Orlando's Outlook: Manufacturing some dry powder
Bottom Line The S&P 500 has rallied by about 7% over the past two months. Yet, economic growth here has decelerated sharply over the past four months, while investor angst grows by the day regarding the deepening eurozone recession, the fear of an emerging-markets hard landing, suddenly resurgent energy and agricultural commodity prices, and the impending fiscal cliff and presidential election down in Washington. Consequently, there’s little doubt that economic visibility through year-end is now as clear as mud. Against this backdrop, we fully expect powerful, coordinated policy responses from central banks and governments from every corner of the globe, including our own. But the timing and efficacy of those yet-unknown fiscal and monetary policy actions does nothing to provide better clarity for investors at this point in time, and the potential risk of a summer accident is rising, in our view. While we clearly remain bullish with no change to our 1,450 year-end target, we are taking this tactical opportunity to lock in some profits and raise 3% cash, thus manufacturing some dry powder to put back to work into equities at potentially better prices over the next few choppy months.
At our July 25 committee meeting, Federated’s Prism asset-allocation team made the following changes in our benchmark primary global model:
Stocks vs. Bonds
We lowered the equity weighting in our moderate growth asset-allocation model by three ticks, from 59% to 56%—which is 40% of our maximum overweight vs. a neutral equity reading of 52%—on concerns that equities have more downside risk than upside-appreciation potential, chiefly because of a softening U.S. economy, domestic policy uncertainty until the Nov. 6 election and ongoing turmoil in Europe. While we firmly believe the current economic soft patch will prove temporary and that a double-dip recession is not on the horizon, we felt that it would be prudent to temporarily pull the reigns in a bit until the dust clears and we have a better sense of where the macro environment is headed. As such, we reduced our allocations to higher-risk small-cap stocks to a neutral 5% and to emerging markets from a double overweight 4% to a still overweight 3%, and we put all of the savings into cash, as we patiently wait out this uncertainty. Our fixed-income allocations remained unchanged at 17%, which is a 10% underweight relative to our neutral position of 27%.
Growth vs. value: We remain overweight in both categories, with a significant nod to growth on a relative basis. We are overweight domestic large-cap growth, which we kept unchanged at 14% versus an 11% neutral reading, compared with large-cap value stocks, which we also kept unchanged at 15% versus a neutral 14%.
Large vs. small: We remain overweight in large-cap growth stocks, which should benefit from attractive relative valuations, strong corporate fundamentals and a global economy that’s still growing, however slowly, and we have a modest overweight on large-cap value stocks, which additionally offer high dividend yields. However, we shifted to a neutral weight in both small-cap growth and small-cap value stocks by removing a tick each to 2 % and 3% allocations, respectively, to lower the portfolio’s beta during this uncertain period. We kept our mid-cap allocation unchanged at a neutral 5%.
Domestic vs. international: So we took our domestic allocation down by 2% to 39%, which is still a 3% overweight. We also trimmed our emerging-markets allocation by a tick down to 3%, which still represents a 1% overweight to a neutral 2% reading, due to our concerns about slowing economic growth in China, Brazil and India. Our developed-markets international allocation remains at 12% versus a 14% neutral allocation, due to our PIIGS-driven recession concerns in Europe, and we kept our international small-cap position at a 2% overweight. That takes our overall international exposure down a tick to 17% vs. a neutral 16%.
Investment Grade Bonds: We kept our recommended allocation to investment-grade bonds at 12%, which represents an extreme 10% underweight relative to our neutral position of 22%. Given record-low 1.38% yields on benchmark 10-year Treasury securities, we also held our duration target at a very low 85%. But it’s important to note that while we clearly do not like Treasuries, because we believe that yields should move sharply higher over time as economic improvement becomes more pronounced both here and abroad, we do find corporate and mortgage-backed bonds to be much more attractive.
High yield: We remained at an overweight 3%, vs. 2% neutral, on the belief that lower-quality bonds should benefit from even modest economic growth, and from healthy corporate balance sheets and strong investor demand for yield. Corporate balance sheets are flush with cash, and defaults are very low by historical standards.
International Fixed Income: We remained at an underweight 2% allocation, versus a 3% neutral allocation, primarily because of our ongoing concerns about the euro.
We have an overweight allocation of 24% to Alternatives (versus a neutral 16%) and we raised Cash from 0% to a still underweight 3% (versus a neutral 5%).
Treasury Inflation-Protected Securities (TIPS): We kept our allocation at an overweight 10% (neutral is 8%). While core year-over-year inflation remains benign at present, we are concerned about the potential longer-term impact from higher commodity prices toward rising inflation and the possibility of a central bank policy error.
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. While it should underperform equities in our base case, we expect that it should outperform cash and possibly bonds, with less downside risk, and serve as an effective hedge to declining stocks during pullbacks, as it did during May 2012.
Real Estate: We maintained a neutral 4% position. But with the commercial and residential housing markets showing signs of life for the first time in years, our bias here is to the upside.
Commodities: We maintained a neutral 4% position, as the recent surge in agricultural commodity prices appears unsustainable: over the past six weeks, corn has spiked by 60%, wheat has soared by 50%, and soybeans have rallied by 35%. Additionally, crude oil has already rebounded by 17% over the past month on Iranian concerns, while gold appears mired in a relatively narrow trading range.
Cash: We have increased easy-to-deploy cash from zero to 3%—compared with a neutral 5% allocation—in our equity allocations, as a tactical and opportunistic short-term strategic move to sit on the sidelines and study where the economic, political and market environment heads over the coming months, both here and abroad. We typically avoid cash because of its low yield and relatively better returns elsewhere. But we successfully employed a defensive 4% allocation to cash during the volatile summer months last year, to both protect our clients during the third-quarter’s waterfall collapse in stock prices and to keep some powder dry to reinvest at a more propitious point in the economic and stock-market cycle. So we’re going back to the well this summer.