Q3 2012 Outlook
By Asset Allocation Committee
June 27, 2012
The second quarter experienced a return to volatility as heightened concerns over the European sovereign debt crisis and an aura of pessimism around the pace of global economic growth have reverberated through financial markets. The year began on a positive note, with all major equity indices posting strong double-digit gains. In the second quarter, risk assets faltered as returns fell to the mid-single digits in the U.S. and by over 10% in developed international and emerging markets. Looking ahead, much has yet to be determined on the global front. Headwinds will persist in Europe due to political uncertainties related to the elections in Greece, the recapitalization of the Spanish banking system, and questions over the stability of the European Union. In the U.S., the markets will likely digest uncertainty over the upcoming presidential election and an increased focus on the U.S. fiscal cliff. Looking at China, its economy is clearly slowing but growth still appears to be relatively stable and policy makers are taking measures to stimulate the economy. While the Asset Allocation Committee believes this global macro backdrop does not provide near-term visibility, particularly as it concerns Europe, it continues to maintain its core view of overweighting equities and underweighting fixed income over the long run. Within equities, the Committee maintains its preference for large-cap U.S. equities, but remains neutral on emerging market equities. Within bonds, the Committee continues to find less value in the highest-grade sectors, particularly Treasuries and developed international fixed income; the lone overweight in fixed income is in high yield as emerging market debt was downgraded to neutral.
INVESTMENT GRADE FIXED INCOME
The Committee downgraded U.S. government securities to a very underweight position due to historically low yields. Although Treasuries have provided an effective hedge to risk assets and could stay low and even decline further, the Committee finds very little long-term value in this fixed-income segment with yields near 1.60% on the 10Y UST and 2.75% on the 30Y UST. Should the situation improve even slightly in Europe in the months ahead, the Committee believes we could see a correction in interest rates later this summer.
HIGH YIELD CORPORATE FIXED INCOME
Yields on high yield corporate bonds are near the 8% range and high yield spreads widened to around 660 basis points. The Committee expects default rates to remain low in the high yield market and is holding steady with an overweight position in the sector. Committee members, however, are expressing concerns over weakening domestic economic data and the potential for negative European headlines to affect investor sentiment. The Committee is closely monitoring events in Europe and their implications on the U.S. markets, but remains constructive on the high yield corporate bond market and believes it warrants additional consideration as a potential source of attractive returns, particularly if yields move up toward the 9%–10% range. As always, the Committee stresses that careful security selection in all fixed income sectors, including high yield, remains paramount.
EMERGING MARKET FIXED INCOME
As the Committee expects a stronger U.S. dollar to dampen emerging market debt returns over the next 12 months, it has downgraded emerging market debt to a neutral position. Due to the global growth concerns and the European sovereign debt crisis, some emerging market currencies have traded significantly lower against the U.S. dollar. While the Committee does not believe in timing foreign exchange movements, members still forecast a more favorable environment for emerging market debt over the long-run and volatility in this asset class may create attractive opportunities.
EMERGING MARKETS EQUITIES
The Committee downgraded emerging market equities to neutral as emerging market growth is linked more to growth in Europe than in the U.S. After a strong start to the year (posting returns of +14% in the first quarter), emerging market equities have again borne the brunt of the financial market volatility and global growth concerns. In the near term, the Committee’s outlook for a stronger U.S. dollar also dampens its return outlook for emerging market equities. However, depending on how key events in Europe play out, the Committee may revisit its position for this sector.
DEVELOPED INTERNATIONAL EQUITIES
The Committee continues to hold an underweight view of developed international equities as members do not envision an answer to Europe’s sovereign debt crisis that will not dislocate markets in the short-term, to some extent. Europe’s political and economic narrative seems to get even worse as events unroll. Key issues revolve around Greece’s recent election and the question over its continued membership in the European Monetary Union, Spain’s undercapitalized banking system, and the contagion risk in Europe. Given this picture, the Committee believes asset prices in Europe will continue to fall before the situation improves. For Committee members to become more constructive on developed international equities, they would like to see a positive resolution in Greece, clear steps toward fiscal integration and more easing from the European Central Bank.
MACRO HEDGE FUNDS
As market volatility can create attractive entry points across a range of asset classes, it also provides an opportunistic environment for hedge funds that employ a macro view of the world. In this regard, the Committee continues to overweight the macro hedge funds asset class and believes there are selective opportunities in the distressed property/debt space. In addition, and although it takes a longer-term mindset, the Committee believes illiquid, specialty credits (such as non-performing loans and aircraft leases) are appealing investments due to significant mispricing today.
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 ten-member panel covers the gamut of investments and markets, bringing together 239 combined years of industry knowledge, with an average of 24 years of experience each.
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