2018 Quarter #1
Given the combination of (1) accelerating global economic growth; (2) sensible monetary policy support by central banks in the U.S., Europe and Japan; and (3) low but rising inflation, portfolio positioning favors equities and real asset alternatives over fixed income:
- Long-term expected returns for all asset classes may be below returns experienced over the last 10 years; however, returns for equities could be well above those for fixed income for some time.
- A number of exogenous threats (the biggest of which include a Federal Reserve Bank monetary policy misstep) could unsettle capital markets at any time, resulting in higher volatility than recently experienced.
- U.S. equity valuations are relatively expensive, versus foreign-developed and emerging-market equity, and have not experienced a bona-fide equity market correction in years.
- Alternatives should offer low-correlation inflation protection and differentiated returns compared to equity and fixed income.
- Reduced allocations to fixed income and cash may be prudent given long-term headwinds, such as higher inflation.
- Assuming your plan, risk tolerance and investment policy are aligned, long-term investors need not take drastic action.
Despite the most recent turbulence in early February, the global equity markets remain supported by accelerating economic growth in both developed and developing regions. In the U.S., economic growth continues to be stable, averaging only 2% gross domestic product (GDP) growth on a year-over-year basis since 2009, but that may change in the near future. Despite dysfunction in Washington, President Trump's economic agenda (dubbed “Trumponomics”) has delivered on pro-growth and business-friendly fiscal stimuli in the form of lower taxes and reduced regulatory burden.
Our interpretation of the eventual outcome is an environment of higher corporate earnings growth, higher aggregate economic activity and a bit more inflation. The risk of recession in 2018 remains low. This is important because bear markets (sustained stock market declines of 20% or more) coincide with recessions based on our study of business cycles over the last 100 years. Note, this is not to say corrections (declines of 10% or more) will not happen periodically and can come at any time. All in, this setup confirms our portfolio positioning of increased equity and decreased fixed income exposure.
We continue to like long-term equity valuation and growth profiles outside of the U.S., such as foreign-developed and emerging-market countries, relatively better than the expensive and slower-growth proposition in U.S. equities. The emerging-market sector has been and should continue to be the prime beneficiary of increased global economic activity. Foreign-developed equity earnings growth should continue to accelerate as central banks in Europe and Japan seem to be providing an adequate tailwind through monetary policy to support growth for the foreseeable future. As a result, we expect higher total returns outside the U.S. given the longer-than-expected business-cycle expansions.
Global real asset alternatives, such as infrastructure, natural resources and real estate investments, should do well if and when inflation rises.
We continue to expect fixed-income headwinds given the positioning of fiscal and monetary policy today, which make for interesting bedfellows. If the impact of Trumponomics is ultimately successful in bringing a meaningful acceleration in economic activity, the Fed may be quick to reign in the economy if there are any signs that inflation may get out of control.
The Fed is in tightening mode after increasing short-term interest rates five times since December 2015. Interestingly, current financial conditions are looser than when the Fed started its interest-rate-hiking campaign. This suggests the Fed has a green light to tighten even more, which we expect it will do in the near future.
One caveat: since the Fed was created in 1913, almost every business-cycle expansion has ended after sustained short-term interest rate increases by the Fed. The Fed does not have a good track record avoiding recessions. Of the 18 hiking cycles since 1913, only three ended with a “soft landing,” meaning without a recession: the mid-1960s, the early 1980s and 1994. The milder-but-longer-than-average global and U.S. (still the world's largest economy) business-cycle expansion is now in its 104th month. No one knows when it will end — the longest U.S. business-cycle expansion in history lasted 10 years — but the odds suggest the Fed may kill it once again by making another monetary policy mistake, such as raising rates too far, too fast or both.
The portfolio profiles outlined above may vary based on the individual investment objectives of your financial plan. As always, we very much appreciate and value the trust and confidence you place in our firm. Please do not hesitate to contact your advisor with any questions or service needs.