Orlando's Outlook: Adding to equities
Bottom line Equity markets are weak across the globe, while benchmark 10-year Treasuries are rallying, due to China’s first-quarter GDP miss, incremental noise out of Cyprus and disappointing retail sales, Michigan confidence and business inventories here at home. So we decided to use this opportunity to raise the equity position in our moderate growth asset-allocation model from 55% (a modest 3% overweight, or 30% of maximum) to 57%—which is half the maximum overweight—to capitalize on the improvement we expect specifically in emerging-market performance.
Unlike the S&P 500, which hit an all-time record high last week and is up 12% year-to-date, many emerging-country equity indices (most notably Brazil and China) have underperformed so far this year. But we believe that their economies are bottoming and could post better second-half results, with stronger equity-market performance to follow. Combined with the Bank of Japan’s massive new stimulus that may also boost economic activity throughout Southeast Asia, we decided to raise our equity overweight position in the emerging markets from a slight 3% overweight to a maximum 5% overweight.
Our goal is to capture what our asset-allocation team believes could be a 10% to 15% run-up for the remainder of the year in emerging equity markets, versus perhaps a more subdued 5% rally for the S&P. To be sure, we’re still at a slight overweight in our domestic equity allocation, but we are clearly hesitant to add to that position at this point in time, given the run we’ve already enjoyed in the S&P, which at current levels is only 5% from our full-year target of 1,660.
We, like many other investors, have been patiently waiting for a 3-8% correction to possibly add more; but as the old axiom goes, a watched pot never boils. Technically speaking, now that the S&P has broken above its double top at 1,576, and with leadership starting to shift out of defensive stocks into more economically-sensitive names, the odds of a substantial pullback below 1,550 appear less likely. The two percentage-point addition to our equity position was funded from a point each out of cash and Treasuries, whose yield has plunged from 2.05% to 1.70% over the past month—thus lowering the overall fixed-income allocation to its minimum 17%.
Growth vs. value: We are at 1% overweight in both categories on better-than-expected fundamentals so far this year.
Large vs. small: We are at 1% overweight in large-cap growth and large-cap value, at 12% and 15%, respectively, for similar reasons. But we remain at a modest 1% underweight in domestic mid-cap stocks at a 5% allocation, and we are neutral on small-cap stocks.
Domestic vs. international: At 37%, our domestic allocation remains at a 1% overweight, while our overall international exposure was raised to 20% (a 4% overweight vs. a neutral 16%) on the increased allocation to the emerging markets, which now sits at a maximum 5%. At 13%, developed international is still at a 1% underweight, while international small cap remains at a 2% overweight.
Investment-grade bonds: Our recommended allocation to investment-grade bonds was lowered by a point to 11% (an 11% underweight relative to our neutral position of 22%), on the aforementioned reduction in U.S. Treasuries, which enjoyed a strong rally in recent weeks on a flight-to-quality trade and the Bank of Japan’s massive stimulus-driven decline in the yen. Our duration target was lowered to 95% from 100% on expectations that rates from these levels are more likely to rise than fall.
High yield: High yield remains at 3% (a 1% overweight) on higher absolute yields and thus more income and spread opportunity, due to less sensitivity to domestic interest rates and policy.
International fixed income: We remain at a neutral 3% on improving emerging-market fundamentals.
We have an overweight allocation of 23% to Alternatives (vs. a neutral 16%) and dropped our position in Cash to 3%, which is a 2% underweight.
Treasury Inflation-Protected Securities (TIPS): We remain an overweight 9% (neutral is 8%), as breakeven spreads remain below the likely outcome of the Fed’s desire for slightly higher inflation.
Absolute return: This stayed at an overweight 6% vs. a zero neutral allocation. Given very low yields on cash, we continue to place some of our normal cash allocation into this asset class. We expect that it should outperform cash and possibly bonds, with less downside, and serve as an effective hedge to declining stocks during pullbacks.
Net short equity: We have no allocation to this category.
Real estate: We maintained a neutral 4% position.
Commodities: We maintained a neutral 4% position, but we’re monitoring the recent knee-jerk plunge in metals and energy closely.
Cash: Despite its underweight position, easy-to-deploy cash remains at a sizable 3% after our decision to tick down this asset class, freeing us to wait on the sidelines to see where the economic, political and market environment heads.