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Quarterly Market Update

Q&A

In this edition of BBVA Compass Market Outlook, Managing Director of Portfolio Management, Gwynne Shackelford and Investment Strategist, Anne-Joëlle Viguier-Galley examine timely investment opportunities from an investor’s perspective. Mses. Shackelford and Viguier-Galley agree that lofty valuations across asset classes, particularly high-yield bonds, make broad diversification and periodic rebalancing even more important today.

Seven Things Every Investor Should Know about Investing in Today’s Markets

1. Faced with equity valuations that are no longer cheap, should investors still be putting money into stocks? In your opinion, is a correction due?

Investing in the stock market requires investors to be both committed to their long term strategy and understand that markets are volatile. The market is very difficult to time successfully – to do so requires you to be right twice, when you sell and when you buy back. The only way to manage volatility is through your time horizon and proper asset allocation reflecting the acceptable level of risk that you, as an investor, find tolerable from a total portfolio standpoint. If you are inappropriately allocated to equities in that you do not have a sufficient time horizon to withstand volatility or a correction, then yes, you should be reducing your equity exposure, but not from a timing perspective.

Certainly, stock valuations are not cheap. We need higher corporate earnings fueled by stronger GDP growth–both in the US and abroad–to sustain the current pace of market appreciation. Year-to-date equity returns are what we might have expected for the entire year. Although we anticipate that the economy will strengthen in the second half, the growth appears to be already factored into the market. This does not mean the market will trade sideways for the remainder of the year, nor does it preclude a correction. Trends can and do stay in place for much longer than would seem possible or logical. We could still be having this same conversation a year from now.

Historically the market has experienced corrections of 10% or more every couple of years, and as there has not been one since 2011, we seem to be overdue. But a correction is not a bear market, it is generally considered a healthy event. It is only when market euphoria runs for extended periods leading to unreasonable valuations with very sluggish growth and/ or specific major stresses that much larger problems can result. The sound strategy is to understand your risk tolerance and adhere to a long-term plan, preparing for rather than reacting to short-term market moves.

2. Should investors increase their allocation to international stocks and bonds?

The U.S. economic recovery is further along than the European recovery and that of other developed countries in part because we entered and exited our recession before them. The reason for owning international stocks is that improvement in these economies will occur on a different time table helping to provide some valuation diversification for investors. However, it is important to bear in mind that quality companies, whether U.S. or European, are not as cheap as they used to be.

The European debt market turnaround has been to a great extent a function of investors chasing yield. ECB President Mario Draghi’s announcements have reassured investors and pushed them to increase their appetite for riskier assets and debt while driving yields lower. This has led to a degree of complacency—which is not limited to Europe, may we add--regarding the debt of some non-core countries in Europe and is another reason for caution.

3. Is an allocation to emerging markets still an important part of a diversified portfolio?

Emerging market returns are being driven by China’s transformation of its massive economy from an export-driven to a more consumer-oriented economy. The resulting slowdown in previously double-digit growth is bound to cause repercussions and the remainder of the world, including emerging markets, will have to adjust. We saw a correction in the first quarter which improved valuations of emerging versus developed economies, and as a result there was some bounce back in those markets this quarter.

The key to emerging markets is diversification which argues for professional management. The wide disparity between cheap countries and stocks and countries/stocks that are cheap for a reason makes it important to pick good companies within countries that are stable or are transitioning their deficits and problems into a positive future as could be the case in India, which recently underwent a political transition. The typical U.S. investor’s portfolio allocation to emerging markets is not a large one, yet active management is even more important here due to those diversions amongst countries, sectors (exports vs. consumer oriented) and companies. We do recommend an allocation to emerging markets for investors who have the risk tolerance and time horizon to benefit from the changes these economies are undergoing, and to benefit from that when it is reflected in the stocks of those companies.

4. We hear so much that interest rates should go up, but bond yields are still falling. Why?

When the Fed concludes the taper in October, the largest purchaser of long-term U.S. Treasury bonds will be less involved in the market (although it will still continue to reinvest the coupons of its holdings). While the original announcement of the taper roiled the markets, the actual taper has been fairly smooth. The Fed is expected to begin raising the federal funds rate sometime in 2015, the anticipation of that event should propel interest rates higher.

