Looking Back: Key Drivers of Our 2017 Portfolio Performance
Our globally diversified balanced (stock/bond) portfolios generated strong returns for the year, consistent with the positive overall return environment for most financial markets and asset classes. Our meaningful exposure to European and emerging-market stocks was a significant contributor, as foreign stocks outpaced U.S. stocks in 2017. Stocks were not the only contributors to our portfolio returns. Our tactical positioning toward flexible, absolute-return-oriented fixed-income funds resulted in several percentage points of outperformance versus the core bond index’s 3.5 percent gain.
Looking Ahead: Updates on Our Asset Class Views
U.S. Stocks: As noted above, U.S. stocks were up 22 percent for the year, driven in part by expectations of a historic corporate tax cut, which the Republican-led Congress duly delivered. We suspect much of the benefit of tax decreases might be priced in based on consensus earnings estimates for the S&P 500.
Foreign Stocks: Political uncertainties notwithstanding, Europe continues its economic recovery within what appears to be a benign fiscal and monetary environment. Europe is matching the United States in terms of economic growth and, according to Capital Economics, is on track to generate its strongest growth since 2007. Earnings have rebounded strongly, with Ned Davis Research analysis showing continental Europe and U.K. local-currency earnings growing over 25 percent and 35 percent, respectively, over the past 12 months. (The United States has seen earnings growth of 14 percent over the same period, according to NDR.) While earnings were up strongly, investor sentiment was relatively depressed (especially during the fourth quarter), leading valuation multiples to compress.
Like European stocks, emerging-market stocks posted strong earnings growth of nearly 20 percent.
Fixed-Income: Our return expectations for core bonds remain muted looking out over the next five years, in the range of 2.5 percent to 3.2 percent (from a current yield of 2.7 percent). Today, we are faced with taking on elevated levels of interest rate risk for low yield. The yield per unit of duration is near its all-time low. For context, a 50-basis-point yield increase in the Bloomberg Barclays U.S. Aggregate Bond Index would wipe out more than a year of income. This explains our meaningful positioning away from core bonds in favor of flexible credit strategies, which we believe will outperform core bonds in a period of flat or rising rates. That said, we still maintain core bond exposure in our balanced portfolios to serve as ballast in the event of a risk-off environment.
As noted above, high-yield bonds had solid absolute returns in 2017. We acknowledge that low global rates, accommodative monetary policies, and healthy overall fundamentals could keep bond spreads historically narrow, at least in the near term. However, we think that higher interest rates in general, but particularly short-term rates, will result in a headwind for high-yield bonds.
Looking Ahead: A Quick Word on the Macro Outlook
In terms of the near-term macro outlook, the consensus view is that there is little risk of a U.S. or global economic recession in 2018. The market expects the in-sync global growth that we saw in 2017 to continue. Most of the investors and strategists we respect seem to share this view. However, when an outlook becomes the strong consensus view, one should assume it is already discounted to a meaningful degree in current market prices. This is where our investment discipline comes in, because we think we have an edge in assessing fundamentals, valuations, expected returns, and risks across different asset classes and over longer-term periods.
We fully expect to get the opportunity to add back to our U.S. stock exposure at prices that imply (much) better expected returns across our scenarios. One obvious trigger for that would be a meaningful drop in the market. We believe a bear market is likely sometime in the next five years (our tactical time horizon). Again, we can’t confidently predict exactly when, but one reasonable scenario would be triggered by ongoing monetary policy tightening, which is already underway in the United States, to be followed by other central banks. Given the boost to asset prices from unprecedented monetary stimulus, it is reasonable to expect some negative impact as central banks stop and then reverse course. On the other hand, should U.S. stocks continue their very strong upward trajectory, we will further reduce our exposure to them. There are a lot of variables involved, but all else equal, one key trigger for U.S. stocks would be if even under our optimistic/bullish scenario, we are seeing low-single-digit five-year expected annualized returns, down from 7 percent-8 percent currently.
Putting it All Together: Our Portfolio Positioning
Currently, our base case scenario implies very low expected returns for U.S. stocks. As such, we remain defensively positioned in U.S. stocks and tilted toward European and emerging-market stocks, where our return expectations are materially higher. We were heartened to see our investment thesis of a European earnings rebound coming through strongly last year. However, we don’t believe our portfolios have been fully rewarded for this yet given European stocks lagged the U.S. market in local-currency terms, so we’re maintaining our tactical overweight to Europe. We also remain comfortable overweighting emerging-market stocks slightly relative to U.S. stocks, although valuations are less compelling than they were a year ago.
Our fixed-income positioning also remains unchanged. In light of the particularly low expected returns for core bonds, along with the risk of rising interest rates (which correspond to lower core bond prices), we have meaningful exposure to flexible, actively managed bond funds. While our base case five-year expected returns for these funds are several percentage points above that of core bonds, they do carry more credit risk than core bonds. We factor this into our overall portfolio risk exposure, and it’s why we still maintain a meaningful allocation to core bonds in our more conservative risk-sensitive portfolios. Despite their poor longer-term return outlook, we expect core bonds to perform well in a traditional bear market/recession.
Lastly, most of our portfolios have allocations to managed futures. The managed futures strategies are “alternative” in that they have different drivers of return and risk than traditional stock and bond investments. We believe they have superior risk-adjusted return potential relative to the mix of stocks and bonds from which they are funded. While the “insurance” value of these investments hasn’t been realized during the strong equity market run-up, we remain confident their relatively low correlation (or no correlation) to other investments in our portfolios is a valuable long-term benefit.
The year 2017 was a very good one for most financial markets and particularly global stocks. Yet we know the path to long-term investment success is simple to describe but not easy to achieve. Acknowledging this, we focus on the more realistic goal of having a high batting average-maintained by following our investment discipline and only taking on risk when we believe it raises the client’s portfolio return potential without materially impacting the potential downside.
Thank you for your continued confidence and trust. We wish you and yours a very happy, healthy, peaceful, and prosperous New Year. -OJM Group
We encourage you to take a few additional moments and read our 2017 Key Takeaways where we discuss how corporate earnings growth drives stellar year for U.S. stocks.