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Today is Friday, July 19th 2013. I'm Peter Nulty and you are On the Trading Desk. Much
of what we're discussing comes from our Midyear Outlook Paper, which we encourage you to read
for its added detail. Today, we want to help investors refocus on their investment goals.
We'll do that by focusing on the asset allocation recommendations in the Midyear Outlook. John,
Jim, Brian, thanks for joining us. Great to be here.
Thank you. It's nice to be here.
Brian, can you briefly describe how you've packaged these recommendations?
Yes. Thank you. And actually, there are all sorts of different ways in which investors
can slice or dice the investment universe. And so we have presented what we think is
a fairly fair representation of the way in which your typical investor would look at
investing in both equities and fixed income. In the equity area, it's pretty common to
look at market capitalization, and that's just defined as the number of shares that
are outstanding times the current market price of those shares. So you add that up and that's
one way that you can determine what would be considered a neutral portfolio. Now, there
are alternative ways of doing it. And so what we've done is we've selected this one method
and then developed strategic allocation recommendations and tactical recommendations, relative to
whatever your neutral recommendation is. So if you have a different way of viewing the
world in terms of what your average investor should be invested in, you would want to make
those sorts of adjustments. On the equities side, one way to do it is
sort of most broadly, looking at developed market equities versus emerging market equities.
From a neutral perspective, about 87% of the invest-able equity universe is in developed
markets, like the United States, the United Kingdom, Japan, etc. So 13% would be in emerging
markets. Now, from a strategic perspective, we think that perhaps an overweight to emerging
markets could make sense. However, from a tactical perspective, considering current
conditions, we think it actually makes a little bit more sense to underweight the emerging
markets. But I'll let John perhaps elaborate as to why it is that we have those specific
recommendations. JOHN: Strategically, we have a pretty good
sized position in emerging markets because we think over a longer period of time they
will emerge. That's how they're defined. They probably will grow faster, over a longer period
of time, with more volatility. There are some issues around right now. And as Brian said
before, you have to be rather specific in choosing the market you want to be in. Developed
equities well, a lot of different things going on here. The U.S. is still, I think, a very
attractive place to be, and since most of the people who are investing or who are listening
to this will be investing in dollars, or retiring in dollars, I think that that in and of itself
adds something of a luster to the U.S. market. I think when you look at large capitalization
shares in big cap markets, you do get a sense of safety and visibility that I think may
be a little more helpful now than it is at most times, given the volatility that's been
going on in both the economy, and from time to time in the markets. Okay. Moving on to
U.S. equities versus non-U.S. equities, what are you thinking, Brian?
In terms of the developed world itself, we think that the United States, both in the
short term and longer term represents some very good valuation opportunities. The United
States economy just as a whole tends to be very dynamic. And a lot of foreign countries,
especially if you look at some of the headlined risks that are out there, we think that could
perhaps pose a bit of a challenge for those markets, if not their economies, as well.
So strategically, we are actually suggesting that maybe a 60% weight to U.S. equities,
40% to non-U.S. developed equities would make sense. Tactically, we think that there's a
little bit more safety in the U.S. markets, which is why we would do even more of an overweight
on a tactical basis, to the U.S. But I'll let John elaborate on some of those points
a little bit. Things, I think, are still very attractive in the U.S. I think, as I said
before, said a number of times, valuations are still quite good in the United States.
We still have corporate earnings that seem to be expanding. We have a very stable system,
too, which I think is very important. And I think those factors make the U.S. an attractive
place to live, to work, and obviously, to invest. When you go overseas, there are some
issues and there are some opportunities. There are issues in Europe that have to be dealt
with. They have to try and rearrange the way they live. That's going to be a very difficult
process. If they're successful, there's opportunities there. I think we'd rather wait and see some
of these opportunities develop. We'd rather be reactive to a certain degree, than trying
to anticipate something. There's potential. There's no question there's potential, but
there's also a little bit a bit more risk than I think we have here in the U.S.
Brian, what is the team thinking about value stocks versus growth stocks?
