Diversification is a common theme at SigFig, 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 SigFig 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 U.S. legislative agenda going into the midterm elections, following tax and 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 reached 4.1%. This is 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 market economies 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 effect of British withdrawal from the E.U. remains a point of uncertainty, which will likely to 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)
By far, the best performer among the asset classes in our recommended allocations were emerging market equities. They jumped ahead of developed countries’ stocks, soaring to 30% returns in 2017. Economic growth and low inflation in developed nations spurred an appetite for imports from emerging markets and fueled growth in emerging economies, leading to top-tier performance for emerging market stocks.
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.
SigFig model portfolio adjustments
In light of the changing interest rate environment, SigFig’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.
In September, the Federal Reserve announced that it would begin selling off its enormous $4.5 trillion portfolio of bonds. This is the clearest sign yet that the bank believes the U.S. economy is well on the path to recovery.
The Fed first began purchasing the bonds in 2009, to ease the effects of the Great Recession. Known as Quantitative Easing (QE), the bond-purchasing program served two purposes: to inject cash into the financial system and drive down interest rates. This, in turn, put money in consumer’s pockets, kick-starting and stimulating greater economic activity.
Buying government securities to manage short-term interest rates is a common strategy used by the Fed. The enormous scale of the bond purchase, however, was unprecedented.
How bonds spurred the economy back into action
It’s easiest to think of a bond as an IOU. It’s a loan that contractually defines the principal amount being borrowed, the interest rate, and the date by which it will be repaid. Because the interest payments — also called “coupons” — don’t change once they’re set by the contract, bonds are commonly referred to as “fixed income.” Their unchanging nature makes them easy to trade in the market — the buyer and the seller just need to agree on a price.
Pricing is often a function of demand. With bonds, it’s specifically driven by the demand for higher returns. A bond’s return depends on how much interest it generates (coupon interest) and how much the net gain will be when it’s repaid (capital gains).
When interest rates increase, as they have lately, fixed income investors prefer to buy newer bonds with higher coupons and sell their older bonds with coupons that reflect the earlier, lower interest rates. Demand isn’t as high for the older bonds with smaller coupons, so their prices drop accordingly. The reverse happens when interest rates fall: the older bonds have larger coupons, so they’re worth more. As a result, prices go up.
In these scenarios, interest rate movement causes price adjustments, but it’s also possible for bond demand to push rates.
When the Fed purchased $4.5 trillion of bonds, its sheer purchasing power caused bond prices — and thus, capital gains — to rise, thereby increasing returns for bondholders. New bonds could then be issued with lower coupons, because borrowers didn’t need to offer a high interest rate to attract buyers. This action drove down interest rates across the economy.
The lower interest rates also meant that companies could cheaply borrow from investors and banks to expand their businesses and hire more workers. This was a shot in the arm for the economy, helping boost inflation from dangerously low levels.
Now that the economy is back on track, the Fed is reversing course, slowly raising interest rates and beginning to unwind its massive balance sheet. Some fixed income investors lament this reversal because their bonds could lose value due to falling rates and the Fed’s bond-selling pressure. In a broader sense, though, it is an encouraging sign of economic health that the Fed has begun this process.
Easing the Fed’s foot off the gas
With more money in consumers’ pockets, the economic engine is primed for continued growth with less direct assistance from the Federal Reserve. Already, the U.S. economy appears quite strong and stable: the second quarter saw a 3.0% increase in gross domestic product (GDP) — the thirteenth consecutive quarter of growth.
Moreover, after a long period of stagnant wages, evidence suggests that an increase in income growth is on the horizon. Unemployment has hovered between 4.2% and 4.4% since May 2017, pressuring employers to increase wages as they struggle to recruit and retain workers in a tight labor market. In fact, Target Corporation recently announced a three-year plan to increase minimum retail employee wages to $15.
(Chart illustrates the year-to-date price performance of VTI, an ETF tracking the total US stock market, as of September 29, 2017; source: Google Finance)
Meanwhile, despite the occasional blip, U.S. equities continue to soar, up nearly 14% for the year. Inflation and interest rates continue to remain low, guided by the gentle nudges of the Fed’s monetary policy.
We still expect the Republican-controlled Congress to push a tax plan that benefits shareholders by reducing capital gains taxes. A tax amnesty bill allowing companies with offshore cash could also enhance stock market returns.
These economic signals suggest continued growth in the broader U.S. economy and stock market, but with a couple of caveats. First, it is nearly impossible to time markets successfully. Second, North Korea uncertainty drags on investor sentiment. Though we anticipate continued growth in US equities, a globally diversified investment strategy continues to be the right call for most investors.
Global equities outperform the U.S.
As well as the U.S. stock market has performed, international developed markets have outperformed, up nearly 18% for the year. Global stability and improving economic conditions in Europe and Japan have contributed significantly to the upswing. European unemployment continues to fall, down to 7.7%. And the re-election of Angela Merkel suggests the strong German economy will continue to lead the European Union through its tough negotiation with the United Kingdom over Brexit.
(Chart illustrates the year-to-date price performance of VEA, an ETF tracking developed market equities, as of September 29, 2017; source: Google Finance)
Emerging markets continue to be a top performing asset class this year, up more than 20% for the year.
(Chart illustrates the year-to-date price performance of VWO, an ETF tracking emerging market equities, as of September 29, 2017; source: Google Finance)
Stay the course
The U.S. stock market is enjoying a fine year, and international stocks are recovering from recent lagging performance to help boost returns. Though U.S. fixed income may soften as the Federal Reserve sells off its bond portfolio and ticks up interest rates, the takeaway is that the U.S. economy is performing well. A stronger economy means good things for bond holders, even if returns weaken.
