In this column last January, when asked to sum up the year in investing in one word, we decided on “uncertainty.” Given the same task this year, with the “fiscal cliff” still looming as of this writing and the outlook for the Euro remaining uncertain, we would have to choose the same term. However, while the one-year outlook remains questionable, the long-term view has come into clearer focus.
The Fiscal Cliff
Much of our current uncertainty is self-inflicted and stems from political jockeying on strategies to reduce the debt and deficit. Under the tax law as written, tax increases and spending cuts would subtract about 4 percent from gross domestic product growth in 2013, which is currently running at about a 2 percent trend. What we do know is that Congress is serious when it says that everything is on the table, and this disposition makes uncertainty the only certainty. In the most likely case, there will be a compromise, but falling off the cliff remains a possibility. In any case, given the state of the budget deficit and the national debt, it’s far more likely that taxes will increase than decrease. For taxable investors, this makes dividend and interest income less attractive and municipal bonds more attractive. However, we should also note that because most investments aren’t taxable (pension funds, foreign investors, 401(k) assets, etc.), studies show that a change in tax policy doesn’t necessarily move the market in the short-term. For example, in 2001 when the dividend tax rate was decreased, there was no evidence that dividend stocks outperformed. Given all of the uncertainty, 2013 market forecasts have a much wider dispersion than normal.
What’s becoming clearer to advisors is that the trend of the past decade is poised to be flipped on its head. Over the next 10 years, there’s a very high probability that equities will outperform bonds. The turn may not happen for a few years, and it may be a bumpy ride. In spite of all of the doom and gloom from the media, the S&P 500 quietly increased 13 percent last year, driven by strong fundamentals—rising profits and reasonable valuations. Meanwhile, high quality bonds, especially Treasuries, no longer pay, as 10-year bond yields are below expected inflation, harkening the end of an unprecedented 30-year bull cycle. While the outlook for equities will always be uncertain, the outlook for bonds is not—returns should be muted.
These changing realities mean that many investors don’t have the right asset allocation to support retirement. For instance, while truly wealthy clients may be able to meet their financial objectives with a bond-heavy portfolio, most individuals must remain committed to equities (or other risky assets). In the past, when clients approached retirement age, the most common advice was to shift more heavily into bonds. Current realities indicate that a more appropriate allocation would be 10 percent to 20 percent heavier in equities than was traditional. Meanwhile, due to recent market uncertainty, mutual fund flows show that typical investors overcompensated the other way, reducing their equity weight by 10 percent to 20 percent, leaving them far off the mark.
Where to Turn?
The main question to ask here is: Where are you getting paid to take on risk?
With so many investors chasing yield, while also pulling money out of equity funds, many assets offering safety or income are relatively high priced. As of this writing, Treasuries bonds were selling at the highest price in our nation’s history and high dividend stocks at a 30+ percent premium to normal conditions. At some point, fund flows are likely to reverse and these assets should underperform. Meanwhile, longer-term equities, such as deep value or high growth companies, are trading well below normal valuations.
Many sophisticated investors are looking to stock and bond opportunities in the emerging markets, where assets are reasonably priced and there’s likely to continue to be higher economic growth than in the developed world. We’re also favoring local currency emerging market debt, as there are positive signs that currency is appreciating in these countries due to higher growth and higher interest rates.
European equities are also potentially attractive, largely due to how cheap they’ve become. While Europe is expected to remain in a mild recession in 2013, markets have sold off across the board. Investors are missing many company-specific opportunities that aren’t as tied to the debt issues of the PIIGS (Portugal, Ireland, Italy, Greece and Spain). While these opportunities are cheaper, they also come with elevated risk.
The estate, gift and income tax rates that will apply in 2013 are still being debated as this article is being written. Many companies and investors are looking to politicians for clarity. Once we know what the rules are going to be, there may be enough comfort to take a long-term view and to make investments. For now, uncertainty remains the overarching theme.
—The views expressed in this article do not belong to any particular participant but reflect an amalgam of views, none of which (individually or aggregated) represents the views of Deutsche Bank, Lazard, Summit Place Financial Advisors or Capital Group Private Client Services. This article is intended purely for educational purposes, and nothing herein should be construed as investment advice or the solicitation to buy or sell any securities.