Fixed Income: Continue to Prefer Risk Assets Over Treasuries. Our fixed income allocations continue to favor risk assets over Treasuries. However, after four consecutive years of strong returns, valuations across the credit markets have deteriorated sharply and future returns will likely be more moderate. High yield is our favorite fixed-income asset class in 2013; we expect total return of around 6%, which is about equal to its current yield, with minimal capital appreciation. Although longer-duration Treasury prices could rise during risk-off episodes, we believe that their risk/reward profile is strongly skewed to the negative.

The Federal Reserve used its printing press to keep interest rates below the rate of inflation throughout the 1940s and early 1950s. This financial repression strategy caused bond investors to lose between 40% and 50% relative to inflation. We believe the Fed will emulate this post-World War II strategy because if it allows short-term interest rates to rise to about 3.5%, the combination of rising interest rates and rising debt would add more than $1 trillion to the annual budget deficit by 2017.

David Fuller's view Will QE be similar to a strong medicine which helps the patient through a crisis, but as that person recovers the longer-term side effects become apparent?

I think this could be a real concern within the next few years. However, I am thinking ahead. I do not believe it is a risk for at least the first half of 2013 and probably longer. My impression is that a majority of market commentators do not expect the Fed's unemployment target to be reached for at least three years. That may reflect overconfidence or just the hopes of T-bond investors, so we should keep an eye on 10-year Treasury yields which could be a lead indicator.


Note - after writing the above, I was astonished to spot this evening's Bloomberg headline while preparing for my Audio: Most Fed Officials Saw QE3 Purchases Concluding This Year.


Meanwhile, the USA has a significant number of strong multinational companies, plus its energy advantage, also shared by Canada. Europe should see some further multiple expansion as its markets continue to recover from the worst-case expectations of last year, before Mario Draghi took over at the ECB. However, the safer markets may be in Asia, plus the resources producers which supply them, energy excepted. Asia may be a little more volatile but aside from Japan, it does not have the West's debt problems. Also, most of Asia's GDP is stronger, especially if China's post-slowdown recovery and stock market rally continue, as I expect.