Investment Outlook 2013

Managing a retirement portfolio is difficult business. It requires investors and their advisers to make crucial long-run decisions in the context of the short run, balancing dispassionate factual analysis of past market relationships against contingent emotional predictions based on a murky future.

Early 2013 represents an especially challenging and conflicting time. Fixed-income assets have been strong for more than 30 years, but a reversal of falling interest rates could turn a traditionally conservative asset class into a risky one. Equities should benefit from improving economic growth, but just when this will occur is conditional on governments’ solutions—and the credibility of these—to chronic budget issues. Those resolutions could result in higher inflation, which can challenge many asset classes.

To assist retirement plan advisers in their search for short-run answers to long-run questions, PLANADVISER consulted strategists from five leading asset managers on their 2013 market views. The group includes Manulife Asset Management, Boston, which manages the John Hancock target-date fund (TDF) series; ING U.S. Investment Management, New York; William Blair & Company, Chicago; and Legg Mason Global Asset Allocation, New York. We also were privileged to listen in on an early December 2012 briefing to clients and advisers by strategists at J.P. Morgan Asset Management, New York. 

Equities

For many people saving for retirement, equities of one form or another compose the bulk of their portfolios. According to the latest data from the Investment Company Institute (ICI), 61% of 401(k) participants’ portfolios were invested in equities at year-end 2011. In 2013, additional equity exposure could be a good thing, as investment strategists place equities of various flavors at the top of their lists for prospective performance.

Recommending U.S. equities without reservation is J.P. Morgan Asset Management. “They are very undervalued, in our view,” says Lee Spelman, the firm’s head of U.S. Equity Client Portfolio Managers. “Just like they were in 2012, U.S. equities are a great place to be in 2013. The market is trading at a discount to historic averages, and the dividend yields of many companies are higher than their bond yields. This is at a time when U.S. corporations’ balance sheets are in terrific shape, companies are more profitable than ever before, and bottom-up earnings’ forecasts for the S&P 500 call for an increase of 7%.”

Spelman also points to strong trends in the U.S. economy that have yet to be fully realized: a renaissance in manufacturing; the convergence of “big data” and cloud computing; and the benefits of cheap energy from shale oil and gas.

One naysayer on the U.S. market is Paul Zemsky, who is head of asset allocation, including target-date funds, for ING U.S. Investment Management. “We’re saying investors should reduce their U.S. equity holdings in favor of global stocks.” His explanation, as of press time: “The fiscal drag that has held back Europe is now shifting to the U.S., and, whether or not the U.S. goes over the fiscal cliff, the size of government in the U.S. will begin contracting [this] year. In Europe, countries have become as austere as they are going to be, and we should start to see a reduction of fiscal drag.”

“U.S. equities are about fairly priced,” says Bryan Singer, head of the Dynamic Allocation Strategies Team of William Blair. (See Figure 1.) “Investors should expect a normal return, on the order of 8%, but there is likely to be significant volatility as we go through the dialogue on U.S. government spending and debt.”

However, Singer sees better opportunities in other markets—the emerging markets and, among the developed economies, Italy, Spain, France and the U.K. “We make no great assumptions about earnings growth, but earnings have come down a bit from normal due to Europe’s economic volatility, so some earnings recovery is likely to come from that,” he says.

The final element, according to Singer, is an incipient expansion in price-earnings ratios. “The massive uncertainty has caused businesses to retrench and investors to re-price securities to high-risk levels,” he explains. “We believe that uncertainty will abate in 2013, and that will lead to price-earnings multiples at a more normal level. It won’t happen quickly, but all of that underpins the European equity markets.” Figure 2 shows historical price-earnings ratios for the MSCI equity indices for developed markets in Europe, Australasia and the Far East (EAFE), alongside data for the emerging markets.

“Number-one on our list is emerging market equities,” says Bob Boyda, head of Global Asset Allocation at Manulife. “Those markets are underappreciated because many people still think [the markets] are just resource plays or that the economies can be scary and volatile.” He adds that many investors fail to realize that the major emerging markets of Brazil, Russia, India and China, plus the emerging Asian countries, are expected to make as large a contribution to global growth in 2013 as will the U.S.

“In the emerging markets, China is a major driver, and we see a bottoming of purchasing managers’ indices, and important indicators such as electricity production and railcar loadings ramping up again,” notes Zemsky of ING. “This is a confirmation that the central bank’s easing of the last 12 months has started to get traction.” 

For the longer term, David Kelly, chief global strategist at J.P. Morgan Asset Management, points out that China’s growth will eventually  slow, and he encourages investors to shop around: “As wages in China go up, countries such as Mexico and Vietnam suddenly look much more competitive as manufacturing bases. There are plenty of opportunities in the emerging markets.” 

Fixed Income

While reasonable strategists may differ as to which equities offer the best prospects, they are in general agreement on allocations to plain-vanilla fixed income, such as U.S. Treasuries and investment-grade corporate bonds. The reasoning holds that an improvement in the U.S. economy or a return to inflation—or both—will drive up interest rates and practically guarantee falling bond prices. For asset prices, on the other hand, the impact is more acute the lower the market yield and increases with a bond’s duration.