Interest rates rose in 2013 but have pulled back this year because the economy has been weaker than expected. The recent announcement of improvements in the job market pushed the yield on the two-year U.S. Treasury note up significantly from around 37 to around 50 basis points. Whereas the short end of the curve is reacting appropriately to the anticipated higher interest rate environment, the long end of the curve is highly influenced by technical factors, chief of which is demand by the Fed, demand from Europe—where yields are even lower than in the U.S.— short covering and demand from institutional participants trying to match their assets and liabilities. Supply is also a factor as the federal budget has decreased substantially from five years ago, and there has been a slowdown in new issues. These events have flattened the yield curve and result in the 10-year yield hovering around a band between 2.40% and 2.60%. However, if forecasted strengthening in the U.S. economy materializes over the second half of the year, we expect the U.S. 10-Year Treasury yield to grind higher. Consensus currently is for a year end yield of 3%, down from recent estimates of 3.25%.

Just as with emerging markets, professional, active management of bond portfolios is critical. In a managed portfolio most people have some degree of balance between equities and bonds and as interest rates rise, the manager is looking at the overall portfolio rather than the components in isolation. Duration management and good credit quality of selective bonds helps mitigate the potential interest rate losses as reinvestment of coupons can occur at higher yields as bonds mature, or sooner if opportunities present themselves.

5. Is periodical rebalancing still important?

In order to control the overall risk level of a portfolio, investors should not be reluctant to rebalance simply to avoid generating capital gains. The more difficult decision is where to go with capital. Choices become more limited as everything appears pricey. The more expensive the valuations, the more broad diversification and periodic rebalancing are important.

Rebalancing may mean buying shorter maturity bonds or may also include further diversification of the equity portfolio or the inclusion of other asset classes including commodities, real assets or real estate. Diversification does not always mean buying the same “eight” things with which you started.

6. Should investors be more concerned about inflation or deflation?

Europe is still quite concerned with deflation, because they are in a different part of the recovery cycle. The ECB has reduced key interest rates and installed a negative rate on bank deposits to encourage banks to lend rather than leaving surplus funds with the central bank, although many banks have chosen instead to buy U.S. Treasuries.

Over the long term, U.S. investors should be more concerned with inflation. The Fed has actively fought deflation by driving interest rates to historical lows – the overriding purpose of the quantitative easing programs of the past six years has been to ward off deflation.

It is possible that the Fed is miscalculating inflation because they are miscalculating employment metrics, including the unemployment and the labor force participation rates. The Fed has stated that it will not raise the interest rates until unemployment reaches a certain level. As part of the equation, it also considers the participation rate which is currently at 62.8%. But it may be that the people that exited the workforce because they could not find a job in the last six years are not coming back. Indeed most of them may not as jobs openings are similar to what they were at the peak of the last cycle. If so, a lower participation rate reflects a permanent structural, secular change. If the current participation rate is lower than the average of the past decade, the Fed could be too slow to raise rates. While not currently an issue, it could be in the future if employment metrics have been miscalculated, more so in view of diminishing productivity.

The fact that core inflation has remained below the Fed’s 2.0% target rate does not mean that prices have not gone up. Indeed the prices of both food and energy have risen. Perhaps the biggest price increase has been in the various financial asset classes. The prices of equities, bonds, anything even remotely related to investments have gone up, and that is also inflation.

7. In conclusion, what other investment strategies should investors keep in mind?

Investors sometimes forget that markets are inherently volatile. For the past few years volatility has been very subdued, leading to the belief that there is a lot of complacency in the markets. We anticipate a pickup in volatility as we move into the fall.

Investors should also keep a close eye on corporate earnings because the big question is whether stocks will be able to sustain current multiples. They will not without an improvement in earnings, so we should not anticipate markets moving higher at the same pace in the second half of the year.

While equity valuations are not cheap, other investment options including high-yield bonds are even more expensive. In its effort to reactivate the economy and investments, the Fed has made cash worth nothing pushing investors into the risk arena. Most investors can no longer produce sufficient income from their bond portfolios and thus now rely on some combination of capital appreciation and income. A correction involving the stock and bond markets simultaneously has the greatest potential to hurt those investors and that is why, to the risk of sounding repetitive, we insist on prudent active management in quality assets, proper diversification and an in-depth knowledge of your risk tolerance as an investor so that when markets move, you can stick to your original plan.

BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).