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May 27, 2014
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Looking Past the Rebound
By: Clayton M. Albright, III, Senior Fixed Income Portfolio Manager
Member, Investment Strategy Team
Wilmington Trust Investment Advisors

Our Investment Strategy Team met this past 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 since mid-March. 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.

A Volatile Period for the US Economy, Global Expansion to face Challenges
Looking back 18 months ago, the financial world was held in suspense by the pending arrival of the "fiscal cliff," a combination of tax hikes and government spending cuts that some thought might prompt a return to recession. The publicity around this set of circumstances was quite heavy, and as the trigger point for a lot of the provisions approached at year-end 2012, policy makers finally resolved many of the issues, averting the worst outcome.

Looking back as 2013 melted into 2014, it is quite obvious now that our economy and financial markets have had to withstand something very akin to the disruptions feared in the "fiscal cliff" scenarios, although they have done so without the kind of publicity that accompanied the pending cliff itself. As reported, Real GDP expanded by 0.1% in the first quarter and we expect revisions to this number to send it into negative territory. While weather is blamed on much of the poor showing, reactions to the Fed's decision to begin reducing their stimulus to the economy, and to a housing market that began to choke on higher home prices, financing costs, and limited credit availability, all played a role in creating an environment during the first half of 2014 that has been frustrating for many investors. Our expectation is that the poor showing in the first quarter will be followed by a pronounced bounce in activity during the second quarter. Real GDP growth in the second quarter could reach around 3.5%, a large pickup from the current +0.1% estimate for growth in the first quarter.

The bigger question for markets and the economy is what happens in the second half of the year once the volatile impacts have faded. The Federal Reserve will likely complete their bond buying program— which will remove stimulus additions from the economy. Actual tightening efforts expected when rates begin to rise are not anticipated to take place until mid-year 2015 at the earliest. We expect the economy to grow at about a 2.5% rate during the second half of 2014 as the modest expansion pace we have seen before reasserts itself. Critical to the economy growing at that pace will be expansions in business investment spending along with continued growth from housing. Recent surveys from the Institute of Supply Management (ISM) point towards a 10% pickup in business capital spending plans. Uncertainty over how the economy responds in the second half of the year is probably contributing to recent equity market price swings that have created a market more prone to move sideways.

On the international front, global expansion is still expected to be the theme of 2014 but there are numerous challenges to this outlook. Europe is expected to continue its recovery largely driven by gains in Germany. However, the Eurozone managed to expand at less than a 1% annual rate during the first quarter and with fears of deflation gaining, the European Central Bank (ECB) has determined that they need to act and have promised policy decisions in early June to stimulate the economy. The potential actions could include negative deposit rates, liquidity infusions, and efforts to further shore up the banking system in order to promote better credit availability. With markets now expecting ECB measures to be implemented, they will be judging how broad and dynamic these efforts turn out to be. Although recent events in the Ukraine are pointing towards a reduction in tensions, 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 likely extend for some time to come.

Japanese economic growth is also expected to be very volatile in 2014 largely driven by the citizenry's reaction to the recent VAT tax increase. Growth during the first quarter exploded to 5.9% but negative growth numbers are likely to follow during the second quarter and perhaps into the final two quarters of the year as well. 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. A brighter note has come from India where recent elections have brought into power Narendra Modi who is expected to press forward with significant economic growth and capital formation reforms.

Overall, we expect the second half of 2014 to see a return to the modest growth environment we have been experiencing which leads us to believe that our more aggressive positioning with respect to equity weights and more growth-oriented sectors will prove correct.

Affirming our Positions on Small-Cap and Growth-Oriented Equities
As markets have had to absorb the volatile environment, the parts of the market most exposed to higher growth assumptions have performed particularly poorly. Growth stocks have dramatically underperformed value stocks while small-cap stocks have finished well behind large-cap stocks so far in 2014. The IST spent considerable time reviewing this situation and agreed to make no changes in our allocations at this point in time. Many of the reasons behind our support for these two markets are similar as highlighted below:

  1. The nature of the market action: Both small-cap stocks and growth stocks seem to have reacted more to unique factors within their respective markets rather than to a bigger economic fear. In most cases where small-cap stocks swoon similar to what has happened in 2014, large-cap stocks will tend to follow behind within a few months. So far, this has not happened. Similarly, the decline in growth stocks 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. So what has taken place largely reflects adjustments that are mostly internal to the respective markets and not reactions to bigger economic trends.
  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 previously, we expect that once the uncertainty around the volatility created by the events that took place at the beginning of the year all subside, markets will again be willing to pay for growth in a world of modest economic gain.
The IST recognizes that these circumstances may change going forward and will continue to monitor this situation.

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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