Asset Allocation Committee Outlook
March 28, 2012
The resurgence of risk appetite witnessed in late 2011 has continued, with most major equity indices up in double digits for the year-to-date. In contrast, fixed income indices have posted very modest and, in some cases, negative returns in the first quarter. Much has been accomplished in the U.S. and globally that has contributed to the now six-month-old equity rally. The European Central Bank's refinancing operations have successfully reduced funding stresses and tail risk in the region. Meanwhile, fears of a Chinese hard landing have eased, although more moderate growth is expected. Concerns remain: inflationary pressures stemming from rising oil and gas prices may impinge on U.S. growth, as they did in 2011; the European sovereign debt situation remains fluid, with the onus on politicians to demonstrate continued progress; and a potential fiscal shock threatens the U.S. late this year due to expiring tax provisions and sequestered spending cuts. Given this picture, the Asset Allocation Committee's core view remains steady—underweight bonds, overweight equities. Within bonds, the Committee continues to find a dearth of value in the highest-grade sectors, but remains overweight high yield and emerging market debt. Within equities, the Committee's preference is for large-cap equities, but outlooks for both small-cap and emerging market equities were upgraded to neutral and overweight, respectively. The view on master limited partnerships, meanwhile, has moderated to a neutral position.
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 nine-member panel covers the gamut of investments and markets, bringing together 195 combined years of industry knowledge, with an average of 22 years of experience each.
Views expressed herein are generally those of Neuberger Berman’s Asset Allocation Committee and do not reflect the views of the firm as a whole. Neuberger Berman advisors and portfolio managers may make recommendations or take positions contrary to the views expressed. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. See disclosures at the end of this material, which are an important part of this publication.
Investment Grade Fixed Income
The U.S. economy has shown signs of stabilization over the last six months, posting 3% growth in the fourth quarter of 2011. As investors continue to gain confidence in the economic backdrop, they will become more likely to seek incremental yield, which may negatively impact the highest-grade portions of the investment-grade fixed income asset class. The Committee’s views for investment-grade fixed income sub-sectors held steady—yields remain sub-par for the asset class as a whole and the Committee expressed concern about the negative impact rising rates could have on investment-grade sectors. While the recent sell-off in the 10-year Treasury—and subsequent rise in rates—may be temporary, the move is representative of the risk that still exists for this segment of the fixed income markets.
High Yield Corporate Fixed Income
Yields on high yield corporate bonds have declined from approximately 10% in early October 2011 to approximately 7% at the end of the first quarter 2012, while spreads have compressed to around 560 basis points. There is still room for further spread compression and the fundamentals of corporations in this space remain attractive. However, the Committee anticipates a more moderate return profile for high yield fixed income over the next 12 months. While it is holding steady at an overweight position for the sector, the Committee has tempered its outlook since first quarter 2012
U.S. Large-Cap Equities
Large-cap U.S. equities continue to stand out to the Committee as the most appealing equity sector from a risk-reward perspective, with attractive valuations of around 13x, strong earnings growth of approximately 15% in 2011, and prospects for 2012 that appear far less uncertain than other equity segments that display comparable or better P/E ratios and/or higher expected earnings growth rates. From an economic standpoint, the labor market continues to improve and consumption remains strong, which should provide a catalyst for steady, if not stronger, economic growth in 2012. Against this backdrop, the Committee continues to hold an overweight viewpoint for large-cap U.S. equities, despite the solid appreciation provided by the segment¡V and equities in general—over the last six months. Even if the equity market rally pauses or pulls back in the near-term, the Committee sees potential for additional appreciation over the next year.
U.S. Small-Cap Equities
The surprisingly positive data points on the U.S. economy that have come to light over the last two quarters point to a strengthening growth backdrop. Meanwhile, small-cap U.S. equities have experienced a strong run, rising nearly 40% since October 4, 2011. Of the U.S. equity sectors, small caps are the most leveraged to the U.S. economy, and should continue to perform as the economy strengthens. Valuations for the segment, however, are a bit lofty compared with the larger cap segments, with a forward P/E spread between small- and large-cap equities that is well above its longer-term average. Despite valuation concerns, margins for small-cap equities remain attractive with room to grow, and accelerating mergers and acquisitions activity could lend further support to small-cap companies in the year ahead. As a result, this quarter the Committee upgraded small-cap U.S. equities to a neutral from an underweight position.
Emerging Market Equities
Investor sentiment has shifted to a more positive stance since December 2011 and investors are demonstrating a willingness to take on risk, creating an environment that may bode well for emerging market equities. Additionally, earnings revision ratios (ERRs), which express the number of analyst upgrades proportionate to analyst downgrades, are most attractive for emerging markets, which are the only region to see an improving ERR over the last five months. Based largely on these factors, the Committee has upgraded its view on emerging market equities to an overweight position, after holding a neutral position for the last year. The Committee will maintain a close watch on China as its growth profile tends to have a significant impact on emerging markets and, more broadly, global growth. While there are issues that need to be worked out in China—specifically related to its overleveraged banking system and homebuilders—the Committee remains constructive on the country’s long-term outlook due to the government’s ability and track record of supplying stimulus as needed to spur growth.
Lower Volatility Hedge Funds
After peaking at 45 in October 2011, volatility, as measured by the VIX index, has declined significantly, dipping below 15 in mid-March for the first time since April 2011 (the long-term VIX average is 20.5). The Committee believes this “Goldilocks” environment of low volatility and steady appreciation is likely to be tested at various points throughout 2012, particularly considering the macro risks present and, given the rosier consensus economic and market forecasts, lower potential for positive surprises. The Committee is maintaining its overweight stance on low volatility hedge funds, citing their potential for mitigating the impact of volatility on overall allocations and achieving less correlated investment returns.
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