From Macro to Micro With more than half the year completed, we are taking the opportunity to review performance across asset classes to understand the various drivers of recent returns. In many cases, declining macro uncertainties have caused performance in risk assets to diverge and more closely reflect underlying fundamentals. Consequently, we believe this environment offers the opportunity for tactical asset allocation shifts on certain asset class exposures that could enhance the overall risk/return profile of a portfolio. Rearview Review With the U.S. economy on the mend, markets have largely performed as we anticipated this year, with most risk assets outperforming safe haven alternatives. Bond yields have risen and virtually all bond indices we track are in negative territory in the wake of losses in May and June. Spread sectors such as high yield bonds have fared better than Treasuries year-to-date, as “carry” and spread compression have offset rising rates. In contrast, inflation-indexed bonds have been among the biggest market losers as inflation expectations have remained low in the face of rising yields.

Among stocks, multiple expansion has largely driven returns for the S&P 500 Index as investor confidence has strengthened. In terms of geography, the U.S. market has outperformed non-U.S. equities, particularly emerging markets, which remain in negative territory year to date. Improvements in the U.S. economy have been reflected across market caps and sectors: Smaller-cap issues, which derive less revenue from overseas sources, have outperformed large-cap stocks, while domestically focused sectors such as consumer discretionary and financials have outperformed globally focused sectors such as materials and energy. Less Macro, More Micro This year has also marked a subtle change in market drivers as declining economic policy uncertainty has caused the market to shift its focus from macro to micro fundamentals (see display). Following the fiscal cliff/sequestration debate earlier in the year, the U.S. political calendar has remained relatively light even as the European recession has abated. Correspondingly, we observe that volatility in U.S. equities has trended downward as is typical of such periods. We anticipate that, as the global economy continues to recover, volatility for risk assets will trend toward the lower end of its historical average—a scenario that we believe could present an opportunity for investors to tactically overweight stocks while staying within their risk tolerances.

Investment Strategy Group

August 2013

The Investment Strategy Group provides guidance on asset allocation and portfolio strategy in support of Neuberger Berman’s clients and investment professionals.

Matthew Rubin Director of Investment Strategy

Ing-Chea Ang Vice President

Justin Gaines Associate

Reinforcing this potential shift, volatility in fixed income assets has risen in the midst of uncertainty over the potential timing of Federal Reserve “tapering,” which we believe is likely to persist over the next few months. STOCK MARKET VOLATILITY HAS DECLINED WITH ECONOMIC POLICY UNCERTAINTY

Source: FactSet (through July 30, 2013). Nevertheless, periodic spikes in equity volatility are to be expected. For example, September may see the beginning of Fed tapering and U.S. budget talks, while the German elections are scheduled for the same month. But, as the economy continues to recover, we would anticipate lower levels of volatility and think September could be an opportune time for investors to rebalance their portfolios. Changing Market Correlations The decline in macroeconomic uncertainty has also caused a shift in asset class correlations, i.e., the tendency of returns to trend together. Most notably, correlations between stocks and bonds have become less negative, implying that bonds have become less effective as a portfolio diversifier (see display). Also, as global growth has picked up, fundamentals have become more of a driver for risk assets. This is particularly true for asset classes such as emerging market stocks and commodities, as decoupling economic fundamentals between the larger BRIC countries (Brazil, China, India and Russia) and the U.S. appear to be the main cause for diverging returns. Such shifting fundamentals could present opportunities for higher alpha generation potential through regional and currency selection.

As the economy continues to recover, we would anticipate lower levels of volatility for risk assets.

ASSET CLASS CORRELATIONS ARE LESS EXTREME

Source: FactSet (through 8/2/2013). Taking Advantage of Diversification Opportunities Based on the observations above and our outlook on various asset classes, we believe certain tactical asset allocation shifts could enhance the risk/return profile of an overall portfolio. The volatility of risk assets has declined, as is typical during periods of global expansion. With the U.S. in mid-cycle and Europe achieving early recovery, we believe it could be an opportune time to tactically overweight stocks as valuations remain at what we consider attractive levels.

Conversely, we currently favor an underweight on “safe haven” bonds based on poor valuations, rising volatility and declining correlation benefits. In our view, diversification within fixed income is less appealing as intra-bond correlations may remain high in the near term, but active management could offer opportunities to take advantage of dislocations.

The declining focus on macro issues points to the potential for individual fundamentals to be key drivers of stock returns. A particularly strong example is the decoupling of U.S. and emerging market stocks. Accordingly, investors may want to consider adding or increasing non-U.S. equities exposures and we believe active managers should have opportunities to generate attractive returns by means of security and regional selection.

Finally, we believe there are a variety of reasons to consider out-of-favor asset classes. Alternative asset classes such as commodities, which saw their diversification benefits diminish in the late 2000s, could begin to make sense for investors with a contrarian perspective.

The declining focus on macro issues points to the potential for individual fundamentals to be key drivers of stock returns.

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