Given the combination of (1) slowing economic growth in a mature global business cycle expansion, (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 threats (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 and a subsequent recovery this year, global equity valuations are above long-term averages and may exhibit lower-than-average returns going forward.
- Real asset equity alternatives should offer low-correlation inflation protection and differentiated returns compared to traditional 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.
While we are still complaining about that crystal ball we bought on the internet – does not seem to work all that great and there is no return policy(!) – it did prove prescient back in January when we guessed that the equity market correction last year was not the beginning of a new bear market. In a powerful reversal from the sharp downturn in the fourth quarter of 2018, most asset classes posted substantial gains year-to-date so far.
This was one of the strongest quarterly performances we have seen in a long time (see the table below comparing 3-month asset class performance ending December 31, 2018 and March 31, 2019). Though infrastructure was the best performing asset class, U.S. equities were not far behind.
Financial markets responded favorably to the Federal Reserve Bank’s January shift away from its recent “autopilot” approach to monetary policy i.e. raising short-term interest rates 0.25% every quarter until the economy breaks. If you view the Fed as the central banker to the world (like we do), then the timing of their shift was pretty good: global economic growth has been slowing down from stronger levels seen in the last few years.
Some believe the 2016-2018 growth acceleration is a direct byproduct of the Tax Cut and Jobs Act (TCJA) of 2017. However, our analysis of the underlying data that ultimately matters to economic growth does not support it (at least so far). Reviewing growth in (1) Annual Gross Domestic Product (GDP) (growth in the aggregate business activity in the U.S. economy), (2) Non-Residential Investment Spending (growth in corporate spending on big capital expenditures), and (3) Information Technology & Software Spending (growth in corporate spending on stuff that can increase worker productivity), economic growth and investment spending growth still appears to be in a range observed throughout the current recovery:
Although we have always believed in the incentive effects of fiscal policy, we were not overly
enthusiastic about a growth kick from the TCJA. Most importantly, the Fed’s monetary policy (raising short-term interest rates and tightening financial conditions) would offset any stimulus from fiscal policy over time. In addition, other growth-retardant policies on trade and immigration were likely to work in the opposite direction as well.
The 2015-2018 GDP growth acceleration in the first chart above likely was due to the Fed’s pause between December 2015-December 2016. This allowed financial conditions to recover, paving the way for faster aggregate economic growth. Given sustained policy tightening over the last two years, it should be no surprise that the recent period of above-trend growth is now coming to an end.
As such, our suite of favorite leading economic indicators is still flashing “chartreuse” and suggests slower, tepid economic growth over the next 12 months but no recession. Interesting side note: the current business cycle expansion is 118 months old (as of April) and is the second longest on record after the mid-90s expansion. If the expansion continues to July this summer, then it will break the record.
The future direction of macroeconomics and, more importantly, capital markets in 2019 is still anyone’s guess. 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. Unfortunately, the Fed does not have a strong track record on this outcome when in rate-hiking mode, achieving a “soft landing” after raising rates only three times in the last 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 “neutral” client portfolio asset allocation remains prudent. We focus 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.