Yeah. Your typical investor would probably be looking at an evenly split portfolio. That's
what would be a neutral allocation. We actually think that there are some better opportunities,
more in the growth space, for longer term investors. And that's why strategically, we're
recommending a 60% weight in growth, 40% in value. However, given some of those valuation
opportunities that are out there right now, we think that it actually does make sense
to have more of that neutral allocation, about a 50/50 split. But I'll let John talk a little
bit more about from that valuation perspective. Ideally, you want to buy your growth equities
at a decent valuation, and have decent growth in your value equities. So to a degree, it's
not the strict dichotomy it might appear to be to some people. I think on a longer term
basis, it's going to be important to have growth. I think you will grow with the economy;
you'll grow fast with the economy in certain areas. I think picking areas that do that,
when they're not exceptionally highly value, which is the case right now, almost by default
makes it the place to go. So I think looking at that from that point of view, from a longer
term, strategic point of view, growth has a tendency to compound. Growth has a tendency
to grow. Value is important, and you want to pick your points of entry. But I think
while we'd be neutral about the whole thing on a short term basis, longer term, I think
those aspects work in your favor. Brian, what is the team thinking about large cap stocks
versus small cap? Almost by definition, in a market cap weighted
portfolio, it's going to have more large cap stocks than small cap stocks, just because
large cap stocks are bigger. So the neutral allocation would be about a 90% allocation
to large cap, 10% to small. And that's where we think that would be a fair allocation,
tactically speaking. However, over the longer term there is something to be said for some
of the big cap stocks in United States. And that's why we would be looking at a large
cap allocation of around 95%, and a small cap allocation of around 5%. But I'll let
John talk a little bit more about why we are having that sort of view of short term versus
long term. JOHN: Yeah. One of the reasons, Brian, is
that I think you get to play the emerging markets somewhat through the large cap names.
You get the long term exposure you probably want to have without having to deal with the
short term volatility. And I think that's a very important factor when you and plan
for the longer term. It's your chance to get exposure to markets you want to get exposure
to, but without picking up the volatility that may affect them on a short term basis.
So I think that, as much as anything else, is what drives us in that direction.
Moving on to fixed income recommendations, I think we have three of them. Brian, can
you tell us about duration? Sure. In terms of our fixed income allocation
recommendations, I think it's important to recognize that our neutral weightings here,
we've selected to make it just 50/50 between the different ways in which we sliced and
diced the fixed income world. It's a little bit tougher in order to figure out what that
neutral allocation should be, just because of the way in which fixed income securities
trade. Just to give you an example, a lot of the securities that are typically out there
tend to be of longer duration than of shorter duration, unless of course you're looking
at cash. So that can muddy the waters. So when you're looking at these asset allocation
recommendations on the fixed income side, just keep that in mind that it's not necessarily
representative of the actual securities that have been issued. Just your neutral is almost
always going to be 50/50 here. So in terms of the duration exposure, duration refers
to the sensitivity of a securities price to interest rate changes. And so we think that
even though interest rates can stay low for a while, there is some significant risk associated
with having too long of a duration portfolio which is why both on the strategic side and
tactical side, we've suggested a bias towards shorter duration fixed income. But Jim can
probably do a much better job explaining some of the nuances of that recommendation.
Well, I think you make a good point that we are at relatively low levels of yields -around
the world, but particularly in the United States economy. And that would suggest this
is not an appropriate time to extend very far out on the yield curve, taking on a lot
of duration risk. But just as important is the fact that we want investors to invest
for income. And looking at yield curves in most markets, we capture most of the income
that the markets provide, in that intermediate space. We don't have to go to the 30 year,
20 year, 30 year maturity sector. But the intermediate sector is where yield curves
begin to kind of level off. That's where you're capturing the income that we think is the
key to good performance over the next couple of years.
Next credit risk exposure. Brian? Well, credit risk refers to the possibility
of an issuer defaulting on whatever it has issued. And in this environment, we think
that when you look at a lot of the Treasury yields that are out there, they're just really
not that compelling. Even though yields have moved up a little bit recently, there are
still probably some better opportunities outside of the Treasury market. And that's why strategically
and tactically we are recommending that investors should be looking at taking on more of that
credit risk, as opposed to less of it. But Jim can give a little bit more detailed answer
as to specifically where some of those opportunities might be.
