Our current outlook
"Optimismůmakes people go out andůstart businesses and spend and do whatever is necessary to get the economy going." – Ben Bernanke
Optimism is a beautiful thing, as the former Federal Reserve chairman noted in a 2012 interview. And this is no less true today, when – in the wake of the very volatile showing we saw in the first half of 2014 – it's understandable that recent positive economic indicators might awaken a renewed sense of hopeful expectation.
The Investment Strategy Team (IST) had its monthly meeting last week to discuss its weightings and outlook.¹ We find that economic activity is pointing toward a more consistent performance in the second half of the year, where growth is likely to range between 2.5% and 3%. The strongest story supporting the economy may be coming from the employment front, where job growth last month reached 288,000 new nonfarm payroll jobs, the unemployment rate slipped to 6.1%, and job openings reached 4.6 million. In our view, all of these could support an economic growth picture that might see GDP growth exceed 3%.
Furthermore, we find that data supporting the economy have also come from a wide assortment of other sources, including:
Reasons for caution
Despite the positive signs, we have tempered our outlook due to the following mild headwinds that continue to blow:
Our investment positioning
From an overall perspective, our belief that the expansion still has time to run and that growth will be modest supports our continued positioning favoring equities and growth. However, against a background that includes the potential risks listed above, we have decided to take on a slightly more defensive position.
The prospect of rising short-term interest rates and a flattening yield curve should not bode well for short-term investment-grade bonds, so we have proactively begun reducing this position, putting money into cash which we feel could outperform bonds, provide safety, and provide us with a source of liquidity to respond to new opportunities. We have added to our non-fully diversified portfolios multi-strategy liquid alternatives, which will give us the ability to adjust exposures to fixed income and equity markets with respect to interest rate sensitivity, credit exposure, and downside protection. Given the use of liquid alternatives, the tactical allocations in this area can be easily changed as market conditions warrant. Our thoughts have not changed on inflation hedges and we remain underweight, since we see inflation as a relatively benign threat.
As we look at the performance gaps between value and growth, and between large cap and small cap, the markets are very near the biggest levels seen earlier this year and at levels that have historically been considered extremes. For that reason and as part of our more defensive posture, we have reduced our exposure to small-cap equities. That said, we maintain our small-cap overweight, since making major modifications now could result in locking in losses at peak levels. In our view, patience is the best course of action at this time.
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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