Our Investment Strategy Team met this week and affirmed the 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. We continue to allocate to non-core bonds, such as speculative-grade floating-rate notes, and are overweighted in those assets by definition, because they are not included in our strategies' benchmarks. 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.
Equities remain our best tactical option
Equity markets, particularly those in the U.S., finished 2013 with a flourish. The S&P 500 added 10.5% during the final quarter of the year, leaving investors both pleased to be aboard for the ride but also skeptical that markets had more to gain. We understand why investors might have dubious feelings about the future but overall we do not subscribe to the sentiment that the market's upside has run its course.
Potential value and protection in the bond market
Investors have not seen the combination of words in the caption above very often recently. Having produced negative returns last year and still facing the prospect of rising interest rates this year, bonds are considered by many to be a poor investment choice. Given our asset allocation comments, you would have to count us among the bond market skeptics as well, but we also believe that the fixed income market is offering a potential haven in the 1–5 year maturity part of the yield curve. The rationale behind this stems from comments made by the Federal Reserve along with the current shape of the yield curve. The Federal Reserve has made it clear that they intend to reduce their quantitative easing program, a process that is likely to reduce pressure on longer-term bond yields, allowing them to normalize at higher levels. At the same time, they have indicated that they are likely to keep short-term rates low for a significant time to come. Figure 2 shows how this is likely to play out with prospective yield curve changes. The longer end of the curve is likely to move higher but we do not expect the short end to respond in the same way. As a result, investors who have portfolios in the 1–5 year maturity range are likely to face minimal principal erosion while picking up income returns that may average 1% for Treasury investors. The same concept works with investments in corporate bonds or municipals with the prospect of higher income returns.
Our recently released Capital Markets Forecast points out this particular opportunity for fixed income investors but it also warns that this will not last forever. When the Federal Reserve decides to start raising short-term rates, investors may want to reevaluate their portfolios, possibly considering that it may make sense to be positioned further out the yield curve, as the bulk of the damage from rising rates will have already been done to that part of the curve.
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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