Taking on credit risk at this stage of the cycle still, in our mind, makes a great deal
of sense. I like to say that we are still in the sweet spot of the credit cycle. In
other words, as John mentioned earlier, corporate profits are quite good. Corporate cash is
strong. Default rates are extremely low. They don't have to decline from here. They're already
quite low, at their cyclical lows, and are not expected to accelerate or rise in a significant
way. So investing for income I keep coming back to the same theme. And we generate income
by taking on some degree of credit risk. Treasury yields, as Brian just mentioned, are very
low. That's not where the markets provide good income. The markets provide good income
in those segments of the market that include some degree of credit risk. And with the support
of good credit research, the investor can capture that incremental income by taking
on risk in the corporate bond markets and in the municipal bond markets.
And finally, we're comparing floating rate debt versus fixed rate debt. Brian?
When it comes to the actual debt that's been issued, very, very little of it is actually
floating rate. And so when you look at the neutral allocation recommendation, 50/50,
keep in mind that it's probably just a very small sliver of the debt that's been issued
is actually of a floating rate nature. But we still think that from both strategic and
tactical, you're effectively buying a form of insurance that you might not need with
that floating rate feature, because if we're in a period in which we have low interest
rates and we don't see a high likelihood of them going up rapidly any time soon, both
strategically and tactically it might make more sense to look at some of that fixed rate
debt that's out there. But Jim can speak to that more specifically.
Well, I think you make a very good point. There are times when floating rate debt makes
a great deal of sense when we're anticipating rising short term interest rates, and perhaps
significant increases in short term interest rates. But in this environment, with short
term rates likely to stay where they are for another 12 months, perhaps even longer than
that, as Brian said, you're buying some insurance, you're paying for insurance when you purchase
a floating rate instrument, that you may not need over the next 12 to 24 months. There's
one other aspect. One of the most popular of the floating rate instruments are the bank
loans. And they've performed very, very well. They have good value. But the investor has
to understand that these are below investment grade loans, just like in the bond market,
below investment grade bonds. They are similar in nature, in terms of credit quality. So
it's very important, I think, to look at the fundamental credit quality aspects of those
portfolios, both in a bond portfolio, a high yield bond portfolio, and in a floating rate
bank loan portfolio those are below investment grade instruments, securities, and we need
good credit research and we need a great deal of diversification when investing in those
arenas. Well, we've covered a lot of territory today,
and we are running low on time. But we'd welcome parting thoughts. John?
Well, I think investors have to realize where all the risks are. As I said, we've focused
on, we're keenly aware, we're very skeptical about the risk of being in the market, the
stock market when it goes down. I think there's still a lot of support for the stock market,
there's value left in the stock market, there's opportunity left in the stock market. Consider
the risk of being in the sidelines. Consider the risk of not earning a decent return. Consider
the risk of risk avoidance. I think you'll make a better allocation in your portfolio
if you do that. Jim? Well, the theme in my section of the Midyear
Outlook is still the same invest for income, not for safety. Underweight cash; overweight
those segments of the market that produce good interest income. And after the May-June
correction that we've just experienced, those segments of the market offer more income today
than they did over the last 12 months. Brian, any last thoughts?
At the beginning of the program I had mentioned about how investors over the last few years
have seemed to sort of miss the forest for the trees. But I think it's also important
that if you're walking through that forest, is to look out for the trees. I mean, you
obviously need some sort of balance between those two different perspectives. I think
investors should recognize that we have made a tremendous amount of progress in the United
States in terms of bringing down the unemployment rate, bringing up corporate profits, and those
are trends that we have to really acknowledge and invest on the basis of, as opposed to
some of these older fears that we might have had. So swap out some of those old fears and
change your perspective to actually look at what are the risks, and recognize that along
with the risks come opportunities. Okay. Well that's it for today. Brian, Jim,
John, thanks for joining us. BRIAN, Jim and John: Thank you. Until next
time, I'm Peter Nulty. Even after then, I'm Peter Nulty. Thanks for watching.