Outside-IN

Where are the next big opportunities in today's market?

Analyzing the current equity and fixed income scene to identify potential growth areas

Sep 30, 2014 @ 7:51 am

By Thomas Hoops

Five years after the end of the financial crisis, asset managers, financial advisers and clients are trying to discern how they should be positioned to avoid many of the pitfalls that may lie ahead, but still take advantage of the opportunities today's markets offer.

At our recent Investor Day, our affiliates' chief investment officers discussed current market opportunities, often based on their macroeconomic outlooks. I thought I'd share some of their key themes and how they might play into portfolio strategy. Of course it's particularly important to keep in mind that individual investors have a wide range of goals, and their asset allocation should reflect their individual objectives.

One of the core themes unsurprisingly revolved around current and future Federal Reserve policy. In particular, as the Fed's tapering is coming to an end, now is a good time to consider the implications this may have on asset prices and what that might mean for portfolio construction.

Most market watchers predict a rising interest rate environment; in fact it has become conventional wisdom that rates, particularly in the U.S., are poised to rise. The consensus among our CIOs is that rates will go up, but at a very measured pace — over 18 to 24 months, if not more.

Five years before, it would have been difficult to foresee the extended low growth global market environment that has led to our current monetary situation. This persistency will likely make it difficult for the Fed to follow through with its announced intentions to raise rates in the short term. Thus policymakers will be very slow to unwind. Inflation should remain low, and we expect that there is not another recession around the corner.

(More market insight: Why separately managed accounts are reborn)

As markets continue to normalize to a post-taper environment, our equity-focused CIOs expect to see 6 to 8% growth in S&P 500 earnings. After the latest bull market, valuations are in the mid-to-higher end of the historical range, and few sector opportunities are left unrealized. Therefore higher valuations will come from, and be dependent on stronger earnings.

Volatility is expected to increase and correlations between markets, sectors, and securities will likely fall. That market backdrop should enhance opportunities for asset managers and investment advisers to differentiate themselves.

It should be noted, however, that there remains a significant amount of leverage in the global financial system. That means even small moves in interest rates could have outsized effects.

Fixed Income Opportunities

This year has turned out much better than expected. At this point many of our affiliates' CIOs expect next year to be much the same. Still, many clients are seeking to manage their risk and looking to diversify their bond portfolios. With global benchmark yields of 1.2% — hardly an exciting starting point — money is flowing into the kind of unconstrained bond funds I wrote about in a previous piece. They offer investors access to a variety of products and geographies. Choosing products among the many options that meet your clients' risk tolerances and income needs is key.

(Related: The time is ripe for unconstrained bond funds)

Our fixed income CIOs are taking advantage of opportunities in the credit markets versus extending maturities. However they do currently like the long end of the U.S. curve. In fact, many of our affiliates have been long on U.S. 30-year bonds for the last nine months. Ultimately, they see long and short opportunities offering the best possibilities for investors; with the intermediate part of the curve being the most vulnerable. Mortgage credit is not expanding and the housing markets are slowly coming back. With the shift from a credit-driven to an income-driven economy in the U.S., what happens to wages — and productivity — will have major impacts.

Global fixed income investing is dependent on a combination of currencies and interest rates. Our CIOs stated that they foresee something of a secular sideways global market, with many in the U.S. preparing for short-term rates to rise (which we again believe will take time), while the European Union and Japanese markets do not have those expectations given the slow healing of their economies. Bonds in Mexico, Brazil and Korea represent attractive possibilities. While China, on the other hand, is in the midst of a secular slowdown that promises to be long lasting.

Given the current outlook, a flexible or absolute return fixed income mandate can help navigate these evolving markets more smoothly. These complexities are another reason to look for professional managers with long, proven track records.

Equity Opportunities

The equity markets have rebounded, running up far and fast to levels few anticipated, and yet many stocks considered “quality” by professional managers have lagged behind, as easy access to capital drove lower quality stocks higher. In a market flush with liquidity, lower quality stocks offered the biggest return.

Looking forward, dividend and income strategies will continue to be important. Opportunities there remain attractive, with a combination of dividends and growth being highly attractive. In selecting an income strategy for a client, it's especially important to understand their needs and risk tolerances.

With record highs on the S&P, opportunities can also be found in managed volatility equity products. While there are currently income opportunities from equities, many of these stocks can come with higher volatility. By eliminating market cap constraints, a manager can create a more efficient, higher-yielding equity portfolio with lower volatility. These strategies have the potential to provide risk management while still participating in an up market. It's a relatively new product category, so diligence in selecting a manager is important.

Another outcome of the expectation of higher interest rates could be an increasingly active U.S. M&A market over the next 12 to 24 months, as companies look to finance transactions while rates are low. Small cap strategies, merger arbitrage, and restructuring could have potential in this environment, as well as following the path of activist investors focused on creating efficiencies at public companies.

Volatility has also been depressed by policymakers' moves. However, as the Fed's market presence declines, volatility will likely increase, and company quality as a differentiator should become clearer. Our equity CIOs called out technology, particularly hardware; health care, specifically insurance; and energy, particularly once commodity prices find a bottom. In small cap markets it can be difficult to find new stocks to buy, given current levels, but with research, opportunities can be found.

So from where will the next big opportunities arise? While many market environments often pose challenges (this one included), opportunities are always available to grow and manage capital. Every adviser should evaluate the available opportunities and take the time to assess whether their existing portfolios still meet client needs in this changing environment.

Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.

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