Given our expectations for the economy, here are some thoughts on the markets….

Attractive equity market valuations (recall the P/E slide) and less overall volatility for the U.S. stock market (recall the VIX slide) would normally call for an overweight in stocks.  However, a modest economic growth environment and uncertainty overseas makes the case for a more defensive allocation.  Taken together, we are keeping a neutral allocation to stocks, bonds, and cash.

Within the bond market, we are bullish on more credit sensitive sectors of the bond market, including investment-grade and high-yield corporate bonds.  Our continued overweight to international bonds is due to our view of a weakening U.S. dollar.  We also favor the taxable Build America Bonds (BABs) previously issued by municipalities, as well as Commercial Mortgage-Backed Securities (CMBS) and Collateralized Mortgage Obligations (CMOs).   We remain underweight more interest rate sensitive sectors like nominal Treasuries and agency debt (i.e. Fannie and Freddie).  And we have a current neutral allocation for Treasury Inflation-Protected Securities (TIPS), agency mortgage-backed securities (MBS), and traditional municipal securities.  Mortgage-backed securities is a sector that was previously underweight and has recently been brought back to neutral.  Municipals was a recent overweight where profits have been taken.

As always, we think broad-based diversification (among and within asset classes) and active management are essential to long-term investment success.  Currently, the market environment may be right for both.  With less overall volatility in the market, there is also less correlation between asset classes.  Historically, this suggests that there may be greater dispersion between what does well, and what doesn’t do well, which promotes diversification.  A similar argument can be used for active management.  Over the past  few years, stocks have exhibited a high degree of correlation, in part because investors have been more focused on macro factors in driving their investment decisions rather than the fundamentals and attractiveness of the individual stocks.  As macro anxieties subside, we think unique company characteristics will once again distinguish the winners from the losers, allowing good active managers to outperform.

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