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April 25, 2014
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The Middle of the Business Cycle
By: Clayton M. Albright, III, Senior Fixed Income Portfolio Manager
Member, Investment Strategy Team
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 investment-grade corporate and municipal debt.


Within our domestic equity allocations, we decided to retain our overweight positions to both growth stocks and small-cap stocks despite the rough performance these sectors have had over the past month. In addition, we retain our half-of-benchmark stakes—5% versus 10% in all strategies—in inflation hedges, which include inflation-linked bonds and commodity- and real estate-related securities.

U.S. Economy in the Middle of the Business Cycle
Our expectations for 2014 have not changed much in the past month and remain fairly positive, as the economy is expected to expand and economic behavior should normalize further as the financial crisis fades. While the profound impact of the financial crisis and the heavy involvement of central banks in trying to promote growth and avoid further damage have made it hard to identify where we stand in the business cycle, we generally believe that we are somewhere in the middle of the expansion portion of the cycle. At this juncture in the typical business cycle, we generally start to see existing capacity unable to keep up with growing demand, requiring further investment by business in capital and labor. Inflationary pressures can begin to build as a result, with the Federal Reserve likely to respond by nudging interest rates higher. Given the extensive issues generated by the financial crisis in labor markets, housing, and the need for deleveraging, we are still some distance from seeing a deliberate attempt by the Federal Reserve to tighten policy and undertake the first rate hikes. However, markets are becoming more comfortable that the normalization process is taking place and that we are getting closer to this event.

A rebound from the difficult winter conditions is likely to dominate the economic data in the near term. Real GDP growth in the first quarter of 2014 is expected to fall below 2% as the winter weather will have a negative impact on consumption spending, housing investment, and inventory accumulation. However, we expect the economy to rebound during the second quarter with real GDP growth likely to be near 3%. This could turn out to be the strongest quarter of the year as we expect growth to moderate towards the 2.5-3.0% range over the remainder of 2014.

On the international front, global expansion is still expected to be the theme of 2014 but there are numerous reasons for investors to temper their outlook. Europe is expected to continue its recovery, largely driven by gains in Germany, but we cannot rule out the possibility of needing further assistance from the European Central Bank. Bank lending is still heavily constrained and it will be difficult for growth to pick up if businesses have difficulty finding financing. The crisis in the Ukraine continues to pose a threat to peace and prosperity. Headline risk is considered very high as further violence or attempts by Russia to encroach upon the country can take place at any time. This is a risk that will extend for some time to come as neither side seems near to finding an acceptable solution.

Japanese economic growth is expected to go against the trend and be lower in 2014 than 2013. The verdict on Abenomics is not complete as concerns center on the negative impacts it may be having on consumer spending, which could be further compromised by the recently implemented VAT tax increase. Annualized Real GDP growth in China slipped to 7.4% during the first quarter and we expect further declines in the quarters ahead as the economy shifts from investment to more consumption spending. In addition, Chinese authorities are wrestling with trying to gain better control of the shadow banking system, thwart corruption, and reduce pollution, all efforts which could further restrain growth.

Affirming our Positions on Growth over Value
At almost the same time that the IST made its decision last month to overweight growth over value in mega- and mid-cap domestic equities, markets took a sharp turn in a direction favoring value over growth and large caps over small-cap investments. This trend has been in place much of the past month, resulting in tactical allocation performance that has been below our benchmarks.

The IST reviewed what happened in the markets, the outlook, and our current model readings and decided to affirm our current positions for these reasons:

  1. The nature of the market action: The overall shift in favor of value has been enormous by historic comparisons, as it was nearly a two standard deviation event. However, despite the overall size, it has been a very concentrated event as the major sectors that have been impacted include social media and biotechnology firms. Both of these sectors sported extremely high P/E ratios that have been trimmed substantially over the past month. Other areas in the market have not reacted anywhere near what these two sectors did. Furthermore, looking at other sectors of the market, we do not see prospective contagion risks. While we cannot rule out further deterioration in the social media and biotech sectors, we believe the vast bulk of this move has taken place.
  2. This was a healthy development: Having absorbed this move, the market is actually in a healthier place than it would have been without the decline in these sectors. The decline has made the purchase of these sectors much more sensible in terms of the price being paid for the projected growth.
  3. The underlying economic thesis behind our original decision remains in place: As pointed out last month when the original decision was made: "We expect that 2014 will see stronger gains in capital spending which should favor industrials, and technology firms. In addition, as the unemployment rate drops, we should see further gains in consumer discretionary spending, helping that sector as well. Given the problems in emerging markets, we see limited upside in the energy, materials (metals and mining), and utility sectors, which may hinder the value side. While we generally like financials, improvements here are likely to be a longer-term story, which may be held up by a significant regulatory burden." Our overall outlook regarding these factors has not changed.
The IST recognizes that these circumstances may change going forward and will continue to monitor this situation.

Evolving Thoughts on the Use of Hedge Funds
For the better part of the last year, the IST has been debating the future role of hedge funds and the growing popularity of mutual fund-based solutions employing hedge strategies—so called "liquid alternatives." Since the financial crisis, hedge funds, particularly fund-of-fund approaches, have had difficulty producing returns in line with their pre-crisis results. More attention has turned to comparing and measuring hedge strategies with underlying fixed income or equity strategies as a means of adjusting beta, risk, return, and correlation profiles of these major underlying asset classes. The IST endorses this concept and is looking to offer advice that will include multi-strategy liquid alternatives in portfolios, probably starting in the second half of this year.

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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