05-28-2014 11:10 AM
By Wasif Latif, head of global multi-assets
The Federal Reserve and the European Central Bank have, in large part, taken differing approaches as they’ve worked to rescue their respective economies from the financial crisis and then generate recovery after the Great Recession.
The Fed started with action in the form of interest rate cuts and several rounds of large-scale bond buying (quantitative easing) to flood money into the system, and it followed up with words to reassure investors and others that the near-zero interest rates would continue as long as necessary.
The ECB, on the other hand, exercised self-restraint in the beginning and felt the pain when sovereign bond markets revolted. However, when ECB leadership changed in early 2012, it began to change course, starting with words — a pledge to do “whatever it takes” to save the euro as a currency and, by extension, lift the broader European economy. This clear reassurance worked well to help stave off the eurozone’s sovereign debt crisis but has been less successful in creating conditions needed for sustainable growth. So now, as the U.S. steadily tapers its QE, the ECB appears on the verge of action with a monetary stimulus program of its own.
The U.S. economy appears to be on the mend. At the very least, it is much further down the road to recovery than Europe, where a number of countries remain in recession or teetering on the brink of falling back into recession. Economic growth came in far below what was expected in the first quarter of 2014, and fear of debilitating Japan-style deflation is still running high. The recent European Union parliamentary elections, in which fringe political parties made sizable gains, shed some light on the depth of discontent with prolonged double-digit unemployment and general economic weakness.
In other words, we think now might be a good time for the ECB to turn words into action, and the route taken by the Fed — rate cuts and QE — might be a good way to support the fiscal reforms that have already happened. A big factor working against the EU economy now is the strength of the euro, which has both reduced the demand for European exports (a key economic driver) and kept a lid on inflation. Further rate cuts would likely weaken the euro, though by how much is hard to know.
If the ECB adds a QE component to its monetary easing, it could opt for a broad bond-buying program or one that is more narrowly targeted. The former, which would be similar to that of the Fed, could help the more cyclical sectors and least liquid markets. These would include the discretionary and materials sectors as well as emerging markets, commodities and European small cap stocks. A more targeted approach, smaller in scale and ambition, could be directed toward specific vulnerabilities, including sovereign debt in the EU periphery or hobbled European banks.
The Fed’s accommodative stance, both in action and rhetoric, has been a valuable constant for the U.S. during a slow, uneven recovery. It has helped offset the impact of sometimes weak data reports and, in doing so, has provided needed time for the economy to develop real traction. A similar effort, however late in arriving, could be just what the doctor ordered for the EU as well.
Looking at U.S. markets, it’s hard to remember a time when new highs for the Standard & Poor’s 500 index were met with as little enthusiasm as what we’ve seen lately. The S&P 500 closed above 1,900 for the first time ever Friday, and that mark moved even higher when trading resumed after the Memorial Day holiday. The elation that typically accompanies a push into new record territory seems to have been swapped out for skepticism that the current advance is real.
But the VIX volatility index — the so-called “fear gauge” — suggests that there’s not a lot of worry that the other shoe is going to drop any time soon. The VIX is at its lowest level since before the financial crisis began in 2007.
This contradiction — little appreciation for the rally but little fear of imminent reversal — could be an expression of complacency as the bull market moves further into its sixth year. As odd as it may sound, complacency can sustain momentum. While we continue to be cautious about U.S. stock valuations that are significantly above their long-term average, particularly on a cyclically adjusted basis, the current momentum is grinding upward and could well continue to carry stocks along with it.
USAA Investments Managed Portfolio Outlook
Our view of caution toward U.S. equities remains unchanged — we are underweight U.S. large caps and small caps. While signs point to continued recovery of the U.S. economy, valuations are stretched and profit margins are near record highs. The USAA Income Stock Fund seeks dividends and dividend growth as contributors to total return.
We are tactically underweight fixed income, primarily to fund a deployable cash position. Within fixed income, we prefer areas of the market that are more credit-sensitive and less sensitive to changes in interest rates, such as investment-grade corporate bonds and high-yield bonds. The USAA Intermediate-Term Bond Fund and the USAA High Income Fund fit this profile.
We are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund provides potential protection against the risks of long-term inflation.
We are overweight non-U.S. developed markets and emerging markets based on relative valuations. Though they have been hit especially hard recently, we believe that emerging markets remain attractive. Along with compelling valuations, they offer an interesting long-term prospect for growth. The USAA Emerging Markets Fund offers exposure to stocks in less-developed countries.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for your individual goals, objectives, risk tolerance and time horizon.
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