The world is entering the synchronous phase of a long but bumpy recovery process that began in 2009. Unlike other synchronized global recoveries, however, developed markets’ central banks are, in aggregate, likely to remain accommodative in an attempt to offset some of the inherent volatility that accompanies deleveraging cycles.
Against this macro backdrop, our asset allocation view for 2014 is to stay the course, retaining key overweight positions in global equities and alternatives, including private credit, special situations and real assets. To fund these risk buckets, we are retaining massive underweight positions in government bonds and investment-grade debt.
No doubt our viewpoint in underweighting these two asset classes runs counter to what many would consider traditional asset allocation theory. But if we are right in our observation about the changing role of traditional fixed income, this high-conviction view may have major implications for how portfolio managers, chief investment officers and investors think about returns, risks and diversification.
Because 2014 will not be an exact repeat of 2013, we have included some important tactical asset allocation considerations.
Remain overweight developed equities, as developed-market equities may enjoy another decent year. Although we do not expect public equities to be as strong in 2014 as they were in 2013, we think equity markets in the U.S., Japan and Europe can provide high-single-digit or better returns. But 2014 will likely be a bumpier ride than last year, and our research shows we should brace for a correction along the way. Key to our thinking is that price-earnings multiple expansion for this cycle is notably ahead of schedule.
Many emerging markets may lag again, but look for some differentiation within emerging-markets equities. Overall, we think many emerging-markets economies will probably fall behind relative to potential growth again this year. Their currencies are probably fully valued, particularly in countries such as Turkey, Indonesia, South Africa and Brazil with current-account deficits. We do expect some differentiation in emerging-markets equities, however, which we believe could allow asset allocators to gain a performance edge.
We are staying overweight on illiquid credit, which remains attractive at this point in the economic cycle. We want to avoid potential duration hangover in high-grade credit and government bonds. As in prior years, we remain convinced that asset-based lending in the three- to five-year duration private credit market is a sweet spot at this point in the cycle. Central to our thinking is that the pickup in relative yield from private markets compared with public credit markets — investment-grade debt in particular — represents a substantial price difference, especially with regard to specific hurdle rates or payout ratios. By comparison, we still believe that long-duration, particularly government-linked debt, may produce another bout of sluggish performance in 2014.
We have reduced our position in emerging-markets debt from 5 percent in early 2013 to 2 percent to zero in 2014. Moreover, as U.S. rates rise and the economy gains momentum, we expect additional bumpiness in emerging-markets debt.
To gain more flexibility, we are switching from bank loans and high-yield into liquid opportunistic credit and adding lower-volatility fixed-income hedge funds. Last year we rotated our tactical asset allocation between high-yield and bank loans. While we had some success with this approach, in 2014 we intend to allocate to opportunistic credit, a strategy that will allow us to toggle among bank loans, high-yield and other credit products as relative undervaluations and overvaluations occur.
We are selling more gold and avoiding traditional commodity notes and swaps that have no yield. We are also staying overweight income-producing real assets. We are again avoiding liquid commodity swaps and notes. Last year we went from overweight to neutral on gold, but now we suggest selling gold short as an asset class. There is still, however, substantial opportunity in hard assets such as real estate, pipelines and even drilling wells (see also “Gold Lost Some Glitter in 2013, but Its Future (As Always) Looks Bright”).
Overweight traditional alternatives, and add a little more to distressed assets and special situations. We retain our 5 percent allocation to traditional private equity and 5 percent to growth capital and emerging-markets private equity. We are also adding another 2 percent this year to our 5 percent allocation of distressed assets. This brings our traditional alternatives weighting to 17 percent from 15 percent, versus a benchmark of 10 percent.
The U.S. dollar rally may continue, though with greater differentiation. During the spring of 2013, we grew more positive on the U.S. dollar. Although it rallied against Asian, Latin American and commodity currencies, it failed to strengthen against the European bloc. But with stronger U.S. growth ahead — and government shutdowns in the past — we think the dollar will likely do well against various European currencies this year.
Volatility may increase in 2014. Overall, we expect equity and fixed-income volatility to rise, so we think hedging makes more sense in 2014. We like trades that take advantage of a steeper yield curve.
Implicit in our global forecasts are two important considerations. First, we expect more positive follow-through legislation in what we consider to be four key reform markets: Mexico, for opening up its energy sector; Japan, for its push to increase base wages; Europe, for bank stress-test credibility; and China, for reforms of state-owned enterprises. Second, we are not expecting any major derailments during U.S. midterm elections or any major political discord following elections in Turkey, Brazil, India and Indonesia.
The major unresolved question is whether government bonds and investment-grade debt can still act as effective shock absorbers and income producers in portfolios. We acknowledge the risks in our approach. But with many bonds trading above par or producing yields just off record lows and with the global economy gaining momentum, we maintain a high degree of conviction in our present asset allocation framework.
Henry H. McVey is head of KKR’s global macro and asset allocation team.
