Many investors start with a strategy for a mix of stocks, bonds, and cash. But after a seven-year bull market in stocks, with the bond market facing the risk of rising rates, and cash offering historically low yields, market conditions pose challenges.
Viewpoints spoke with Ramin Arani, lead portfolio manager of the Fidelity® Puritan® Fund (FPURX / Get Prospectus), to get his perspective on the relative appeal of different parts of an investment mix. The Puritan Fund is a classic balanced fund, meaning it has a baseline mix of 60% stocks and the remainder in bonds and other debt securities. But Arani actively manages the fund, adjusting the levels of stocks and bonds, and adding in cash and high yield bonds based on market conditions. Arani explained why his outlook has been cautious for stocks and investment-grade bonds over the next 18 to 36 months. He preferred to put money to work in high yield while building up cash, in case things get rockier.
Q: How have you been positioning your fund in recent markets?
Arani: Last summer, I started to believe that the outlook for stocks was becoming less exciting. Markets had been on a great run, fundamentals had been good, and valuations were OK but no longer cheap.
For many years, we had central banks all around the world putting tequila in the punchbowl—adding stimulus to encourage economic activity. We had this “blessed if you do, blessed if you don’t” scenario. When things were weak, you got more stimulus, and that helped stocks, and when things were strong, you didn’t need the stimulus—the strength meant earnings growth, and that helped stocks.
We now have a little bit of a hole in the punchbowl—the U.S. Fed’s desire to raise rates is like someone draining some of the tequila out of the bowl. It is kind of a “damned if you do, damned if you don’t” scenario. If things are strong, the Fed’s going to hike more aggressively, and the tequila comes out of the punch bowl. Europe and Japan are putting a little bit in; China not so much. So, the strength of the punch is being diluted. And as that happens, you have sort of a rebalancing.
Equities and high yield were taking the brunt of that early in the year. I don’t think the dynamic will change any time soon. The Fed is really not going to reverse course unless things are weakened materially and they feel like they’ve got to step on the gas again, and pour the tequila back in.
So, the case for overweighting stocks certainly is not the fat pitch that it had been for many years.
Q: With the outlook for stocks changing, where have you been seeing more opportunity?
Arani: I think of asset allocation in terms of the right positioning among stocks, high yield, and investment-grade bonds, and cash for the next 18 to 36 months. With that perspective, it has been really hard to get excited about investment-grade bonds, because the yield on the 10-year Treasury has just been so low—recently around 1.8% or 1.9%.
So, given my concerns about stocks, the appeal of cash increased, and I have felt that high yield offered relative opportunity. When energy prices fell, the energy issuers in the high yield sector really started to take a hit. Then, late into the year, high-yield funds started to see redemptions, there was a wave of selling, and the high-yield market broadly started to get crushed. As valuations for high yield bonds fell, certain securities within the asset class began to look more appealing.
Relative value: Comparing yields on stocks, investment-grade bonds, and high yield bonds
High yield is represented by Barclays U.S. Corporate High Yield Index, investment grade is represented by Barclays Aggregate Bond Index, stocks are represented by the S&P 500® Index forward earnings yield. Forward earnings yield compares the consensus estimated earnings to price per share. Yield-to-worst measures the lowest potential yield for a bond that does not default, taking into account the possibility of prepayment, call, or other provision. Data as of 5/31/2016. Source: FMRCo.
Q: What do you expect will happen going forward?
Arani: High yield is not a screaming buy, but relative to investment-grade bonds, I think high yield still looks attractive. The big question is, will we see credit deterioration—will the companies move closer to default?
My sense is that you’ll see default rates in energy go up. But, broadly speaking, what has happened in the energy complex doesn’t have a lot of implications for the rest of the high yield space. If you’re a health care company, or a consumer discretionary player with high-yield debt, your credit quality and your default rate are not really impacted by what’s going on in the energy side of the house, but your bonds may still have sold off. So, ideally, investors could take advantage of those opportunities.
Things don’t look as good for high yield as they did back in 2008 and 2009, but at the margin, I think a combination of valuation and fundamentals favors high yield.
Q: What about the cash you mentioned?
Arani: For my fund, I think it makes sense to hold a bit more cash than usual in these markets. This is because I think stocks have to travel a choppy road over the next several months. And, at the same time, I haven’t thought investment-grade debt looks all that attractive.
Q: Are you concerned that rates will rise?
Arani: Rates are not, in my opinion, likely to move up significantly. As long as you’ve got weakness coming out of emerging markets and a strong dollar, and the concurrent association with commodities, it’s hard to argue that rates are going to go up a lot.
If rates were to go up, I believe being underweight bonds and owning a fair number of growth stocks is the right call.
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