Rich Weiss Senior Vice President and Senior Portfolio Manager
Global growth remains weak, but central banks are going all out in a bid to improve economic and financial conditions. Sentiment on the economy seems to swing from one extreme to another, taking financial markets along for the ride.
While we believe much of the media handwringing about the political climate is overdone, we nevertheless think investors would do well to prepare for a bumpy ride ahead. But even as considerable risks remain, we continue to see a number of attractive investment opportunities. We believe that a disciplined, diversified approach is well suited to minimize volatility and capitalize on resulting opportunities.
This chart 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.
Allocation Highlights
- We see a number of reasons to be positive on corporate America, but faced with significant risks and in the wake of the big summer rally in stocks and corporate bonds, we took some profits and reduced many of our overweight positions.
- At a high level, we maintain a modest overweight to equities relative to bonds and cash because stock valuations and earnings yields are attractive compared with historical averages and fixed-income alternatives.
- Within the equity allocation, we hold a modest preference for growth over value-oriented shares and continue to overweight global real estate investment trusts (REITs).
- In the fixed-income slice, we continue to favor corporate (both high-quality and high-yield) and mortgage-backed securities over Treasuries. In addition, we prefer inflation-adjusted over “plain vanilla” Treasuries at the short end of the yield curve.
Economic Backdrop
In contrast to much of the rest of the developed world, the U.S. can look forward to positive, if only modest, economic growth. The economy is likely to expand at an annual pace of about 1-3% in 2013, according to our estimates, with near-term growth heavily dependent on geopolitical issues. On a positive note, the housing sector has made significant improvement in 2012, seeing sales volumes and prices increase. What’s more, consumer balance sheets are healthier now than in years past, and the job market has improved marginally. Given that roughly two-thirds of our domestic economy is driven by the consumer, these trends may help to sustain, if not fuel, future growth.
Finally, the Federal Reserve (the Fed) remains committed to aggressive monetary policies to boost growth, saying it has a “range of tools” at its disposal should growth slow. However, there is some question about the efficacy of the tools in question—we believe the “QE3” (the Fed’s third round of quantitative easing) asset purchases have minimal economic impact, though they undoubtedly benefit financial markets. In addition, conditions in the corporate sector have moderated, as reflected in a slowing rate of corporate profit growth. And unfortunately, the low growth trajectory means that any economic shock—such as a deepening crisis in Europe, hard landing in China, or failure to avoid the worst consequences of the fiscal cliff—is likely to be more problematic than would otherwise be the case.
Looking at global growth, it is hard to come to any other conclusion than that already slow-growing developed economies are decelerating. Japan is flirting with a third recession in two years; the most debt-laden European countries are already there. What’s more, concerns over sovereign solvency and liquidity continue to weigh on confidence, as investors and businesses remain frustrated with the lack of decisive government policy. Spain in particular faces a difficult road ahead, with its economy suffering from a severely depressed real estate market and 25% unemployment at a time when the government is enacting strict austerity measures and investors question the health of its banking system.
On a positive note, the European Central Bank (ECB) pledged to do “whatever it takes” to preserve the common currency, and announced more aggressive policies to assist countries with funding issues. Emerging economies are generally enjoying much higher absolute levels of growth, but they, too, are slowing. We expect China to avoid a so-called “hard landing,” but even projected 8% growth will feel much worse after years of double-digit economic expansion.
Equity Environment
As you might expect in a highly uncertain economic environment, equities too face a number of questions. On the one hand, we can cite a number of positives. First, stock valuations around the globe remain attractive relative to historical averages. Similarly, equity earnings yields are also compelling when measured against long-term averages, as well as against current bond yields. On the other hand, however, corporate profit margins have begun to decline from record highs, with earnings per share almost certain to follow. And though equities have generally performed well so far in 2012, they have done so despite economic and political uncertainty, reflecting in part, reasonably pessimistic expectations about future growth. As a result, equities are somewhat more vulnerable now than they were just three or six months ago to disappointments on any of these fronts.
Nevertheless, we should point out that even though economic growth and corporate earnings in aggregate are slowing, it’s still possible to find individual companies growing earnings. These are companies benefiting from fundamental business trends as a result of a new product launch, market share gains, secular change, or beneficial acquisition. Indeed, when we speak with the managers of the underlying allocations, we hear of no shortage of attractive investment ideas.
Fixed-Income View
Heightened uncertainty in global financial markets and mixed domestic economic fundamentals mean predicting the direction and magnitude of interest rate changes—never an easy task—is extremely difficult at present. This task is made more difficult by the Fed’s decision to buy bonds on the open market, affecting the level of interest rates out the bond maturity spectrum.
In that sort of environment, we prefer to keep our duration (a measure of bond price sensitivity to interest rate changes) close to neutral. For similar reasons, we are neutral with respect to our yield curve positioning (the yield curve is a graphic representation of bond yields at different maturities). Instead, we prefer to spend our risk budget making sector allocation decisions. Here we continue to favor corporate and mortgage-backed securities over Treasury bonds. We also hold an allocation to short-term Treasury inflation-protected securities in place of nominal Treasuries. Finally, we hold an allocation to non-dollar bonds because comparatively lower growth overseas means interest rates should stay lower longer.
Tune Out the Political Noise
One look at the financial media today and it’s easy to feel anxious—headlines scream about election uncertainties, political gridlock, fiscal cliffs, European debt debacles, coordinated global slowdowns, climate disasters, and on and on we could go. At such times, we’re reminded of the 1980 single by The Police, “When the World Is Running Down, You Make the Best of What’s Still Around.” You don’t have to be a fan of reggae-influenced pop music to grasp the notion that financial life goes on despite political uncertainty and market volatility, and that we must make the best investment decisions we can no matter the environment.
The lyric “turn on the radio, [financial] static hurts my ears,” never had more relevance than today, when talking heads constantly urge us to make ill-advised, snap investment decisions without regard to our own unique financial position and goals. It is important to realize that most of the troubling issues on the geopolitical front have been around for some time. As such, these “known unknowns” are, arguably, already discounted in asset prices in whole or in part.
The Importance of a Multi-Asset Approach
We believe a disciplined, broadly diversified approach is particularly well suited to periods of elevated risk and uncertainty. First, by combining asset classes that behave differently for a given set of economic and market conditions, investors can reduce overall portfolio volatility and improve risk-adjusted performance. In a period of heightened uncertainty such as this, we think it is very important for investors to maximize returns for the risks they are taking. Second, lower volatility over time tends to produce better compound returns, all else equal.
There is a further benefit to diversifying in an attempt to manage risk and reduce volatility. It turns out that the difference between abandoning and sticking with a financial plan can come down to the volatility of returns that investors experience. Specifically, a broadly diversified approach that seeks to reduce volatility and to provide more predictable returns actually increases the chance that an investor will stay the course even when markets are volatile. We think that’s a crucial consideration that should not be overlooked in the current investing climate. After all, the best-laid financial plans only have utility if we are able to stick to them.
In that context, it’s important to reiterate that when we write here about overweighting or underweighting a particular asset class, we are talking about modest tactical adjustments around our long-term strategic asset weightings. We are absolutely not talking about wholesale trades into and out of the investing flavor of the month. Rather, we prefer a structured, well-thought-out approach that seeks to manage risks for investors while looking to generate excess return on the margin. We believe that individual investors can also benefit from a similarly disciplined, objective approach to their own portfolios amid market volatility.
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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.
Understanding inherent risks such as interest rate fluctuation, credit risk and economic conditions are important when considering an investment in real estate.
High-yield bonds invest in lower-rated securities, which are subject to greater credit risk, default risk and liquidity risk.
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.
