These views represent the opinion of the Asset Allocation Committee and are informed by subjective assessment of the relative attractiveness of asset classes and subclasses over a 6- to 18-month time horizon. The approach is largely qualitative and valuation based, with attention to a broad scope of potential risks and potential return scenarios. (Third Quarter 2014)

Asset Allocation Key

ASSET ALLOCATION: Stocks vs. Bonds

We are overweight to stocks relative to bonds. Stocks are priced at levels at or above historical averages across multiple measures, with some segments of the market appearing expensive such as U.S. small-cap.

The current low-yield environment remains less favorable for bond returns. We expect central bank monetary policy to remain accommodative for some time to come, helping to support growth and reduce downside risk.

Our global growth expectations remain modest over the next several quarters. Gradual improvement in U.S. economic activity is supported by diminishing fiscal headwinds, improving private sector demand, moderate job growth and associated expectations for increased household formation. While on an improving economic trend, Europe remains hindered by high debt loads, high unemployment, and deflation worries. Slowing growth in China, Brazil, and other emerging economies weighs on global trade.

U.S. corporate balance sheets and profit margins remain healthy. Revenue growth in the low- to mid-single digits is consistent with modest economic growth. Earnings growth impacted by severe weather in the 1st quarter, with expectations to improve over the balance of the year.

EQUITIES: Favor Non-U.S. Over U.S.

We are overweight to non-U.S. equity as valuations are relatively more attractive outside the U.S. and economic growth expectations have gradually improved. Labor market reforms and tempered austerity in several European countries are showing signs of positive results. U.S. economic cycle is further advanced than many non-U.S. economies which are in earlier stages of recovery.

EQUITIES: Favor Emerging Over Developed Markets

We are overweight to emerging market (EM) equities as valuations are at attractive levels relative to developed markets. The potential for slowing EM economic growth and U.S. Federal Reserve tapering leading to higher interest rates and increased volatility remain near-term risks. However, recent currency devaluations may offer opportunities for some export-related EM companies as developed market growth picks up.

EQUITIES: Favor Global Equity Over Real Assets

We are underweight to real assets as prospects for muted global economic growth weigh on energy and materials prices. While the sell-off in commodities has presented relative value opportunities amongst sectors, the broader secular trend remains skewed to the downside. Increased global energy production capacity has improved supply. Demand for commodities is expected to remain subdued as China continues shifting its growth model away from industrial production and exports toward domestic consumption. Fundamentals for REITs are favorable, yet valuations remain rich and the sector is susceptible to shifts in interest rates.

EQUITIES: Favor Large-Cap Over Small-Cap

We are underweight to small-cap stocks as small-cap stocks in the U.S. have risen to levels that appear richly priced to us. Small-cap stocks outside the U.S. are more reasonably valued and could be beneficiaries of an increase in domestic demand as major markets, such as Europe, see improving economic growth.

EQUITIES: Favor U.S. Growth Over U.S. Value

We reduced our overweight to U.S. growth stocks. While the current low level of economic growth favors growth stocks, which tend to be less reliant on a strong economy to generate rising corporate earnings, a gradually improving economy has moderated this outlook.

EQUITIES: Favor Non-U.S. Value Over Non-U.S. Growth

Outside the U.S., we are overweight to value stocks. Value stocks outside the U.S. are supported by attractive valuations with prospects for improvement as systemic risks abate. Many non-U.S. economies are in earlier stages of economic expansion which should be supportive for value stocks as growth and earnings improve.

FIXED INCOME: Favor High Yield Over U.S. Investment Grade

We trimmed our overweight to high yield relative to investment-grade bonds. While we continue to favor the yield advantage and lower duration profile provided by the high yield sector, we are paring back our overweight as liquidity conditions are favorable at this time and price levels supported by persistent investor demand for yield.

Although the covenant terms in recent issuances have become less favorable to investors, high yield bonds remain attractive relative to other sectors in this low-yield environment, particularly given prospects for a slowly improving economy. Many high yield issuers have improved their liquidity profile by extending maturities and refinancing to lower-coupon debt. Default rates remain low, and the tendency for high yield debt to be less sensitive to changes in interest rates has appeal given that the general level of interest rates remains low from a historical perspective.

FIXED INCOME: Neutral Between Emerging Markets and U.S. Investment Grade

We initiated an overweight to emerging market bonds relative to U.S. investment-grade bonds as EM bond yields have moved to more attractive levels, which serve to compensate for near-term risks of slower economic growth and rising rates due to Federal Reserve tapering. Considerable disparity exists in the strength of various EM economies. Countries with meaningful current account deficits are most vulnerable, and lower commodity prices could pressure the fiscal accounts of net commodity-exporting countries even further.

FIXED INCOME: Favor U.S. Investment Grade Over Nondollar

We increased our underweight to nondollar bonds relative to U.S. investment-grade bonds.

The U.S. dollar is supported by prospects for improving growth and the potential for higher rates in the U.S. as the Federal Reserve’s tapering program evolves and U.S. interest rate policy normalization begins. European Central Bank (ECB) policy shift toward further easing to defend against deflation could provide catalyst for weaker Euro.