Holding course as we look toward 2014
- We think the U.S. will continue its loose monetary policy, given the economy’s tepid growth rate.
- We believe markets are cyclical and in general think we're near a midpoint in a full market cycle.
- We still think equities are the preferred investment choice in relative value terms.
- We think China's economic reform plan will give markets confidence that it can sustain strong growth.
In a year of strong performance in U.S. equities capped by more stomach-churning headlines from the U.S. Congress, our outlook and Fund allocations generally have been stable. We still expect positive economic growth in the U.S. and across the globe in 2014 in an environment dominated by aggressive monetary policy.
Slow growth and economic stimulus
We expect low growth and low inflation in the U.S. next year with continued aggressive monetary policy and economic stimulus. We think the decision by the Federal Reserve (Fed) to delay any “tapering” in its massive bond-buying program combined with the expected confirmation of Janet Yellen as the next Fed Chair support our view. While the timing of the Fed’s tapering may remain a topic of market speculation and a cause of market volatility, we don’t think the program will wind down in the short term. We think U.S. policy makers will continue to err on the side of loose monetary policy, given the economy’s tepid growth rate.
The monetary policy measures implemented thus far were intended to address the lack of consumer demand versus an excess of supply. Central banks are increasing the money supply in order to stimulate that demand.
However, easier money has inflated asset prices – including equities. Those who have benefited from higher asset prices have seen their net worth improve. Those who are not participating to the same degree in financial assets have had very little growth in disposable income. Many consumers have not repaired their personal balance sheets and still have too much debt. In addition, there has been tepid job growth and stubbornly high unemployment. Given the slack in the economy, there is no immediate reason to think these indicators will change significantly.
We think consumer spending is unlikely to grow rapidly in such an environment. Consumers recently have been willing to take on some additional debt and lending standards have become a little less stringent. While spending has increased, improvements have been uneven and we are carefully watching housing to see if rising mortgage rates will temper enthusiasm.
In the face of ongoing economic stimulus, stock markets also have continued to re-price risk. We think that is evident in a variety of metrics, including rising valuations, the level of the S&P 500 Index, decreasing correlations and decreasing volatility. As we have noted in the past, equity prices have risen faster than fundamentals so forward-looking return expectations should be falling for investors. But we do not think that is happening. Investors are showing rising enthusiasm for equities, as can be seen in part through the increasing flows into equity mutual funds.
Effects on Fund allocations
We are paying close attention to the Fund’s risk profile in the current market environment and over the course of 2013 have broadened the equities allocation. We have increased the number of holdings and worked to get away from some of the single-name risk in the portfolio.
The largest sector in the Fund continues to be consumer discretionary, which is about one-third of the portfolio. While that may seem to be a large allocation given our views on consumer spending, we think it’s important to look at the Fund’s consumer discretionary holdings as allocations to three distinct sub-sectors:
- the gaming industry, with a focus on Asia; Galaxy Entertainment Group Limited, Sands China Ltd. and Wynn Resorts, Limited are among top holdings;
- media, with CBS Corporation a key holding;
- autos, although the allocation has been reduced this year; Hyundai Motor Company is a top holding.
The allocation to the financials sector is the second-largest portion of the portfolio and a prime area we have diversified in the Fund this year. AIA Group Limited is among the Fund’s top holdings and a key example. Finally, we also have broadened holdings in the technology sector.
We still think the expansion of the middle class in emerging markets, including China, will continue to be a source of revenue and demand growth for companies across these sectors.
For the stock market overall, third-quarter earnings were uneventful with generally good results supporting already positive market sentiment. Forward-looking earnings expectations for 2014 have declined somewhat. We think the data imply an 11% increase in aggregate earnings next year, with a factor of 16 times trailing earnings or 14.5 times forward-looking earnings on the S&P 500 Index. That’s not what many would consider a demanding level to reach. But it also is not what we think most would consider an immediate buying opportunity, compared with the levels of a couple of years ago.
There also were several high-profile initial public offering (IPO) deals in the past quarter. IPOs have not been a focus for the Fund, but we believe these represent another indication that investors are beginning to think more seriously about future growth and are more willing to take on risk and participate in such deals.
Several valuation metrics on IPOs are approaching levels that typically would cause investors to be more cautious. But the market remains open for IPOs, especially from companies that investors think have good growth potential.
Fundamentally, we believe markets are cyclical and in general we think we are near a midpoint in a full market cycle. That means we believe investors must be especially diligent in their equities research going forward.
We have maintained a position in gold in the Fund based on our long-held belief that gold is a hedge against aggressive monetary policy and a way to protect against future policy mistakes. The monetary policies around the world in response to the global recession continue to hold interest rates at low or negative real levels, reinforcing our view on gold. But the price of gold has not reacted positively to some recent moves to keep rates low, including an early November rate cut by the European Central Bank.
As policy makers in the future reduce economic stimulus and rates begin to rise more steadily, we think the environment for gold will be more challenging. We have placed some hedges on the Fund’s gold position while maintaining much of the underlying allocation.
In our view, the current market environment means there are no easy choices for pursuing returns. Cash still basically offers no yield, government bonds offer what we think is an unacceptably low yield and many other fixed-income securities offer low yields for what we believe is the risk an investor takes on in that asset class. We still think equities – while perhaps less compelling than a couple years ago in this low-growth environment – are the preferred investment choice in relative value terms.
China: Reform on the horizon?
China in mid-November announced an ambitious economic plan following the close of the Third Plenum of the 18th Party Congress. The plan covers reforms in 16 major areas with a target of 2020 for “decisive” results.
Among the plan’s key objectives:
- reduce government regulation, spending and intervention in the economy
- reform the system of dominant state-owned enterprises and promote the private sector of the economy, including allowing private banks and more open markets
- reduce limits on foreign investment
- liberalize prices on major commodities
- open household registrations in small- and mid-size cities and get permits for work, education, health care, etc.
- give farmers land title and allow title tradings
The plan also has other important political and human rights elements, including changes to the controversial one-child policy and “reeducation” labor camps; assignment of more responsibility for areas such as education, pensions and health care to the central government; and evolving a legal system that is independent of local governments and officials, promoting the rule of law throughout the country.
We are encouraged by China’s plan, but we think implementation will be difficult. We believe many of the problems the country faces are complicated and entrenched in its society. However, this reform plan is the biggest that China has undertaken in more than 20 years and could be the most dramatic since Deng Xiaoping announced the opening of China’s economy in 1978.
We think the reform plan will give markets confidence that China can sustain its strong economic growth rate for at least another seven years. It also reinforces our view that China’s leaders want to grow the economy by increasing domestic consumption and improving standards of living, not through continued government spending and exports.
Percent of net assets as of 10/31/2013: Galaxy Entertainment Group Limited, 5.4%; Sands China Ltd., 4.4%; Wynn Resorts, Limited, 2.9%; CBS Corporation, 2.4%; Hyundai Motor Company, 2.6%; AIA Group Limited, 3.0%
Past performance is no 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 Dec. 5, 2013, 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.
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