Preparing for the Second Half of 2013

We’ve officially entered the second half of the year, and after the erratic market behavior of the past few weeks clients are asking me how to position their portfolios for the back half of 2013.

I am changing some of my investment views. For instance, I am now advocating lower exposure to gold. But while I’ve been surprised by the recent sharp spike in interest rates and the weakness in emerging markets, most of what occurred in the first half generally met my expectations.

Here’s a closer look at how the first half of the year shaped up compared with my initial view, and a look ahead at the remainder of 2013.

The US Economic Landscape

First Half: As I write in my latest weekly commentary I came into 2013 with the view that, due to higher taxes and lower government spending, this was not the year that the US economy was likely to breakout. So far, 2013 has played mostly to this script, with continued equity-friendly slow growth of around 2% and low inflation.

Second Half: I expect growth to remain positive, but below trend, with some modest acceleration from 2% toward the end of the year.

Interest Rates

First Half: While I expected rates to rise this year, I wasn’t expecting the rise to be as sharp as it was in the second quarter.

Second Half: In the near term, nominal rates may continue to overshoot to the upside, but I believe the 10-year Treasury yield will ultimately finish 2013 around 2.25% to 2.5%. This is because, as I’ve mentioned before, there are a number of factors conspiring to keep long-term yields from rising too much.

Investment Calls

First Half: My broad allocation call – equities over bonds – was successful, with equities trouncing bonds year to date. But overall, my fixed income calls were generally more successful than my equity ones.

On the fixed income side, I advocated generally overweighting credit over duration. This practically translated into a preference for municipals, bank loans and floating rate notes (as well as high yield for more aggressive investors) over Treasury bonds and TIPS. So far this year, high yield, floating rate notes and municipals have all outperformed Treasuries and TIPs.

On the equity side, my calls were more mixed. I advocated a bias toward large and mega-cap stocks; a focus on a yen-hedged position in Japan; and an overweight to emerging markets. While Japan has performed well year to date, emerging markets have been a disaster and my style bet has been a bit of a wash.

Second Half: I’m generally sticking with my calls. But while I still like emerging market stocks over the long term, I’m now advocating selectively trimming some exposure, particularly to Russia and South Africa.

As I write in a new midyear outlook paper from the BlackRock Investment Institute, differences between emerging markets are growing and investors must be discerning. Russia, for instance, is likely to be hurt by less liquidity and a stronger dollar. Meanwhile, South Africa looks expensive given the country’s prospects for weak growth and ongoing political uncertainty.

Finally, with real rates rising, I now advocate lowering exposure to gold. Stay tuned for more on my outlook for the second half.

Source: Bloomberg

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