Where to Invest $10,000 Right Now

Six veteran investing experts share their best ideas.
Illustration: Steph Davidson
By Suzanne WoolleySuzanne Woolley

Cutting back on stocks and moving more money into cash can bring peace of mind—and also pain, if it means missing out on the marathon bull market in U.S. equities. The opportunity cost of sitting out equities in the second quarter, when the S&P 500 rose 3.8% to a new record, was significant but far from as crazy-making as missing the first quarter’s 13% jump. Still, the continued rally lends urgency to the conundrum among investors about whether to do nothing, cut exposure to equities or run for shelter.

The appeal of safe havens such as cash or fixed-income is undoubtedly strong, though the expected returns aren’t. Uncertainty tied to trade conflicts, worries about weakening economic growth and increasing tension between the U.S. and Iran are just some of the reasons to be jittery. While inflation pressure remains subdued, talk of a coming recession is getting louder. 

To get a read on what opportunities may exist today, we asked our panel of investment experts for their best ideas on where to stash a $10,000 windfall now. Two names are new to the group: Brian Singer, portfolio co-manager of the William Blair Macro Allocation Fund, and Terri Spath, chief investment officer at Sierra Mutual Funds. Suggestions range from funds focused on infrastructure and emerging market debt to gold and global telcos. Bloomberg Intelligence exchange-traded fund analyst Eric Balchunas adds his suggestions for how to use ETFs to play on the ideas presented by the panel, and looks at how last quarter’s ETF suggestions performed. 

Before making any moves to a portfolio, however, it’s smart to do a financial tune-up. Take a look at “The Seven Habits of Highly Effective Investors” to see if you’ve set yourself up for financial and investment success. 

Sarah Ketterer

Chief executive officer and fund manager, Causeway Capital Management

Look to Global Telcos

Equity markets don’t typically deliver double-digit percentage annual returns each year for 10 consecutive years. As of June 30, the U.S. and many foreign markets have achieved that feat. Super-normal returns reflect the tsunami of global monetary liquidity bidding up asset prices. 

In this long-running bull market, investors seek growth and appear indifferent to valuation. For example, the percent of IPOs of companies with negative earnings in the past year exceeds the late 1990s technology bubble highs.

Rather than chase market winners—especially those in traditionally defensive sectors such as utilities and consumer staples—investors can find cheaper havens elsewhere. The unpopular global telecommunication stocks may have the right characteristics. Revenue growth for the telco industry should accelerate in the next few years as customers consume more data at an increased pace. A wider usage of additional devices—such as smart watches and a second mobile phone for work—is also driving up data usage and subscriber growth.

In Asia, the larger countries tend to have three telco competitors controlling the bulk of market share and enjoying favorable regulation. Several of these stocks trade at extremely low valuations relative to their markets and their own history. In Europe, the telco companies have acquired spectrum in various countries, defended their market positions against telco upstarts and are consolidating operations to improve returns. 

For Europe to commercialize world-class 5G mobile telecommunications, the regulatory environment must become more supportive of the telco service providers. In all geographies, telco competitors will likely collaborate on infrastructure investments, sharing the cost of mobile phone towers. Meanwhile, many of the better-managed of these companies generate abundant surplus cash flow, and reward investors with generous dividends, which equate to yields well in excess of market averages.

Way to play it with ETFs: Balchunas’s choice is the iShares Global Communications Services ETF (IXP), which he expects will benefit from growth in telcos both domestic and international. It has direct exposure to three of Europe’s largest carriers, Deutsche Telekom, Telefonica, and Vodafone Group, as well as China Mobile and Japan’s NTT Docomo. The fund is market-cap weighted, with 34% international exposure and an expense ratio of 0.47%.

Performance of last quarter’s ETF plays: The Pacer Developed Markets International Cash Cows 100 ETF (ICOW) fell 1.3% in the second quarter. 

Look for the Tide to Turn

Cycles tend to turn when least expected. The past decade of massive global monetary accommodation has produced side effects such as asset inflation, fiscal deficits and rising levels of private and public sector debt. The excess liquidity effect in public equity markets has encouraged investors to care less about valuation—and more about growth.

Yet, as the pace of liquidity expansions slows, valuation will matter. Over the past decade to March 31, the U.S. market has returned almost 16 percent annually on average, a generous result for a developed-markets index. And it’s generous, indeed, given the shrinking risk, measured by near-record-low volatility.

Value stocks have underperformed growth for much of this post-2008 period, resulting in historically wide gaps between value indexes and growth indexes. From the year 2000, cheap stocks in the MSCI All Country World Index have outperformed expensive stocks by more than 40 percent over the next 12 months when the earnings yield spread (earnings yield of cheap stocks minus earnings yield of expensive stocks) has been in the top decile. At the end of March the earnings yield spread was in the 92nd percentile. At some point, extreme levels of depressed valuations will inspire buyers to snap up bargains.

The most undervalued stocks in many markets globally discount recession and structural disruption. Banks, maligned in a period of falling interest rates, trade at near-crisis levels, especially European ones. Global auto stocks trade at meager valuations versus history and compared with other cyclical segments of the markets, such as capital goods. Energy stocks are also trading at historically depressed levels. 

For many growth stocks, earnings and cash flow are promised far into the future, which makes them the most sensitive to interest-rate fluctuations. As rates rise, these types of stocks typically swoon. In contrast, companies that generate surplus cash flow today, and return much of that to shareholders, offer immediate returns. With liquidity ebbing, a bird in the hand will (once again) be worth two in the bush.

Way to play it with ETFs: Balchunas points to Pacer Developed Markets International Cash Cows 100 ETF (ICOW). The ETF offers international equity exposure to 100 securities with high free-cash-flow yields. ICOW has an expense ratio of 0.65 percent.

Performance of last quarter’s ETF plays: The iShares MSCI Europe Financials ETF (EUFN), Balchunas’s pick to play on Ketterer’s theme of buying battered European bank stocks, rose 7.1 percent.

There’s a Price for Everything

By the close of 2018, global equity markets had punished—more like pulverized—stocks with economically cyclical earnings and typically rewarded those in the most defensive industries. The defensive havens included stocks in such industries as utilities, household and personal products, food and staples and retailing. In contrast, banks and insurance stocks, especially those in Europe, fell in price so sharply that their valuations have reached levels consistent with a severe recession and a financial system crisis.

That’s a value investor’s dream: to buy stocks whose valuations already discount an unlikely scenario, and then wait for the inevitable recovery. Even better, the most battered of European bank stocks pay investors to be patient via generous dividends.

Early this month, the MSCI Europe Banks Net Total Return USD Index traded at a multiple of eight times 2019 earnings and 0.7 times book value, and had a dividend yield of almost 6 percent. But these are not the same banks as during Europe’s last banking crisis. These companies have strengthened their capital positions to have four times as much capital as a decade ago. U.K. banks have enough capital, according to their regulator, to withstand an economic collapse, a huge rise in U.K. unemployment, a 33 percent drop in residential property prices and a 27 percent devaluation of the pound sterling. That’s akin to multiple shocks, and even after that nightmare, the banks would have twice the required capital.

Admittedly, banks are leveraged into economic conditions, good or bad. Adept bank managers (and there are plenty of these in Europe) know how to use their two primary levers to improve shareholder returns: cost control and capital management. With disciplined lending, ultra-cost efficiency and savvy technology spending, these well-capitalized banks should have a rosy future. At these bargain valuations, misery is already priced in.

Way to play it with ETFs: The closest thing to a play on European banks is the iShares MSCI Europe Financials ETF (EUFN), which is made up of 60 percent banks. The ETF has a fairly reasonable expense ratio of 0.48 percent. Since the ETF is market cap-weighted, big players such as HSBC Holdings and Banco Santander make up a big chunk of holdings.

Performance of last quarter’s ETF plays: The First Trust Morningstar Dividend Leaders Index Fund (FDL) fell 9 percent in 2018’s final quarter.

Cash Today Beats Cash Tomorrow

High-dividend-yielding, undervalued stocks may finally reign over growth stocks. In this global environment of gradually tighter monetary policy, the cash that a company returns to its shareholders in the next few years may be much more valuable than a potentially unfulfilled promise of rapid growth in profits many years ahead.

The massive growth in liquidity created by global central banks after the financial crisis has stalled in 2018, and will likely shrink in 2019. Meanwhile, valuation spreads between expensive and cheap stocks, measured by relative price-to-earnings ratios, are at extremely wide levels vs. history. In the past 20 years, these especially wide valuation spreads typically led to a narrowing of the gap and subsequent outperformance of cheap stocks.

The global consumer staples sector contains some of the cheapest, highest-dividend-yielding stocks. Many of these companies generate mountains of near-term cash flow. Within staples, the most maligned and possibly misunderstood segment is tobacco. Both U.S. and European-listed large-cap tobacco stocks trade at sizable discounts to their history. The discount may stem from investor concerns about the FDA’s tobacco regulation, shrinking U.S. cigarette volumes, a surge in demand for alternative products such as e-cigarettes and weakness in emerging market economies and currencies.

Much of this may be transitory, leaving investors with well-managed consumer marketing giants able to transition to a growing e-cigarette category. Heavily-taxed (and clearly very unhealthy) combustible cigarettes will likely disappear in the years ahead, replaced by less harmful forms of nicotine delivery. The more that global regulators focus their efforts on vapor, the better for these large incumbent tobacco companies, which are better able to absorb the costs of regulation than new entrants. Even in the shift to noncombustible products, global tobacco giants have the financial strength and prolific free cash flow generation to reward shareholders today and invest for tomorrow.

Way to play it with ETFs: Balchunas suggests the First Trust Morningstar Dividend Leaders Index Fund (FDL) which screens for stocks that have shown dividend consistency and then picks the 100 highest-yielding names. It’s heavy in consumer staples stocks, with big tobacco companies among top holdings. The $1.4 billion ETF charges 0.45 percent.

Performance of last quarter's ETF plays: Balchunas pointed to the SPDR Oil & Gas Equipment & Services ETF (XES) as a way to play Ketterer’s suggestion of oilfield services companies. The ETF rose about 1.5 percent in the third quarter.

Check Out Oilfield Services Companies

Despite the recovery over the past year in crude oil prices, some energy-related equities can’t seem to shake investor skepticism.

One of the most undervalued areas of the U.S. unconventional oil and gas industry is oilfield services. Of the onshore oilfield service stocks, the pressure pumpers have sagged significantly in price.