We continue to recommend that our clients invest in a strategic, globally diversified portfolio aligned to their preferred risk tolerance and time horizon. If you have questions about what the right asset allocation is for you based on your goals, take our risk questionnaire or talk to one of our financial advisors.
Over the past quarter, the US economy has continued its slow but steady growth trajectory. The stock market is up 8% for the year to date, and we continue to see signs of confidence in the economy’s direction.
In our Q2 review we explain why you shouldn’t confuse stability with predictability or try to time the market, and why our view of the US economy and markets remains consistent for now.
Suppose we flip a quarter three times and each time, it comes up heads. What does that tell us about the next flip?
Some might draw the conclusion that the coin is rigged in some way, and the next flip will also be heads. Others fall prey to the gambler’s fallacy and bet on the opposite, believing tails are “due.”
But the fact is, we can’t know what the coin will do after just three flips. A perfectly fair coin lands heads three times in a row about once in 8 sets of tosses. So if the coin is rigged, three flips is too small of a sample size to tell. As a result, our best guess should remain at 50% heads.
It’s not all that different from what’s going on in the current market environment: the US has been experiencing a long stock market boom, and many international markets are doing quite well—but does that mean we know what will happen next? Have we seen enough data to change our current investment strategies?
The short answer is, probably not. Let’s take a closer look at why, as we work to separate the signal from the noise.
Chugging right along
We previously noted that, though its growth has been modest, the US economy has been steadily improving, with gross domestic product (GDP) up 1.4% in the first quarter. Unemployment reached a 10-year low in May, and all major U.S. banks successfully completed stress testing, alleviating concerns that the financial sector is undercapitalized. Then, in June, the Federal Reserve Bank nudged its benchmark interest rate a quarter point higher, to 1.25%, further signaling confidence in a strengthened economy. There are plenty of signs that consumers, too, are feeling good about the economy: restaurants are full of patrons, and airports and roads are full of travelers.
(Chart illustrates the year-to-date price performance of VTI, an ETF tracking the total US stock market, as of July 10, 2017; source: Google Finance)
In Q2, the US stock market continued to rise, up almost 8% for the year to date. Even better for investors, the market has enjoyed 258% gains in the S&P 500 since March of 2009. So, how much longer can we expect this good fortune to continue?
Although the current bull run has been long, it’s not recordbreaking in length or return. Since 1926, US investors have enjoyed 11 bull markets (periods that follow declines of 20% or more). The current market boom still trails the 1990s dot-com bubble in both length (113 months) and total return (417%).
Right now, inflation and interest rates remain low, despite the fact that we are near full employment. Through gentle nudges, the Fed can tighten monetary policy to raise interest rates while still encouraging economic growth.
As a result, short-term interest rates have crept up, yet long-term rates have not moved appreciably. That means bond prices haven’t fallen for long-run fixed income investors, either. The yield curve is flattening and we are watching that closely. Continued low unemployment should drive wage increases, and combined with a growing economy, this should move inflation toward the central bank’s long-run target.
We also still expect the Republican-controlled federal government to make an effort to reduce capital gains taxes. Tax cuts are important to their conference and could be positive for investors. A tax amnesty bill on repatriating corporate cash could follow tax reform.
Growth should continue, but the future is unpredictable. Given how little has changed over the last few months, our view of the US economy and markets remains consistent. It’s nearly impossible to time the market—and empirical evidence suggests it is better for investors to simply ride the waves than to try to enter at the bottom and exit at the top. A diversified investment strategy continues to be your best bet.
Abroad, a similar story
Economic growth continues slowly and steadily in developed countries in a similar trajectory to the US. Developed market equity returns are up 12.6% and are outpacing the US in the first half of the year. This upward trend is encouraging stability, especially in markets that are hungry for predictability.
(Chart illustrates the year-to-date price performance of VEA, an ETF tracking developed market equities, as of July 10, 2017; source: Google Finance.)
Following recent elections in France and Britain, major European markets are on the upswing. Since the Euro credit crisis, the Eurozone has grown steadily, now at a 1.9% growth rate. At the same time, unemployment, which hit a high of 12.1% in major European economies, has fallen to 9.1%.
And while over the last twenty years, the Japanese economy struggled to gain traction, growing its GDP just 0.7% per year, now their GDP growth rate has almost tripled the long-run average at 2.2%, while the Japanese market benchmark, the Nikkei, is close to three-year highs.
These signs and others point to consistent growth and improved returns for developed markets. Furthermore, because developed markets have trailed the US stock market in bouncing back from the global recessions in 2008, international equities may have significantly more room to advance.
(Chart illustrates the year-to-date price performance of VWO, an ETF tracking emerging market equities, as of July 10, 2017; souce: Google FInance.)
Emerging stock markets have been the top performing asset class this year, up 14%. This sort of global economic growth is encouraging, though commodity prices continue to lag. Down the line, this could weigh on emerging economies that rely on the export of raw materials. However, as developed economies continue to expand, their demand for raw materials and imports from emerging economies will grow as well.
So are we getting a clear picture?
For the last several years, and especially in the last few months, investors have enjoyed steady returns in their portfolios. US and international equity markets are seeing double-digit annual returns, and bond yields have held firm even as the Fed increases short-term rates.
Though the US’ eight-year bull market run feels like a long time, it is important to remember that it is still a relatively small sample. Plus, it is nearly impossible to accurately predict market behavior, and research shows that early exits from bull markets or late entries following bear markets create significantly worse long-run returns than a buy-and-hold strategy that rides the waves.
We continue to recommend a strategic, globally diversified portfolio that is aligned with your preferred risk tolerance and personal time horizon. If you have questions about what the right asset allocation is for you based on your goals, take our risk questionnaire or talk to one of our financial advisors.