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INVESTMENT OUTLOOK – Fourth Quarter 2015 Heritage Market Brief

SECURITY SELECTION COMMITTEE VIEWPOINTS

Fourth Quarter 2015

THEMES

  • Despite a 5.1% unemployment rate and second quarter GDP revision up to 3.9%, the Federal Reserve did not raise interest rates on September 17th as the committee feared higher U.S. interest rates would further strengthen the U.S. dollar and cause further weakness among emerging markets
  • During the third quarter, the market experienced its first correction in four years upon heightened concerns surrounding China’s slower expected economic growth, the strong U.S. dollar, weak oil prices, and reduced capital spending in response to the former
  • While corporate credit spreads have increased over the last 6 months, the current default rate of 2.3% remains relatively low compared to the historic default rate of 4.5%; therefore, we currently view this as an opportunity to buy corporate debt where necessary and appropriate rather than viewing it as an economic health warning
  • U.S. auto sales soared 16% in September and are on track to reach a 10-year annualized high of 18.17 million units
  • Housing remains strong with new home sales at the highest level since February 2008
  • U.S. consumers remain healthy as signaled by a 3.2% year-over-year increase in disposable income
  • With September nonfarm payroll additions of only 142,000 relative to an expected 200,000, continued global growth uncertainty, and inflation levels below 2% with no sign of increasing as indicated by TIPs and commodity prices, it is very likely the Fed will postpone its first rate hike until 2016
  • While interest rates remain range bound, individual bonds held to maturity should continue to provide downside protection
  • It is likely that volatility will continue as long as the market remains concerned about the timing of rate hikes and global economic health
  • Emerging market economies remain at risk to rising U.S. interest rates; however, the asset class should be additive to long-term returns as demographics are favorable and the sub- asset class remains attractively valued at just 10.7 times next year’s estimated earnings.
  • Structural unemployment as well as a slow recovery from a severe recession may be playing a key part in the lowest labor force participation rate in 37 years.

ASSET ALLOCATION

We expect the central bank to remain committed to an accommodative monetary policy which should keep current yields low relative to historical levels. Thus, we believe an overweight in stocks relative to bonds is appropriate from a risk/return perspective. Our focus on valuations has led us to believe that U.S. small-cap stocks are rich relative to historical long-term averages. Therefore, we have taken the opportunity to trim from U.S. small-cap equities in order to lock-in gains and increase our exposure in asset classes that are more attractively valued. Despite weaker growth outside the U.S., we remain disciplined and maintain a strategic allocation to foreign markets, especially emerging markets where valuations appear much more attractive. Foreign small-cap stocks should be additive to the portfolio return in the long-run as small-cap companies tend to enjoy higher earnings and cash-flow growth relative to large-cap companies.

Since, much of our small-cap exposure is in European small-cap companies, European accommodative policy should prove to be beneficial in the long-run as well. While our fixed income exposure remains underweight due to the current risk/return profile, we continue to purchase individual fixed income securities as bonds play a vital role in the portfolio.

We believe alternative exposure remains vital to portfolio diversification. While we maintain a position in U.S. REITs, we have taken the opportunity to trim where necessary due to our belief that the asset class has potentially reached overvalued territory after outstanding growth throughout the recovery. Additionally, we continue to hold our strategic weight in commodities despite recent lackluster performance. We believe that the long-run inflation hedge as well as diversification benefits will be well rewarded in time.

These views represent the opinion of the Security Selection Committee which are based on qualitative as well as quantitative factors. These quantitative factors are primarily driven by valuation research which then forms our subjective assessment of the relative attractiveness of asset classes and subclasses over a 3- to 5-year time horizon.

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