Evolving markets highlight importance of active management
- We think investors should consider lowering overall return expectations for 2014, especially versus the past three years.
- Active management and careful stock selection will be especially important in this environment.
- We think central banks would like to be less aggressive in monetary policy, but economic data may not support a change yet.
Equities have strongly outperformed other asset classes in recent years and especially in 2013. The Waddell & Reed Advisors Asset Strategy Fund continues to use its complete flexibility to position for changes in the market environment. Portfolio Managers Michael Avery and Ryan Caldwell discuss the direction of the Fund and the ongoing impact of aggressive monetary policy on the global economy.
Moving forward with the Fund
Equities strongly outperformed other asset classes in 2013, with the S&P 500 Index up 32.4% for the year, and they generally have done well since the global financial crisis. Given that performance, our outlook for 2014 and beyond now starts from a different point in terms of expectations, and we must continue to carefully assess the risk/reward of investments in the Fund. We think investors also should consider lowering their overall return expectations for 2014, especially relative to the past three years.
Stock multiples are returning to more normalized levels in markets around the world, whether based on sales, free cash flow, price-earnings ratios or other factors. In general, we think corporate margins can stay at current high levels for a long time. Corporate managers and boards of directors have strong incentives to keep costs down, particularly labor costs; to enhance productivity to reduce those labor costs; and to return capital to shareholders via share buybacks or increased dividends.
There is little incentive for those management teams to increase capital expenditures or add employees without a matching increase in business and consumer confidence. In our view, margins are likely to stay at current levels until corporations change focus and use capital to expand their operations.
Active management and careful stock selection – essential elements of our investment process – will be especially important in this environment. That is likely to mean fewer holdings in the Fund over time. For example, the Fund at the end of 2013 totaled 92 equity holdings. We expect the holdings to decline, perhaps to a range of 60 to 75, with a tilt toward growth stocks. We focus on companies that are growing, innovating, improving margins, returning capital through dividend growth or share buybacks, and offering what we believe to be sustainable high free cash flow. We think those are the characteristics of successful companies.
We still believe the opportunity to generate return in fixed income is limited, given the likelihood that interest rates will remain at low levels for some time.
We also continue to hold a gold position in the Fund as central banks globally have persisted in using their balance sheets to address economic issues. A year ago, we thought these aggressive monetary policy measures around the world would have an inflationary impact by now. That has not been the case thus far and there may be more disinflationary, or even deflationary, factors affecting economies than inflationary at this time. We’re concerned that central banks in general are ignoring the fact that the problem is not a lack of demand, but rather too much global supply. It will take a long time in a world with low growth in real gross domestic product (GDP) to increase demand enough to overcome the excess supply.
The cash allocation in the Fund in part reflects our uncertainty about how global central banks will respond to upcoming economic data and whether there could be further accommodative policy moves. Cash also allows us to be patient and opportunistic in our investment selections in this changing market.
View the fund's current holdings on the Fund Detail page.
Ongoing impact of central bank policy
The collective actions of central banks since 2008’s global financial crisis were designed to arrest a fall in real GDP and to prevent a deflationary spiral. Those actions included pushing interest rates dramatically lower and then holding them at those very low levels.
Stocks have gained steadily for five years on the belief that central banks would continue aggressive monetary policy and perhaps generate even more stimulus if economic problems returned. We think central banks now would like to be less aggressive, but it’s not clear whether economic fundamentals will support such a change.
For example, for some time there have been questions from investors about the sustainability of the growth rate in China’s GDP. It has grown at a very rapid rate and in excess of 7.5% for several years. We think it is likely that real GDP in China will slow to an annual pace closer to 5-6% over the next few years. Such a slowing could create problems for China’s government, including its ability to generate sufficient employment to hold down social tensions.
In addition, there are questions about how aggressively the U.S. Federal Reserve (Fed) will take actions that result in a reduction of its balance sheet. The Fed in the past has dismissed the implications for emerging markets of expanding its balance sheet, but we think it’s something to watch closely. In looking at the situations in China and the U.S. together, we see the world’s two largest economies trying to pull back simultaneously on their aggressive monetary policies with minimal disruption to their respective growth trajectories – something that we think will be difficult for both.
Capital has flowed to emerging markets in a search for yield as a result of global monetary easing. For example, significant capital was invested in emerging-market debt and equities in just the last three years. But money flows are reversing from emerging markets back to developed markets as the Fed “tapers” its bond-buying program, and this has negative implications for already-vulnerable emerging markets.
This liquidity move explains in part the heavy focus on the Fed’s tapering, on whether the People’s Bank of China will move aggressively on so-called “shadow-banking financing,” and on actions by the Bank of Japan and the European Central Bank.
If there were to be a significant market correction in U.S. equities or bonds markets, for example, or in some emerging markets, we wonder if the Fed would reverse its tapering and even increase quantitative easing. We do not think that would be a good solution, but it could be a short-term action to avoid devaluations that would add to a global deflationary cycle.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s portfolio managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Mar. 3, 2014, and are subject to change due to market conditions or other factors
Risk Factors: As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. The Fund may allocate from 0 to 100% of its assets between stocks, bonds and short-term instruments of issuers around the globe, as well as investments in precious metals and investments with exposure to various foreign securities. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed-income securities are subject to interest-rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The Fund may focus its investments in certain regions or industries, thereby increasing its potential vulnerability to market volatility. The Fund may seek to hedge market risk on various securities, increase exposure to various markets, manage exposure to various foreign currencies, precious metals and various markets, and seek to hedge certain event risks on positions held by the Fund. Such hedging involves additional risks, as the fluctuations in the values of the derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative’s value is derived. Investing in commodities is generally considered speculative because of the significant potential for investment loss due to cyclical economic conditions, sudden political events, and adverse international monetary policies. Markets for commodities are likely to be volatile and the Fund may pay more to store and accurately value its commodity holdings than it does with the Fund’s other holdings. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.
The S&P 500 Index is an unmanaged index of common stocks that generally is considered to represent the U.S. stock market. It is not possible to invest directly in an index.