Heading into 2014, the biggest question for many investors was how the tapering of the Federal Reserve’s bond-buying program would affect their portfolios. Today, their attention has turned to when the Fed will begin hiking the federal funds rate. But the decision on rates is not the only driver of markets. We believe there are other important factors at work:
||After sluggish growth in the first half of 2014 due to the harsh winter, GDP growth is likely to improve in the second half.
||Despite an improving economy, the downside risks to stocks have increased, from geopolitical tensions around the globe to stretched valuations in the United States. However, most risks will likely have only short-term effects on stocks.
||The downside risks to benchmark bonds have also increased. These risks include the potential for a re-pricing of the short end of the yield curve, the lofty valuations of US Treasuries and the risk of capital depreciation. These risks may have long-term consequences, given that the potential for rising rates has become more imminent.
5 Tips for Investors
Align asset allocations with time horizons.
Many investors with longer time horizons are in jeopardy of being unable to fund their goals because their allocations suggest a they have a much shorter time frame. Most investors have a lot of exposure to cash and core fixed income. That’s appropriate if they need to use the money in the short term, but it’s not appropriate if they need it to fund long-term goals like retirement or a college education. Alternatively, some investors have a short time horizon but a large exposure to stocks, which could prove problematic as downside risks to the equity market continue to mount.
Beware of interest-rate complacency.
At some point, the Fed has to guide rate expectations higher, which may startle investors. If the Fed revises its forecast for when the tightening cycle will begin, then it doesn’t necessarily imply equity markets will fall back appreciably. But we could see some negative short-term reaction in the stock market. Keep in mind that, ordinarily, equities can sustain several rate rises before declining and, given their low base, short-term rates are unlikely to constrain output and activity, which means any equity-market selloff may be limited. The greater risk of complacency is in US Treasury yields, where investors anticipating continued lower rates may be unpleasantly surprised.
Follow the value.
With US stock valuations becoming stretched, investors should seek adequate exposure to lower-valuation stock strategies, both in the United States and abroad, where there are more bargains.
Maintain a healthy dose of dividends.
Whether or not we have a market correction this year, we still don’t expect huge returns from the stock market. Dividend-paying stocks have historically provided a substantial portion of total return in this type of environment—and have tempered volatility.
In this unique and unpredictable market environment, investors should be well diversified, ideally in an actively managed multi-asset investment. These investments offer exposure to a wide variety of assets and can adjust allocations depending on current opportunities, such as low valuations, and current risks, including rising rates. Multi-asset strategies help investors offset behavioral biases and self-inflicted psychological obstacles by providing one professionally managed investment that they can “set and forget.”
The bottom line:
In the second half of 2014, investors need to recognize that downside risk has increased for both stocks and bonds. However, if they have a long time horizon, then they need adequate exposure to risk assets in order to meet their long-term goals.