04-23-2014 11:30 AM
By Bernie Williams,
Chief Investment Officer of USAA Investment Solutions
Stock and bond markets are approaching an inflection point. The Federal Reserve’s bond-buying program known as quantitative easing is being steadily wound down, and the Fed is preparing for short-term interest rates to start going up. The arrival of spring means everything is thawing out, and that includes the economy, so there’s no reason to think, at this point, that the Fed will change its pace of monetary tightening.
For U.S. stock investors, this looming inflection point is creating a choppy market, though not a lot of outright fear. The Volatility Index (VIX), which measures the market’s expectations of stock volatility in the coming month, is down 38% from its year-to-date high on Feb. 3. On that same day, perhaps not surprisingly, the Standard & Poor’s 500 index dipped to its lowest point of the year. Since then, the S&P is up 8%, although its path has seen a lot of daily ups and downs.
Almost half of that gain since Feb. 3 has come in the past six trading sessions, as corporate earnings for the first quarter of 2014 so far have come in better than many had feared. More importantly, companies have not been reining in their outlook for the rest of the year. We’re waiting for most of the industrials to report to get their perspective on how the economy is shaping up for the next couple of quarters, both in the U.S. and in Europe. It would be good to see economic activity picking up in the rest of the developed markets at a pace that might help them catch up to the growth rate in the U.S.
We would like to see the increase in economic activity translate into revenue growth, which has been muted during the five-year bull market. Without an acceleration in revenue to drive future earnings, stocks will have a hard time justifying their high price multiples. We are underweight both U.S. large-cap and mid-cap stocks due to our concerns about valuations.
For bond investors, an end to QE and rising interest rates will likely present a headwind, at least in the short term. Those 6% to 8% annual returns with little risk that we’ve been seeing in the past few years will, in our view, give way to more modest returns as rising yields drive down the prices of existing bonds.
As a result, we’ve trimmed back the bond exposure in our asset allocation portfolios. We’ve also shortened the duration of our bond holdings to reduce the impact of rising interest rates on our portfolios, and we’ve taken on more credit risk at a time when the default rates on corporate bonds are near record lows.
Gradually rising interest rates as the economy continues to improve will likely be good for bond investors over the longer term. As existing bonds mature, income-focused investors will be able to reinvest their principal in bonds with higher yields. In the meantime, a bond position will continue to serve as a good way to diversify a portfolio and balance risk against the possibility of stock market correction.
We also see a good opportunity in emerging market stocks and emerging market debt. On the stock side, the valuations are more attractive than what we’re seeing in developed markets. To a large degree, EM stocks are a leveraged play on developed markets; as the economies of the U.S., Europe and Japan pick up speed, export-oriented countries in the developing world benefit from rising demand for their output. We are currently overweight EM stocks.
EM stocks were rocked last summer and again in January when the QE taper was first discussed and then became a reality, so we think the Fed’s policy action is already reflected in current prices. The European Central Bank is now mulling its own QE program to try to kick up the growth pace in the European Union. If it follows through, that would most likely be a positive for EM stocks. If history is any guide, monetary stimulus by the ECB would also be a positive for EM bonds, as yields would fall and bond prices would rise.
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 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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As interest rates rise, existing bond prices fall.
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Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability. Emerging market countries are most volatile. Emerging market countries are less diverse and mature than other countries and tend to be politically less stable.
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