We are decreasing our U.S. Small Cap Equity allocation after a long period of outperformance; valuation in this asset class is now stretched vs. its long-term average and U.S. Large Cap Equity.

Greetings All,
We would like to review the Sequoia Strategic Investment Outlook. The key points associated with our current outlook are as follows:

Key Points

Global Growth is Still Poised to Accelerate

  • UNITED STATES – Fundamentals are Improving
  • EUROPE – Exiting Recession
  • JAPAN – Growing for the First Time in Recent Memory
  • CHINA & EMERGING MARKETS – Stabilizing with Turbulence

Continue to overweight fairly valued equities on improving macroeconomics & relative valuation vs. fixed income and alternatives.

Equity Investments

We are decreasing our U.S. Small Cap Equity allocation after a long period of outperformance; valuation in this asset class is now stretched vs. its long-term average and U.S. Large Cap Equity.

We are increasing our International Developed Equity allocation in order to take advantage of the remaining relative valuation opportunity and benefit from developed markets (primarily Europe and Japan).

Fixed Income Investments

In order to protect our fixed income portfolio in this environment, we continue to lower portfolio duration and increase exposure to opportunistic areas such as floating rate, high yield, and convertible bonds.

We are reducing our exposure to Emerging Market fixed income due to the recent volatility in the foreign exchange currency rates of Emerging Market countries with large current account deficits.

Alternative Investments

Serve to increase portfolio diversification, reduce risk, and protect against inflation.

We are initiating a new allocation to Alternative Trading Strategies that seeks to provide reliable risk-adjusted returns that will have low correlation to the broad performance of Equity and Fixed Income.

Market Performance

The equity market’s performance in 2013 was impressive: the MSCI All Country World Index was up 23%; U.S. based indices were up even more: the S&P 500 Index finished up 32% and the broad Wilshire 5000 Total Market Index was up better than 33%. The rally in stocks last year looked past the drama in the government shutdown, the debt ceiling fiasco, the Federal Reserve Bank’s monetary policy planning, geopolitical conflict in the Middle East, Chinese market turbulence as the country transitions through historic economic reforms, and European recession, deflation, and Cyprian scares. Fixed income returns were disappointing as global and U.S. bonds in aggregate were down 2% on the year.

Year to date in 2014, we have seen trends reverse: equity markets are down worldwide, while fixed income markets have rallied. Market participants are second guessing the global economic momentum that had been building through 2013 due to the potential economic impact of brutally cold weather in the U.S., worries about an economic growth slowdown in China, and Emerging Market currency volatility. This quick reversal in market performance and fear flare-up is a great reminder of the importance and benefits of asset allocation and portfolio diversification.

Global Growth is Still Poised to Accelerate

We monitor a focused set of global leading economic indicators that cut through the economic noise and short-term anxiety in order to continually gauge our position in the business cycle. Let’s take a moment to review the economic trends in key geographic regions based on these indicators and frame our portfolio asset allocation decisions:

United States

The best leading economic indicators we follow still suggest the economy is moving in the right direction despite recent economic data that has been marred by winter weather or otherwise. We continue to believe this will be a longer-than-average business cycle expansion, considering still high unemployment, low inflation, and a Federal Reserve that continues to support the business cycle instead of suppressing it. It is extremely rare to enter a recession when we do not have direct monetary tightening: out of 19 recessions since the inception of the Fed Reserve Bank, there has been only one (1945, due to fiscal WWII demobilization) that was not associated with direct monetary tightening.

Europe

While not necessarily clear sailing due to recent choppy economic data (e.g. unemployment) and deflation fears, the region continues to emerge from its 18-month recession with help from the European Central Bank in the form of increased monetary accommodation.

Japan

The economic plan prescribed by Prime Minister Abe and the Bank of Japan – aggressive monetary stimulus, increased public infrastructure spending, and currency devaluation to make exports more attractive – should continue to be a powerful tonic for increasing the GDP rate up from 0% to 3% and combating debilitating deflation.

China & Other Emerging Markets

All major developed economies are moving in the right economic direction for the first time in a long while, and this will benefit emerging markets: developed countries buy commodities, industrial manufacturing products, and other raw materials from emerging market countries. China, the biggest emerging market by far, still appears to be free of a major financial crisis despite recent fears associated with ongoing economic reforms; however worries about a more severe economic slowdown persist.

Remain Overweight Equities vs. Fixed Income

Our asset allocation positioning remains overweight equities, which are fairly valued relative to our forward growth projections in an improving global macroeconomic scenario but still inexpensive vs. fixed income.

Equity

As our macroeconomic themes continue to improve, we continue to reposition our equity allocation based on the relative valuation opportunities in the asset class as broad valuations, measured by price-to-earnings (P/E) multiples, remain fairly valued compared to historical averages. We are reducing our U.S. Small Cap Equity allocation after a long period of outperformance; valuation in this asset class is now stretched vs. both its long-term average and the U.S. Large Cap Equity valuation.

We are increasing our International Developed Equity allocation in order to take advantage of the remaining relative valuation opportunity and benefit from developed markets growth opportunities (primarily Europe and Japan). Despite recent underperformance, we remain committed to Emerging Markets equity a valuation remain attractive.

Fixed Income

As a reminder, an improving economy, over time, leads to an increased level of employment; more jobs = more wages = more spending on goods and services = more inflation. The perceived outcome of this relationship will cause interest rates to go up, not down. In order to protect our fixed income portfolio in this environment, we continue to lower portfolio duration and increase exposure to opportunistic areas such as floating rate, high yield, and convertible bonds, while continuing to prefer tax exempt/municipal bonds over taxable core fixed income.

We are reducing our exposure to Emerging Market fixed income due to the recent volatility in the foreign exchange currency rates of emerging market countries with large current account deficits.

Alternatives

We remain committed to alternative assets such as Real Estate and Commodities that have lower correlation to equity and fixed income, increase portfolio diversification, and protect against inflation. We are initiating a new allocation to a liquid alternatives multistrategy fund that seeks to provide reliable risk-adjusted returns and low correlation to the broad performance of Equity and Fixed Income.

The portfolio changes outlined above will vary based on the individual investment objectives of your financial plan. As always we very much appreciate the trust and confidence you place in our firm. We value that trust every day and will continuously strive to retain it. Please do not hesitate to contact your advisor for any questions or service needs.

Sources: Algonquin Advisors|Barclays Capital |Bloomberg|Bureau of Labor Statistics|Capital Economics|Citigroup Global Markets|The Conference Board|Deutche Bank|JP Morgan|MKM Partners|Morgan Stanley|Ned Davis Research Group|Organisation for Economic Co-operation & Development|U.S. Census Bureau – U.S. Department of Commerce