Pressure pumping is closely tied to drilling rig activity and is used in development of oil fields. After the well is drilled, pumpers mix water, sand and chemicals, then blast it into the reservoir rock so that the hydrocarbons will flow. Aided by technological improvements, producers have exceeded even their own expectations.

In the Permian Basin of western Texas, producers have extracted oil faster than the pipeline infrastructure can transport it to Gulf refineries and port terminals. The Permian Basin, notable for its enormous supply of crude oil and gas, has no near-term answer to these serious transportation bottlenecks. However, the problem should disappear in 2019 with the addition of pipeline capacity.

Investors, apparently unwilling to wait, have cast aside oil services stocks, especially those with sizable exposure to the Permian Basin. But pipeline squeezes don’t last long in the shale era; they incentivize midstream companies to accelerate new pipelines or expand existing capacity to fill the gap.

Meanwhile, oil prices seem well supported. New crude oil discoveries since 2013 probably can’t offset the drag from aging oilfield production declines, falling reserves and insufficient replacement of produced volumes. Supply constraints in countries such as Venezuela, Iran, Libya, Nigeria and Mexico may get worse.

As a recent affirmation of U.S. shale’s promising future, energy majors are making sizable acquisitions of U.S. onshore oil and gas assets. Producers will need oil services companies—even the beleaguered pumpers—to develop these newly acquired fields.

Way to play it with ETFs: To play the oil services industry, investors could use the SPDR Oil & Gas Equipment & Services ETF (XES), an equal-weighted basket of large, mid- and small-cap oil services companies; its expense ratio is 0.35 percent.

Performance of last quarter’s ETF plays: The iShares Global Telecom ETF (IXP), which Balchunas chose as one way to play on Ketterer’s investing themes in the second quarter, dropped 5.7 percent in value over the quarter.

Go for Defensive Value

There’s a lot to be said for investment income, especially delivered via companies that are fully capable of sustaining that income for many years ahead. In sagging stock markets, some portion of an investor’s portfolio needs to produce returns now, not later. With plenty of dividend income, the wait for a market recovery shouldn’t seem quite so painful. Peer inside the global telecommunications sector and you will find many generous dividend payers also boasting financial strength far in excess of overall market averages.

These telecom stocks, unloved for their lack of recent growth and bland forecasts, have lost the interest of bull market investors. Mention Tencent or Alibaba and people will listen intently; refer to China Mobile or SK Telecom for yawns of boredom. Yet telecom behemoths offering mobile and fixed broadband services should grab our attention as ideal ballast for the inevitable bear markets. We need the services they offer—and will need them even more when fifth-generation wireless systems (5G) become commercially available.

The MSCI All Country World Telecommunications Services Index is made up of 81 constituents in developed and emerging-markets countries. By one valuation measure, enterprise value-to-Ebitda, it trades at a discount of more than 40 percent, compared with the aggregate equity market benchmark, the MSCI All Country World Index. (Enterprise value includes debt and cash when calculating company value, rather than just multiplying a company’s shares outstanding by its share price to arrive at market capitalization; Ebitda, a cash flow measure, refers to earnings before interest, taxes, depreciation and amortization.) The index also has a dividend yield almost 50 percent higher than the benchmark.

If sustainability of dividend yield makes you sleep better at night, focus on the companies with very low (or zero) net debt, defined as a company’s long-term debt less cash. In capital-intensive industries such as telecommunications, larger company size brings scale economies and cost advantages. Competitive, mature telecom markets typically cannot support more than three players, or returns on capital will decline for all participants. China, Japan and South Korea are three of the most attractive mature telecom markets globally.

Three-player telecom markets, in which competitors typically don’t engage in devastating price wars, often have stable participants generating reliable streams of cash. Companies rewarding shareholders by returning capital, through dividends and share repurchases, are less likely than growth-oriented peers to squander shareholder capital through overpriced acquisitions. Many telecom companies have learned that stability is one of their most attractive characteristics.

Way to play it with ETFs:  There is no ETF tracking the MSCI All Country World Telecommunication Services Index, but Bloomberg Intelligence analyst Eric Balchunas says there is something very close: The iShares Global Telecom ETF (IXP) tracks 43 telecom stocks from about a dozen countries. It is notable for its high dividend yield of 3.5 percent, says Balchunas—and for its above-average fee (for a sector ETF) of 0.47 percent.

Performance of last quarter’s ETF plays: Balchunas chose the Vanguard Utilities ETF (VPU) and the Global X Lithium & Battery Tech ETF (LIT) as ways to play Ketterer’s suggestion that investors consider global utility stocks. In 2018’s first quarter, VPU fell 4.1 percent and LIT tumbled 15.3 percent. LIT fell as analysts turned bearish on lithium, fearing a supply glut, as well as possibly less demand for electric vehicles in 2019.

Think Smart Power

Utility stocks around the world have generally trailed their respective equity market performance over the past year. In the U.S., rising interest rates will push up utility borrowing costs, and corporate tax reform won’t boost earnings if the tax benefit must be passed on to customers. But just look a few years ahead, and the prospects for electric utilities may be considerably brighter than they are today.

The global conversion of internal combustion engine vehicles to electric vehicles (EVs, including plug-in hybrids) will boost the demand for electricity delivered efficiently to public charge points and homes. If large concentrations of EVs were to charge in the same hour, demand could spike to several times the norm, overloading the grid, causing overheating and blackouts. To avoid this, many electric utilities, especially in countries determined to reduce carbon emissions, will need to increase power utility investments substantially.

With new capacity, utilities may find it more efficient and cost-effective to provide power to large industrial customers, possibly operators of autonomous vehicle fleets, where recharging can be centralized rather than scattered across countless garages and parking spots. Electric utility regulators should allow the utilities to earn a healthy return on grid upgrades, new connections (such as new power lines to electrify parking bays), smart architecture, digitization and new peaking capacity. According to Goldman Sachs, these will be big global investments: $2.6 trillion for charging infrastructure to support full passenger vehicle electrification, plus another $3 trillion spent by the utilities for transformers, new lines and smart infrastructure.

Without a proper reconfiguration of a country’s electricity distribution grid, as well as security of electricity supply, the EV rollout simply cannot happen. This effort to build infrastructure for a massive global conversion to EVs should benefit electric utilities able to distribute low-cost power incorporating renewables such as solar and wind.

Way to play it with ETFs: For a cheap and deep utilities ETF, the Vanguard Utilities ETF (VPU) tracks 77 utility stocks for a fee of 0.10 percent. A more out-of-the-box but related play on the move to electric vehicles is the Global X Lithium & Battery Tech ETF (LIT). It tracks lithium miners and battery producers and has a fee of 0.76 percent.

Performance of last quarter’s ETF plays: Last quarter, the ETF that was the closest fit for Ketterer’s theme of investing in China’s health care demand was the Global X China Consumer ETF (CHIQ), which had about 8 percent of assets in the sector. In 2017’s final quarter, it gained 8.7 percent.

Invest in China’s Health Care Demand

Shifting from an emerging to a developed country, China can’t escape its demographics. As a byproduct of the one-child policy, China’s enormous population increased at only 0.6 percent per year from 1996 to 2015. That compares with the U.S. population’s expansion of 0.9 percent a year over the same period.

Low growth implies an aging population, and aging has its societal costs. Many Americans are struggling to pay for health care, and the Chinese are facing an even bigger tab. By 2050, roughly a quarter of China’s citizens will be older than age 60. With less than 6 percent of gross domestic product spent on health care (vs. 9 percent to 12 percent in most developed countries), the Chinese will likely devote more of their resources to staying healthy.

With rising disposable income per capita, China’s demand for health care, especially top-tier hospital services, exceeds supply. The central government recognizes the problems and aims to relieve congestion at the most reputable public hospitals by welcoming private capital into the industry. This flow of funds should improve conditions and spawn many higher-quality private hospitals. Other reforms include the elimination of unneeded middlemen in drug distribution, as well as prohibiting the markup of drug and medical devices.

Hospitals had become heavily dependent on drug sales to keep the lights on. To supplement their measly salaries, doctors accepted prescription-related bribes from pharmaceutical manufacturers. After a successful pilot program, zero markup of drugs became reality for most hospitals across the country this year. To speed up the approval process for efficacious drugs, the China Food and Drug Administration quadrupled its staff in 2015-16 and is on track to increase staff by 50 percent this year.

China’s health-care industry reforms, combined with the inevitable consolidation or demise of smaller or weaker players, will likely result in much greater efficiency and profitability in such areas as hospital management, drug and medical equipment distribution, private supplemental health insurance, and new-drug discovery and launch.

To complement reforms, the Middle Kingdom boasts a rising supply of young scientific talent, who are paid about a third as much as their peers in the developed world. Add to the mix a 15 percent corporate tax rate plus government subsidies to spur innovation, and the investment landscape looks very promising for Chinese health-care companies. (The standard Chinese corporate income tax rate is 25 percent, but the rate could be reduced to 15 percent for qualified enterprises engaged in industries encouraged by the Chinese government. Indigenous Chinese health-care companies are included in that category.)

Way to play it with ETFs: There are many China ETFs but none specific to the health-care sector, and most broad China ETFs have next to nothing in health-care exposure. The ETF with the most exposure to health care is the Global X China Consumer ETF (CHIQ), which has about 8.7 percent of its assets in the sector.

Performance of last quarter’s ETF plays: The Energy Select Sector SPDR Fund (XLE) rose 5.6 percent in the quarter ended Sept. 30. Top holdings Chevron Corp., Schlumberger Ltd., and Exxon Mobil Corp. rose 12.6 percent, 6 percent, and 1.6 percent, respectively. 

Fuel Up on Energy

Buy high-quality energy. Investor skepticism weighs heavily on the sector, making this one of the more promising areas in this mature bull market.

Oil and gas companies exhibit cyclicality in sales and earnings, traits that investors have shunned in recent years in favor of steady growth. Relative to high-flying technology stocks, the recent performance of energy equities looks abysmal. Over the past 12 months, global energy indexes have underperformed global technology by more than 30 percent and are trading at a sizable valuation discount.

The forces of supply and demand dictate the price of semiconductors as well as oil, with the lowest marginal cost producers having a distinct advantage over the competition. Advertising, including the internet, also has a cycle. The last time markets ignored the cyclicality of technology was in the late 1990s, a rough period for the most overvalued stocks.

