Given the persistent combination of low inflation, mediocre global economic growth and declining monetary policy support, we favor a portfolio balanced between equities, fixed income and alternatives.
- 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
- Financial assets may remain supported with some downside risk; a number of exogenous threats (the biggest being a global economic slowdown led by China and a Federal Reserve Bank monetary policy blunder) can continue to unsettle markets, especially given relatively full valuations and the fact that we have not experienced a bona fide equity market correction in years
CAPITAL MARKET PERFORMANCE & ASSET ALLOCATION COMMENTARY
The second half of 2015 was difficult for capital markets. The start of 2016 has not been any easier as the milder-but longer-than-average global and U.S. business cycle expansions are being attacked from all sides. First, fears of an economic "hard landing" in China are cascading into worries about global growth. Second, declining commodity prices — especially oil — have the potential to depress earnings growth (the ultimate driver of equity prices in the long run) in the U.S. and create a financial credit contagion in the bond market (20% of junk bonds are exposed to commodity end-markets (1)). Finally, all of this comes at a particularly sensitive time as the Fed pivots to increasing the short-term interest rate (first increase in almost 10 years). The move ends months (years really) of suspense and expectation by investors the world over of when the Fed was going to raise rates, only to shift the nervous debate to what the ultimate impact on the economy is going to be.
The events of the past eight weeks — namely the big global equity market sell-off — has raised the risk that financial market volatility could feed back into the real global economy and become a self-fulfilling prophecy. To be sure, the magnitude of the sell-off appears exaggerated relative to the current set of global macroeconomic fundamentals we monitor. Our comments to you last quarter remain valid:
We are more cautious about the global economy than we have been in several years. While we believe fears of a global recession are overblown, growth is likely to remain mediocre in 2016 with some risk to the downside. Meanwhile, global assets are generally fairly priced even after the sell-off in the third quarter with few new pockets of opportunity.
Global growth is mediocre, but the economy could expand in 2016 and the chances of a broad recession, while growing, are still unlikely. This view is not premised on a simple expectation for a pro-cyclical economic recovery. To the contrary, we acknowledge that global excess capacity and high debt levels in some emerging markets may pressure industries linked to capital spending. Global trade, which has suffered mightily under the weight of a strong U.S. dollar and a slowing Chinese economy, is likely to recover slowly. The globalization trend that was driven by China's 15-year journey toward industrialization appears to be cresting and emerging-market economies — which comprise more than 50% of global trade2 — are beginning to look toward the development of domestic services and consumer spending. And therein lies the source of our optimism for global growth in 2016. There is simply too much tailwind behind the global consumer, namely an improved balance sheet (i.e., low debt-to-income levels) and lower energy costs.
Of the 18 broad-asset classes to which we make our asset allocation decisions, only half were positive in 2015 and the best returns were found in emerging-market-fixed-income and municipal bonds, up only 1.2% and 3.3%, respectively2!
However, this relatively unremarkable set of returns required concentrated active management and a certain bit of luck to achieve or beat basic benchmarks and, probably, your expectations. Most investors with broadly diversified asset allocation portfolios underperformed the flattish U.S. stock benchmarks. The rout in commodities extended to MLPs (Master limited partnership), high-yield fixed income and emerging-market equity, while strength in the U.S. dollar obscured gains in unhedged international equity markets. Unlike the last few years where very narrow segments of global assets outperformed — really we are talking about large cap stocks in the U.S. such as the S&P 500 — the implications for investors was that portfolio diversification broadly failed. We expect a better outcome in 2016.
ASSET ALLOCATION THESIS: REMAIN OVERWEIGHT EQUITIES VERSUS FIXED INCOME & ALTERNATIVES
We are disciplined in our asset-allocation methodology and will only choose attractive investment opportunities that meet our rigorous asset-class evaluation criteria (made up of qualitative assessments of fundamental valuation, momentum and global macroeconomic effectiveness).
In the U.S., there seems to be minimal upside potential as valuations remain higher than historical averages with negative earnings revisions increasing over the past few quarters. The biggest challenge comes from the persistently bullish investor sentiment that has been pervasive for many years now. Going forward, U.S. equities may continue to lag behind foreign equities.
