We continue to see a modest U.S. economic recovery, with substantial headwinds in the form of Europe, China, and the Fiscal Cliff to offset all of the monetary stimulus in the system. Markets seem certain to remain volatile and continue to trade in broad “risk-on/risk-off” moves driven by macro news and events.
Financial markets are beholden to a macroeconomic environment characterized by heightened risk and tremendous uncertainty. Indeed, bond yields in the U.S. are at record lows, while many European sovereigns face prohibitive borrowing costs; central banks continue to deploy radical policy tools to stimulate growth and support the financial system, even as the International Monetary Fund slashes its estimates for global growth; and European countries are caught between competing policy goals of austerity and growth; while the developing world in general and China in particular try to author a modest—rather than rapid—economic slowdown.
The chart below details the difference (Over/Under) between current target weightings and the long-term benchmark strategic allocations as applicable to American Century Investments’ asset allocation strategies.
At a high level, we believe equities are attractive relative to bonds and cash, primarily as a result of equities’ greater earnings yield versus historically low cash and bond yields. But economic and corporate earnings uncertainty means we are only modestly overweight stocks relative to fixed-income investments.
We also favor global real estate investment trusts (REITs) for their attractive yields and valuations at a time when real estate conditions are improving in select markets. Global REITs have the additional benefit of diversification by geography and currency.
In the bond allocation, we hold an overweight position in high-yield versus investment-grade securities. We believe high-yield bonds offer attractive yield spreads relative to Treasuries and historical default rates. Within the high-quality allocation, we favor corporate credits and mortgage-backed securities over Treasuries. In addition, we prefer inflation-adjusted over “plain vanilla” Treasuries. Breakeven rates (the difference in yield between inflation-protected and nominal Treasuries) on short-term securities are very attractive after collapsing along with commodity prices in recent months.
We’re underweight cash, preferring to put a portion of this allocation to work in more attractive alternatives, such as REITs. With cash-equivalent yields near zero, we tend to view our money market investments as a portfolio diversifier, catastrophe hedge, and potential source of funds to execute trades in asset classes we deem more attractive.
Our view on the economy has changed little, despite all the ups and downs in economic expectations over the past couple of years. We continue to see a subpar recovery with economic growth of 1-3% or so. If there’s been a change to our economic outlook, then it’s with respect to the housing sector, which we no longer see as a clear drag on the economy. We’re not saying housing will be a source of strength going forward, but it’s no longer a total bust. Nevertheless, employment remains a concern, manufacturing activity appears to be slowing, and our own proprietary business scorecard has rolled over, though readings remain at a relatively high level compared with recent years.
Meanwhile, against a backdrop of modest growth, slack in the job market, and falling energy prices, inflation in the U.S. remains tame. Weaker global macroeconomic fundamentals and falling commodity prices further eases inflation concerns in the near term. While we see a number of factors that argue for higher inflation down the road, the lack of inflation pressure at present gives the Federal Reserve (the Fed) room to act on the economy and employment should conditions weaken further.
In Europe, the sovereign debt crisis colors every discussion. For example, with respect to growth, European countries implementing aggressive fiscal austerity have entered recession. This increases the odds that Germany and other “core” countries may also see their economies slip into recession. In terms of market access, the Greek debt restructuring has been completed, but attention now turns to Spain and its troubled banking system. Looking at emerging economies, growth in China and other major developing countries appears to be slowing along with the developed world. Indeed, the International Monetary Fund recently lowered its growth estimates and warned of the increasing likelihood of a “hard landing” for China. Nonetheless, China is still expected to grow in the neighborhood of 8% for all of 2012.
Tolstoy once famously wrote that “happy families are all alike, but every unhappy family is unhappy in its own way.” This analogy can be stretched to include financial markets, where different asset classes express their discomfort over the economic outlook each in their own way. In equities, one way to measure the uncertainty in the economic environment is to look at the global earnings revision ratio. The ratio—which reflects analyst estimates of future corporate earnings growth—declined in May and June, suggesting analysts have become more cautious about earnings forecasts.
This metric is also useful for pointing out perceived differences in growth outlooks for the various regions of the globe. For example, the ratio actually increased (analysts upgraded earnings expectations for more stocks than they downgraded) in emerging market economies and in Asia (excluding Japan). However, the ratio was down sharply in the U.S. and Europe. Despite uncertainty around economic growth, we still find valuations for U.S. equities to be attractive, and the managers of our underlying equity allocations report no shortage of compelling investment ideas.
Our fixed-income managers pull four levers in search of excess returns—duration, yield curve, sector allocation, and security selection. At present, we have the most conviction about opportunities presented by valuation and yield disparities across broad market sectors. In this regard, we continue our long-running overweight to corporate bonds, which we believe offer historically attractive yields relative to Treasury bonds and corporate default rates. This at a time when corporate America has done so much work in recent years to improve its balance sheets and sits on record amounts of cash. In addition, we believe that many types of mortgage-backed securities represent attractive values at present.
In contrast, we remain roughly neutral to our fixed-income benchmarks in terms of duration (a measure of interest rate risk) and yield curve exposure. This is because of the high degree of uncertainty and political risk in the bond market at present. For example, the Fed is actively manipulating the level of interest rates and shape of the yield curve by the use of aggressive monetary policies. Longer-term bond yields have also been volatile as a result of developments overseas—bad news out of Europe sends investors fleeing en masse for the perceived safety of Treasury bonds, while progress on the sovereign debt crisis sees a Treasury sell-off and return to risk assets.
We should also say something about the importance of credit research and individual security selection for investors and advisors looking to invest in credit-sensitive corporate bonds. Investors who increase their credit risk exposure may find their portfolios exhibiting increasingly equity-like behavior during periods of economic weakness. High-yield corporate bonds in particular act like a mix between stocks and bonds. As a result, we believe in this uncertain economic environment that fixed-income credit analysis should be handled by experienced professionals.
Individual investment goals and financial needs don’t wait for ideal market conditions—the college tuition bill will show up in August regardless of whether the market is up or down that month. In such an environment, we believe that it is crucial for individual investors, either working alone or with a financial representative, to settle on an asset allocation strategy with the aim of managing market risk (volatility) and maximizing risk-adjusted returns over time. Of course, it is true that diversification cannot ensure a profit or protect against loss in a declining market. But we believe a broadly diversified approach gives investors their best chance to meet pressing financial goals despite all the uncertainty currently surrounding markets and the economy.
We manage American Century Investments’ asset allocation portfolios using just such a diversified approach and make only modest tactical adjustments around our long-term strategic asset weightings. We make these changes when we believe there is a compelling fundamental investment case that can be confirmed by our proprietary asset allocation models.
Download a PDF of this post.
International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.
High-yield bonds invest in lower-rated securities, which are subject to greater credit risk, default risk and liquidity risk.
Understanding inherent risks such as interest rate fluctuation, credit risk and economic conditions are important when considering an investment in real estate.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of Rich Weiss and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.