Investors may be worried about a global glut of crude oil, especially from rising U.S. shale oil production. U.S. shale productivity continues to surprise on the upside, especially in the Permian Basin. As marginal costs have fallen from 2014, oil producers have increased wells and drilling volumes. The threat of a possible lack of OPEC production discipline also clouds the oil price outlook.

But exploration and production costs have recently turned upward in pressure pumping, sand, rail, trucking and labor. Oil-producing nations, including OPEC members as well as U.S. shale producers, cannot afford to spend more cash than they generate. As industry profits get squeezed, oil and gas companies’ credit ratings deteriorate, constricting lending to energy. At current spot prices, the world’s oil and gas industry doesn’t generate enough cash flow to sustain the spending required to expand capacity. In U.S. shale, production volumes per well decline particularly rapidly without additional investment.

On the demand side, the energy industry will not thrive in a recession. But technology doesn’t fare well in that scenario, either. Expect at least two more decades of rising demand for crude oil and gas, as electric vehicles will only gradually substitute for gasoline.

Look for companies with productive acreage and experienced management, financial strength, and cyclically low valuations. As the crude oil price recovers—perhaps approaching $60 per barrel, with natural gas reaching $3.25 per thousand cubic feet—energy sector share prices should prove rewarding.

Way to play it with ETFs:The Energy Select Sector SPDR Fund (XLE) is high-quality energy. Top holdings Exxon Mobil Corp., Chevron Corp., and Schlumberger Ltd. make up more than 40 percent of the portfolio. There’s a liquid market for the ETF, and it's cheap, with a fee of 0.14 percent.

Performance of last quarter’s ETF plays: The SPDR S&P International Health Care Sector ETF (IRY) was Balchunas’s pick as a way to play Ketterer’s focus on big pharma companies selling at a discount. It returned 7.9 percent from Mar. 31 to June 30. 

Buy the Pharma Discount

Why do several of the large global pharmaceutical stocks trade at above-market dividend yields and below-market price/earnings ratios? Perhaps the repeated threats by President Trump to cut drug prices have scared investors.

The president will likely claim victory for something that is already happening. The large buyers of U.S. pharmaceuticals, such as pharmacy benefit managers and health insurers, continue to exert tremendous pressure on drug companies to discount prices. This is evident in 2016 data from Express Scripts that show year-on-year price percentage shrinkage in traditional pharmaceuticals and a slowing, mid-single-digit percentage increase for specialty drugs.

Importantly, utilization growth rates are greater than unit cost rises, indicating product efficacy. If the drugs weren't effective, doctors wouldn't prescribe them. Assuming buyers will pay for efficacious drugs, then the prognosis for the more innovative pharmaceutical companies is good.

Notably, several of the European drug giants with promising pipelines trade at valuation discounts to the health-care sector and to their own historical averages. Examples include Novartis AG, AstraZeneca Plc, Roche Holding AG and GlaxoSmithKline Plc. These well-managed, shareholder-friendly companies generate plenty of surplus cash to reward investors. Many of them have dividend yields at least a full percentage point in excess of the global pharmaceutical and biotech industry and well above overall equity market averages.

Famously profitable, the best-managed pharmaceutical companies should be able to offset reduced unit prices with volume growth. In their report dated January 2017, Evercore ISI analysts Umer Raffat and Akash Tewari note that most of Medicare/Medicaid spending increases are due to higher enrollment, not because of pharmaceutical costs. While total U.S. health-care spending continues to increase, the percentage attributable to prescription drugs has stayed flat, at around 10 percent.

Proposed drug pricing reforms, such as bidding, reimportation, Medicare negotiating prices and value-based pricing either already exist or have serious, likely insurmountable flaws, such as public safety. Even Medicare, the colossus of U.S. pharmaceutical buyers, probably can't negotiate prices more favorable than under current law without being forced to restrict access, as drug demand may rise. Aging demographics imply increased drug usage over at least the next decade. The most innovative pharmaceutical companies will likely benefit, even as traditional branded drug prices fade.

Ways to play it with ETFs: The  SPDR S&P International Health Care Sector ETF (IRY) has the most exposure of any ETF to international pharma companies such as Novartis AG and AstraZeneca Plc. Those companies are in the top 10 holdings. The ETF has 75 percent allocated to pharma companies, 25 percent of which are based in Switzerland. IRY comes with a fee of 0.40 percent.

Performance of last quarter’s ETF plays: The  iShares MSCI India ETF (INDA) rose 16.9 percent over the past three months. Balchunas's other pick, the  PureFunds ISE Mobile Payments ETF (IPAY), gained 10 percent.

Think Long, Think Far

India is far. Flying from Los Angeles to Mumbai via Hong Kong takes about 24 hours, several meals, and almost 10,000 miles. Despite the distance, Causeway has this populous country on our investment radar. India’s demographic bulge of young consumers want to buy smartphones, cars, and homes, and their spending power rises annually.

India’s 2016 real gross domestic product growth of 7.3 percent tops the charts, beating all major countries including China. The recent demonetization to encourage a shift from cash to a digital (taxable) economy should ultimately fuel growth. Rising tax revenues facilitate fiscal spending on roads, bridges, highways, hospitals, etc., thereby boosting commerce. India’s stock market, which is severely lagging most global markets this year, has become a source of investment ideas for our clients.

Imagine a country with 90 percent of all transactions in cash. Of the roughly $240 billion of currency in circulation, the government has recently made 86 percent of that currency illegal. Exchange your soon-to-be-obsolete bank notes or they become worthless. A shortage of legal tender has placed severe working-capital constraints on businesses and harmed roughly half the population without a bank account.

Poorly implemented, the demonetization has dragged on the country’s economy as the banking system could not meet the demands of cash distribution. Longer term, the formal, taxable economy should prosper, and the central and state governments can proceed with much-needed infrastructure projects. The payment and growth inefficiencies of a cash economy should lessen.

We expect the population to open hundreds of millions of new bank accounts, resulting in a lower overall cost of funding for the country’s banking system. Prime Minister Modi's demonetization offers India an opportunity to leapfrog several banking stages, avoiding checks and bank cards and moving directly to digital payments. We believe non-cash transactions should grow 50 percent annually through to 2025 and account for 40 percent of payment transactions. Banks that already have scale in credit and debit cards, point of sale, and mobile banking should see a substantial pickup in market share.

Way to play it with ETFs: The iShares MSCI India ETF (INDA)  is the fastest growing and cheapest of the India ETFs, with an expense ratio of 0.68 percent. There is an ETF that specifically tracks the move to mobile payments, called the PureFunds ISE Mobile Payments ETF (IPAY) , but it holds 80 percent of assets in U.S. companies, with just a dash of international exposure. It's also a little expensive, with a fee of 0.75 percent, and doesn’t trade a lot, so potential buyers should use a limit order that specifies the price they want to pay.

Performance of last quarter’s ETF plays: The ETF Balchunas chose to track Ketterer's advice back in October was First Trust NASDAQ Technology Dividend Index Fund (TDIV) . It rose 3.6 percent for the three months ended Dec 31.

Invest in Corporate ‘Self-Help’

In this seemingly endless environment of economic stagnation, what will drive revenue and profit growth? Central banks may be running out of monetary solutions to stimulate credit and demand. While we wait for the political landscape to become less muddled, investors can get access to companies engaged in operational restructuring or “self-help.”

These companies, boasting strong balance sheets and modest levels of debt, typically have managements committed to a continuous and inexorable process of cost cutting and increased efficiency. In mobile telephony, especially in Japan, China, and South Korea, several of the largest listed companies have found increasingly ingenious ways to extract above-industry-average returns from the mature telecommunications market. [China Mobile Ltd. and SK Telecom Co. Ltd. were in the top 15 holdings of the Causeway International Value Fund (CIVIX), as of June 30.] Smart self-help moves by senior managements of these companies have led to a reduction in capital expenditures and operating costs.

These companies are typically creating innovative and value-added services, introducing popular data plans and benefiting from supportive local regulations. Similarly, in the more mature segment of technology, “legacy tech” companies also have managements committed to reinvigorating growth. Even though these companies have valuable proprietary technology, sell-side analysts put some of them in the dinosaur category. But the analysts often take a short-term view. Market pessimism can give investors a chance to buy world-class technology franchises in transition.

For example, large enterprise software companies must make a successful transition from an on-premises licensing business model to a cloud-computing subscription-based model. Semiconductor companies currently expert in mobile wireless technology are making measurable progress to deliver next-generation technology. Look for efficient operations, focused and shareholder-friendly managements, as well as inherent advantages in research and development expertise and resulting defendable intellectual property. [SAP and Samsung Electronics are CIVIX holdings.]

Economic malaise aside, these great companies, albeit often labeled mature and in transition, still trade at valuations that imply the potential for above-market returns.

Way to play it with ETFs: The First Trust NASDAQ Technology Dividend Index Fund (TDIV)  holds tech companies that pay the highest dividend, which means it has the largest percentage of “legacy tech” names such as Intel Corp., Microsoft Corp., Cisco Systems Inc., and Oracle Corp. This “I love the 90s” portfolio has the lowest volatility, lowest average price-to-earnings ratio, and highest dividend yield of the technology ETFs.

Performance of last quarter’s ETF plays: The ETF Balchunas chose to track Ketterer's advice back in June was The WisdomTree Japan Hedged Equity Fund (DXJ) . It rose 11 percent for the three months ended Sept. 30.

Play Japan

Something interesting is happening in the Land of the Rising Sun. The Japanese equity market has slipped 20 percent from its five-year high, reached last August, reflecting an economy unresponsive to monetary stimulus. Despite this gloom, many Japanese companies have the financial wherewithal to reward shareholders with dividends.

As of late May, over 200 Japanese stocks with market caps above $1 billion also have dividend yields greater than 2 percent (several offer yields of 4 percent), with dividend payout ratios less than 50 percent. In other words, these dividends should be well covered by earnings, and (thanks to the low payout ratios) have room to grow.

Some of the best-managed companies with generous dividends include Sumitomo Mitsui Financial Group Inc. (4 percent yield), Japan Airlines Co. (3 percent), Komatsu Ltd. (3 percent), KDDI Corp., and Hitachi Ltd. (both 2.5 percent). Bonds can’t compete. The 10-year Japanese government bond yield is negative, making generous dividends all the more appealing.

