Market Perspectives - July 2012
2012 mid-year outlook: Looking past the cliff
Asset allocationBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
Investment horizonsFrom our perspective, even with the decent run-up in the equity markets in the first quarter, stocks still represent good long-term value, especially relative to fixed income. We have been expecting volatility to return, but it seems late in coming. In the meantime, while high-yield fixed income might not offer substantial capital appreciation potential, it can provide some decent income.
EquitiesWith continued and prospective austerity measures in Europe, we prefer U.S. equities and some select Japanese exposure for developed market exposure. Despite the slowdown in China, we think emerging markets can present strong growth opportunities, but some of those opportunities are probably better tapped through U.S. equities rather than directly in the emerging markets. Some of our favorite long-term investments are U.S. consumer staples and health care stocks, which carry a sense of status and quality in the emerging markets. Broad and sweeping allocations to emerging markets may prove to be excessively volatile, but a prudent and well-researched exposure to emerging markets could pay dividends. We are growing increasingly skeptical about the health of the Chinese financial system, but we are hopeful that the country's five-year plan may bring about important political and economic reforms.
Value versus growthThere appears to be increasing skepticism about the sustainability of the pace of global economic growth. We understand that skepticism, especially given the potential for further austerity measures in Europe and the possibility that the U.S. government will allow the past 10 years of tax policy to lapse. However, we think this simply means investors will eventually pay up for companies that can deliver real growth in a slow-growth environment. We believe those companies are primarily in the U.S. consumer staples, health care, and IT sectors. Even U.S. financials could grow as their European counterparts shed their crown jewels.
Large caps versus small capsWhile we prefer large-cap stocks, because they are most likely to be able to penetrate new markets or grow their market share in existing markets, we do not recommend a heavy overweight because there are many selective opportunities in the small-cap space. Large companies with huge amounts of cash on hand will likely look to expand market share or penetrate new markets through strategic acquisitions. As evidenced by some recent acquisitions, executives at large-cap companies may be willing to pay premium prices for acquisitions. For this reason, it will be important to be selective and invest in companies that are making prudent acquisitions. It's not just size or cash hoards that matter, but also the quality of management. That sort of information only comes from bottom-up stock selection, not just broad sector allocations.
Fixed incomeBased on our economic outlook, interest rates are likely to remain low (but volatile) for the next two years. This presents an opportunity for investors to consider taking on additional duration and credit risk. Provided that the economy does not dip into a recession, default rates should not increase, meaning the increased yields on higher-yielding debt may provide better income to investors than the lower-credit-risk issues.
Asset allocation summary tableThe blue bar on each diagram below represents our recommended tactical positioning for investors looking to make adjustments to their portfolios based on current market conditions. The green bar represents our recommended strategic positioning for investors with a time horizon of three years or more.*