Reality, Risk and Return
THE WEEK AHEAD
Markets suffered losses last week as investors weighed a variety of threats to global growth, notably China. Commodities remain under pressure and emerging markets continue to feel the pinch from global slowing. As the dust settles, we believe the United States will remain an attractive destination for global capital. We continue to focus strongly on quality and consistency in equity selection while tactical allocations have been moved closer to policy portfolio allocations. Volatility is likely to remain elevated.
Update on Our Outlook
The past week again reminded investors that volatility is still with us. Since 2012, stock markets advanced amid unusual calm and ultra-supportive central bank policies. The S&P 500 sits near record highs today, despite last week’s decline (Chart 1). From 2012, the market’s advance has also been made all the more comfortable since it has been accompanied by historically low volatility and negative real interest rates. Recent declines and a spike in volatility are awakening investors from a long and peaceful rest. From a volatility point of view, it is important to realize that volatility has been below average in recent years, and the recent pickup in volatility has only moved the volatility meter back to normal (Chart 2).
There are as many answers to this question as there are individuals to ask it. China continues to slow, the Federal Reserve (Fed) continues to move toward a long-awaited rate hike, and commodity prices are inexorably falling. Emerging market countries are beginning to succumb to a long stretch of poor performance, and a rag bag of emerging market currencies are becoming unhinged from Brazil to Malaysia to Kazakhstan. Argentina devalued its currency back in early 2014, and Russia’s ruble has proven to be volatile. Many commodity-based countries are back in, or headed rapidly toward, recession. Europe remains disjointed with a two-speed economy under a single and questionable currency. The rest of the world is in a general state of disarray, but we’ve all known this for most of the past several years. All along the path from 2012, these issues have been with us to a greater or lesser extent.
Still Dollar Bulls
Against this backdrop of global tumult, the United States remains a relative island of prosperity. As we discussed last week, we’ve begun to see a turnaround from a growth perspective. The slowdown that brought U.S. growth to a standstill in the first quarter ended sometime during the spring, and the last few months have seen a general pickup in the data. We see the economy growing north of 2% at present. Profits are picking up, and expected earnings for the S&P 500 companies are moving higher. More people are working and coming back to the workforce. Final demand remains relatively steady. All-in-all, the domestic economy seems reasonably sound on its own merits and a good deal better than many other countries around the globe. Add in the potential for higher real interest rates and a stronger dollar, and it is easy to see why the U.S. is an attractive place for capital to flow.
We remain tilted toward domestic investments in U.S. dollars for this reason and tactical allocations have been moved closer to a neutral risk position and more closely aligned with longer term strategic policy portfolio allocations. Fundamental trends in the domestic data are improving in absolute terms and in relation to foreign indicators, further strengthening our commitment to a U.S.-centric tactical posture at this time. We continue to monitor trends in volatility, but there is no significant change in our long-run risk assessment at this time.
Reality, Risk, and Return
The simple reality of all this is that return can never remain fully divorced from risk indefinitely, and vice versa. Uncertainty and risk are part of the game. The important things that matter are fundamentals, and these are the things that we focus on when allocating assets. We begin with an expected return derived from a review of fundamentals. We monitor how a changing environment shapes the fundamentals we rely on for allocating capital. We do all of this in a systematic way and always look to avoid costly pitfalls of knee jerk reactions. We do this by having a process, focusing on fundamentals, and accepting the reality that investing comes with its share of down days along with the ups.
One of the most critical lessons we have learned over the decades has been the importance of sticking with a plan and avoiding at all costs the temptation to jump in and out of markets, especially when times get tough. It is far better to reassess initial assumptions, gather information, and make adjustments only after considering all the facts. The facts we have worked over in the last few months are these:
- Expected returns are positive but lower given the move higher in equity prices and flush margins, but equity returns should outpace bonds and cash over our long-term forecast horizon;
- After a four-year period of “high risk” market leadership, we feel the slow-but-steady segments of the market are due to provide leadership for a time (focus on consistency — avoid chasing momentum);
- The United States is leading the global recovery, and we expect this to continue to be the case as investment seeks higher returns in an increasingly bifurcated and low-return world;
- The compendium of data suggests divergent trends globally, suggesting a balanced approach to portfolio allocation at this time;
- A pickup in volatility is to be expected given the nature of volatility to ebb-and-flow from cycle to cycle. We have existed in a low-volatility / high-return world in recent years. Long-run returns are likely to drift lower as volatility moves back toward its historic average as well.
On Short-Term Timing
We are again reminded of the influence of emotions on investment decisions. Accepting that risk as part of the game is important, and understanding that volatility can cut in both directions is important too. Consider the fact that many of the best single days of market performance followed immediately after days of sharp declines (table below), and it is easy to see how following the herd and selling merely out of fear can lead to poor results. Another way to look at the potential downside of short-term market timing is to consider the fact that if poorly timed trades kept a trader out of the market for just the best 10 trading days of the past 15 years, the trader would have lost money by just missing out on those ten days (chart 3 below). When volatility picks up it can lead to large swings, both up and down, and emotional reactions to volatility are almost always ill-informed. It is far more helpful and important to consider all the facts and make informed judgments from a point-of-view consistent with your time horizon and risk tolerance. Generally, short-term thinking leads to greater losses long term than careful planning and discipline.
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Asset Allocation Portfolio Posture
LONG-RUN STRATEGIC POSTURE: Strategic allocations are set to reflect our long-run forecasts for key asset classes. We expect policy rates to remain low as central banks continue to push lower-for-longer rate strategies and the Fed moves slowly on tightening. Eventually, rates should rise back to more normal levels, but this is expected to happen gradually and unevenly. Fixed income returns are expected to lag current yields as rates rise. Equity returns will track moderate growth in global GDP with little to no further lift from margin expansion (margins are already elevated). Equity valuations appear reasonable and just slightly ahead of with historic multiples. Dividends and net buybacks are expected to contribute a larger share of total equity return.
The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.
Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small company stocks are typically more volatile and carry additional risks, since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher quality bonds. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains.
Kevin Caron, Portfolio Manager
Chad Morganlander, Portfolio Manager
Matthew Battipaglia, Analyst
Suzanne Ashley, Junior Analyst