In the U.S., investor demand for high-dividend-yielding stocks, and exchange-traded funds that track such stocks, has risen sharply in our own prolonged low-interest-rate environment. Perhaps the same will happen in Japan. Mrs. Watanabe, the proverbial Japanese retail investor, wants income. It may make sense to own some of these income-generating, better-quality Japanese stocks before she does.

Ways to play it with ETFs: The WisdomTree Japan Hedged Equity Fund (DXJ)  goes long the stocks mentioned by Ketterer, and many more, said Balchunas. It also shorts—bets against—the yen, and weights stocks by the size of their dividend. It yields 3 percent.

Russ Koesterich

Portfolio manager, BlackRock Global Allocation Fund

The Case for European Equities

With the S&P 500 up almost 20% year-to-date, investors can be forgiven for staying close to home. That said, the case for international diversification remains sound, in part because other markets are also producing stellar returns. China is up almost 30% year-to-date. To many investors’ surprise, another bright spot is Europe. While not quite keeping pace with the U.S., European equities are up 15% in 2019. For investors under-invested in non-U.S. stocks, Europe is worth another look.

While there are challenges, including structurally lower growth, there are several factors favoring European equities: valuation, dividends, low growth expectations, the composition of the index and finally, the European Central Bank (ECB).

Starting with valuations, European equities trade at 13 to 14 times next year’s earnings, which is cheap relative to the almost 18 times next year’s earnings for the S&P 500. Europe also scores much better on dividend income. Dividend yields are approximately 3.5% for the continent and 4.5% for the U.K., almost double the 1.8% on the S&P 500.

While Europe is struggling to grow, this appears well-discounted in the market. The Citi European Economic Surprise Index is close to flat. In contrast, the U.S. economic surprise index is near a two-year low. To be clear, this doesn’t mean that the U.S. will grow slower. But relative to expectations, European growth is coming in better than in the U.S.

Even if European growth is soft, European equity indices are more exposed to global, rather than local, growth. Most of the big names in the index are global champions, such as SAP in technology or Royal Dutch or BP in energy. The fortunes of these companies are more tied to global conditions.

Finally, there is the ECB. The ECB is likely to extend its stimulus—and potentially its asset-buying program—later this year. As my colleague Rick Rieder has suggested, this may even involve the eventual purchase of equities, as the Bank of Japan has been doing for years.

The bottom line: Europe has its challenges, but also some fairly consequential tailwinds.

Way to play it with ETFs: Balchunas likes the iShares Core MSCI Europe ETF (IEUR) as a way to play Koesterich’s themes. The market-cap weighted fund offers healthy exposure to the global equity sway that could help growth, and would benefit from European Central Bank stimulus. The fund has a good market-cap range, with 7% mid-caps and 3% small caps, and a 0.09% expense ratio.

Performance of last quarter’s ETF plays: The iShares Core MSCI Emerging Markets ETF (IEMG) fell 0.5% in the second quarter.

Surf the Emerging-Market Wave

With stocks up about 16 percent year-to-date, and more than 20 percent from the December 2018 low, investors could be forgiven for believing there are no bargains left.

In the U.S., for example, multiple expansion—i.e., what an investor is willing to pay for a dollar of earnings—has left large-cap U.S. equities about 15 percent more expensive than they were at the end of 2018. That said, many market segments outside the U.S. still look cheap. More specifically, emerging-market (EM) equities are not only cheap but are also likely to benefit from the current economic environment.

At the end of March, the MSCI Emerging Market Index was still trading at less than 13 times trailing earnings, a discount to the post-crisis average since 2010. Relative to developed markets, EM equities are trading at a 26 percent discount.

While EM looks inexpensive, the stocks can struggle even with modest valuations, as investors were reminded last year. Often the challenge is U.S. monetary policy. Emerging-market stocks were some of the worst performers last year as the Federal Reserve hiked rates and the U.S. dollar rose. In contrast, the current environment looks much more supportive. The Fed is on hold, real interest rates are stable and, most important, the dollar appears contained, with the U.S. Dollar Index (DXY) stuck in a range for the past six months.

To the extent that the Fed remains on hold, while the European Central Bank and the People’s Bank of China are attempting to stimulate their respective economies, this creates an ideal regime for emerging-market assets. After one of the sharpest rallies in recent memory, EM equities still offer further upside. Among the countries where we see particularly good opportunities, I would highlight China, specifically in internet commerce and other consumer-oriented companies.

Way to play it with ETFs: The iShares Core MSCI Emerging Markets ETF (IEMG) is Balchunas’s pick to get broad, market-cap weighted emerging market exposure. Its highest country allocations are China, South Korea, Taiwan, India and Brazil. It has an expense ratio of 0.14 percent.

Performance of last quarter’s ETF plays: Balchunas’s ETF choices to play the oil patch, Energy Select Sector SPDR Fund (XLE) and the Invesco S&P 500 Equal Weight Energy ETF (RYE), rose 16.2 percent and 18 percent, respectively, in 2019’s first quarter.

Head for the Oil Patch

Of the casualties in the 2018’s fourth-quarter carnage, energy stocks were some of the worst hit. Even after the recent rebound, the three-month rolling return for the U.S. energy sector as of Jan. 10 was -16 percent (excluding dividends), while the S&P 500 price return was -6 percent. The rout has left many of these stocks looking cheap, particularly considering the recent stabilization in crude oil prices.

As of the end of December, the S&P 500 energy sector was trading at a multiple of roughly 1.55 to book value (P/B). That’s the lowest since early 2016 and about on par with the trough valuation during the financial crisis. Valuations look even cheaper relative to the broader market. The current P/B represents nearly a 50 percent discount, the largest since at least 1995.

The sector also appears inexpensive compared with the price of oil. As you’d expect, the sector’s relative valuation tends to move (roughly) in tandem with crude prices. When oil prices are lower, the sector trades at a lower valuation compared with the market. Based on oil prices at $48 per barrel, history would suggest a 20 percent discount to the market, not a 50 percent one.

In addition to value, there are two other reasons to consider raising the allocation to energy shares. Historically, energy stocks have been more resilient than the broader market during periods of rising interest rates and/or inflation. If part of what has dislocated the market is the challenge of navigating higher interest rates, energy companies offer a reasonable hedge. Finally, large integrated energy companies are offering dividend yields north of 4 percent. In a yield-starved world, this looks attractive.

Way to play it with ETFs: The Energy Select Sector SPDR Fund (XLE) is most people’s go-to way to play energy stocks in the short-term, according to Balchunas. It has good liquidity and a low fee of 0.13 percent. However, the ETF is market cap-weighted, so Exxon Mobil and Chevron make up 40 percent of the portfolio. For those who want a more diversified play there’s the equal-weighted Invesco S&P 500 Equal Weight Energy ETF (RYE). It has a fee of 0.40 percent.

Performance of last quarter’s ETF plays: The ETFs that Bloomberg Intelligence ETF analyst Eric Balchunas highlighted as possible ways to play Koesterich’s theme of scooping up bargains in Asia—the iShares MSCI Japan ETF (EWJ), Franklin FTSE Japan ETF (FLJP) and JPMorgan BetaBuilders Japan ETF (BBJP)—all fell about 15 percent for the quarter. 

Asia on Sale

As many markets started the year at already-full valuations, investors could be forgiven for thinking that there are few bargains left. Interestingly, many Asian equities appear really cheap.

For example, as of the end of September, Japanese equities remain the cheapest in the developed world. The Topix Index (TPX) is trading at 1.3 times price-to-book (P/B), less than half the level of the S&P 500. The current discount is close to the widest since 2012, a period that preceded a three-year, 150 percent rally.

The Asia discount applies to a number of emerging markets as well. South Korean equities remain not only the cheapest in this category, but looking across equities, sovereign debt and credit, they are by some measures the cheapest asset class. The current valuation represents a 35 percent discount to the rest of the emerging markets, the largest discount since the Asian financial crisis.

Historically, many of these markets, especially Korea, have traded at a discount. The same is true for Japan, but while the discount may have been justified in the past, much has changed in recent years. Japan has witnessed a significant improvement in both corporate governance and profitability. The return on equity for Japan’s Topix index now stands at around 10 percent, close to a multi-decade high. When you factor in Japanese monetary conditions that are still ultra-accommodative, the low equity valuations seem even harder to justify.

Rather than resting on fundamentals, today’s Asia discount can arguably be attributed to three trends: stellar U.S. earnings growth, a stronger dollar as a headwind for emerging markets stocks, and rising trade frictions.

While trade and the U.S. dollar remain real issues, these concerns already appear reflected in equity prices. As a result, Japan and much of Asia appear to be that increasingly rare find: a bargain.

Way to play it with ETFs: The iShares MSCI Japan ETF (EWJ) is far and away the largest Japan ETF, at $17.4 billion in assets, said Bloomberg Intelligence ETF analyst Balchunas. It has a fee of 0.49 percent. For cheaper ETFs that basically track the same stocks he likes the Franklin FTSE Japan ETF (FLJP), which charges 0.09 percent, and the JPMorgan BetaBuilders Japan ETF (BBJP), which charges 0.19 percent.

Performance of last quarter’s ETF plays: Balchunas highlighted the SPDR S&P Emerging Asia Pacific ETF (GMF). It fell 2.4 percent in the third quarter.

Seek Value in Emerging Markets

Following a stellar 2017, emerging-market equities are once again on the back foot. Despite bouncing in recent weeks, so far this year the MSCI Emerging Market Index is trailing the MSCI World Index of developed countries by about 8 percentage points. The selling has left many of these markets cheap at a time when economic prospects are improving and the dollar is stabilizing.

The MSCI Emerging Market Index is trading at 13.5 times trailing earnings and 11.3 times forward earnings. The former represents a 26 percent discount to developed markets. Based on price-to-book (P/B), emerging-market stocks look even cheaper. Currently, the stocks are trading at a 30 percent discount, the largest since the summer of 2016.

The magnitude of the discount looks odd given that EM economic data is improving relative to expectations. From late March through mid-June, the Citi EM Index of Economic Surprises plunged from a positive 40 to a negative 25. In other words, economic data went from reliably beating expectations to chronically missing estimates. However, since late June, things have started to improve.

It’s important to highlight that a more constructive view on EM equities comes with three big caveats: financial conditions, trade and precision. EM assets are still vulnerable to tightening U.S. financial conditions, particularly a stronger dollar. Outside of the dollar, investors should be concerned about trade. While trade issues have faded in recent weeks, fundamental tensions with China haven’t been resolved. If trade concerns escalate, EM assets are vulnerable.

