Asset allocation: The conundrum of 2014

Jeffrey Knight, CFA, Global Head of Investment Solutions and Asset Allocation | March 3, 2014

  • When economic growth levels off, the headwinds for bonds subside, which fits the patterns of 2014 so far.
  • With bond yields at current levels, the attractiveness of interest rate risk from a valuation standpoint is meager.
  • Should the economic data reaccelerate, we would expect equities to perform well and rate sensitive bonds to struggle.

In 2013, both the S&P 500 Index and the yield on 10-year Treasury bonds finished the year at their highest levels of the calendar year. So ended a year when equity markets dominated the return landscape, while bonds and numerous other assets struggled. The environment apparently changed, though, with the turning of the calendar to 2014. In the New Year, bonds have performed quite well, with yields on 10-year Treasuries, as an example, falling from 3.03% to 2.67% so far this year. Stocks meanwhile, have been volatile, yet stand close to unchanged on a year to date basis.

Knight2

Source: DataStream, February 2014

There are two good reasons for bond yields to have fallen this year. First, having closed 2013 above 3%, bond yields had reached a level where interest rate risk was no longer over-priced. With valuation back to fair value, at least in the short run, bonds had become a relevant choice for portfolio diversification once again. Second, the economic data have been markedly weaker so far in 2014 than most forecasters expected. Our research on asset class sensitivities to economic activity suggests that in an economy that is both growing and accelerating, like we saw last year, equities perform well while interest rate sensitive bonds, like Treasuries, struggle. When economic growth levels off, the headwinds for bonds subside, which fits the patterns of 2014 so far quite well.

The last two months notwithstanding, we think that investors should hold off on declaring the environment of equity hegemony (see Q1 Investment Strategy Outlook for discussion on equity hegemony) to be finished. Stocks, as measured by the S&P 500, have recently eclipsed their 2013 highs and as of this writing stand in record territory. Bond yields, meanwhile, remain far below their 2013 closing levels. This inconsistency bears watching in the weeks ahead. With bond yields this low, the attractiveness of interest rate risk from a valuation standpoint is once again meager. Should the economic data reaccelerate, we think the recent equity breakout would be validated, and the friendlier environment for bond yields that has defined 2014 so far would be but a memory.

Knight1

Source: DataStream, February 2014

This week, several key U.S. economic releases will shed some light on these issues. Personal income, purchasing managers surveys and the monthly payroll report, all bellwether releases, are being reported during the week. Should these data (or subsequent statistics, in fact) portray reacceleration, we would expect further equity market strength but also bond market weakness. Markets, we think, would revert to their 2013 patterns. This remains our central case for the months ahead. Stubbornly low Treasury yields going forward, therefore, would signal that we should rethink our central case. As always, we continue to closely monitor global markets and adjust our investment strategy accordingly.