So far, 2016 has been characterized by stomach churning swerves in market direction with little actual change in levels.
The most obvious of those factors is the Federal Reserve (Fed), which now looks set to deliver only two rate hikes this year, when as recently as December the market expected as many as four. FOMC policy makers seem willing to let the dollar act as a substitute for further tightening while they await stronger economic data and evidence of core inflation growth that's closer to their 2 percent target. The coupling of oil and equity prices is acting as another governor on higher valuations, making it hard for risk assets to sustain advances.
Elsewhere, other major central banks are seemingly stuck in neutral against an uninspiring economic backdrop. European Central Bank (ECB) chief Mario Draghi received a chilly response in suggesting no further rate cuts would be coming after unveiling a new easing package in early March. In Japan, there is a genuine crisis of confidence in quantitative easing efforts now that negative rates have only produced similarly negative feedback. Meanwhile, China is caught between the need for additional stimulus and adherence to its reform agenda, increasing the risk of a significant devaluation of the yuan.
In light of these constraints, the Committee believes that the recent rebound in equity prices, while welcome, needs evidence of rising earnings and improving economic fundamentals to continue. At the same time, we observe that the market has been experiencing rapid rotations among sectors and across asset classes, creating significant divergences that may yield opportunities to add value within and across individual categories.
As such, with little visibility over the coming three to six months, we favor an approach of continued selectivity in pursuing risk asset opportunities through trades within asset classes rather than large directional bets, and to wait for pullbacks to consider adding to positions. Outside of non-U.S. developed market equities, the Committee maintained its neutral stance on U.S. and emerging market equity and adjusted its outlook for master limited partnerships (MLPs) to a neutral position. We are maintaining an underweight view of most developed market government securities because of our view that low yields do not compensate for the risk of higher rates, and remained cautious on emerging market debt with a bias toward hard currency sovereigns.
Global Equities Among Few "Slightly Overweight" Calls
History has shown that U.S. equities (as measured by the S&P 500) have often benefitted when the Fed is in the midst of a tightening cycle. The main reason is that corporate earnings tend to rise as the economy strengthens, offsetting the impact of higher borrowing costs. But if you look at what's happening during this cycle, average price-to-earnings ratios have declined by a full percentage point in the face of tepid to flat earnings growth. This fact was not lost on the Committee, which voted to maintain its neutral stance on U.S. equities even as most members expressed their belief that the country will avoid another recession for the time being.
On the other hand, the Committee believes that global equities--and particularly those in developed markets outside the U.S.--may provide more opportunities over the coming 12 months. Despite the latest ECB posturing on rates, evidence is growing that past stimulus is providing a tailwind for growth. Business confidence continues to be decent, credit demand is rising, and corporate profits have yet to recover to post-crisis levels as they have done in the U.S.
Among fixed-income assets, the Committee continues to favor high yield given current prevailing yields and the outlook for credit quality. But given the likelihood for ongoing fallout from weakness in the energy sector, we continue to prefer short-duration issues and higher-rated credits, at least for the near term. We feel clients looking for additional fixed-income exposure may want to consider shifting their exposures in assets such as core European bonds, burdened by negative yields, to high yield and select portions of the emerging market debt universe.
Move to "Neutral" on MLPs
The move to neutral from slightly overweight on MLPs was a difficult one given our prevailing belief that investors had unfairly punished the asset class amid ongoing weakness in energy markets. Many market participants have been caught off-guard by both the depth and persistence of that weakness, and the Committee feels that further declines in commodity prices in recent months have increased the potential for additional restructuring in the energy sector and added to the downside risks faced by midstream operators in particular.
Broader Array of Risks
The Committee agreed that a step-devaluation of the Chinese yuan remains the centerpiece risk in the investment outlook over the coming 12 months, but other downside scenarios featured more prominently. Chief among these was the risk that the Fed proceeds with tightening too quickly and undermines confidence in market liquidity, and that emerging markets such as Brazil create a contagion effect for developed market risk assets. Political risks are also rising, including the possibility of "Brexit" as the UK holds a June referendum on membership in the EU, and uncertainty around the U.S. presidential election.
Driving in neutral can still get you down the road, but not without shifting into "drive" from time to time. In the months ahead, we believe it will be important to be vigilant for opportunities to add during market pullbacks and pursue trades within broad asset categories when the associated risks are acceptable. We believe the value of active management may be more evident during periods when asset allocators have little cause for conviction, and we anticipate that a firm hand on the wheel over the coming months will be key in helping navigate this uneven terrain.
About the Asset Allocation Committee
Neuberger Berman's Asset Allocation Committee meets every quarter to poll its members on their outlook for the next 12 months on each of the asset classes noted. The panel covers the gamut of investments and markets, bringing together diverse industry knowledge, with an average of 24 years of experience.
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