As we head into the second half of the year, it seems a natural time to take stock and look ahead. This has been a great year for equities. Global stocks are up nearly 15% as of July 17. Even better, emerging markets are up nearly 25% on the back of a cyclical upswing that we began highlighting a year ago. All of this has happened with exceptionally low volatility; realized equity volatility recently hit new lows for the cycle.
Will the party continue, or are there reasons for caution? In our case, we have decided to take a step back from the punch bowl.
Signs of Slowing Global Growth
As we noted last month, we are seeing signs that global growth is slowing, particularly in China and the United States, with only Europe remaining in our expansion regime. Additionally, strong returns have come at the price of higher valuations, leaving less upside potential.
With these factors in mind, we have moved our overall risk position to neutral in anticipation of more modest returns going forward. In addition, we have rotated towards assets that we believe offer better relative value opportunities and prospects for future growth.
Within equities, we are overweight Europe and underweight the United States. The case for European equities rests on two points. First, our leading indicators show continued expansion in Europe versus a slowdown in the U.S. Second, valuations are more favorable, as European equities are currently priced at a 17% discount to U.S. equities on a forward earnings basis. After a period of strong returns, we recently reduced our overweight in emerging markets to neutral based on signs of slower growth.
In addition, we have reduced our overweight exposure to growth equities. U.S. growth stocks have outpaced U.S. value stocks by over 10% year to date. With this outperformance, the relative discount of value stocks now exceeds 20% ― far higher than it was at the beginning of the year. We remain overweight growth in total, but to a lesser degree than before.
Fixed Income Positioning
Within bonds, we are maintaining a neutral duration overall, but are significantly overweight the United States compared with Europe and Japan. While yields remain low across developed markets, we see very little cushion in Europe and Japan.
In contrast, several emerging markets continue to offer attractive real yields, despite having handily outperformed developed markets year to date. We are also maintaining our exposure to emerging currencies, which offer higher yields and more attractive valuations relative to developed markets.
In credit, we moved from high-yield bonds to loans earlier this year, given higher quality and attractive spreads in the loan market. In hindsight, this move was premature, as high yield has outpaced the loan market thus far, but we believe the risk/reward tradeoff favours loans overall.
Adding Exposure to MLPs
Finally, I should note that, while many assets have had very strong performance this year, there is one notable exception ― energy commodities, which are down over 15% year to date. While our view is that oil will remain range-bound given the latent supply in the market, we have added a modest position in MLPs, which we believe offer an attractive source of income to the portfolio.
In closing, while we may be early to take a step back from the party—these things sometimes take on a life of their own—we would rather err on the side of caution until we see signs of renewed strength in the underlying environment.
The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The index is unmanaged and cannot be purchased directly by investors.
The Russell 1000® Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. The index is unmanaged, includes the reinvestment of dividends and cannot be purchased directly by investors.
This material is for informational purposes only and is not intended to be investment advice, a recommendation, or to predict or depict the performance of any investment.