Markets had a difficult start to the year. After experiencing negative returns in January, both U.S. and European equities recovered in February and are now slightly positive for the year. The best returns have come from U.S. small-cap equities along with shares of equities domiciled in the periphery of Europe. These two broad groups are both up mid-single digits. Emerging market equities continue to lag developed market performance. And, Japanese equities also regained some ground lost in February but are still down for the year in total.
Fixed-income returns have been positive across all sectors with longer dated Treasuries, municipal debt and high-yield corporate bonds leading the way. The dollar weakened against both emerging market and developed market currencies.
Despite a slight slowdown in recent economic growth, our Global Asset Allocation proprietary investment clock for the U.S. signals continued economic expansion. The investment clock allows us to better understand the behavior of the business cycle and the resulting impact on asset class performance. We believe growth continues to be on a solid footing, somewhere between 2% and 3%. The recent slowdown in U.S. growth could be attributed partly to weather and partly to the payback from the strength in inventory stocking witnessed throughout most of last year.
Signals from our equity scorecard model also point to a moderately bullish outlook for equities. Equity momentum remains in a favorable state and macro factors on balance support this trend. In our country scorecard, U.S. rankings improved significantly. Earnings growth has improved and technical conditions have strengthened. U.S. monetary policy remains largely accommodative and stock market valuations are not overtly elevated for this stage in the business cycle. In light of these developments, we raised our preference for U.S. equities from a modest underweight to neutral. Related to this increase, we raised U.S. large-cap equity exposure from a modest underweight to neutral, but maintained an underweight to small caps given their elevated valuations in relation to large caps.
European countries presented a slightly different picture with core economies such as Germany and France deteriorating, while those on the periphery of the continent improving. Overall, the eurozone declined somewhat on our scorecard as earnings growth weakened. Ever since the speech by European Central Bank President Mario Draghi which promised to do “whatever it takes” to support the monetary union, European markets have been willing to look through these earnings downgrades. As a result, European equities have risen in value while earnings have not kept up. This month, we moderated our overweight in European equities from overweight to neutral.
In the past few weeks emerging economies — particularly those in Eastern Europe — experienced heightened volatility. For the moment, the situation is relatively calm but risks remain that volatility could re-emerge. We maintain a neutral outlook on overall emerging markets equities, but have lowered our overweight to EMEA region from a modest overweight to neutral. Growth expectations continue to deteriorate, inflation remains high and central bankers have embarked on a monetary tightening cycle. In addition, political risks are elevated in the region. To a large extent, this view is already expressed in the markets and valuations appear attractive. But leading indicators of growth, such as the PMIs have continued to deteriorate putting into question the prospects for near-term improvement in the region.
In addition, we raised TIPS (Treasury Inflation-Protected Securities) exposure from underweight to neutral, mainly on attractive valuations. Lack of inflation was a concern last year and still remains below the Fed’s preferred target of 2%. Nevertheless, we believe inflation measures have seen their lows and are set to edge higher.
Finally, we upgraded convertible bonds from underweight to neutral. Over the past year, convertible returns have been largely driven by the equity component of their return function rather than the bond component. Given our modest overweight to equities and expectations of rates being rangebound we expect convertibles to continue to perform well.
As always, we continue to monitor global markets and adjust our investment strategy accordingly.
Source: Columbia Management Investment Advisers, LLC. The chart reflects the views of the Global Asset Allocation team as of February 24, 2013. Asset classes are ranked from 1 (overweight) to 5 (underweight), with 3 representing a neutral allocation.