03-21-2014 12:57 PM
By Matt Freund,
Chief Investment Officer, USAA Mutual Funds
When Federal Reserve Chair Janet Yellen spoke a little too clearly on Wednesday about her expectations on interest rate hikes, investors rushed to sell, and markets tanked. But on Thursday, when several key indicators pointed toward an improving economy, investors quickly became buyers again and the markets bounced back.
Investors have been dreading the end of more than five years of monetary stimulus intended as a crutch for a limping economy. It’s easy to understand why: The Fed’s easy-money policies, intended to encourage economic activity, have helped fuel one of the strongest bull markets in U.S. history.
And on Wednesday, at her first press conference as Fed chair, Yellen made what many have called a rookie mistake by suggesting a fairly specific timeline for raising short-term interest rates. For months, the forward guidance had been that rates would remain near zero “for a considerable time” after the Fed winds down its bond-buying program. After the press conference, however, the market faced the possibility that rates would go higher sooner than had been expected.
Perhaps Yellen’s announcement about the accelerated timeline wasn’t a mistake at all, but instead a reflection of the more hawkish views of the Fed’s current voting members when it comes to potential inflation. Under former Fed chair Ben Bernanke, the view was that the Fed would rather raise rates too late and risk higher inflation than raise them too early and risk derailing the economic recovery. If this week’s change in tone is for real, we think the concern that inflation may spike dissipates a bit.
After a couple of months of subpar growth numbers, blamed largely on weather, some better news came Thursday. The Conference Board’s leading indicators index supported the bad-winter narrative by turning in its best results in three months, while the latest unemployment measure was better than expected. This seemed to take the focus off Yellen’s rate-raising comment.
Still, it appears that markets are being driven by momentum, not fundamentals. Given the continued tapering of the Fed’s bond buying (down from $65 billion to $55 billion per month starting in April) and greater uncertainty on when rates will start rising, we should not be surprised to see more volatility in markets in the near term. From a valuation perspective, we believe U.S. stocks are currently overpriced, and thus we are underweight in our managed portfolios.
Emerging-market stocks may find themselves under renewed pressure in the coming months as the impact of reduced liquidity more than offsets the impact of potential economic growth in the U.S. The situation in Ukraine, which looks to be escalating, albeit slowly, obviously doesn’t help matters in emerging Europe.
There are some reasons for optimism in emerging markets over the longer term. The first is fundamental: Valuations overall remain attractive, and we think companies are getting closer to bottoming out on earnings. At that point, emerging-market stocks will be positioned to begin rebounding. The slowdown in developed markets has been weighing on the export-dependent emerging economies, so when conditions in the developed markets normalize and healthy levels of growth return, that growth could pull along the emerging markets as well.
In addition, the developed markets are not all in the same place when it comes to monetary tightening and interest rate hikes. Whereas the Fed loosened first and now is the closest of the group to start tightening, the central banks in Great Britain and Japan are still in easing mode, and the European Central Bank indicates it has no plans to start raising interest rates any time soon. The additional liquidity derived from those sources, and any economic growth that results from the stimulus, could also lift emerging markets.
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. We are also tactically underweight fixed income. We remain slightly overweight cash in our diversified managed portfolios.
We also are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund also provides potential protection against the risks of long-term inflation.
Emerging markets represent another opportunity. Though they have been hit especially hard recently, we believe that emerging markets remain attractive. They offer both an interesting long-term prospect for growth and compelling valuations. 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 you based on your individual goals, objectives, risk tolerance and time horizon.
This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.
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