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:
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.
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.
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.
What would you say drives your investment decisions: hard facts or gut feelings? The line between the two can feel blurry when your methodology isn’t well defined. Even when you swear you’d never let world affairs distract you from your strategy, natural human biases can sabotage your best efforts.
When it comes to portfolio analysis and investment decisions, we know we should emphasize facts and critical thinking. However, we tend to gravitate toward the data that supports our beliefs — this is called “confirmation bias.” Unfortunately, simply being aware of your biases isn’t enough to steer clear of their effects. You need controls in place that will help you sidestep subjectivity when emotion threatens to obscure logic.
Seeking evidence in an echo chamber
When faced with complex matters such as investment evaluation or political views, the data and evidence we gather is often imperfect. We accept or discard facts based on personal opinion rather than objective relevance, and our views often determine which data we seek.
Take the recent US presidential election, for example. Though there were no major economic events directly preceding or following the election, Gallup observed strong shifts in public perception of the US economy during that time. The direction in which those perceptions skewed depended on the political leaning of poll respondents.
Objectively, the condition of the US economy should not change in such a short timeframe, which suggests the influence of prior opinion. How the respondents felt about the election seemingly affected their response to the question.
Humans are biased to prefer information that conforms to our existing worldviews and avoid data that does not. Consider how rarely we read or watch news from sources that tend toward an opposing political viewpoint. A 2012 Pew Research poll indicates that just 10% of Fox News viewers classified themselves as liberal, while 32% of MSNBC viewers classify themselves as conservative.
Seeing what we expect to see
Not only do we struggle to gather adequate information, but we also tend to shape our interpretations of that data to fit our worldviews. When confronted with facts that directly contradict their convictions, humans tend to double down on their beliefs and ignore the evidence. Consider how often anyone actually “wins” that heated Thanksgiving dinner debate.
Rather than making a conscious effort to be open-minded as to where data and investigation take us, our rationale is often distorted by our desired result. In her excellent review of motivated reasoning research, social psychologist Ziva Kunda concludes, “People are more likely to arrive at conclusions…they want to arrive at.”
This human tendency is important to remember when reviewing the markets’ performance. Though equities largely performed well in Q1, the psychological lesson here is crucial: In order to objectively evaluate all the relevant data, you must first establish a complete methodological approach.
A healthy start to the year
Following last year’s presidential election, US stock markets responded positively, rising more than 10%. About half that gain came in the first quarter of 2017, with US stock markets up 5% since January.
(Chart illustrates the price history of the S&P 500 from November 8, 2016 through March 31, 2017; source: Google Finance.)
Though market performance and economic conditions are not always in sync, the US economy is healthy and the underlying economic data continues to improve. Unemployment nudged down to 4.7% in February and inflation has slowly risen to meet the Federal Reserve’s 2% target.
In mid-March, the Fed affirmed the general assessment that economic recovery is in full swing by bumping up its benchmark interest rate to 0.75%-1.00%. The stock market responded positively to the increase — the third of its kind since the Great Recession. Meanwhile, US fixed income — which is sensitive to changes in interest rates, inflation, and economic outlook — has been a stable store of value for bond investors through the first quarter.
In last year’s closing letter to our clients, we suggested that Republicans might move quickly to lower taxes on corporations and investors. Though they stumbled with their initial efforts to replace the Affordable Care Act, tax reform remains high on their agenda — which could be a positive development for some US investors. On the other hand, President Trump has suggested trade deal renegotiations, the longer-term impacts of which are uncertain.
Nonetheless, with a strong economy and the continued prospect of tax cuts, US stock investors should continue to see promising short-term conditions.
Opportunities and challenges abroad
Internationally, stock markets are also generally healthy, though Europe continues to face challenges and uncertainty, with looming elections in several major countries, lagging economic growth in several nations and negotiations regarding the United Kingdom’s exit from the European Union. International developed stock markets, including Europe and Japan, outperformed US equities, rising 7.5% in the first quarter of 2017.
(Chart illustrates the year-to-date price performance of VEA, an ETF tracking developed market equities, as of March 31, 2017; source: Google Finance.)
Last quarter, we noted that anti-trade and nationalistic sentiments in a number of developed countries might impede the economic growth of emerging markets. We also cautioned that though the US stock market outperformed other countries to close out 2016, it was a trend that probably wouldn’t continue. Disciplined investors who diversified their portfolios to lower expected risk and gain greater exposure to different markets were rewarded in the first quarter, when emerging market stocks averaged an 11% jump in value.
(Chart illustrates the year-to-date price performance of VWO, an ETF tracking emerging market equities, as of March 31, 2017; source: Google Finance.)