Finally, the notion of EM equities assumes a homogenous asset. In reality, EM is a heterogeneous collection of countries, with wildly varying fundamentals and valuations. Turkey is not Taiwan, and Brazil is not Poland.

For myself, I see the best opportunities and value in EM Asia. While not without risks, this part of the world looks to once again offer some value.

Way to play it with ETFs: To play emerging-market countries in Asia, investors could use the SPDR S&P Emerging Asia Pacific ETF (GMF), said Balchunas. It has heavy allocations to China, Taiwan and India, but also includes countries like Malaysia and Indonesia. It charges 0.49 percent.

Performance of last quarter’s ETF plays: The iShares Core MSCI Emerging Markets Index (IEMG) was Balchunas’s choice to play emerging-market stocks; it had a rough second quarter, falling 10 percent.

Emerging Markets May Be Cheap

Given that we’re in the 10th year of the bull market, the second-longest on record, investors are not inundated with investment bargains. Most asset classes are somewhere between reasonable and off-the-charts expensive. At the same time, volatility has returned with a vengeance, and an escalating trade dispute has the potential to disrupt what was supposed to be a year of synchronized growth. This combination does not immediately suggest adding to one of the riskier asset classes: emerging-market stocks. That said, given cheap valuations, a still-resilient economy and a stable dollar, emerging markets may represent one of the more interesting opportunities in 2018.

In an environment where valuations have been pushed ever higher by an extended bull market, most emerging-markets countries stand out as cheap. The MSCI Emerging Market Index is trading at approximately 1.6 times its book value, a 27 percent discount to developed-markets indexes. The current discount compares favorably with the 10-year average discount of 15 percent.

A larger discount might be justified, given higher volatility and political uncertainty. The irony is that much of that uncertainty is emanating not from emerging markets but from the United States. And despite the lingering questions over trade, most indicators still suggest a year of solid growth, which has historically been a tailwind for emerging markets’ outperformance.

Finally, there is the U.S. dollar. While investors sometimes exaggerate the role of the dollar in emerging markets, a weaker dollar has generally been supportive of emerging markets assets.

To be clear, there are risks. An economic slowdown or a more abrupt tightening of U.S. monetary conditions, particularly in the context of a stronger dollar, would probably cause emerging market stocks to lag. However, to the extent that the global expansion continues, emerging markets is the rarest of things in a prolonged bull market: a cheap asset class.

Way to play it with ETFs:  Balchunas points to a “cheap and deep” way to play EM in the iShares Core MSCI Emerging Markets ETF (IEMG). It serves up nearly 2,000 stocks across several countries, with China the largest weighting at about 24 percent of assets. It charges a 0.14 percent fee and has quietly grown assets to $50 billion since launching a little over five years ago.

Performance of last quarter’s ETF plays: Balchunas’s picks to play Koesterich’s previous recommendation to expand stock holdings internationally, the SPDR Euro Stoxx 50 ETF (FEZ) and the iShares MSCI Australia ETF (EWA), fell 1.7 percent and 6.2 percent, respectively, in 2018’s first quarter.

 

Stick With Equities—Just Cast a Wider Net

The past year was, in every sense, as good as it gets. Stocks posted gains of more than 20 percent, with virtually no pullbacks. While we’re unlikely to be so fortunate in 2018, this is not the time to abandon stocks. Given a synchronized global recovery and still-easy financial conditions, 2018 is likely to be another year in which stocks beat bonds. For those already heavily invested in U.S. equities, there are four reasons to consider adding to your holdings of international stocks.

Cheaper valuations. Based on the trailing price-earnings ratio, the S&P 500 is trading at a 13 percent premium to other developed markets. While the U.S. has recently enjoyed a strong rebound in corporate earnings, valuations have expanded even faster. This leaves the U.S. as the world’s most expensive stock market.

Faster earnings growth. Part of the reason U.S. valuations have risen relative to the rest of the world is that while earnings are growing in the U.S., they are rebounding even faster elsewhere.

More income. As stocks have risen, dividend yields have fallen. In the U.S., the dividend yield on the S&P 500 is below 2 percent. For the first time since the financial crisis, the dividend yield on large-cap stocks is now below the yield available on a 2-year Treasury note. In contrast, the dividend yield on the Euro Stoxx 50 is well above 3 percent. Australian equities yield over 4 percent. Income-oriented investors should ponder the opportunities outside the U.S.

Easier monetary policy. To be sure, 2018 is the year when most of the world’s large central banks will either be withdrawing monetary accommodation or publicly pondering its withdrawal. That said, the U.S. Federal Reserve is ahead of the curve in tightening monetary policy. Other central banks, notably the Bank of Japan, will be slower to withdraw easy money policies.

Way to play it with ETFs: The SPDR Euro Stoxx 50 ETF (FEZ) is a way to track that European blue chip stock index, and investors can use the Shares MSCI Australia ETF (EWA) for exposure to Australia. The ETFs charge 0.29 percent and 0.48 percent, respectively.

Performance of last quarter’s ETF plays: The ETFs chosen to play on Koesterich’s theme of not giving up on value investing were the Vanguard Value ETF (VTV), the iShares Edge MSCI USA Value Factor ETF (VLUE) and the ValueShares US Quantitative Value ETF (QVAL). The ETFs gained 6.5 percent, 8.1 percent and 13.1 percent, respectively.

Don’t Give Up on Value 

After a stellar back half of 2016, U.S. value names have largely disappointed in 2017. As the post-election euphoria faded and everyone faced up to the reality of still modest growth, most investors reverted to old habits: a focus on yield and growth at the expense of value.

Still, value’s relative performance may once again be inflecting. Value stocks outperformed their flashier growth cousins in September, and there are several reasons to believe that trend can continue.

First, value is cheap. While value stocks are by definition cheaper than growth, today they are much, much cheaper. Since 1995 the average ratio between the Russell 1000 Value and Russell 1000 Growth Indices (based on price-to-book) has been 0.45; i.e., value typically trades at a 55 percent discount to growth. Currently the ratio is 0.30. Value has not been this cheap relative to growth since early 2000.

In addition to being cheap, for the first time this year value may once again have a catalyst. It normally outperforms when economic expectations are improving. In contrast, when economic growth is modest, investors are more likely to put a premium on companies that can generate organic earning growth, regardless of the economic climate. This dynamic helps explain the strong year-to-date rally in technology and other growth stocks.

Recent economic data, however, have been modestly stronger, and investors are, once again, entertaining visions of tax cuts. Granted, the economic impact of temporary tax cuts is more a sugar high than structural reform, but you take what you can get. At this point, even a modest boost in near-term growth expectations is arguably enough to shift investor preferences.

This creates an opportunity for value. In an environment in which investors are more sanguine about economic growth, they are more likely to notice that value stocks are not only cheap but also offer better leverage to any economic acceleration. Value is not dead yet.

Way to play it with ETFs: When it comes to picking a value ETF, the question is how bargain basement you want to go. The Vanguard Value ETF (VTV) is the most popular but has only a slight tilt toward value. The iShares Edge MSCI USA Value Weighted Index Fund (VLUE) is much more exposed to value stocks. For hard-core value seekers, the ValueShares US Quantitative Value ETF (QVAL) goes very deep to “buy stocks everyone else hates,” as its manager puts it.

Performance of last quarter’s ETF plays: Balchunas pointed to the iShares U.S. Preferred Stock ETF (PFF) as a way to play Koesterich’s preference for preferred stock in last quarter’s writeup. It was down 0.8 percent for the quarter.

Seek Yields With Protection

There are times to stretch and take more risk, and there are times when discretion is the better part of valor. Following a bull market that turned eight years old in March and countless trillions of dollars of central bank asset purchases, few asset classes are obviously cheap. Still, in a world in which interest rates are barely 1 percent, investors can be forgiven for not wanting to stick their spare cash under the mattress.

This suggests to me a compromise: finding assets with a respectable yield that will provide downside protection if markets turn south.

U.S. preferred stock is currently yielding about 5.50 percent. This compares favorably with most of the other alternatives, including high-yield, investment-grade and emerging-market debt, and a basket of U.S. common dividend-paying stocks. [Preferred shares are sort of a stock and bond hybrid; they generally pay a fixed dividend and put you ahead of common-stock holders in cashing in shares if the company's assets are liquidated.]

More to the point, following a disastrous period during the financial crisis, preferred stock has become a much less volatile asset class, currently offering the most attractive ratio of yield to volatility of the yield-oriented plays. Comparing the yield to the three-month trailing volatility of the asset class, you get a ratio of more than 1.3. In other words, investors are receiving 1.3 percentage points of income for every percentage point of annualized volatility. This is significantly higher than any of the alternatives.

Some will recall that preferred stocks did not live up to their reputation for low volatility during the financial crisis. At that time, an index of U.S. preferred, dominated by financial issuers, fell approximately 70 percent, worse than the broader market.

I see much less downside risk today. It is not clear that U.S. financials will be at the epicenter of the next crisis, as was the case in 2007-09. The sector is much better capitalized and run more conservatively than it was 10 years ago.

While preferred stocks aren't likely to send anyone’s heart racing, a yield of 5 percent-plus in a world still characterized by low rates, high valuations, and uncomfortably low volatility is worth a look.

Way to play it with ETFs:The iShares U.S. Preferred Stock ETF (PFF) currently yields 5.6 percent and has great liquidity. Its 0.47 percent fee is high for an ETF but below average for an ETF specializing in preferred stocks.

Performance of last quarter’s ETF plays: To follow Koesterich’s strategy of focusing on Asian equities, Balchunas pointed to the iShares MSCI Japan ETF (EWJ), which gained 5.2 percent, and the iShares MSCI Emerging Markets Asia ETF (EEMA), which returned 8.5 percent.

Look to Japan

We see the best opportunities within Asian equities, with an emphasis on Japan.

We’re now in the eighth year of the bull market in U.S. equities, and it's increasingly difficult to find bargains. U.S. stocks have done exceptionally well, but investors have been pushing valuations to somewhat extreme levels. Large-cap U.S. equities are trading at approximately 22 times trailing earnings, the highest multiple since 2010 and at more than 30 times the CAPE ratio, a level last seen near the peak of the tech bubble. Making matters worse, U.S. Treasury bond prices look extremely rich after several years of buying by central banks.

