Overview: The year 2011 saw an abundance of changes, but more changes are likely coming. In light of a sustained low, but volatile, growth environment, we are advocating the use of three broad themes for 2012: macroeconomic and political risks are the new fundamentals; within the broad asset classes, investors should seek managers that are nimble, that cast a wide net, and that employ both a superior buy and sell discipline; and investors shouldn’t just consider principal preservation sacrosanct—they should weigh the opportunity cost of protecting their principal.
The economy: Investors are wondering whether some of the growth we’ve seen is sustainable, especially considering two big risks: What’s the tax picture going to look like in the U.S., and what’s going to happen in Europe? While both are legitimate concerns, we think the market is pricing in too high of a probability that the U.S. economy will stumble and the European Union (E.U.) will crumble.
Equities: Nearly everything that was predicted for 2011 came true, at least for part of the year. The year began with rising economic expectations, growing confidence that Europe could handle its problems, and the expectation that the U.S. could muddle through its issues. Although U.S. equity markets ended little changed, the internal volatility was staggering. While the market’s volatility was unsettling, it did increase pressure on decision-makers to deal with the problems at hand and those yet to come. We do believe there will be a number of excellent opportunities for patient investors.
Bonds: The bond markets in 2011 were pummeled by swings in investor sentiment that, in turn, reflected major shifts in the outlook for the economy and even greater swings in conditions in the debt markets of Europe. In
an economy characterized by slow growth, moderate inflation, and exceptionally weak private-sector borrowing, interest rates would be expected to remain extremely low during 2012. For the third consecutive year, the cost of “safety”—in the form of foregone income—is expected to be extraordinarily high.
Asset allocation: For investors with an investment horizon of three years or longer, we recommend a strategic overweight to equities relative to fixed income. Within the equity portion of a portfolio, we prefer a barbell strategy focused on U.S. assets and selective emerging markets assets over the long term. Within fixed income, based on our economic and interest-rate outlook, we are biased toward an underweight to government debt and an overweight to higher-yielding corporate bonds.