An analysis of the economy and
Recession in the U.S. appears likely according to leading indicators we follow, including the ECRI weekly leading index. The Conference Board’s Leading Economic Indicators have now turned negative as well, and coincident and lagging indicators have generally been below expectations and worsened significantly, including negative revisions to the data. Seasonal and measurement factors likely boosted winter’s indicators as well. In Europe, the positive effects from liquidity efforts have faded, banking and sovereign credit crises continue to loom, and misguided austerity measures and structural issues continue to point to recessionary conditions for much of the continent. The U.S. also remains vulnerable to further adverse shocks, such as a disorderly default or exit from the EU for Greece or Portugal and especially Italian and Spanish fiscal and bank concerns. American corporate balance sheets remain in reasonable shape, but could be strained as earnings pressure begins to mount. Companies are largely unwilling to add workers given the uncertain economic and policy environment in Washington. Consumer real income growth is very weak and consumer savings remain quite low. Meaningful economic improvement, however, hinges on global policy makers shifting to a pro-growth stance, staunching the European crisis, and the global economic downturn running its course. A potential bright spot is that the housing market in the U.S. appears to be bottoming and should shift to more of a tailwind within the next year or so. This has positive long-term implications for the U.S. economy.
Among the bright spots we see is the expectation of continued low inflation and historically low interest rates and plenty of liquidity in the United States. Still numbering among our concerns are weak income growth, continued high unemployment and fiscal drag looming for 2013.
For about the past few months, U.S. economic data has been well below consensus after roughly a six-month period of beating expectations. As we have discussed, much of that perceived improvement was due to an unseasonably warm winter “pulling forward” demand as well as measurement issues related to using the very uncharacteristic years 2007 and 2008 as a base (normal or typical) with which to compare current economic activity. Recession is likely, and profit margins and earnings should weaken accordingly. The U.S. is very vulnerable to shocks such as the European crisis or Mideast tensions. We therefore favor a more diversified portfolio that offers greater growth and defensive exposure, with strong financial strength and attractive valuations. We believe these companies should outperform in this environment. While equity valuations in general remain attractive on a long-term basis, stocks are vulnerable in the near-term due to economic weakness and external shocks. While eventual Fed quantitative easing should help financial assets temporarily and weaken the dollar, the underlying economic and company fundamentals will remain challenged.
We have reduced risk in portfolios over the last few months by trimming our corporate bond position. We have moved from a significant overweight to a slight overweight. Given the significant volatility and increased event risk in Europe it makes sense to have smaller bets until the investing environment becomes clearer. Spread products remain attractive to Treasury and Agency debentures on a valuation basis but underperform when headline risks are prevalent. Based on our forecast of future inflation, Treasury securities now offer negative real yields at several tenors along the term structure.
The sovereign debt crisis in Europe spurred a flight-to-quality that has significantly increased risk premiums, which in many instances do not reflect the fundamentals of the individual securities.
Our short-term portfolios will be managed long relative to benchmark duration, as we believe the front-end of the yield curve will be anchored by an accommodative monetary policy. However, intermediate- and long-term portfolios will be managed neutral to benchmark duration due to the potential for headline risks in Europe. Our portfolio positions will be underweight Treasury exposure versus corporate bond and securitized products; underweight government-related securities in favor of municipal bonds; and overweight select commercial and residential mortgage-backed securities. Our municipal portfolios will be managed long across all mandates as the municipal sector has become extremely attractive.
We believe the balanced allocation should perform well in a variety of situations, including if the U.S. economy enters recession or if it merely maintains a stable lower growth pattern. It will tend to underperform if the economy (and company earnings) grows at a much stronger clip, although this is an unlikely occurrence in our opinion. We are maintaining our strategic allocation to equities, fixed income, and diversifying assets and continue to have a major underweight to international developed equities versus U.S. stocks and equal weight to both growth and value stocks. Emerging markets remain at their strategic weighting.
The opinions expressed herein are those of Jeffrey J. Schappe, CFA, Chief Market Strategist of Sterling Capital Management, and the Sterling Advisory Solutions Team, and not those of BB&T Corporation or its executives. The stated opinions are for general information only and are not meant to be predictions or an offer of individual or personalized investment advice. They also are not intended as an offer or solicitation with respect to the purchase or sale of any security. This information and these opinions are subject to change without notice. Any type of investing involves risk and there are no guarantees. Sterling Capital Management LLC does not assume liability for any loss which may result from the reliance by any person upon any such information or opinions.
Investment advisory services are available through Sterling Capital Management LLC, a separate subsidiary of BB&T Corporation. Sterling Capital Management LLC manages customized investment portfolios provides asset allocation analysis and offers other investment-related services to affluent individuals and businesses. Securities and other investments held in investment management or investment advisory accounts at Sterling Capital Management LLC are not deposits or other obligations of BB&T Corporation, Branch Banking and Trust Company or any affiliate, are not guaranteed by Branch Banking and Trust Company or any other bank, are not insured by the FDIC or any other government agency, and are subject to investment risk, including possible loss of principal invested.