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First Quarter 2014
Senior Vice President and Senior Portfolio Manager
Asset Allocation Strategies
We believe the best way for investors to reach their financial goals is to pursue a disciplined, broadly diversified approach over time. So while markets struggle with uncertainty around global growth, emerging market currency woes, and less accommodative monetary policy in the U.S., we adhere to our disciplined approach looking for short-term tactical opportunities within a long-term, strategic framework.
Stock Returns Revisited
In the last edition of Global Asset Allocation Perspective, we addressed whether we thought stocks were fairly valued. Since then, equities have seesawed widely, but ultimately ended up right back at a record high. We've done some more work on this question in the meantime with a member of our Asset Allocation team, Radu Gabudean, recently publishing an analysis, A Macroeconomic Perspective on Current Markets. In the paper, we argue that the fundamental factors driving equity returns look attractive in both the short- and long-term. Briefly recapping that work here, equity returns are determined by three elements--dividend yields, earnings growth, and price/earnings (P/E) multiple expansion. Dividend yields bottomed in the wake of the dot-com bubble, but have been steadily rising since. In part this reflects a 2003 change to tax laws giving preferential tax treatment to dividends, and changing corporate views on ways to return value to shareholders. With a 2013 St. Louis Federal Reserve report showing a record amount of cash on corporate America's books, we see plenty of fuel for dividend payouts going forward.
We believe earnings growth will also remain positive, given economic improvement in the U.S., Europe, and Japan, while China appears to have avoided a hard landing. P/E ratios make for a more nuanced discussion. With U.S. equities at record highs and earnings growth moderating, some argue that stocks are overvalued based on simple historical P/E comparisons. However, we believe a more sophisticated approach is required, arguing that an analysis of stock valuations should account for not only P/E ratios, but also dividend payouts, Treasury yields, and volatility in inflation and corporate earnings, among other factors. The lower interest rates and inflation, the higher the fair value P/E will be, other things equal. Because our outlook calls for modest economic growth, positive corporate earnings, tame inflation, and gradual increases in interest rates, we believe equity valuations can expand further.
In terms of the outlook for equities outside the U.S., we expect developed markets to continue to outperform emerging market equities. We're positive on Europe, where monetary and fiscal authorities seem to be taking the necessary steps to support a recovery, while corporate earnings are improving and valuations appear reasonable. We're generally positive on Japan as well, though we will monitor closely the effect of the new consumption tax on the economy and growth opportunities for Japanese companies. The outlook for emerging market stocks is less clear. First, we should point out that the developing world is not a monolithic bloc but instead presents myriad unique investment conditions and opportunities. Second, the long-term, secular growth story in emerging markets remains intact. But in the near term, we expect emerging market stocks as a whole to lag their developed counterparts until we see progress on issues around debt, growth, inflation, and currency values. For a more detailed region-by-region analysis, see our latest Global Equity Outlook.
Economy on the Mend
We're encouraged by what we see from the U.S. economy, though our base case continues to be for moderate economic growth. We've raised the lower end of our growth forecast from 1-3% to 2-3%. Among the positives, our measures of business activity remain above average, while the unemployment rate continues to fall and our gauge of consumer strength shows no sign of deteriorating. Enough questions remain, however, to prevent us from calling for a more dramatic improvement in growth--fiscal consolidation and budget battles remain the norm in Washington, and the Fed has begun to take its foot off the monetary gas pedal.
The outlook for growth outside the U.S. is also fairly positive for developed markets. In Japan, "Abenomics," Prime Minister Shinzo Abe's efforts to jumpstart the economy, appears to have had the desired effect, with many measures of economic activity in Japan hitting their highest levels in years. Our optimism here is tempered by the knowledge that there is a big tax increase coming later this year, and that so far Japanese exports have yet to respond to the devaluation of the yen. In Europe, the economic situation finally appears to have stabilized after some very difficult years, though we continue to see a wide disparity in growth rates across the eurozone. Conditions in emerging markets are more challenging. High levels of debt, falling currency values, uncertain growth prospects, and less liquidity from leading central banks mean developing economies in general face more challenges today than at any time since the financial crisis.
Modest growth also argues for modest inflation--in Europe and Japan, inflation continues to run below central bank targets. Nevertheless, our view remains that longer term, there is a risk that unprecedented monetary stimulus and massive levels of debt in developed economies will lead to greater-than-expected inflation down the road. You can read our Fixed Income team's in-depth analysis of the economy and bond market in their quarterly Fixed Income Macro Outlook.
Global Fixed-Income Opportunities
In the U.S., steadier economic growth and a less stimulative Fed argue for the continued normalization of interest rates. Just as we have increased the lower end of our U.S. growth projection, we have also raised the lower bound of our interest rate forecast. Looking 12 months out, we expect the benchmark 10-year Treasury yield to trade in a range between 3.0% and 3.75%. Given our expectation for higher rates, we have shortened the duration (price sensitivity to interest rate changes) in our bond allocation. Instead, we have focused on opportunities in non-dollar bonds, securitized credit (such as mortgage- and other asset-backed securities), and short-term high-yield bonds. At the same time, we hold a corresponding underweight in Treasury and government agency debt.
Our global fixed-income allocation is positioned similarly to our domestic slice--short duration and overweight non-government holdings denominated in euros and British pounds. We are also short German government bonds in favor of exposure to Norway and Sweden. In terms of currency exposure, our largest overweight positions are the Australian, New Zealand, and U.S. dollars, as well as the pound. Our most significant currency shorts are the Japanese yen, Canadian dollar, and Swiss franc.
Diversification, Diversification, Diversification
The old joke goes that there are only three things that matter in real estate: location, location, and location. We think of investing in much the same way, where the three things are diversification, diversification, and diversification. We think broad-based diversification (among and within asset classes, as well as geographic regions) and time in the market is essential to long-term investment success. Well-diversified investors are more likely to realize attractive risk-adjusted returns and ride out market volatility, sticking to their investment plan, than those that are not. Those are crucial reasons for investors to adopt and stick with a diversified, long-term approach to their financial goals.
International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.
Understanding inherent risks such as interest rate fluctuation, credit risk and economic conditions are important when considering an investment in real estate.
High-yield bonds invest in lower-rated securities, which are subject to greater credit risk, default risk and liquidity risk.
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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