Given the combination of (1) slowing global economic growth; (2) sensible monetary policy support by central banks in the U.S., Europe and Japan; and (3) stable inflation, our portfolio positioning favors a “neutral” approach, balanced between equities, real asset equity alternatives and fixed income with the following expectations:
- 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, with higher volatility.
- Several exogenous treats (the biggest of which include a Federal Reserve Bank monetary policy misstep, tariff policy changes/trade wars, geopolitical turbulence and a rising risk of a global economic slowdown) may continue to unsettle capital markets in the form of higher-than-normal market volatility.
- After correcting last year, global equity valuations are below long-term averages for the first time in a long time.
- Real asset equity alternatives should offer low-correlation inflation protection and differentiated returns compared to traditional global equity and fixed income.
- Fixed income investments remain prudent given potentially rising bouts of volatility.
- Assuming your plan, risk tolerance and investment policy are aligned, long-term investors need not take drastic action.
It was just one short year ago we dubbed 2017 “the year that made asset allocation great again.” Every major asset class we track was not only up for the year but up well above our current and future return expectations. Volatility was strangely low — especially for global equities.
However, 2018 was the exact opposite.
Most major asset classes we track were down for the year, except fixed income, which was up a whopping 0.01%. And volatility returned with not one but two global equity market corrections greater than 10% (January through February was -10.2%, and September through December was -19.8%). Note in the current equity bull market, which began in March 2009, the U.S. equity market has seen only five corrections prior to 2018. To some degree, this is normal market behavior given we are in the later innings of the business cycle.
Going forward, the future direction of macroeconomics and, more importantly, capital markets in 2019 may be anyone’s guess. President Trump’s fiscal policy thrust in the form of lower taxes and regulatory burden will still be a slight tailwind next year but will be offset by the Fed’s monetary policy in the form of higher short-term interest rates. The chaotic trade policy that has bit into some of the positive business sentiment both here in the U.S. and globally may remain a headwind in 2019. This macroeconomic setup along with higher wage growth translates into slowing corporate earnings growth next year … and it is corporate earnings that drive equity prices over the long-run.
Our suite of favorite leading economic indicators is flashing somewhere between yellow and green (a nice chartreuse perhaps?) and seem to suggest slower economic growth over the next 12 months but no recession (yet). Using history as a guide, we know sustained equity bear markets (market declines greater than 20%) and fixed income outperformance are rare except in the run-up to and during recessions.
So, our best guess is that the equity market correction late last year is just a correction and not the beginning of a new bear market given the lack of a recessionary smoking gun (so far). With the downdraft, equity market valuations are now below the trailing 25-year average and seem to be discounting the expected earnings slowdown and then some.
As always there are many factors that complicate our outlook. These include the persistence of the volatile U.S. and global geopolitical environment, along with a growing potential for overly tight financial conditions as the Fed moves ever closer to its next monetary policy mistake. We are more focused on the latter. The Fed’s current challenge is to deliver a soft landing otherwise known as the monetary policy “triple crown” through its control of short-term interests: keeping employment strong, inflation under control and no recession. Unfortunately, the Fed does not have a strong track record on this outcome when in rate-hiking mode, achieving it only three times in the 100 years.
As responsible financial advisors, we have the humility to know we cannot predict the future with precision. With sound financial plans in place, we believe our current client portfolio asset allocation is prudent after moving to a more neutral positioning between equities and fixed income during the summer last year. We will remain focused on conducting ourselves as long-term investors delivering investment outcomes that help our clients meet their wealth-planning objectives.
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.
Contact our Chief Investment Officer, Russell Moenich to learn more about this topic.
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