in Europe. More recently, new circus acts have entered the big top world, including the commodity producers, the high-deficit countries within the emerging markets, the energy sector, the European financial balance sheets, and the massive restructuring in China, which is one of the world’s fastest-growing and least transparent economies.

We see several trend reversals, and there are many reasons why we are encouraged.

This year, two new and opposing catalysts are on a high-wire act: There’s the economic growth backdrop that is improving and the strengthening dollar that has high velocity behind it. These clashing trends are causing a major dispersion between central bank policies in Europe and Japan when compared with those in the United States. Similar differences exist within emerging markets. These differences are causing pressur eacross areas of the world outside of the Eurozone and the United States that have traditionally been viewed as “safe havens.” Switzerland and Denmark are experiencing upward pressure on their currencies, which has also created a negative-yield backdrop. Furthermore, pressure is building to show resolve in U.S. monetary policy by signaling to the market that ultra-accommodative policy is coming to an end, and equal but opposite pressure is on the European Central Bank to stop deflation in its tracks with an increasingly easy policy.

And the impact on portfolios?

With these major turning points comes a wave of borrowing in a cheap currency with ultralow rates (from the yen initially, to the dollar during and after the credit crisis, and now to the euro) and significant shifts in portfolios. When financial institutions gather high-quality long-dated bonds to shore up balance sheets and boost capital, the supply of bonds is strained and rates drop. This creates a lack of yield for investors in an asset class usually designed to provide cash flow and a level of principal protection.


Mis Imagenes/Getty Images

 

The further the yields drop, the less the cash flows. Then a shift begins, and along with it the search for yield outside fixed income investments. Investors switch their allocations to bond proxies in the equity markets — higher-yielding equities, sectors such as utilities and telecommunications, real estate investment trusts (REITs) and master limited partnerships (MLPs). In addition, some increase weightings in high-yield bonds and emerging markets debt help to make up for the gap from general fixed income. And still others add cash, lower fixed income and boost equity exposure at the same time to protect against a “correction” or to have liquidity ready if a correction ensues.

This is still occurring, and it is one of the catalysts driving the value of the dollar. As borrowers of our formerly cheap currency pay back their loans at record low rates, the scramble for dollars occurs, and the dollar’s strength increases. We expect this to slow down but continue well into the future. On the flip side is the euro. The euro’s weakness has been rapid, and its rates have been historically low. This is tonic for borrowing to shift from dollars to euros. It causes volatility and further complicates asset allocation for investors who are searching for cash flow.

A strong dollar is a plus

In our view, the strength in the dollar is a plus for world growth. The issue is the speed of its strengthening, which is forcing some profit-taking in risk assets. We believe this is temporary since the effect on earnings per share (EPS) should not be as negative as forecasters believe. The strength of the dollar should keep U.S. interest rate policy and inflation moderate, and the weakness in the euro and the fall in oil prices are growth-friendly for struggling areas.

We expect equities to outperform fixed income, albeit at a slower pace and with slightly more volatility than in recent years.

We believe this is a normal pullback and not an extended correction. Big corrections occur when excessive overvaluation is present (not the case), EPS rolls over as recession looms (not the case), the interest rate curve becomes inverted (not the case) and oil prices are excessively high (not the case). The midcycle under the big top world is still on track.

In short, we would be buyers on a pullback. For the full year, we are maintaining our estimate of 2200 for the S&P 500, and we are looking for a 2.5% yield at the top end on 10-year Treasuries.

Portfolio considerations and investment themes

We continue to expect equities to outperform fixed income, albeit at a slower pace and with slightly more volatility than in recent years. We expect non-U.S. developed equities to outperform the United States on a hedged basis, as the relative increase in growth versus expectations is more pronounced overseas. Also, valuations outside the United States are more favorable. We would continue to emphasize our get-paid-to-wait equity strategy and continue to lower the overall beta in portfolios by allocating to lower-volatility investments. Specifically, we are still slightly overweight U.S. and European equities, and slightly more underweight emerging markets.

We remain overweight financials, information technology, healthcare and energy; and remain neutral materials and industrials, and the consumer sector. We would underweight utilities and telecommunications.

For asset classes, we are underweight fixed income and commodities. We’re neutral hedge funds, private equity and real estate. We continue to emphasize the manufacturing renaissance, cybersecurity, personalized medicine, obesity, the emerging markets middle-class consumer, long-term North American energy and the natural resource revolution.

IMPORTANT INFORMATION

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

Equities 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.

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.

Technology stocks may be more volatile than stocks in other sectors.

Master Limited Partnerships (MLPs) are limited partnerships or limited liability companies that are taxed as partnerships and whose interests (limited partnership units or limited liability company units) are traded on securities exchanges like shares of common stock. Currently, most MLPs operate in the energy, natural resources or real estate sectors. Investments in MLP interests are subject to the risks generally applicable to companies in the energy and natural resources sectors,including commodity pricing risk, supply-and-demand risk, depletion risk and exploration risk.

Fixed Income Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.

Investments in high-yield bonds (sometimes referred to as “junk bonds”) offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer’s ability to make principal and interest payments.

Treasury bills are less volatile than longer-term fixed-income securities and are guaranteed as to timely payment of principal and interest by the U.S. government.

International Investing 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.

Commodities 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.

Alternative Investments 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.

Other Nonfinancial assets, such as closely held businesses, real estate, oil, gas and mineral properties, and timber, farm and ranch land, are complex in nature and involve risks, including total loss of value. Special risk considerations include natural events (for example, earthquakes or fires), complex tax considerations and lack of liquidity. Nonfinancial assets are not suitable for all investors.

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.

The Standard & Poor’s (S&P) 500 index tracks the performance of 500 widely held, large capitalization U.S. stocks.