Committing to consistency
Remember, typical investors are inherently biased toward preferred outcomes in reasoning. We naturally want to find and accept information that aligns with our preconceptions. For example, you may hear that stock markets are doing very well across the globe and incorrectly conclude that shifting to a stock-heavy allocation is the best path forward.
The evidence remains, however, that a cautious approach is more effective, and investors shouldn’t try to time the markets. Asset class performance is seldom consistent or predictable, and economic challenges and pitfalls are inevitable. Though the US economy is strong and tax reform appears high on the Republican agenda, we don’t know the effect that trade negotiations, international elections, and interest rate hikes may have on investor portfolios.
Through careful consideration of relevant data, we can objectively evaluate portfolio performance and make informed decisions about how to invest for the future. This is especially important in today’s market environment, which is fraught with political influences and confusing economic data.
SigFig works to avoid these biases by using diverse and consistent sources to reveal the adequate depth and breadth of the underlying characteristics of the market. Whether markets are up or down, our investment team stresses objective analysis and a consistent methodological approach. In the coming quarter, our investment team continues to recommend a strategic, internationally diversified portfolio that invests in a wide array of asset classes to provide a balanced tradeoff of risk and return.
As 2016 closes, we reflect on the year’s performance and macroeconomic trends and provide a perspective for the future. The portfolios SigFig recommends are diversified across thousands of companies in nearly 50 countries, with exposure to equities, corporate and government bonds, and real estate. We build these globally-diversified investment allocations from our analysis of performance and volatility across many countries and sectors.
Five key points summarize this analysis:
- The aggregate data indicate a strong U.S. economy, coupled with an incoming, tax-reductionist Republican government, which should bode well for the U.S. stock market’s near-term prospects.
- Technological advances and globalization provide American consumers with tremendous value, while simultaneously creating forces that push industrial jobs overseas, with mixed long-term prospects for U.S. economic and stock market growth.
- Globally, challenges remain in nearly all developed economies, while anti-trade and nationalistic sentiments strain emerging markets’ growth.
- Major central banks will be slow to reverse significant quantitative easing measures, potentially leaving interest rates at or near historical lows.
- Long-run returns may be lower than in prior eras, leaving investors to update their long-term investment strategies.
Since Donald Trump’s election, globally diversified portfolios have underperformed the U.S. stock market, but year-to-date performance may surprise many investors who have only recently checked on their portfolio performance. Since January 1, 2016, emerging markets have outperformed U.S. stocks. Even so, over the last few weeks and over the last few years, the U.S. has been among the best performing markets, making it psychologically difficult to hold a well-diversified portfolio, especially when that lags behind our national index.
||Trailing Annualized 5-Year Returns
|Source: Ben Carlson, A Wealth of Common Sense
The disciplined investor remembers that there have also been significant periods where the U.S. lagged behind dramatically, as the table above illustrates. When the U.S. market inevitably falters, international equities may rise, cushioning the impact. Long-term investors should remain committed to a globally diversified portfolio, which smooths out volatility and increases long-run returns, because chasing the latest “hot” market usually underperforms the strategic approach over the long term.
We remain cautiously optimistic about diversified portfolio returns over the next twelve months, while cognizant that some asset classes may do very well, and others may lag behind or even fall in value.
For more detail, please read our full analysis below.
As advisors for well-diversified investors, we evaluate a lot of conflicting information in building a thorough view of the macroeconomic forces that shape the global economy. Some data are clear; the U.S. economy is quite healthy. Other data are fuzzier; developed nations struggle to bounce out of their economic doldrums while emerging markets are threatened by nationalistic agendas in the U.S. and Europe. Meanwhile, the positive and negative effects of globalization and technology on economies and workers are becoming more salient issues in many industrialized nations.
Our analysis compiles data from around the globe to develop expectations about economic performance. It is worth cautioning that investment performance and economic growth are often not linked, in much the same way that a good company does not always make a great investment.
We are nonetheless cautiously optimistic about the near term for a globally diversified portfolio, while recognizing that some asset classes will outperform others. In the longer term, however, we urge our clients to remain cautious about inflating performance expectations, and recommend that they adjust their long-term investment strategy to guard against more challenging long-term returns.
The U.S. economy is quite healthy. The S&P 500, the broad market, large-cap index is on a seven-year bull run, with no obvious end in sight. With Republicans in charge of the federal government, likely to lower taxes and enact business-friendly legislation, there are strong signs the U.S. stock market continues its run into 2017.
By nearly every aggregate measure, the U.S. economy is enjoying healthy growth.