Earnings are everything, and the long-awaited recovery in European and Japanese earnings revisions seems to finally be here, which is in direct contrast to the U.S. earnings situation. European equities are valued favorably and should benefit from the European Central Bank’s (ECB) efforts to stimulate the economy. As a result, we would expect better economic data surprises and improved earnings growth. Japanese equity valuations are very low, and corporate behavior is changing, with a clear anticipated improvement in profit margins.
The relative valuation attraction of emerging-market equities versus developed equities remains but has declined. Today there appears to be a high level of dispersion within the emerging-market equity universe with select opportunities in emerging Asia and Europe.
A still improving global economy and a range-bound interest rate environment may call for moderate exposure to the more globally opportunistic areas of fixed income. We prefer full allocations to traditional fixed-income sectors and proven managers with broad mandates targeting tactical investments, such as foreign developed bonds, Emerging Markets (EM) bonds, senior bank loans, high yield/junk-rated convertible bonds and preferred stock when appropriate.
Fixed-income markets appear to have been very resilient in the face of Fed Quantitative Easing reductions and prospective interest-rate hikes; markets may be too complacent about the timing and speed of the Fed tightening cycle. Time will tell.
We remain committed to alternative assets such as hedge fund trading strategies and “real assets,” e.g., infrastructure and real estate. These assets can have lower correlation to equity and fixed income, increase portfolio diversification and may help protect against rising inflation.
GLOBAL MACROECONOMIC SUMMARY
We monitor a focused set of global leading economic indicators that cut through the economic noise and short-term anxiety to continually gauge our position in the business cycle. Our quarterly review of the economic trends in key geographic regions helps frame our portfolio asset-allocation decisions.
Leading economic indicators suggest mediocre global growth of 3.1% in 2016 versus an estimated 3.0% in 20152 as a whole:
- After six years of a global expansion, we appear to be moving into a phase of the global business cycle in which labor markets are improving and both wage growth and inflation appear to be bottoming, suggesting that the global recovery needs to become self-sustaining as monetary policy may not be as overwhelmingly supportive
- The constructive trends of easier monetary policy and declining oil prices, which had been in place since mid-2014, seem to have stalled
While trying to maintain the role as leader of the global business cycle, U.S. economic growth remains choppy in a longer but less robust business cycle expansion:
- In the second half of 2015, the lackluster economic growth of 2.1%2 should continue in 2016; strength in consumer spending and a new government spending tailwind could offset declining capital expenditures
- We expect the economy to grow fast enough to keep the unemployment rate down but not support aggressive Fed interest rate hikes in the future
- How long this cycle lasts from here will largely depend on Fed management:
o Business cycle expansions do not die of old age, but, rather, are killed by aggressive monetary policy: a sustained but mild business-cycle expansion can continue, considering employment and inflation are below the Fed’s targets
o Every business-cycle downturn over the last century (save 1930s and 19812) came after the output gap went positive and unemployment fell to below average levels; the former is negative and the latter is above average
Reports of Europe's death have been greatly exaggerated, and economic growth seems set for a period of genuine recovery:
- Leading economic indicators predicting further acceleration in overall economic activity in coming quarters after the second half of 2015 GDP (Gross Domestic Product) surpassed expectations
- The region is the largest beneficiary of the recent moves in global market and policy trends (aggressive monetary policy and lower oil/commodity prices)
Prospects for Japan's economy look considerably better for the immediate future, although the bar is low:
- GDP has been stubbornly below expectations
- With the yen falling sharply in "trade-weighted" terms, exports — a key component of the economy — have rebounded significantly
Near-term outlook is less clear with diverging reactions to weaker oil/commodity prices (positive for China & India, negative for exporters) and a slowing China; positive long-term outlook driven by demographics remains a key thesis
The portfolio profiles outlined above may vary based on the individual investment objectives of your financial plan. As always, we very much appreciate the trust and confidence you place in our firm. We value that trust every day and will continuously strive to retain it. Please do not hesitate to contact your advisor for any questions or service needs.