Outlook 2012
Exploiting Volatility
Our Research experts on the Outlook 2012 roundtable panel agree that the big global economic questions are unlikely to be resolved during the coming year. What this means, among other things, is that, for the time being, investors will continue to play a waiting game.
Some of the panelists believe it’s possible that the world’s markets will get a lift during the second half of the year. If that happens, you’ll probably want to take a second look at your holdings and perhaps think about adjusting your asset allocation. But in the meantime, how can you see to it that your portfolio is taking advantage of opportunities that are available now, tapping the most promising sources of growth and yield?
Lisa Shalett
For insights on the subject, Merrill Lynch Advisor spoke recently with Lisa Shalett, Merrill Lynch Global Wealth Management CIO and co-author of the recent whitepaper The Great Global Shift: New World, New Rules.
Q: Will we finally see some relief from volatility in 2012?
That’s something we’d all love. Even the most resilient investors are experiencing volatility fatigue at this point. So it would be great to forecast that the markets will calm down and become more predictable next month or even in the next year. But we’re going through an extraordinary period in history that’s bigger than any business cycle. It’s really about fundamental changes taking place around the world, a great shift in financial power away from the traditional centers we’ve known all of our lives. So I don’t think we’ll see volatility slowing down in the near term.
Q: Why is lower volatility so hard to achieve?
There are huge imbalances between debtor nations in the developed world and creditor nations in the emerging world—in a nutshell, Europe and the U.S. vs. China. There are imbalances between growing economies and those that are maturing, and between those with youthful populations and those with aging populations. Within the U.S., there are imbalances between the employed and the unemployed, and between the wealthiest people and the rest of the population. All of these are structural rather than economic imbalances, which means that the solutions involve politicians and policymakers, and historically take more time. So it’s critical for investors to factor a rise in global economic volatility into their portfolios.
Q: How do you factor in volatility? Isn’t it unpredictable by nature?
The way to think about it is to make volatility work to your advantage. The analogy I use is of world-class open-water swimmers who find ways to make the waves, the wind and the current work for them, not against them. The best way investors can do that is by rebalancing more often. For instance, if you have historically rebalanced once a year, in an environment in which volatility is three times as high as normal, you may want to rebalance three times a year. That will allow you to exploit any opportunities that turbulent markets present.
Q: How does more frequent rebalancing help in times of volatility?
High volatility increases the likelihood that the markets will skew your portfolio. Say your strategy calls for 50% of assets in stocks and 40% in bonds. If your equities have drifted downward and bonds are up, suddenly the ratio may be, say, 42% stocks and 48% bonds. You can get your portfolio back in line by working with your Financial Advisor to make opportunistic changes. This has nothing to do with market timing, which involves rapidly getting in and out of investments with the hopes of a fast payoff. Market timing is dangerous at any time but particularly during volatile periods, when price swings—and potential losses—are amplified.
Rebalancing does not protect against loss in declining markets and may trigger a tax event and additional fees.
Q: What portfolio adjustments should investors be considering?
This looks like it might be a year for tilting toward bonds and away from stocks. Stocks remain a big part of most portfolios, but they do carry more risk than bonds. Today, investors shouldn’t be weighted too heavily in stocks and other higher-risk assets. Although the exact mix will depend on your age, risk tolerance, goals and other factors, a moderate investor—neither excessively conservative nor particularly aggressive—might shift from a ratio of 41% stocks and 27% bonds, with the rest in investments such as hedge funds, and private equity (for suitable investors), real assets and cash, to 37% stocks and 31% bonds.
Q: How should investors go about adding fixed income to their investment mix?
We suggest a diversified, truly global fixed-income position for investors in 2012. We believe that central banks around the world will aggressively cut rates to try to get their economies going again. As rates go down, we would expect to see a rise in prices of global bonds. At the same time, economic growth is likely to remain slow, suppressing gains for stocks. Taken together, these circumstances create what looks like a near-perfect environment for bonds.
Investors should think about including more than just the traditional kinds of bonds, such as municipals—though we continue to like those. People might want to consider a bit of exposure to European sovereign debt, in expectation that European reforms will succeed. But as ballast, you should also have safer exposure to U.S. investment-grade and high-yield corporate bonds, and perhaps some sovereign debt from emerging-market creditor nations as well.
We also like very high-quality municipal bonds—that is, double A- or triple A-rated. What many people don’t understand is that most municipalities, unlike the federal government, have chartered or constitutional requirements to balance their budget. As a result, they’ve already undertaken painful cuts, showing a lot more discipline than the federal government has demonstrated. That’s one reason default rates for municipalities remain extremely low, even during these difficult times.
Q: How does an investor gain exposure to this year’s most compelling opportunities?
Managing riskier assets is probably not something you want to do on your own. The world is still very uncertain. Instead, I’d look for funds that are actively rather than passively managed by people who have extensive experience in international bond markets—experts trained to spot opportunities and pitfalls.
Q: You suggest taking a step back from stocks. A large step or a small one?