In this environment, Asian equities stand out as a relative bargain. In recent years, Japanese stocks have traded at a discount to the U.S., and that discount is particularly large today. The Topix index is trading at approximately 1.3 times book value, vs. more than 3 times for the S&P 500.

Japanese profitability has been improving since 2012, thanks to better corporate governance and share buybacks. In addition, Japanese equities offer accounting standards that are strict relative to the U.S., low leverage and the continuing tailwind of monetary accommodation. Finally, to the extent the global economy is likely to modestly accelerate in 2017, Japanese exporters are well positioned to benefit from improving global growth and a firmer economy.

We also see select opportunities in other parts of Asia, including emerging markets. In particular, Indian companies offer an interesting take on emerging markets. [Click on last quarter's tab for Sarah Ketterer's take on India.] India is a large, domestically oriented economy that is relatively insulated from many of the more macro risks that often derail other segments of the emerging-market universe.

Ways to play it with ETFs: Investors can use the iShares MSCI Japan ETF (EWJ)  for Japan exposure. It is by far the most popular Japan ETF and charges 0.48 percent, about average for a single-country ETF. For Asia emerging markets, the iShares MSCI Emerging Markets Asia ETF (EEMA)  tracks many Asian countries such as China and Taiwan, as well as India, which has a 12 percent weighting in the ETF. EEMA charges a fee of 0.48 percent.

Ian Harnett

Chief investment strategist, Absolute Strategy Research

Play on Volatility, Infrastructure

The record highs seen in the U.S. equity market have come against the backdrop of U.S. 10-year Treasuries falling through 2%, global growth slowing and inflation pressures moderating.

The typical market narrative is that equities are gaining support from expectations of lower policy rates in the U.S. and elsewhere at the same time as global trade disputes are resolved.

We worry that this comfortable complacency will unwind in the coming quarters as investors realize that both equities and bonds cannot be right. Either global growth will re-accelerate with global trade, pushing bond yields higher as rate cuts are priced out of the market, or low bond yields will be validated by activity slowing further, with disappointing corporate earnings forcing policy makers into more aggressive rate cuts than currently expected. We view this as the more likely scenario.

We see this bond-friendly/equity-negative scenario as being supported by the rising recession risk indicators being published by the regional Federal Reserve banks. The fault line for equities will likely be the upcoming earnings season. We don’t expect it to go well. However, the rally in global equities has seen valuation multiples rise, which puts greater emphasis on companies meeting their earnings-per-share forecasts. U.S. companies are already guiding expectations lower, and we expect EPS growth in the coming year to be down 5%, rather than the 7% gain currently forecast by analysts.

Against this backdrop, we maintain our cautious stance on risk assets. After the recent equity rally has pushed market volatility measures down toward a 12-month low, we expect the VIX index to rise back toward 20 or higher in the coming six months. We would be buying equity volatility products.

If economic growth slows further, as our models suggest, bond yields should continue to fall, perhaps toward 1.5% on U.S. Treasuries, and zero for Treasury Inflation-Protected Securities (TIPS). Rather than investing directly in these declining bond yields, investors could buy infrastructure-related funds (which might also benefit from any domestic fiscal initiatives) or data-center real estate investment trusts.

Finally, while gold has been a strong performer in recent months, we suspect that this will continue if real yields fall and risk aversion rises across global markets.

Way to play it with ETFs: Way to play it with ETFs: Balchunas’s pick is the iShares U.S. Infrastructure ETF (IFRA). It covers a less risky corner of the equity market, and is largely weighted to utilities, materials and industrial companies. The ETF may be helped by U.S. fiscal infrastructure initiatives and would benefit from a larger pivot to risk-aversion equity assets. The expense ratio is 0.40%.

Performance of last quarter’s ETF plays: Balchunas’s pick, the Schwab U.S. Large-Cap Growth ETF (SCHG), rose 4.8% in the second quarter. 

Target Tactical Trades

After a torrid December, the first-quarter risk rally saw U.S. equities dominate global asset returns, with tech stocks and cyclicals leading the way. The surprise, however, was that this rally came as U.S. Treasury yields collapsed through 2.5 percent, global activity slowed and pricing power evaporated.

We worry that the year’s second quarter will see these downdrafts played out in the earnings data. Despite analysts’ downgrading their estimates across most sectors in recent months, consensus U.S. earnings-per-share growth remains optimistic, at almost plus 6 percent for the coming 12 months and a 16 percent compound annual growth rate for the next five years. These compare with our expectations of minus 5 percent and plus 5 percent, respectively.

The market view is that these earnings worries take into account the relatively low valuations in U.S. cyclicals. While this depressed sentiment can provide scope for a short-term rally, as we’ve seen in the first quarter, we doubt that this is the start of a more major rotation into cyclical value.

For investors who want a bit more of a “tactical trade,” however, cyclical sectors such as basic resources and oil and gas may still have scope for further improvement in the second quarter, especially if commodities rally because of low real yields.

We also expect some investors to lock in gains from the U.S. market after its stellar performance—you’ve just seen three years’ worth of performance in three months! These investors may well begin looking at euro-zone equities thanks to their low valuations. The weak euro and signs of China recovering might boost European exporters—especially in the unloved German market.

The U.K., after several years of being largely uninvestable, might begin to benefit from its low valuations as Brexit uncertainty eases. If we are to see U.K. and euro-zone equities rally, we will also need to see banks rally. There is scope for a tactical rally in banks if bond yields bounce back from their recent lows.

For the full year, we remain cautious on the outlook for U.S. and global economic activity and maintain our cautious strategic stance by staying overweight growth versus value, and preferring quality to momentum.

Strategic caution and tactical agility may be important in a world where volatility appears ready to trend higher in the next year or two.

Way to play it with ETFs: Balchunas highlights the Schwab U.S. Large-Cap Growth ETF (SCHG) as a fund that offers more growth than the S&P 500. It overweights information technology, consumer discretionary and communication services, and underweights staples and financials. The fund has a low correlation with the S&P 500 and an expense ratio of 0.04 percent.

Performance of last quarter’s ETF plays: Balchunas’s pick, the iShares Global Infrastructure ETF (IGF), rose 13.8 percent in 2019’s first quarter.

Focus on Wealth Preservation

Our cautious approach to risk assets and our preference for U.S. Treasuries was well-rewarded last quarter. The question now: Is it safe to “buy the dip”?

The narrative behind our caution was straightforward. Higher U.S. interest rates and the Federal Reserve’s cutting the size of its balance sheet created a global liquidity shortage at a time when global growth was already slowing. This challenged the outlook for U.S. (and global) equities and made the more than 3 percent yield on Treasuries attractive.

The Fed decided to stay more focused on the tight domestic labor market instead of the weakening global economy and global financial markets. But increasingly, the markets have taken the view that the Fed will change course through 2019. As a result, Treasury yields and the U.S. dollar have started to fall.

This implicit easing in monetary conditions, combined with the S&P 500 moving into “oversold” territory in December, provides some scope for a short-term bounce in U.S. equities. Equity volatility should fall and encourage a recovery in risk assets such as emerging-market equities and technology. There might even be scope for U.S. banks to bounce if bond yields head back to 2.8 percent and oil prices firm up.

Actions speak louder than words, however, and until policy easing is more explicitly embraced by the Fed, the omens for the longer-term outlook for U.S. equities and risk assets more generally remain clouded.

Our models show an increased risk of U.S. recession in 2020, confirmed by credit yields starting to rise even as Treasury yields are falling. In China, where policy is being eased more explicitly, trade wars and tech wars continue to obscure the picture. And in the euro zone there are early signs of unemployment fears beginning to rise just as the European Central Bank finishes its quantitative-easing program. We also worry that several systemically important euro-zone financial institutions have fallen more than 40 percent through 2018.

Thus, for longer-term investors, or those for whom wealth preservation is key, we recommend maintaining a defensive bias. When U.S. new orders fall as they have recently, real yields tend to fall. This will help support precious metals, equity income, utilities and infrastructure stocks.

Way to play it with ETFs: Balchunas points to the iShares Global Infrastructure ETF (IGF). The ETF has 40 percent allocation to utilities and a 3.3 percent yield. It has a dose of emerging markets exposure, although its biggest allocation is the U.S., at 37 percent.

Performance of last quarter’s ETF plays: The ETF Balchunas chose as the best proxy for Ketterer’s views last quarter, the iShares U.S. Treasury Bond ETF (GOVT), rose 2.1 percent.

Go Long on Treasuries

U.S. Treasuries have seen a perfect storm these last few weeks. The key question for investors is whether they are now a buy or a sell. We say buy!

The Treasury sell-off started with the short end of the yield curve, as the Federal Reserve hiked rates. The hawkish tone was bolstered by a record number on the ISM Non-Manufacturing index, which measures business conditions in nonmanufacturing industries. Inflation fears intensified as unemployment fell to 3.7 percent, its lowest level since 1969, and OPEC promised continued supply discipline, boosting oil prices. Finally, yields on very long-dated Treasuries went well above long-held ranges in the wake of Federal Reserve Chair Jerome Powell’s suggestion that this economic cycle might persist “effectively indefinitely.” As a result, U.S. 10-year yields moved toward 3.25 percent and the 30-year pushed toward 3.45 percent.

Such yields will be hard to maintain. Although U.S. growth currently remains healthy, rising real [inflation-adjusted] rates and a stronger dollar will begin to challenge activity, as will higher oil prices squeezing real incomes. The rest of the world will also suffer as dollar strength increases the funding costs for the $12 trillion of dollar-denominated debt raised outside the U.S.

For us, therefore, the expectation of rising prices on Treasuries makes those with yields above 3 percent attractive now. Slower global growth and an inability of OPEC to maintain its supply discipline will likely see West Texas Intermediate crude prices closer to $65 than $75 by yearend. We suggest buying very long-dated bonds—all the way up to the 30-year—with yields close to 3.4 percent, since even the hawks don’t expect more than four rate rises in the coming year.

Bonds also look attractive relative to equities. The recent weakness in equities suggests some investors are already selling them to lock in additional income. Alternatively, we suggest buying bond-sensitive equities. Although health-care stocks have already done well, utilities, telecoms, and food producers have yet to catch up.

Another equity strategy is to buy U.S.-exposed stocks in markets that have sold off aggressively for other reasons. A basket of U.S-exposed euro-zone stocks will likely perform well, and with Italian equities stressed due to domestic politics, companies such as Fiat-Chrysler Automotives N.V. and Luxottica Group SpA, which both have over 50 percent of their sales in the U.S., could provide a cheap route to buying U.S. earnings.