In short, the overall data about the economy looks great as the Obama era comes to a close.
(Chart illustrates the year-to-date price history of the S&P 500 as of December 7, 2016; source: Google Finance.)
More positively for investors, Donald Trump and Republican legislators may move quickly to lower tax rates on dividends and capital gains. Moreover, Congress may again provide amnesty to corporations for repatriating offshore cash, repeating a Bush-era tax break. Since that 2004 “one-time” amnesty, $2.5 trillion has been stashed on offshore company balance sheets, allowing U.S. companies to escape income tax in the hope of future tax breaks. With the federal government now unified in Republican control, corporations again have an opportunity to bring home these profits with minimal taxes, and will likely distribute repatriated cash through dividends and buybacks. This combination of lower investment taxes and the repatriation of trillions in offshore cash keeps the near-term outlook for the U.S. stock market positive.
Over the long term, however, the picture is murkier. On both sides of the Atlantic, the UK’s Brexit vote and the U.S.’s presidential election demonstrated the power of nationalistic agendas, underscored by the unequal effects on workers from globalization and technology. Despite data that suggest a strong economy, unskilled American workers are pessimistic about their future, with good reason. The unemployment rate among workers without high school degrees is 7.9%, while the highly educated enjoy an exceptionally low 2.3% rate. Unfortunately, this inequality is not likely to correct itself anytime soon.
Regardless of the political response to globalization, increasing automation will undoubtedly continue to impact lower-skilled labor. As a thought experiment, consider the future of the U.S.’s two million long-haul truck drivers, who may soon become obsolete. One day — and it may come sooner than we think — we will see driverless long-haul trucks. We will (probably) continue to employ last-mile drivers (the equivalent of tug-boat or pilot-ship captains) and gas station attendants (until a more significant overhaul of gas stations), but future trucking companies could rapidly swap out human drivers for lower cost, automated technology. The unemployment rate could soar to 10% as millions of truckers become jobless nearly overnight. This will have profound impacts on national economics, politics, and policy.
Though the press cast the presidential election as a statement about the negative impact of technology and globalization on workers, its benefits are widespread, thoroughly enjoyed, and are often hiding in plain sight. You may be reading this on your Chinese-made iPhone while watching a Korean-manufactured LG television. Your coffee, tea, chocolate, and bananas likely hail from Latin America and Africa. You can almost feel an athlete’s sweat watching sporting events on huge high definition television sets in the living room. We seamlessly video chat with friends on the other side of the country; transatlantic trips take hours, not days. We have air conditioning and refrigeration. In many respects as consumers, we live richer lives today than did the richest man 100 years ago, in no small part due to the effects of technological innovation and globalization.
In spite of looming technological impacts on the American workforce, the reality is that the U.S. economy is strong. As the Obama Administration wraps up, we note that most metrics of the U.S. economic situation are far improved from eight years ago. We anticipate a modest December increase in the Federal Reserve’s benchmark rate, just the second since the Great Recession, a signal of the central bank’s increasing confidence in the permanence of the recovery. Further efforts at normalizing the Fed’s quantitative easing and reversal of its balance sheet growth remain far off. Though mortgage rates started to climb this fall, we expect reasonably low rates for the near future.
Around the world, the situation is less overtly promising in the near and longer terms. Developed nations face political and economic challenges, especially in Europe. The EU faces protracted negotiations over Brexit, the Italian financial system struggles to stay afloat, and across the continent, far-right parties push nationalistic, isolationist agendas, threatening the established integrated and cooperative order. Japan’s Abenomics program successfully fought off deflationary concerns with massive fiscal spending, yet that economy suffers the same weak growth as many other developed countries. Overall, 2016 was fairly volatile for developed nations, just breaking ahead for the year.
(Chart illustrates the year-to-date price performance of VEA, an ETF tracking developed market equities, as of December 7, 2016; source: Google Finance.)
In general, developed economies’ continued sluggishness suggests that central banks are reluctant to begin any monetary tightening policies. Keeping interest rates very low, the thinking goes, will eventually boost capital investment and spark a sustained growth spurt.
Among less developed nations, China’s rapid expansion continues, albeit at a modestly less torrid pace than in the prior decade. Barring a tumultuous regime change or conflict with the U.S., it is clear that China will continue to grow rapidly. Emerging market investors will be rewarded in a future that encourages their economic progress and deeper connectedness with developed nations. These relationships reduce conflict risk and encourage partnerships in solutions to global problems, like climate change and pollution.
