Global Asset Allocation Perspective
Global Opportunities, Global Diversification
Second Quarter 2015
Senior Vice President and Senior Portfolio Manager
Asset Allocation Strategies
The biggest change to our positioning is a shift toward European stocks, which have underperformed relative to U.S. equities and offer more attractive valuations. Central bank policy, a weaker euro, and lower oil prices all support a European recovery. We are also making some enhancements across the board in our asset allocation portfolios to move away from our U.S. equity bias and toward global and non-U.S. equity strategies, as well as adding exposure to non-U.S. bonds. These changes are part of our disciplined, systematic approach in which we routinely evaluate various asset classes for inclusion in the portfolios. We believe these changes will broaden the portfolios’ diversification, reduce exposure to any single country, and increase opportunities to improve risk-adjusted performance at a time of heightened economic and policy uncertainty.
We remain positive on U.S. equities, but are mindful of heightened risk and volatility relating to the Federal Reserve's (Fed’s) exit strategy from years of unprecedented monetary stimulus. With stocks at record highs and the Fed likely to begin raising rates, investors would do well to prepare for volatility ahead. In contrast, we are positive on European stocks because of their more attractive valuations, and because the European Central Bank (ECB) is only now undertaking its own quantitative easing (QE) program.
- Our quantitative models show a continued preference for stocks over bonds and cash based primarily on equities’ attractive earnings yields. Within equities, we have increased our exposure to European and non-U.S. stocks, primarily because of relative valuations.
- Our fixed-income team’s macroeconomic view suggests that global economic growth is likely to remain subdued, with the U.S. the healthiest of the developed economies. This divergence in growth also results in important differences in interest rates, monetary policy, and currency values across the U.S., Europe, and Japan.
- In our fixed-income allocation, we continue to underweight U.S. Treasury and government agency bonds in favor of higher-yielding corporate- and mortgage-backed securities, and hold select European investment-grade corporate bonds. believe the best way to deal with financial and geopolitical uncertainty is through broad diversification among and within asset classes, as well as geographic regions. Well-diversified investors, who are taking an appropriate level of risk in their portfolios, should be properly positioned to ride through the market ups and downs.
Divergent Growth, Market Conditions
A great deal of economic analysis of late has talked about decoupling in growth between the U.S. and the rest of the world, and between the U.S. financial markets and other financial assets. Our own forecast for the U.S. calls for moderate economic growth, with real gross domestic product (GDP—a measure of the total economic output in goods and services) likely between 2% and 3% for all of 2015. However, we think it’s possible that growth could surprise to the upside, as many of our consumer metrics have increased notably over the last 12 months. In addition, corporate profit margins remain high and revenue growth is steady in the neighborhood of low single digits.
With growth likely modest, energy prices falling, and the dollar strong, inflation should remain tame. Here we see the greater likelihood that inflation could come in lower than expected, largely as a result of weaker commodity prices. Indeed, market- and consumer-based inflation expectations continue to decline. One convenient measure of bond investors’ inflation expectations is the current 10-year breakeven rate between plain vanilla and inflation-indexed Treasury bonds. This measure has fallen to 1.59%, below the one-year average of 2.05% and the five-year average of 2.18%. At the same time, our U.S. inflation scorecard is weakening. The same trend is in evidence in our global inflation metrics. Nevertheless, we continue to believe that the large amount of monetary stimulus coupled with an improving U.S. economy will eventually create higher inflation than is currently priced into the market.
In Europe and Japan, economic activity is expected to remain subdued in 2015. The International Monetary Fund (IMF) projects the euro area will grow at a 1.2% annual rate, with Japan at 0.6%, and the U.K. at 2.7% for the full year. We do, however, expect Europe to avoid recession thanks to low rates, a declining euro, and falling energy costs. Concern is growing, however, over deflationary forces, with the latest headline inflation readings in the eurozone showing outright price declines.
The U.S. recovery can largely be attributed to the aggressive monetary policies of the Fed, whose actions helped the U.S. become the first major economy to emerge from the 2008-09 financial crisis. At the same time the Fed was aggressively cutting interest rates and enacting QE, many European countries were adopting austerity measures—the exact opposite of what was required to stimulate growth.
But today the monetary policy ground is shifting. The Fed ended its QE program in late 2014 and is preparing to raise interest rates this year for the first time since the crisis began. At the same time, the ECB is belatedly embarking on quantitative easing of its own. These profound differences in growth and monetary policy have important implications for financial asset performance in the U.S. and around the world.
Normalization of Interest Rates in the U.S.
In the U.S., higher interest rates and a stronger dollar suggest a modest drag on economic activity, so while we’re still generally positive on the U.S. economy and financial markets, we think some caution is in order as the Fed prepares to unwind unprecedented stimulus policies. We would expect the normalization of interest rates would likely lead to greater volatility in stock and bond markets than we have seen in many years.
Indeed, financial market volatility jumped in late 2014 around the end of the QE program and remains elevated compared with much of the post-crisis period. In the bond market, interest rate volatility as measured by the MOVE index1 reached 95 in February 2015, compared with the one-year average of 63. Stock market volatility, as measured by the VIX index, has been trending higher since mid-2014. These shifts in growth and monetary policy are having profound effects elsewhere as well, as Japan has seen its stock market hit a multi-year high, while volatility in Japanese government bonds reached record levels in recent months.