Not that large—we’re more neutral to slightly underweight on equities. Stocks—especially those of companies that have the capacity to increase their dividends—are still crucial to a diversified portfolio. Sectors such as technology, consumer staples and the most innovative companies in health care are among the most attractive.
U.S. companies have done a spectacular job during the past year, outperforming both emerging markets and European equities. For the most part, the best choices are large companies with global franchises that have a distinct brand, pricing power, distribution opportunities, better technology or some other advantage.
It’s important to note that corporate earnings were extraordinarily high in 2011, given the overall economy. In many cases, that has made stocks look like a great value—because share prices have seemed fairly low relative to earnings. That could change this year if profits fall back, and our concern is that those 2011 numbers were often achieved by restraining such costs as hiring, labor and capital spending. So we’re not convinced that the profitability is sustainable.
We do think that at some point in 2012 it may be a good time for many investors to move more aggressively back into equities. But first there will need to be greater clarity about the U.S. and global economic outlook.
Q: Are there any overlooked domestic stock opportunities?
Pockets of value are hard to find, but they exist. Regional banks, for example, sound like a contrarian call, because the financial sector as a whole looks to be in for a challenging 2012. But deep down, the U.S. economy is showing some resilience. Despite the debate over whether regulations and taxes are holding them back, small businesses are doing reasonably well and are starting to hire. It’s a simple story. When regional banks get more deposits from small businesses, they make more loans. For investors looking for deep value, the upsurge in local lending is something to consider.
Q: How should equity investors approach Europe?
Our advice throughout 2011 was to lessen exposure, and we suggest the same course at least through the first half of this year. Policy changes, even if successful, will take time to implement. Even so, we think that patient investors may find this a good time to consider the highest-quality European companies, whose universally known brands depend on exports to the rest of the world. These very solid companies can present extraordinarily good values now, because they’ve been thrown out with the bathwater of wider European concerns.
Q: Should investors move more assets to cash this year?
Actually, we suggest the opposite. One of our central themes for 2012 is to move out of cash positions. While cash and cash alternatives seem safe and defensive, holding too much of them amounts to locking in negative yields when you factor in inflation. In December the Consumer Price Index was rising at 3.5%. That’s not high inflation, historically, but if you’re making only a quarter of a percentage point on your cash, you’re guaranteed to lose 3.25% in real terms. And, if the European Central Bank and the Fed use monetary easing during the second half of the year to spur growth, that could lead to rising inflation. Particularly for retirees who need to preserve principal, hiding in cash is actually doing damage to a portfolio. As an alternative, think about gaining exposure to real assets that can protect you from inflation, such as real estate and gold, as well as other commodities.
Q: What’s the best way to invest in commodities?
Clearly, individual investors aren’t in a position to buy and store barrels of oil or silos of grain. Until fairly recently, the only practical alternative was to buy stock in commodity-related oil or mining companies. But that meant missing out on a chief benefit of commodities—the fact that their performance is not closely tied to stock market performance. That’s a huge advantage when you’re working toward genuine diversification among your holdings. Today, actively managed mutual funds and exchange-traded funds (ETFs) offer direct exposure to the investment performance of commodities themselves, and although these funds aren’t stocks, they’re traded on markets and have the liquidity of stocks. But it’s important to choose carefully to get the best hedge against potential inflation. Gold, oil and other energy commodities are good inflation hedges. Agricultural commodities, in contrast, may be fine investments for other purposes, but they’re less reliable, because unpredictable weather plays a heavy role in their pricing.
Q: You’ve brought up diversification several times. Is this a continuing theme in 2012?
Structurally higher volatility increases your need to be global, to be flexible, to expand the set of opportunities and asset classes you’re willing to consider. You need to be broadly, not narrowly, focused. That is pretty much the definition of diversification. And to keep all of your options open, you need to be dynamic and somewhat more opportunistic when you rebalance—to make volatility your friend. The investors who can do that are likely to manage well during the coming year.
International investing presents certain risks not associated with investing solely in the U.S. These include, for instance, risks related to fluctuations in value of the U.S. dollar relative to the value of other currencies, custody arrangements made for a fund’s foreign holdings, political and economic risk, differences in accounting procedures, and the lesser degree of public information required to be provided by non-U.S. companies. Foreign securities may also be less liquid, more volatile and harder to value, and may be subject to additional risks relating to U.S. and foreign laws relating to foreign investment. These risks are heightened when the issuer of the securities is in a country with an emerging capital market.
Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. Tax-exempt investing offers current tax-exempt income, but it also involves special risks. When interest rates go up, bond prices generally drop and vice versa. Interest income from certain tax-exempt bonds may be subject to certain state and local taxes and, if applicable, the alternative minimum tax. Any capital gains distributed are taxable to the investor.
Investments in high-yield bonds (sometimes referred to as “junk bonds”) offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer’s ability to make principal and interest payments.
Trading in commodities is speculative and can be extremely volatile. Market prices of the commodities may fluctuate rapidly based on numerous factors, including changes in supply and demand relationships; weather; agriculture; trade; fiscal, monetary and exchange control programs; domestic and foreign political and economic events and policies; disease; technological developments; and changes in interest rates.