Manulife’s Boyda ranks developed country sovereign debt as the least attractive asset class for 2013. “There is some use for Treasury bonds as a tail risk hedge, but our view is that the U.S. economy is recovering and in better shape than most people are willing to give credit for,” Boyda says. “Anyone who is optimistic on an economic recovery can’t be optimistic about the 10-year Treasury bond, and with a yield of just 1.60% or 1.70%, it’s simply not good value.” (Figure 3 illustrates the record lows of U.S. Treasury bonds.)

Anne Lester, managing director at J.P. Morgan Asset Management, agrees on bonds’ merits as a diversifier but urges advisers and investors to be realistic about their prospects in an environment of rising yields. “Even at low rates, fixed income can be helpful in managing a portfolio’s volatility as an asset that moves countercyclical to equities. Eventually, though, investors have to face a possible backup in interest rates, so be sure you know what you are using fixed income for.”

In the high-yield bond market, some strategists point to a low default rate and to borrowers’ balance sheets—in much improved health compared with 2008—as offering the high-yield investor a margin of safety. However, an opposing and authoritative view on high yield is advanced by Martin Fridson, CEO of FridsonVision LLC, a financial research firm based in New York, and a long-time scholar of the high-yield market. Through the lens of rigorous quantitative models, Fridson sees the high-yield market as expensive and says: “Historically, an extremely rich valuation has been associated with a negative excess return.” (Figure 3 also shows that the high-yield market is at historically low yields.) 

This is not to mention that high yield has become a “crowded trade,” with the Investment Company Institute reporting a 46% rise in U.S. mutual funds’ exposure to high yield between 2007 and 2011, amounting to $212 billion. Morningstar reported a further 38% rise in high-yield mutual fund assets in the year ended September 2012. 

Real Assets

Investments in real assets to protect portfolio purchasing power against rising inflation also are on strategists’ radar screens for 2013, although just barely and the images are faint. “Given the unusual monetary policy around the world—the unconventional monetary policy from the Fed and the ECB, coupled with easing by the People’s Bank of China and signs that the Bank of Japan will do something about its sluggish growth—inflation protection is something investors should be aware of, although not panic about,” says Wayne Lin, an investment strategy analyst at Legg Mason.

Some strategists recommend investments in real estate investment trusts (REITs) to counteract inflation, while others think conventional equities can do the job. A strong consensus exists, however, that what has been one of the best inflation-protecting assets fails to make the cut in current market conditions: U.S. Treasury inflation-protected securities, or TIPS.

“Do not look at TIPS,” says J.P. Morgan’s Kelly. “There’s nothing wrong with the embedded inflation protection, but there is everything wrong with the underlying asset class. Today’s yield on the 10-year TIPS is about negative 70 basis points. If I give you $100 now, you are promising to pay me back $93 in 10 years, which makes no sense at all. Find some other way to protect against inflation.”

On the other hand, most strategists look favorably on the inflation protection of equities, given the right environment. “Companies’ input prices may go up with inflation, but they can raise their output prices along the way,” says Singer of William Blair. “As long as the inflation is not too quick and extreme, most business models can keep up.”

The pace and severity of inflation tests different assets’ hedging ability. Most strategists currently are looking for an inflation environment in the near- to mid-term of prices rising at a slow pace (3.5% or less). According to J.P. Morgan, in the seven such inflation regimes observed in the last 40 years, the best performing asset was equities—offering inflation protection superior to bonds, cash and commodities. Equities win most of the time, notes J.P. Morgan, and provide the best inflation protection in all environments except high inflation.

In relating their top-of-mind ideas for 2013, all firms stressed the importance to retirement savers of maintaining diversified strategies and emphasized that their views were guides for tilting portfolios rather than staking out concentrated investment positions. 

Investors also need to bear in mind the inherent challenge of forecasting the financial future. To paraphrase high-yield master Fridson, most one-year forecasts are extrapolations of current conditions and often wind up wide of the mark because, by their nature, they cannot take into account the shocks that often determine short-run returns. Accordingly, we offer these strategic ideas to plan advisers as tools for reaching their own market views. 

Dividend-Paying Stocks

As yields on conventional bonds have headed toward zero, many investors have tried to replace that lost income in the regions of the equity market that pay high dividends—utility, telecom and consumer staples companies. But this is an old story, and some stocks that are sought for their high dividends could be threatened by rising interest rates. Clare Hart, portfolio manager of J.P. Morgan’s Equity Income Fund, observes: “Some of the stories of stocks that look like a bond are becoming stretched, and not everything in the equity market with yield on it has room to move higher.”

She advises looking for stocks or funds with portfolios of shares that happen to pay a dividend but also offer products people want and smart management teams that can navigate difficult times. As Hart puts it: “If you’re sailing and hit a tsunami, you want to be in the best ship and have the most capable captain who will get you back to sailing on course. It’s not helpful to put someone in a stock yielding 4% and have something go wrong in the business that sends the stock falling by 30%.”