Of course, tighter monetary policy does not in and of itself spell the end of the road for stocks’ record run. It is possible to point to past Fed tightening cycles when stocks did well. However, this time really is different in at least some sense of the word—the amount of assets on the Fed’s balance sheet is unmatched in the bank’s history. The unprecedented nature of Fed rate policy and divergence in global growth and monetary policy increases uncertainty and puts a premium on the Fed’s ability to clearly articulate and execute its exit strategy.
Importantly, members of the Fed’s rate-setting Open Market Committee have frequently and explicitly discussed the matter of volatility in the market. In a December 2014 speech and again in February 2015, New York Federal Reserve Bank President William C. Dudley said that the Fed would look beyond “short-term volatility and movements in financial markets.” He seemed to be trying to explicitly address the notion that Fed policy would be responsive to potential losses in the stock market, saying that “we do not care about the level of equity prices.”
There is an additional dimension to the problem. Investors, advisors, and consultants often make allocation decisions based on three- and five-year track records. Market conditions have been remarkably consistent and supportive of risk assets since 2009.
Our concern is that investors may have been lulled into complacency by favorable markets and be ill prepared for an increase in volatility. If we are correct about the coming normalization of interest rates and market conditions, then these investors would do well to review their risk exposures and trim overly aggressive allocations.
These risks and uncertainties argue for a broadly diversified approach. Effective diversification in asset allocation portfolios means achieving the highest rate of return for the risk taken, or maximizing the risk-adjusted return of the portfolio. A well-specified asset allocation strategy will generate sufficient return to meet the capital growth objectives of its investors while controlling volatility and limiting downside risk. In addition, strong risk-adjusted performance may provide a steadier, more consistent pattern of gains, which will help to reduce the likelihood that investors will abandon the strategy in periods of market volatility, well before reaching their stated financial goals.
With these potential risks and benefits in mind, we routinely evaluate asset classes for inclusion in the portfolios. As a result of this process, in March of this year we will begin implementing some enhancements to our asset allocation strategies. The objectives of the enhancements are to improve diversification, broaden non-U.S. exposure, and reduce U.S. interest rate risk.
The resulting modifications to the portfolios incorporate additional asset classes, adjust certain risk exposures, and introduce additional and different sources of potential alpha. Significantly, the broad-brush glide path or weighting for equity/fixed-income exposures over time will not change. Rather, the biggest change will be reducing our U.S. equity bias and moving more toward non-U.S. equities, and adding exposure to non-U.S. bonds at the margins. This is effectively a move away from the U.S. at the margin with the aim of reducing reliance on a single market and improving country diversification.
Given our expectation for normalization of interest rates and volatility going forward, we are positioned somewhat cautiously in our fixed-income allocation. In terms of exposure to rate changes, we have a slightly short duration. This means that the portfolio has less exposure than the benchmark to price volatility resulting from changes in interest rates. Nevertheless, we are not aggressively short our benchmark because of countervailing forces keeping interest rates low, such as geopolitical stresses, and the slow pace of global growth and inflation, among other factors.
In terms of sector allocation, we continue to favor mortgage-backed and shorter-term corporate bonds, which offer attractive yields relative to Treasuries. We also continue to maintain an overweight exposure to non-dollar bonds, diversifying away from U.S. bond markets. However, we think it’s important to note that investors would do well to hedge the currency effect of non-U.S. bond allocations in light of the dollar’s continued strength. You can view a more in-depth discussion of our fixed-income managers’ insights in the Fixed Income Macro Outlook.
In essence, since the financial crisis, U.S. financial markets have been dominated by a single factor—monetary policy. The Fed’s policies were intended to encourage risk taking, ultimately leading markets to record levels as volatility declined. In these conditions, passive investment strategies performed well relative to active management approaches. That’s because there was little concern for differentiation among individual securities—which stocks you owned was not as important as simply owning some stocks. You can see this expressed in statistics such as correlation and return dispersion among different securities and portions of the stock market. Since 2008, correlations have been high and return dispersion low by historical standards.
But all that began to change in late 2014 with the end of the Fed’s QE program, and talk of ratcheting up short-term interest rates in 2015. A more normal market characterized by higher volatility—as well as a greater dispersion and lower correlation of returns among individual securities—would present active managers with greater opportunity to generate excess performance through stock selection. Factors such as valuations, the rate of corporate earnings growth, and the quality of those earnings would matter again.
In regard to valuations, we believe European equities to be most compelling at present, while valuations in the U.S. and select emerging market economies are comparatively less attractive. With respect to earnings, roughly two-thirds of the companies in the MSCI World Index—a broad gauge of global equities—reported better-than-expected revenues and earnings through February 2015. Attractive valuations and positive earnings growth help explain why we remain positive on equities, even though we think investors should expect an increase in volatility as interest rates normalize. See our Global Equity Outlook for greater analysis around the current state of world equity markets.
1The MOVE (Merrill Lynch Option Volatility Estimate) Index measures the implied volatility of U.S. Treasury markets.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of American Century Investments (or the fund manager) 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.
For detailed descriptions of indices or investing terms referenced above, refer to our glossary.
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