Though 2014 so far has seen a number of surprises, the year has played out mostly according to the 2014 outlook my colleagues and I laid out late last year.
First, about those surprises: The U.S. economy's weather-related first quarter slowdown was unexpected as were the geopolitical tensions dominating headlines. More importantly, we were surprised by the magnitude of the spring bond rally and the associated drop in interest rates.
Still, as we expected, stocks have outperformed bonds, and the global economic recovery remains on track. So, as Jeffrey Rosenberg, Peter Hayes and I write in the Mid-Year Update to our 2014 Outlook - The List: What to Know, What to Do, we're sticking with our early-year outlook. We continue to see stocks finishing the year with returns in the mid to high single digits, interest rates trending modestly up and the economy improving, albeit with below-trend growth.
As for what this means for investors, to navigate in this market environment, we suggest focusing on five portfolio moves.
Favor stocks with a caveat. While stocks aren't cheap, we don't believe they're in a bubble. Rather, their value is perhaps best characterized as "not unreasonable," particularly given the low inflation environment. As the economy improves, we believe stocks have room to move higher this year. In addition, they still appear more attractive than the alternatives, notably cash and bonds. But given that many areas of the market do look expensive, a selective approach is key. We would focus on those market segments that offer good value and potential downside protection, such as large- and mega-cap stocks, cyclical sectors and international equities.
Make sure you have sufficient exposure to international equities. Today, most of the stock market bargains are found overseas. So, while increasing international exposure makes sense in general, it makes even more sense these days. We would encourage investors to consider investing in international developed equities, particularly those in Europe and Japan, as well as in select emerging markets.
Choose your bonds wisely. Though bonds remain an important source of income and play a vital role in a portfolio, there are very few bargains out there, yields are likely to be volatile and some areas of the bond market are more vulnerable to rising rates than others. So, we suggest considering a flexible, go-anywhere bond portfolio that can make adjustments on the fly. At the same time, we're cautious of shorter-maturity bonds (those in the 2- to 5-year range), which could face greater upward movement in yields and resulting principal losses. We also see opportunities in municipal bonds (more on that below).
Keep munis in mind. Municipal bonds saw a significant rally in the first half of the year, but similar returns are unlikely in the second half. Still, given their tax-exempt status, and improving credit conditions among state and local issuers, munis offer some relative value. While they may not be cheap per se, they continue to look attractive versus both Treasuries and corporate bonds.
Go beyond traditional stocks and bonds. The traditional asset classes are not without their challenges today. Stocks are no longer cheap, and neither bonds nor cash offer compelling value. By incorporating non-traditional, or alternative, strategies into your investing arsenal, you can potentially enhance diversification and amplify your portfolio's growth potential. Diversification doesn't guarantee profits or prevent loss (nothing does), but it does allow you to spread your risk across a broader set of instruments that may respond differently to a given set of market conditions.
To be sure, the second half may bring surprises as well. Given today's low market volatility, an unexpected event or a further escalation of violence in Iraq would likely cause at least a temporary correction. And we're closely watching for any signs of a pickup in U.S. inflation.
Still, for the foreseeable future, we believe the five investing opportunities above are worth considering. To learn more about navigating markets for the remainder of the year, check out the Mid-Year Update to our 2014 Outlook - The List: What to Know, What to Do as well as BlackRock's other mid-year outlook pieces: the special mid-year check-in edition of Investment Directions and the BlackRock Investment Institute's mid-year investment outlook.