Market Perspectives - January 2014

Outlook 2014: Are we in the eye of the storm?

Asset allocation

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

Investment horizons

For investors with an investment horizon of three years or longer, we recommend a strategic overweight to equities relative to fixed income. Short-term, over the next three months, we think investors may still be rewarded by looking at higher-yielding fixed-income investments as well as equities, whether growth or value.

Equities

Global equities still look attractive from a valuation perspective. There are risks, as the economic recovery is still middling at best. But pessimism is already priced into stocks, especially European and emerging markets equities. Commodity-oriented emerging markets could get cheaper, while manufacturing-oriented emerging markets could continue to recover.

Value versus growth

Choosing between value and growth is like choosing between walking to the store and breathing. Why not both? We think pessimism about the future—of which there is plenty—has contributed to mispriced growth opportunities that blend value and growth characteristics.

Large caps versus small caps

Large-cap companies are probably better positioned for global growth than small-cap companies. That doesn’t mean small- and mid-cap companies should be ignored. However, we think it’s more important to be discerning about the economic exposure of a company rather than judge it solely on its size.

Fixed income

Based on our economic outlook, we believe interest rates are likely to remain low for the balance of the year and next year. This presents an opportunity for investors to take on additional duration and credit risk, but we prefer more credit risk to more duration risk. Provided the economy doesn’t 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 would.

Asset allocation summary table***

Understanding the table
Neutral positioning for equities is the percentage of market capitalization meeting the classification criteria of a broad market index. Because the fixed-income market tends to be dominated by sovereign debt, we chose to represent the neutral weight as 50%. The strategic positioning represents our guidance for investors with a time frame of three years or longer. The tactical positioning in the pie charts below represents our guidance for investors with a time horizon of less than one quarter.

Equity recommendations

  Developed equities/emerging markets equities

 

Strategic: There is still likely long-term growth in emerging markets, but not every emerging markets economy is going to emerge. Some may submerge.

 

Tactical: As the developed economies slowly grow, emerging markets are like high-leveraged plays on that growth. For example, Mexico is almost an amplified way to invest in U.S. growth. We prefer to avoid commodity-oriented emerging markets because their currencies can depreciate.

  Developed equities/emerging markets equities
  U.S. equities/non-U.S. developed equities

 

Strategic: The consensus seems to be that the U.S. is doomed to low growth. We think this stance ignores the ability of U.S. businesses to adapt and thrive in a changing world. Sector selection is likely more important than country selection.

 

Tactical: Valuations are attractive outside the U.S., and growth estimates of the U.S. economy are likely too negative.

  U.S.equities/non-U.S. developed equities
  Growth/value

 

Strategic: Look for real growth, which could be in traditional value sectors. We think the theme for the next few years will be to identify mispriced growth opportunities—that means looking for value stocks in growth sectors and growth stocks in value sectors.

 

Tactical: Industrials, energy, and technology (not just information technology) remain our favorite areas. Growth with value characteristics or value with growth characteristics seems to offer the best investment opportunities.

  Growth/value


  Large/small

 

Strategic: There isn’t a compelling valuation or thematic reason to overweight any particular category.

 

Tactical: Large-cap stocks are attractive, but some large-cap companies may be tempted to overpay for acquiring small-cap companies. Maybe mid-cap stocks are more the sweet spot.

  Large/small

 

Fixed-income recommendations

  Fixed-income duration

 

Strategic: The Fed’s projections call for low rates until late 2015. Until the Fed increases its target for the federal funds rate, we don’t think we’ll see a sustained move up in interest rates. That does not mean we won’t see volatility, though.

 

Tactical: The Fed and other central banks will likely keep short-term rates low until the end of 2015. Thus, we think there is little reason to fight the central banks. Foreign bonds may offer better tactical opportunities than U.S. bonds, as the Fed is closer to raising rates than the ECB.

  Fixed-income duration
  Credit risk exposure

 

Strategic: Default rates are low, but investors need to be careful about new issuances. Some credit risk might not be worth taking on.

 

Tactical: We think default rates will continue to fall, which should be good for high-yield debt. The rise in rates from May 2013 to August 2013 flushed out some of the excesses in the riskier parts of the fixed-income market.

  Credit risk exposure
  Fixed rate/floating rate

 

Strategic: We prefer fixed-rate short-term debt over floating-rate debt. Until the end of 2013, buying floating-rate debt might be like buying insurance for an unlikely event.

 

Tactical: Some floating-rate debt may be prudent, but it really depends on the credit quality of the issuer. In general, we’d prefer to leave the decision to a portfolio manager who does bottom-up credit analysis.

  Fixed rate/floating rate

 

 

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