Finally, in a world where global growth is slowing, food producers typically outperform industrial metals, and with expectations of a new El Niño this year, prices on soft commodities [commodities that are grown rather than mined] should rally.

Way to play it with ETFs: Balchunas points to the $6.5 billion iShares U.S. Treasury Bond ETF (GOVT) which invests along the entire yield curve. It charges 0.15 percent.

Performance of last quarter's ETF plays: The iShares 20+ Year Treasury Bond ETF (TLT) and the Consumer Staples Select Sector SPDR ETF (XLP), Balchunas’s choice to play on the consumer staples theme, rose 5.2 percent in the third quarter. The iShares 20+ Year Treasury Bond ETF (TLT) fell 3.4 percent.

Look for ‘Peak Growth’ in the U.S.

A defining feature of 2018 has been how the Trump tax cuts have helped boost U.S. GDP to be consistently faster than other developed economies. However, GDP growth of 4.1 percent in the year’s second quarter will likely be “peak growth” for this cycle. Our early-warning indicators suggest that activity is now likely to slow in most major economies through the second half.

Despite the risk of slower U.S. growth, Federal Reserve Chair Jerome Powell has indicated his willingness to push rates higher in coming months. The U.S. dollar has gained due to the divergence in relative growth, higher U.S. rates and a faster pace of tightening. Not only has this meant pressure on developed markets, it’s also signaled that global liquidity conditions are tightening rather than easing. We expect dollar strength to be sustained through the second half.

U.S. investors have largely escaped the consequences of dollar strength and tightening global liquidity. The pain has been felt not only in emerging-market bonds, equities and currencies, but also in the global systemically important financial institutions (SIFIs), which fell 20 percent between late January and the end of June.

Given this backdrop for the global economy and liquidity, we expect markets to reward wealth preservation in the second half, with bonds looking increasingly attractive relative to equities. We believe there should be opportunities to make money buying 10-year and 30-year U.S. Treasuries above 3 percent.

For equity investors, such a backdrop will tend to keep financials under pressure and favors consumer staples and consumer service stocks. We are becoming less positive on the outlook for technology stocks; the adoption of the new communication sector will likely add to the regulatory volatility within the sector. [S&P Global Ratings and MSCI Inc. are reclassifying a number of stocks previously in the technology, telecom and media sectors, and including some of them in a new communications-services group.]

We remain buyers of equity volatility, which we expect to rise on a trend basis in the next year, given the rise in real and nominal rates.

Way to play it with ETFs: For a Treasury play, investors can use the iShares 20+ Year Treasury Bond ETF (TLT), which is extremely liquid and charges 0.15 percent, Balchunas said. For the consumer staples play, there is the Consumer Staples Select Sector SPDR ETF (XLP). It, too, is super-liquid and also super-cheap, at 0.13 percent.

Performance of last quarter’s ETF plays: Balchunas suggested the VanEck Vectors ChinaAMC China Bond ETF (CBON) for those who wanted exposure to Chinese government debt. The ETF fell 4.5 percent in the second quarter.

Sell the Rallies

Equity clouds may have a silver lining.

Many investors appear to be assuming that the equity volatility of early February and mid-March was largely technical. It was shallow, short-lived and lacked major contagion into other asset classes, prompting an apparent willingness to “buy the dips.”

We, however, view these bouts of market nervousness as part of an incomplete market correction and suggest that investors should “sell the rallies” and focus on more defensive assets and strategies.

Why so cautious? First, we believe that the global economic cycle has begun to slow. Our activity surprise measures, which track the extent to which economic data deviates from forecasts of investment professionals on a daily basis from the previous quarter, are negative for the first time since 2016. We doubt that the U.S. can “decouple” from a global slowdown. U.S. tax cuts may only serve to offset the impact of the higher U.S. bond yields and Fed funds rates seen in the last 18 months. With Chinese growth slowing, euro-zone activity decelerating and global real money growth decelerating rapidly, global “peak growth” is probably behind us, making U.S. and global earnings forecasts liable to disappointment.

Despite these signs of slowing growth, policymakers in the U.S. and other developed economies appear intent on “normalizing” monetary policy. The combination of rate rises and the reduction in the pace of monetary stimulus from the European Central Bank and the Bank of Japan, as well as the reduction in the Fed balance sheet in the U.S., will challenge the upside for global risk assets.

Slower growth and tighter monetary conditions are also a toxic combination for highly indebted companies or economies. That means U.S. high-yield debt will likely struggle, as will the banking sectors and currencies of highly indebted economies such as Canada, Australia and Sweden, which may unsettle markets more generally.

In such an environment, where are the investment opportunities? As economic growth disappoints, expect bonds to beat equities. We favor U.S. Treasuries over other developed-market government bonds. Slowing growth and easing inflation pressure also favor Chinese government debt. Options strategies that bet on a long-term higher level of market volatility or that hedge equity risk will also likely be rewarded.

Finally, many investors typically turn toward gold if global growth slows. However, silver has lagged behind gold by 17 percent in the last year and almost 50 percent in the last five years, suggesting that it may have more upside potential if the economic outlook becomes cloudier.

Way to play it with ETFs: For Chinese government debt, an asset class thought impossible for retail investors to get exposure to just five years ago, Balchunas points to the VanEck Vectors ChinaAMC China Bond ETF (CBON). It tracks fixed-rate, renminbi (“RMB”)-denominated bonds issued in the People's Republic of China by Chinese credit, governmental and quasi-governmental issuers. While the fee of 0.50 percent is decent for such exotic exposure, Balchunas notes that the ETF is very small, at $4.8 million. Those wanting to buy the ETF should use a limit order to specify the price they are willing to pay.

Performance of last quarter’s ETF plays: The Guggenheim Defensive Equity ETF (DEF) was Balchunas’s pick as a defensive market maneuver. The ETF was virtually flat in the first quarter, down 0.1 percent. Two other picks, the PowerShares DB Agriculture Fund (DBA) and the VanEck Vectors Agribusiness ETF (MOO), were both positive, if barely—up 0.2 percent and 0.1 percent respectively.

 

Start Selling the Rallies

At the end of 1996, then-Federal Reserve Chairman Alan Greenspan chided market participants for their “irrational exuberance.” Today, there appears to be little reason to repeat his comments. The shift into risk assets by investors looks like rational exuberance in response to a benign economic backdrop not seen since the 1960s, with tax cuts and low rates expected to boost economic recovery. We doubt, however, that this can become sustainable exuberance, as 2018 will likely see this benign growth and inflation mix challenged. Fear will replace greed, rewarding more-defensive investments.

Signs of excess appear almost everywhere. The global economy looks close to a cyclical peak. The U.S. ISM manufacturing index, the Institute for Supply Management’s measure of economic activity in that sector, and similar measures for the euro zone are close to 30-year highs. Falling unemployment rates during the last six months in most of the Group of 20 biggest industrialized and emerging economies have helped boost consumer confidence, while low interest rates and stable inflation have encouraged consumers and corporations to reduce their savings and spend more.

Equities are showing classic late-cycle signs, with industrial stocks up 30 percent over the last 12 months. Basic-resource stocks are up 35 percent, while the 40 percent rise in oil prices is also characteristic of this phase for the global economy. The Goldilocks economy (sustained low inflation despite economic recovery) has helped push U.S. price-earnings ratios to 25 times trailing earnings and 32 times on a CAPE (cyclically adjusted p-e) basis, levels seen only in the tech bubble during the last 70 years—higher even than in the Nifty 50 era of the early 1960s.

With interest rates subdued and central banks adding $2.5 trillion to their balance sheets in the past year, liquidity has been plentiful, keeping volatility stubbornly low and creating some of the most benign financial market conditions of the last 30 years. Such benign conditions for the global economy and markets have rarely been sustainable for long. We worry that a China growth slowdown has the capacity to offset any U.S. or euro zone recovery, while liquidity is likely to be reined back in the U.S. as the Federal Reserve tightens monetary policy and in the euro zone with tapering by the European Central Bank.

If global growth slows, then interest rate expectations may have run ahead of themselves, making shorter-dated Treasuries attractive. With liquidity likely to be less plentiful, Treasury inflation-protected securities (TIPS) could underperform conventional Treasuries. Equities are now signaling “overbought” relative to bonds on our short-term tactical models and sentiment indicators. If earnings-per-share growth is 5 percent to 6 percent, as our models suggest, rather the consensus of 13 percent, oversold defensive sectors such as consumer staples and health care may outperform. Agricultural commodities are relative safe havens compared with industrial commodities.

Successful long-run investors are typically those who avoid the losses at the peaks of markets rather than those who focus on the next big win. It may not yet be time to be in full defensive mode. But after the gains of the last year and the post-credit-crunch bull market, it is time for equity investors to start selling the rallies rather than buying the dips.

Way to play it with ETFs: For defensive sectors, there’s the Guggenheim Defensive Equity ETF (DEF), which tracks the 100 companies that have the best risk and return profiles during a bear market. It charges 0.60 percent. To play agricultural commodities, there is the PowerShares DB Agriculture Fund (DBA) or the VanEck Vectors Agribusiness ETF (MOO). DBA charges 0.89 percent, and MOO’s fee is 0.54 percent.

Joe Davis

Global chief economist and head of investment strategy, Vanguard Group

Consider Active Strategies

While I often extol the benefits of indexing in this column, active management can play an important role in a well-diversified portfolio. While index funds should continue to serve as the base for most investors’ portfolios, active funds are appropriate for some investors who can tolerate increased risk. 

While we can’t predict how the market will behave over the next three months, U.S. investors should prepare for higher inflation and muted returns. Active management may help certain investors hedge against some of these risks. Perhaps an investor seeks an actively managed TIPS fund to protect against inflation, or wants to overweight to a particular sector they believe could outperform the rest of the market over the coming years.

Before selecting an active strategy, investors should always take a careful look at a few factors—risk tolerance, time horizon, manager talent and, of course, cost. Actively managed funds can have extended periods of outsize performance and underperformance that require investor discipline. If managed appropriately, though, an experienced, cost-conscious manager who can clearly articulate and execute on a strategy can add value and achieve outperformance. 

It’s important that investors have a clear understanding of their personal risk appetite, time horizon and investment goals. Remember—active funds are not “one size fits all” products. A fund that works for someone looking for tax-exempt interest income may not be a good fit in a growth investor’s portfolio. Whether it’s an indexed or active product, don’t be a passive participant when it comes to fund selection. Investors need to take an active role, do the research and select a strategy and portfolio manager that align with their personal financial goals.  

