Investment Insights for 2013

--courtesy content by USAA

How did 2012 treat investors?

Despite tremendous uncertainties and a stubbornly slow economy, investors appear to have done surprisingly well, with essentially every major asset class in the black.

As we began 2012, Europe was at center stage, with many wondering if the eurozone would survive in its current form. Most of the attention centered on Greece and its ability to stay in the European Monetary Union. However, once European Central Bank President Mario Draghi stated his intention to do "whatever it takes" to save the eurozone, the immediate crisis receded and European stocks began to gain traction and started to outperform U.S. stocks. That said, with much of Europe still in a recession, the full story has yet to be told.

In the United States, corporate earnings posted strong gains in the first half of the year as surprisingly warm weather boosted hopes that the recovery was gaining momentum. As the weather effects subsided in the second half, weak revenue growth and softening fundamentals took their toll. While the Federal Reserve continued its extraordinary — and controversial — measures to maintain easy monetary conditions and keep interest rates low, doubts about the economic recovery grew, compounded by concerns about the so-called "fiscal cliff."

How is the U.S. economy looking?

The economy is probably best described as "muddling through." On the positive side, many corporate balance sheets are flush with cash, and the boom in domestic natural gas and oil production is lowering energy costs for businesses and consumers. Also, the U.S. housing market continues to gain momentum and most major market indicators have turned positive. Sales are up, prices are rising and homebuilders are increasingly optimistic.

Unfortunately, the negative side of the ledger has more items than we would prefer to see. In addition to higher taxes and spending cuts, falling capital expenditures by businesses over the next several quarters could be an omen of a pending rise in unemployment.

Taken together, we think the economy will grow, at best, by 1.5% to 2.0% over the next year, once a fiscal compromise is reached. Not that long ago, a 2% growth rate would have been considered "slow." Today, however, a far more difficult global economic environment is causing investors to recalibrate, making 2% the new "moderate growth" and a rate we'd be relatively grateful to see.

Will the Federal Reserve raise interest rates in 2013?

No. The Fed has indicated its intention to maintain a near-zero interest rate policy until unemployment falls to 6.5%, a milestone the central bank projects won't be reached for several years.

Will Europe take center stage again next year?

Probably. While we think that the road to resolution of the crisis and stabilization of the eurozone continues to be a long and difficult journey, we believe they have finally started walking down what may be considered as a reasonable path.

Which asset classes is USAA emphasizing today?

We believe several areas have the potential to outperform next year, including:

• Non-U.S. developed market equities (largely Europe).
• Emerging market equities (i.e., Brazil, Russia, India, China).
• Gold and gold mining equities.

Meanwhile, we've reduced our allocations to U.S. stocks, including large-cap, small-cap and mid-cap.

Is now the time to invest in international stocks?

We believe so. The global markets have been on a roller-coaster ride ever since the start of the European financial crisis. All that began to change when Mario Draghi became the new president of the ECB. He argued that if the banks could be protected, the crisis could be averted. He cut the overnight lending rates and then initiated a bond-buying program that is now credited with bringing Italian and Spanish government bond yields down. When Draghi finally made his now-famous speech where he promised to "do whatever it takes," markets started rallying in earnest on the comfort that ECB was willing to act as a lender of last resort to the eurozone crisis.

Still, much of Europe is in or entering recession, as is Japan. However, these equity markets largely reflect the somewhat dire economic conditions in the countries and look relatively undervalued. Yet, given the relative undervaluation, we think non-U.S. developed markets could outperform U.S. markets.

What about emerging market stocks?

We think most investors should have an allocation to emerging markets. While emerging market equities have underperformed U.S. equities over the last two years, their economies are healthier from a fiscal point of view, are benefiting from structural reforms made in the last decade, and tend to have growing populations with rising disposable incomes.

Does the precious-metals rally have any steam left?

Even after a multiyear run that has seen the price of gold soar more than 18% annually since 2008, we believe the outlook for gold remains favorable.

The "looser for longer" stance adopted by central banks at home and abroad means they will continue printing vast sums of money with a goal of boosting their sagging economies. As more and more dollars are created, the less each dollar is likely worth, and the falling value is typically reflected by a rise in the price of gold and other precious metals. Because it is a volatile asset class, a weighting of 2% to 5% may be appropriate for many investors, while a weight higher than 10% may begin to diminish the diversification benefits.

Where are the best opportunities in U.S. stocks?

We think investors could be well served by emphasizing the dividend component of stock returns. With interest rates likely to remain near record-lows for the foreseeable future, a dividend strategy may provide higher income returns than those available in many areas of the fixed income world.

What are your thoughts about fixed income?

Many investors have fled stocks to the perceived safety of bonds. Looking back over the last few years, this shift to more fixed income has not detracted significantly from performance (as interest rates fell, bond prices rose, providing a decent total return).

However, going forward, high-quality fixed income assets will probably be unable to earn a meaningful return after inflation.

It's important for investors to understand that "quantitative easing" refers to the Fed's printing of enormous quantities of money, which will result in inflation down the road. That's a big reason why we prefer bonds that provide more income than U.S. Treasury securities, which are becoming overvalued and more susceptible to rising interest rates. We are finding opportunities in corporate bonds, asset-backed securities and commercial mortgage-backed securities.

We think the municipal bond market, comprising securities issued by state and local governments, offers opportunities as well. State budget-tightening efforts may be bad news if they result in shrinking the services you receive, but they're good news for credit-conscious investors, since they bolster these governments' ability to stay current on their obligations.

What role should cash play in a portfolio?

The Fed's zero-interest-rate policy has made it difficult for investors to earn a "safe" return. Cash levels should be closely monitored to ensure they are appropriate for an investor's time horizon. If cash is needed for an emergency fund or an identifiable expense, it should be left in an ultrasafe, liquid investment vehicle.

That being said, many investors have cash on the "sidelines" waiting for better investment opportunities. These investors should consider alternatives that provide higher yields, albeit with higher risks. These investments include short-term bonds and CDs.

Instead of selecting several mutual funds, is there an easier way to apply these strategies in my portfolio?

Any final thoughts?

Investors should be prepared for increased volatility in 2013 and focus on the long term. While it's sometimes hard to distinguish between being early from being wrong, a disciplined investment program will outperform in the long run.