As we assess the global markets in early 2014, our overall portfolio strategy remains modestly overweight equities and underweight fixed income. While we have been anticipating an increase in volatility, we still believe equities will outperform bonds over the course of the year. The current low level of interest rates suggests returns from bonds remain unattractive on a longer term strategic basis. Real returns are likely to be low to potentially negative over a longer holding period for a number of fixed income markets.
Although interest rate risk remains strategically unattractive, we note that valuation improved considerably during 2013, and we find rates to be closer to fair value for longer duration bonds. In addition, we find that some fixed-income risks remain attractive. Certain spread sectors offer adequate compensation for credit and liquidity risk. We continue to find high-yield U.S. corporate bonds to be attractively priced. We also see some value in emerging market (EM) sovereign bonds, though we continue to monitor liquidity pressures for these bonds. Lastly, we see value in municipal bonds on both a relative basis and in light of higher tax rates this year.
While we have an overweight position in equities, we remain slightly underweight U.S. equities. Our analysis indicates a continued decline in the attractiveness of U.S. equities. Instead, we opt for more geographic diversification and find better valuations in select markets abroad. While short-term valuations have run up recently, we continue to favor both the UK and eurozone on better economic momentum. In addition, we maintain our strong overweight to Japan as we see both favorable monetary and macro conditions continuing. EM equities present a challenge. While global liquidity and valuations are supportive of the asset class, sentiment remains negative and after many years of positive capital flow we are currently seeing that reverse. As a result, we remain neutral on EM equities.
We continue to recommend adding non-traditional diversifiers, like absolute return strategies and liquid alternative strategies. Strategies like these that are designed for positive returns and low correlation to major asset classes are particularly attractive when the power of bonds to diversify is weakening.
Lastly, we recommend that investors embrace the idea of asset allocation flexibility and prepare to reduce equity risks should prospects for stocks deteriorate. Among our numerous indicators, we look to monitor credit market weakness, negative economic surprises or weakening stock price momentum as three key indicators that may provide a timely indication of oncoming equity market volatility. As always, we continue to monitor the 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 January 24, 2013. Asset classes are ranked from 1 (overweight) to 5 (underweight), with 3 representing a neutral allocation.