*Article and content provided by SigFig Wealth Management, LLC.
Diversification is a common theme at Connect Invest, and with good reason. A portfolio that is globally diversified across multiple asset classes helps balance risk and return for long-term investors. That’s why Connect Invest diversifies its managed portfolios across thousands of companies in nearly 50 countries, ensuring a balanced mix of equities (stocks), corporate and government fixed income (bonds), and real estate.
Our advice remains consistent for the coming year: Investors should diversify their portfolios with many investment vehicles across many countries and markets. In continued support of this strategy, we are adjusting our recommended allocations, which you will see reflected in your updated portfolio.
Our 2017 review and 2018 outlook covers several points that informed these updates:
- The continued strengthening of the US economy
- A calmer US legislative agenda going into the midterm elections, following tax & healthcare reform bills
- The continued growth of a still-uncertain global economy
- Rising interest rates and the slow but steady unwinding of quantitative easing by major central banks
- Lower expectations for long-term returns than in prior eras, as investors work to update their long-run investment strategies
A year ago, in the wake of the 2016 presidential election, we noted that although the U.S. stock market outperformed a globally diversified portfolio during the final months of 2016, long-term investors should continue to focus on a broad, multi-asset class approach. In 2017, globally diversified investors were rewarded: Though U.S. stocks had an excellent year, international markets did even better.
We remain cautiously optimistic that near-term prospects for diversified investors are positive, though long-term investment performance is expected to be lower than we’ve seen in the past 12 months.
Strong growth continues for U.S. economy
The U.S. economy is healthy; most statistical and qualitative measures indicate a full recovery from the Great Recession of 2008-2009, and economic data for 2018 remains encouraging:
- Unemployment is at 4.1%, near or below most economists’ estimate of full employment
- Job creation remains strong, increasing by nearly 200,000 jobs per month, while wages inch up
- Inflation remains low, close to the Federal Reserve’s 2% target
- Gross Domestic Product has been above a 3% annual rate for two consecutive quarters
- Consumer confidence, down a touch in December, remains high
- The stock market is at record highs
However, it is important to distinguish between economic performance and stock market performance: A strong economy does not necessarily equate to an up market, or vice versa. It is empirically difficult to predict how markets will perform in the future. That said, the current macroeconomic climate is promising for continued market growth.
U.S. stocks had an excellent 2017. The S&P 500, a large-company index, rose 18% last year to reach record highs. It’s also worth noting that U.S. equity markets were reasonably stable — consistently marching upwards throughout the year, with few hiccups.
(Chart illustrates the 2017 price performance of VTI, an ETF tracking U.S. stocks; source: Google Finance.)
Domestic politics have not distracted the market...yet
In previous updates, we noted that although Washington’s focus was on healthcare, investors should stay focused on the Republican tax reform agenda. This proved to be a sound strategy, as the primary repeal of the Affordable Care Act faltered. Republicans ultimately shifted their attention to tax reform, resulting in two key changes that affect investors.
One was a reduction in lower corporate taxes, easing the way for business expansion. The other established rules requiring companies to pay tax on overseas earnings, though they can then bring that cash back to the U.S. without paying additional tax.
Moody’s estimated that U.S. companies have amassed $1.9 trillion in overseas holdings, which is likely to come back to U.S. shareholders. Though companies may initially report losses from this near-term tax bill, we expect U.S. investors to benefit over the coming years as companies redistribute capital in the form of higher dividends and share repurchases and reinvest in their businesses.
As Congressional campaigning for this year’s election cycle gets underway, we don’t anticipate any major challenges. The debt ceiling debate will return in March, but we anticipate that Republicans will negotiate an extension of credit through at least the November election. With legislative stability in Washington and tax reform in the rearview mirror, the coast is clear for the U.S. stock market to continue its bull run — at least until election season gets into full swing.
Developed markets strengthen and emerging markets bound forward
A similar story is echoing across a number of international markets: As economies in Europe and Japan continue to recover from the 2008-2009 global recession, stock market growth is accelerating.
Though unemployment in the Eurozone is notably higher than in the U.S., it continues to tick down. Germany, the European Union’s largest economy, has seen its unemployment rate fall to just 3.6%. Though most of the economic news from Europe is positive, the effects of British withdrawal from the E.U. remain uncertain, which will likely drag on medium and long-term growth.
Stocks in developed markets outpaced those in the U.S. with an excellent year, up 23%. Similarly, international developed markets enjoyed relatively low volatility throughout the year, marching consistently upwards.
(Chart illustrates the 2017 price performance of VTI (in blue), an ETF tracking U.S. stocks; VEA (in red), an ETF tracking Developed International Market stocks; and VWO (in orange), an ETF tracking Emerging Market stocks; source: Google Finance.)
Though international economies are growing and stock markets appear poised to continue their strong performance, uncertainty should remain a core concern for any investor. Tensions on the Korean Peninsula, issues with Russia, and management of China’s slowing economic growth are but a few issues that could spark change in our positive outlook. Despite these uncertainties, we continue to recommend a globally diversified equity portfolio.
Global interest rates are on the rise
Positive performance in 2017 was not limited to equities. Though central banks in developed markets began raising interest rates, fixed income still provided modest returns for investors.
As U.S. and international economies grow, central banks around the world are raising interest rates to moderate this growth. The U.S. Federal Reserve began its rate-hike process in late 2015 and continues to slowly increase its benchmark borrowing rates in an effort to mitigate any chance of economic overheating. The European Central Bank began raising rates later than the U.S., but globally rising rates are contributing to a long-term expectation that bond values will fall.
(Chart illustrates the 2017 price performance of AGG (in blue), an ETF tracking Investment Grade U.S. Fixed Income; TIP (in red), an ETF tracking Treasury Inflation-Protected Bonds; and EMB (in orange), an ETF tracking Emerging Market Fixed Income; source: Google Finance.)
Emerging market bonds, a source of extra yield for fixed income investors, provided better returns than U.S. investment grade bonds through 2017. As global interest rates inch up, however, the search for yield will become easier, likely reducing the demand for bonds from emerging market countries.
Connect Invest model portfolio adjustments
In light of the changing interest rate environment, Connect Invest’s portfolio allocations are shifting away from longer-duration and international fixed income positions, which are more sensitive to interest rate changes, towards shorter-duration bonds.
We continue to value high-quality investment-grade fixed income for diversification and volatility balance in all of our managed portfolios. The resulting change in our allocations reduces exposure to longer-duration Treasury Inflation-Protected Securities (TIPS) and emerging market bonds while increasing exposure to U.S. Investment Grade Bonds and Short-Term Treasuries.
Meanwhile, the mix of stocks and bonds will remain consistent with our historical view that investing in a wide range of asset classes provides a balanced approach to risk and returns.
We remain optimistic about the global economy in 2018 and believe the prospects for long-term investors are positive. We continue to recommend that our clients invest in a strategic, globally diversified portfolio that is aligned with their preferred risk tolerance and time horizon.