Way to play it with ETFs: One way Balchunas suggests taking a more active stance through ETFs is with the PIMCO Enhanced Low Duration Active ETF (LDUR). This is an actively managed, low duration fixed income fund that offers both preservation of capital and higher yield opportunities on the short end of the yield curve. The fund rebalances monthly and has an expense ratio of 0.40%.

Performance of last quarter’s ETF plays: The Vanguard Total Stock Market ETF (VTI), Balchunas’s choice of a way to play Davis’s second-quarter themes, rose 3.7%. 

Beware Performance-Chasing

Over the last quarter, the market has reacted to events such as Brexit negotiations, U.S. Federal Reserve policy, global monetary policy normalization, trade wars and the Chinese economy (to name a few). With Vanguard predicting moderate 4 percent to 6 percent U.S. equity returns over the next decade, would now be a good time to take advantage of market volatility? With greater risk comes greater reward, right?

Not necessarily.

Vanguard’s Investment Strategy Group predicts that—along with modest returns—monetary policy normalization, slowing growth and disparate interest rates may bring increased bouts of volatility. While it’s tempting to react to day-to-day market swings in the hopes of adding return, it may backfire.

Investors who abandon best practices in search of short-term returns end up eroding as much as 3 percent of their portfolio’s value, according to Vanguard research. I’m not discounting the appeal of such strategies, but rather cautioning investors against the reality of other macroeconomic developments that could unduly harm their portfolio.

For investors looking to mitigate the varying risks to their portfolios, even in the near term, it’s essential to keep a portfolio with a high level of diversification that aligns with their risk tolerance. Whether it be Brexit, trade negotiations, breaking company news or other events, keeping a well-diversified portfolio spreads the risk across multiple asset classes, countries and sectors. Such a portfolio may not produce immediate outsize returns, but it may better protect against an economic downturn or significant market swings.

Way to play it with ETFs: For low-cost, diversified ownership of global and domestic equities, Balchunas looks to the Vanguard Total Stock Market ETF (VTI). Without being fancy, the fund has returned 11.1 percent over the past five years, and 17.1 percent for the year-to-date. It has an expense ratio of 0.04 percent.

Performance of last quarter’s ETF plays: The Vanguard Balanced Index Fund (VBINX) gained 9.5 percent in the first quarter.

Keep Calm and Carry On

The recent volatility in the U.S. stock market can make any investor uneasy. But changing your investment strategy in reaction to short-term market moves can backfire. In fact, typically when investors have a strong urge to make changes, the benefits of making that change are the weakest. For example, if an investor sold out of the S&P 500 at the end of 2008, over the past decade, they would have missed out on more than 300 percent in gains as of Dec. 31, 2018.

We know there’s no surefire way to protect investments from market swings. However, a diversified “all-weather” 60-40 portfolio split between stocks and bonds, while it won’t always deliver the best returns, can soften the blow of a market downturn and continue to deliver strong results over time. To ensure you’re maximizing your long-term returns, focus on factors you have control over—spending less, saving more and paying attention to your investment costs.

If you have strong convictions about how the economy and markets will perform in the next few years, does it make sense to change your portfolio in an effort to capitalize on those convictions? Maybe, but the trade-offs can be expensive.

We compared the returns of a 60-40 global stock and bond portfolio with two other portfolios, one optimized for a recession and one for a high-growth economy. (We characterize today’s economy as moderate growth). If you adopt a portfolio designed to benefit from recession, and the recession actually materializes, you’ll do better than the 60-40 portfolio.

But if there’s no recession? You’ll lose more than you would have gained if you’d made the correct economic call. The same trade-off is at work when positioning a portfolio for high economic growth—decent rewards if you’re right, higher costs if you’re wrong. Before making any decision, investors should have a firm understanding of their risk tolerance and the costs and benefits of these strategies.

During times of market volatility, it’s easy for investors to get distracted by the day to day and lose sight of their long-term plan. My advice? Ignore the headlines, keep calm and keep your focus on the long term.

Way to play it with ETFs: If the goal is a 60/40 portfolio split, a mutual fund may actually work best here, according to Balchunas. The Vanguard Balanced Index Fund (VBINX) invests in roughly a 60/40 allocation to plain vanilla equities and bonds. It is huge, at $36 billion, and cheap, with a 0.19 percent fee.

Performance of last quarter’s ETF plays: Balchunas highlighted the Vanguard Total Stock Market ETF (VTI), which fell about 15 percent in the quarter.

Ride out Market Cycles

Do the Fed’s plans for continued rate hikes signal trouble for bonds? We don’t think so. While rising short-term interest rates may sting, these losses will be offset by higher future returns as interest payments are reinvested at higher yields. And despite the recent volatility, we don’t expect a big impact on long-term bonds. Long rates are less influenced by the Fed than by inflation and the long-term growth outlook.

While a multilateral trade war seems unlikely in 2019, significant risks remain in the U.S.-China trade conflict. We haven’t changed our outlook on either country, as we have yet to see any major reaction to the current tariffs in the economic data. However, should the U.S. go forward with further tariffs in January, we may begin to see material effects in select sectors and lower market sentiment overall.

What about equities? While some equity investors may be spooked by higher rates’ impact on earnings and overall growth, Vanguard’s research has shown that in the last 50 years, equity returns remained positive during 10 out of 11 previous rate-hike periods. This time may be different, of course, but market timing is the wrong strategy.

A better approach is to stick with stocks through the market cycles to take advantage of discounts in the market and benefit from their potentially higher returns over the long term. With the large return differentials between the U.S. stock market and equity markets in the rest of the world, consider rebalancing into non-U.S. stocks if your portfolio has strayed from your target allocation. And even if bond returns are more muted, fixed income will continue to moderate volatility in equities and other assets.

So what should you do with $10,000 today? If you already have a diversified mix of stocks and bonds, more of the same.

Way to play it with ETFs: Balchunas’s pick is the Vanguard Total Stock Market ETF (VTI), a classic buy-and-hold ETF. The broad market fund covers the entire U.S. stock market. It charges 0.04 percent and recently crossed the $100 billion mark in assets—only the third ETF to ever do so.

Terri Spath

Chief investment officer, Sierra Mutual Funds

Target Emerging Market Debt

U.S. stock and bond markets are in a state of confusion. The S&P 500 and other benchmark indices for U.S. stocks are tapping on new all-time highs, anticipating a soft landing for the economy, engineered with finesse by the Federal Reserve. The U.S. bond market seems much more concerned—there is nothing normal about a 10-year Treasury bond below 2% and a 90-day Treasury bill above 2%. More daunting is that this relationship in yields has historically signaled negative economic growth in the near future.

The confusion in financial markets has, and surely will, contribute to further uncertainty and volatility. Managing volatility, or risk, is one of the few things investors can control. For these reasons, we favor emerging markets debt over emerging markets equity, and recommend that readers with $10,000 to invest put that in an actively managed emerging markets debt fund (EMD).

Why EMD? The asset class is currently, and often has been, overlooked—and it shouldn’t be. The global economy is growing, albeit at a slower rate than last year at this time, but growing. At the same time, debt-to-GDP ratios are stronger across the board for emerging countries over developed ones, a fact that has been largely missed. Also, yields for EMD funds are at least 5%, offering a built-in return if prices remain stable.

EMD also has a lower correlation to more traditional asset classes like stocks or bonds, providing strong diversification. Against a backdrop where U.S. asset classes are acting confused, EMD has delivered steady returns with low volatility. This isn’t limited to the U.S. Over the past year, emerging markets equities have lost money (based on EEM, the iShares MSCI Emerging Markets ETF) and shocked with an almost 20% drawdown. EMD is up more than 10% (based on EMB, the iShares J.P. Morgan USD Emerging Markets Bond ETF) on a generally smooth ride. More return, less risk.

The key to successful investing in EMD is to use an actively managed mutual fund. The performance of any particular developing country can be vastly different—what is impacting Russia can be very different than what is driving Turkey. An active manager can guide a portfolio more effectively than a benchmark that is required to hold the best and the worst securities. An actively managed fund will also hold hundreds of bonds, allowing far greater diversification than an individual can achieve through an individual portfolio.

Our top picks in EMD are DoubleLine Emerging Markets Fixed Income Bond fund (DBLEX) and MFS Emerging Markets Debt Fund (MEDIX). For those with a view of a weakening dollar, PIMCO Emerging Markets Local Currency and Bond Fund (PELBX) looks great.

Way to play it with ETFs: Balchunas suggests WisdomTree’s Emerging Markets Corporate Bond Fund (EMCB), which has gained near 10% year-to-date on both income and capital appreciation from corporate issuers. The geographic exposure spans Luxembourg, Netherlands, Mexico, Turkey and India, among others. The fund has broad industry diversification and maturity range, and a 0.60% fee.

Brian Singer

Portfolio co-manager, William Blair Macro Allocation Fund

Anticipate Shocks—and Short Mexico

Over the last number of years, the equity market story has been largely a story of rallies built on central bank policy. That includes direct communication from the Federal Reserve, ECB and others, as well as changes in market expectations, as investors attempt to predict what central bank committees might do.

At present, the perception that the Fed and ECB will continue to act to support equities has become pervasive. When stocks fall, as they did in May and last fall, interest rate markets revise expectations from expected rate increases to no change or cuts and longer periods of low or negative levels.

Central banks’ support of equity markets—implicit and explicit—is also now set against a backdrop of slower global economic growth. Indicators of slowing growth may justify flat or lower interest rates, but also offer less compelling support for repeated stock market rebounds.

We think liquidity is king, so we want to lower equity exposure and keep cash on hand to limit the pain of downside shocks and have the opportunity to deploy capital when drops occur.

We are also identifying particularly overpriced markets such as Mexico, where we have one of our largest short positions in equities. The country’s finance minister abruptly resigned, and we have concerns about whether economic and fiscal policy will be able to counter the serious challenges the country faces.

Way to play it with ETFs: For those who want protection against shocks, Balchunas points to the Innovator S&P 500 Power Buffer ETF (PJUL). It protects investors from losses greater than 15% in a steep drawdown if held to maturity in July 2020. The fund, a set of actively managed options on the S&P 500, maintains some exposure to equity growth but caps gains at 8.88%. It has a fee of 0.79%.