The world is emerging from a “low-everything” environment. The economic news has finally turned positive after a long slump in most indicators of economic oomph such as GDP growth, job creation, interest rates, home sales, manufacturing activity and inflation.
GDP growth in the U.S. has improved this year, as has the pace of job creation. Europe and Japan are doing slightly better on both fronts as well, though not nearly as well as the U.S. Short-term interest rates have risen slightly as the Federal Reserve is finally discussing raising its policy rates. Longer rates, however, remain constrained by low inflation—even though central bankers around the world are doing their best to boost inflation. Rates across the board will eventually rise as economic progress continues.
It won’t be a smooth upward path, though. Market volatility should increase as the U.S. and world economies transition to their next phase. Some countries will climb faster than others. Developed countries must overcome the challenges of heavy debt levels, high taxes, aging populations, trade restrictions, inadequate infrastructure, and inadequate investment in human capital (i.e., education). Europe and Japan are particularly challenged here. Emerging countries face a different challenge: to build infrastructure and remove the impediments of government control and corruption so that their economies may grow.
Meanwhile, investors are also changing. They care about many factors beyond risk and return. They increasingly want to use their investment choices to have an impact on a single company or the whole world. Some want to unlock value for company shareholders through activist or “suggestivist” investing. Others demand that profits be achieved with attention to the environment, to society, to workers, to customers, and to a variety of other stakeholders. Companies that ignore the big picture are severely punished in the marketplace, especially when they misstep. Companies that display concern for what happens outside their walls get the nod from a new generation of investors.
Stock prices have recently hit all-time highs. Investors will naturally wonder whether they are too late to join the party or whether there is still room for growth.
Domestic large-cap and mid-cap stocks are attractive right now because the U.S. is leading the recovery amongst developed nations. These stocks are attractively valued, have strong cash flows, and pay good dividends. Developed-market stocks have growth potential as well, at least in those countries that are taking the right steps to boost their economies.
This is a good environment for cyclical stocks.
Consumer Discretionary stocks benefit when consumers have money to spend, which happens when employment rises and the price of necessities (like gasoline) falls.
Information technology companies are inventing products that improve living standards and make other businesses more efficient.
Industrials (like manufacturing and transportation) benefit from rising economic activity; being generally energy-intensive, they benefit from lower input costs (like oil and gasoline).
The health care sector, while traditionally considered non-cyclical, has innovative companies that are improving technology and processes in a sector that accounts for around 18% of the U.S. economy, according to government numbers. However, the sector faces heavy regulation that could limit profitability.
Bonds remain a mainstay for investors, but old-school Treasury bond ladders won’t pay the bills. Treasury yields are rock-bottom. Yields on government debt of many European countries are even lower. Investors have to venture into the municipal or corporate sectors—including below-investment-grade bonds—to generate higher levels of income. Foreign bonds can also offer solid income, however, currency issues complicate the picture. Where the dollar is strengthening against the local currency, such as in Europe and Japan, returns are eroded unless the investment is hedged. Developed-market bonds in general are attractive as long as investors heed this caveat. Where the dollar is weakening, such as in certain emerging markets, returns are enhanced.
Whatever types of bonds the investor utilizes—and the more diversification, the better—the one risk that investors should steer clear of is maturity risk. This is not a good time to buy long bonds.
The world hasn’t gone entirely virtual yet. Real estate and commodities are still as important in portfolios as in real life.
Commercial properties in markets with high barriers to entry can be solid income generators, especially where the leases are short and rents can be raised as the economy improves. They can serve as an inflation hedge when, not if, inflation picks up. Commodity demand (except for precious metals) should also rise with economic growth, which should raise prices when supply does not keep up.
Portfolio stabilizers such as hedge funds and other nontraditional investments can smooth a portfolio’s returns, yet another way to manage volatility.
THRIVING IN A CHANGING WORLD
Many things have changed, but the investment basics remain the same. The areas of opportunity will continue to shift. A couple of risk-management rules to help investors participate in market trends without suffering from sizable fluctuations in value: Diversification of investments, and of income streams that investors depend on, is essential to control the coming volatility. So is rebalancing of portfolios that have been pushed away from their target mixes by market shifts.
Rebalancing actually exploits volatility by buying low and selling high in a systematic way. It’s better to “buy and manage” than to simply “buy and hold.”
Matching the risk and time horizon of the investments with the investor’s financial goals helps keep the portfolio on track and avoid panic-induced decisions.
Erik Davidson is chief investment officer at Wells Fargo Private Bank.
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