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Perspectives

Getting gradually more defensive

Steven Wieting

By Steven Wieting

Chief Investment Strategist

March 29, 2016

Is a lasting bear market in equities at hand? Despite the turbulence in financial markets in the first two months of 2016, we think the answer is no.

At the same time, though, we do believe that we are now in a new phase of the cycle, where short-term market corrections are deeper and more frequent. And we are shifting our tactical asset allocation accordingly.

On 16 March, the CPB Global Investment Committee cut its allocation to equities and raised its allocation to fixed income and cash. We also made small weighting changes within our neutral allocation to hedge funds to favor assets that we believe may dampen portfolio volatility.

As a result, our overweight to Global Equities has moved to +1.0%. That’s down from +6.8% from when we began to de-risk the allocation gradually from late 2014. Our Global Fixed Income allocation is now -1.5% below its strategic benchmark, up from -6.9% at its late 2014 low. In light of global economic and market risks, we expect to keep shifting from equities to fixed income and cash.

In recent months, we argued that global growth fears were overdone and markets were putting too much emphasis on crude oil’s decline.  We still expect slow growth across the world, with oil-producing economies showing lingering weakness. But we also believe continued global economic expansion and some pick-up in corporate profit growth may benefit the equity markets that we overweight.

Market volatility today is no more severe now than in years such as 2010 and 2011. But the economic recovery is now in its later stages. As well as the economic risks, there are local-market political risks to contend with, such as the UK’s June referendum on EU membership. These could also create near-term volatility.

At current price levels, we find near-5% long-term investment grade US corporate fixed-income yields particularly appealing. This asset class has historically seen half the volatility of US equities and has also achieved positive returns in equity bear markets. For US tax-advantaged investors, municipal debt remains even more appealing in a diversified portfolio.  By comparison, we are still deeply underweight zero- or negative-yield sovereign-bond markets in Europe and Japan.

We also see a change underway in emerging-market risk, tilting away from commodity-linked Latin America and towards manufactured goods-exporters in Asia. As a result, we’ve begun to cut our underweight in Latin American equities and this month upped our allocation to neutral in hard-currency Latin American debt.

As we discussed in our Outlook 2016 report, we see emerging markets as an opportunity in the making. A long period of strong, sustained returns, however, will likely have to await a new recovery cycle following a mild, global recession.

Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer's credit rating, or creditworthiness, causes a bond's price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.

There may be additional risk associated with international investing, including foreign, economic, political, monetary and/or legal factors, changing currency exchange rates, foreign taxes, and differences in financial and accounting standards. These risks may be magnified in emerging markets. International investing may not be for everyone.

Diversification does not ensure against loss.

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