- Going forward, investors should look for return opportunities that do not depend upon easy money.
- Diversification strategies must take into account expected high correlations and the vulnerability of “safe” assets to changes in monetary policy
- The repricing of many assets as the second quarter drew to a close has created an expanded set of attractive investment opportunities.
For most of 2013, financial markets have been responding to a nearly unanimous backdrop of global monetary accommodation. Many asset classes have surged in price, particularly developed market equities.
As the second quarter drew to a close, however, this backdrop began to shift. In May, the Fed began to articulate its methodology for scaling back asset purchases. By sending the signal that policy will eventually be “tapered,” the Fed has initiated an inflection point by gradually tightening policy and has essentially ended the period of unanimous central bank accommodation.
The markets didn’t react well. There are two stark messages we can infer from those broad asset class declines:
- First, those asset class returns that have been driven by easy money are vulnerable to its reversal, particularly those most affected by financial repression. This includes those deemed historically “safe” by investors in the past.
- Second, the patterns of correlation that have prevailed for most of this decade may be shifting, as nearly all asset classes reacted similarly to this monetary policy turning point. If the eventual removal of policy support results in a correlated reaction across all assets, then even well-balanced portfolios will see only marginal benefits from diversification.
Consequently, the challenge for investors going forward is two-fold:
- First, you must identify return opportunities for which policy support is not a necessary condition for success.
- Second, you must reconsider the dynamics of portfolio diversification in an era where policy tightening might be expected to generate simultaneous losses across many asset classes.
Our favored areas for taking investment risk
Recent volatility might have soured investors’ taste for investment risk-taking, but we believe that numerous opportunities for positive expected returns remain for the balance of 2013. In fact, the repricing of many assets as the second quarter drew to a close has created an expanded set of attractive assets. Importantly, our economic performance outlook for the United States does not support accelerated withdrawal of monetary policy support, so recent volatility might well be a short-term overreaction. In terms of overall asset allocation, we recommend a neutral weighting to equities, an underweight exposure to fixed income, and an overweight exposure to certain alternative investments, particularly absolute return strategies.
Within equities, we remain positive on the outlook for U.S. stocks. With the overall economy on more solid footing, and with the corporate sector in very good health, we expect an ongoing expansion of corporate earnings. Further, with valuations not terribly demanding, we expect that this earnings growth can translate rather directly into investment return. However, we note that the rapid gains in U.S. stocks over the last year have been driven by multiple expansion, not earnings growth. This dynamic may cease in an era of tighter monetary policy. We expect stable earnings multiples going forward, which means that we expect stock price appreciation to be more gradual.
Within fixed income, we expect some mean reversion in certain sectors, especially TIPS, that make them attractive on a tactical basis as the third quarter begins. We continue to find high-yield bonds attractive, given our expectation of low defaults. After recent spread widening, we believe compensation for high-yield credit risk is more than adequate. However, we note that even attractive sectors of the bond market faced sharp price declines during late June, and we advise not relying too heavily on these investments as portfolio diversifiers in turbulent markets.
For an extended analysis, read our Q3 Investment Strategy Outlook.
Asset allocation and diversification does not ensure a profit or guarantee against a loss.
Alternative investments involve substantial risks and are more volatile than traditional investments, making them more suitable for investors with an above-average tolerance for risk.
There are risks associated with fixed-income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer term securities. Non-investment-grade securities, commonly called “high-yield” or “junk” bonds, have more volatile prices and carry more risk to principal and income than investment-grade securities.