A low-risk environment
At State Street, we start our investment process by gauging the environment for risk. We look at three things: implied volatilities on equities, credit spreads, and currencies. Right now, all three indicate that we are in a fairly low-risk environment, arguing for a sizable overweight to equities, generally.
An underrated U.S. recovery
The U.S. economy is a lot stronger than people have been giving it credit for. In the first half of the year, its strength has been masked by geopolitical tensions, weather conditions, and other factors. I expect inflation to remain fairly low, and monetary policy is favorable globally. I think oil prices will remain fairly stable, and with a lot of excess capacity in the economy, we could see real (inflation-adjusted) U.S. GDP grow as much as 2.6% in 2014 and more than 3% in 2015.
I expect cyclically oriented sectors of the market to do well, so I am overweight consumer discretionary stocks, financials, and industrials. If capital expenditures continue to rebound, I expect that strength to flow through to technology and industrials.
Given valuations, earnings expectations, and momentum, I think it’s a good time to be overweight risk assets. So I am overweight equities, specifically developed-market equities in the U.S., Europe, and Asia Pacific. At the same time, I am underweight emerging-market equities in Europe and Asia Pacific. From a market-cap perspective, we have reduced our small-cap holdings from overweight to underweight, and are overweight large-cap growth and value.
I have been anywhere between sizably underweight and neutral in all parts of the fixed income market, with the exception of long-term credit, and that’s more of a diversification tool than anything else.
The international outlook
Profit margins in the U.S. are high, but margins in Europe are about three percentage points below their peak levels of the mid-2000s. I expect this differential to close and European companies to get back to peak profit levels, which is one reason I remain overweight to Europe.
Emerging markets have become a lot cheaper. I view them through three time frames. In the short term, the next 12 to 18 months, those with very low levels of debt and stable currencies, for example Taiwan, are likely to do well. In the intermediate term, 24 to 36 months, I would look for economies that have put forward structural reforms geared toward growth, like those in emerging Asia, Mexico, and Poland.
Long term, three years and out, look for solid secular attributes like rising incomes, a growing consumer base, and increased production efficiencies. Look beyond the BRICs to countries like Indonesia, Malaysia, Taiwan, and the Philippines, which are likely to benefit from China’s long-term transition from an incredibly strong export-oriented economy to a still-strong consumption-led economy.
Investors will reward conservative management
I expect equities to continue performing well, but they could stumble if investors demand much higher levels of revenue growth and margin expansion. That said, I think investors will continue to want corporate executives to manage their businesses conservatively, returning capital to shareholders through share buybacks and increasing dividends. Stocks that have returned capital to shareholders have been rewarded, and I expect that to continue.