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February 21, 2014
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Whether or Not the Weather?
By: Clayton M. Albright, III, Director of Asset Allocation
Wilmington Trust Investment Advisors

Our Investment Strategy Team met this week and affirmed the broad weightings of our model asset allocation strategies.1 As depicted in Figure 1, we are overweighted, relative to our benchmarks, in equities. We are underweighted in fixed income securities—nominal bonds and cash equivalents combined. We are especially light on core bonds, such as U.S. Treasuries and investmentgrade corporate and municipal debt.


However, we decided to remove our allocations to emerging market debt and reinvest these proceeds into short-term fixed income instruments with maturities of 7 years or less. We retain our half-of-benchmark stakes—5% versus 10% in all strategy models—in inflation hedges, which include inflation-linked bonds and commodity- and real estate-related securities.

Weather Impacts
In real life, we know that weather can impact visibility. Fog or blizzard conditions can make it impossible to see very far, creating any number of hazards. Dealing with bad weather has become a way of life for many of us this winter but this has now extended into the realm of economics, where data releases—many of which have been below expectations—are quickly dismissed as being impacted by "the weather." We entered 2014 believing that the economy was well-positioned for growth in the 2.5-3.0% range, but weather has at least temporarily reduced our economic visibility. We still believe that 2014 should continue the process of normalization from the financial crisis but we are attentive to the fact that the jury is still out regarding weather being entirely to blame for some of the economic misses we have seen. For example, housing start data released this week showed overall activity down by 16%, but the declines took place in locations that experienced both good and bad weather. The employment report for January was also below expectations but the total number of people who could not work because of weather was actually below the normal average for January. Again, as in real life, we will have to wait for the weather to clear from the statistics to measure the full impact and, perhaps more importantly, to see if other factors are holding activity back. Our own expectations for the first quarter are below consensus as we see GDP growth in the 2.2-2.4% range, versus 2.5% for the consensus. In our expectations we are factoring negative weather impacts as well as some pullback from the strong showing last year that involved considerable inventory accumulation. However, we still look for growth to be in the 2.5-3.0% range as the year progresses, which enables us to remain comfortable with our overweight equity exposures.

Fixed Income Retooling
Our decision to remove U.S. dollar-denominated emerging market debt from our asset allocation and replace it with domestic investment-grade bonds with maturities below 7 years was driven by a number of factors. At the heart of this trade is a decision to reduce credit risk exposure in an area of the market where we have no benchmark coverage. Emerging markets are in a period of transition, where the benefits that they have enjoyed over the past decade or so—of cheap labor leading to foreign investment flows—appear to be coming to a close. This will require adjustments that may very well lead to slower economic growth rates, which would further complicate efforts to find stability. Given the unpredictable nature of these changes, we do not feel it's warranted to remain exposed to a situation in which default risk in the credit markets could become a bigger concern.

Prospective returns played a major role as well in this decision. Emerging market debt has carried a fairly sizeable spread premium (currently about 350 basis points, or 3.50%) to the US Treasury market, which would likely allow it to outperform. However, this asset class is also more vulnerable to rising rates due to the longer average maturities of the bond investments, which points to considerable principal risk. When combined with the possibility that the current spread premium could widen further, return expectations over the next 6-12 months could easily be below our expectations for core fixed income asset returns, and could even turn negative.

As outlined last month in Market Insights and in our recent Capital Markets Forecast, the steepening of the yield curve would likely make short maturity bonds more attractive, at least until the markets begin to price-in the potential increases in overnight rates by the Federal Reserve. Given this, returns in the shorter-maturity segment of the fixed income market have less exposure to any resultant price declines and, therefore, we believe they have a better opportunity to outperform broad benchmarks. For these reasons we elected to allocate the proceeds from liquidating emerging market debt into this part of the fixed income universe.

Holding Firm with Our Favored Equity Positioning
After a dismal showing in January, equity markets have found support and recovered a large portion of the ground they gave up last month. Markets in Europe have actually moved into positive territory for the year, while popular domestic indices such as the S&P 500 are sitting just below breakeven. Earnings have been relatively positive, finishing up for 2013 with the fourth quarter showing an improvement of about 10% for the S&P 500, up from a comparable gain of 8.8% in the fourth quarter of 2012. We are expecting the S&P 500 to finish 2014 somewhere in the range of 1890-2015, which represents an average gain of 6.2% across that range, a level that should be more than competitive against other asset classes. Given this, we remain committed to our favored equity overweight.

1 The construction of our model asset allocation strategies generally reflects a combination of asset-class valuation and momentum measures, overlaid by the judgment of our Investment Strategy Team. The extent to which—and speed with which—strategy-following client accounts reflect the Investment Strategy Team's models may vary, reflecting client-specific circumstances such as liquidity, tax sensitivity, and investment horizon.

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