For other developing nations, the outlook also remains optimistic, tempered by recognition that emerging markets, reliant on commodities or trade for export, face significant headwinds in a global political environment with a dim view of international trade. Though investors who have only paid attention in the last few weeks might be surprised, emerging markets actually outperformed the U.S. stock market, up more that 12% on the year, even after a 2.5% drop since Trump’s election. More broadly, even as the President-elect has spoken critically of the cheap imports preferred by American consumers, global integration and increasing international trade are not trends easily reversed by a President alone. Emerging economies should continue to expand, even if that growth is not immediately reflected in their stock markets.
(Chart illustrates the year-to-date price performance of VWO, an ETF tracking emerging market equities, as of December 7, 2016; source: Google Finance.)
Since Donald Trump’s election, U.S. equities outperformed most asset classes, especially international developed and emerging markets. The last few weeks’ outperformance has been especially stark and makes many investors question the wisdom of investing outside the U.S. Even over the last few years, U.S. markets have outperformed other countries’ markets, so why do we remain committed to a diversified strategy? Because it’s the only one that makes sense for the long run.
In a fascinating recent blog post, “Diversification Is No Fun,” Ben Carlson highlighted how diversification makes sense after realizing the unpredictability of asset class returns over an appropriately long investment horizon. Consider the June 2001 – May 2006 investment period, graphed below, when U.S. stocks languished with a 8.7% total return over five years. Developed markets were up 45%, while emerging markets rocketed skyward 130%!
(Chart illustrates price returns for VTSMX, VGTSX, and VEIEX, mutual funds tracking indices of the U.S., developed markets, and emerging markets, respectively, from June 2001 through May 2006; source: Google Finance.)
This is a pattern that has happened before, as Carlson notes in the chart replicated below. There are times, as now, when U.S. stocks beat the rest of the world, just as there are long periods when the international stocks are better investments. For the long-term investor, however, it makes sense to diversify across the board to capture the upside, while diversification also smooths out the swings of individual markets and asset classes.
||Trailing Annualized 5-Year Returns
|Source: Ben Carlson, A Wealth of Common Sense
It is psychologically difficult to remain committed to an internationally diversified strategy when it underperforms the local major index. Nonetheless, it is important to stay on track and ignore the movements of a few weeks, months, even years. We encourage our investors to remain committed to a long-run allocation, smoothing out volatility and increasing long-run returns, because chasing the latest “hot” market often underperforms the strategic approach over the long run.
What composite picture does this paint? Continued economic growth in the U.S., coupled with favorable tax changes for investors and corporations. Over the long-term, however, the picture is fuzzier: there are dangers ahead which could upset the basic characteristics of our economy. Elsewhere, developed economies struggle to sustain growth with little reason for near-term optimism. Emerging market economies, whose stock markets fell after Trump’s election, should nonetheless continue to grow, in spite of nationalist preferences of some developed nations. Further, U.S. bonds and emerging market debt have underperformed in expectation of a Fed rate hike. Across both stocks and bonds, with questionable paths to long-term growth, long-run equity returns may be lower than seen over the last few years, while interest rates are likely to remain quite low for the foreseeable future. It may become a challenging environment to achieve once “normal” returns.
SigFig’s Investment Team regularly reviews all these factors when considering future expectations about asset class returns and building our clients’ asset allocations. Adjustments to allocations may be small or negligible, even if we have reduced expectations about long-run returns. Our investment philosophy, based on the mathematics of Modern Portfolio Theory, outlines how to develop a diversified portfolio which balances the tradeoffs of risk and return for our clients.
Lowered expectations about long-run returns have implications for our clients’ financial planning. Lower long-run returns mean weaker benefits from compounding; savings rates must increase significantly. Unfortunately, we cannot solve for lower long-run returns simply by identifying the high-return asset classes: that approach implies significantly more risk in search of higher returns. Moreover, the intuition of Modern Portfolio Theory is that the search for “hidden” excess returns is costly and nearly impossible. Instead, we must rely on more disciplined investing and savings.
Our year-end financial planning advice:
- Save more today by trimming excess spending. Make a plan to pay yourself first: deposit savings immediately after payday as a mechanism to enforce low spending rather than saving only whatever is left after monthly spending.
- Think critically about the size of the nest egg you need in retirement.
- Remain a disciplined investor, with a broadly diversified investment strategy.
- Retake our risk tolerance questionnaire to confirm your risk tolerance.
Ultimately, because asset class returns are unpredictable and vary significantly from year to year, a diversified approach remains our recommended strategy. For the coming year, our guidance remains consistent: a strategic, globally diversified portfolio provides the best tradeoff of balancing risk and returns.