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Year-end Investment Outlook

I provide my clients with an up-to-date investment policy statement. Here are my latest thoughts, which are updated quarterly (or more frequently) as need be.

Next March will mark the 10-year anniversary of the start of the current bull market. Both the U.S. economy and the U.S. stock market have fared far better since the 2008/2009 financial crisis than many would have imagined.

Until recently, the stocks markets had been steadily marching higher—and for good reason. The current U.S. economy is characterized by full employment, higher corporate cash flows, and an uptick in consumer and corporate spending. Companies, in particular, have been aggressively investing in technology to increase output while keeping staffing levels in check. This trend has helped the technology sector to be a top stock market performer over the past decade. A recent summary of quarterly earnings reports suggests that tech spending trends remain robust.

Despite this positive backdrop, stock markets have grown more volatile. That is due to a growing sense that the current economic expansion may come to an end in the next few years. The primary reason is the current series of interest rate hikes by the Federal Reserve.

The Fed is currently expected to raise interest rates by a quarter percentage point on four more occasions over the next 12 months before ceasing the series of rate hikes. When that process is complete, interest rates won’t be high enough to choke off demand for stocks. Recall that in past periods of high interest rates, investors preferred the safety and high-yield of bonds. This time around interest rates are unlikely to climb quite as high as in past cycles.

Still, higher interest rates tend to lure investors towards fixed income (e.g. bonds), which will siphon off demand for equities. That means that any further market gains in the near-term may be very muted.

In tandem with higher interest rates, economically-sensitive sectors of the economy will start to shift gears. New home construction may steadily slow as higher mortgage rates put home prices out of reach for younger first-time home buyers. Auto sales are already below their peak, and signs are pointing to lower auto sales in 2019 and again in 2020. Note that consumer spending still accounts for two-thirds of the American economy, and a slowdown in such key sectors has often created the conditions for a recession.

More broadly, the risk profile for stocks has become heightened in late 2018, due to rising geopolitical tensions and a destabilizing run on currencies in emerging markets. We don’t know if and/or when these kinds of exogenous events will trigger a market sell-off, but they represent another risk factor for investors to consider.

Pivoting back to growth vs value stocks, growth stocks are richly valued, relative to historical benchmarks. Value stocks, in contrast, are priced much more conservatively. In light of the aforementioned economic commentary, a rebalancing of portfolios to ensure a proper allocation towards value stocks is recommended.

Emerging markets stocks and bonds are experiencing an elevated amount of volatility this year due to changes in interest rates, currency relationships and geopolitical strains. While this asset class will always deliver more erratic returns, know that demographic trends strongly support emerging market investments over developed market investments over longer time frames.

Fixed income investments (mostly bond funds) are already feeling the impact of rising interest rates. (Higher bond yields equate to lower bond prices). Note that Federal Reserve policies only impact short-term interest rates. Longer-term interest rates (such as the yield on the 10-Year Treasury Note) are also subject to other influences such as inflation trends, the volume of bond issuance, and global interest rates.

Right now, interest rates in Europe and Japan remain near historic lows. Yet they are set to rise in the next 24 months. That could lead to a corresponding (albeit more muted) rise in our long-term interest rates as well.

With that interest rate backdrop in mind, investors should count on very low, flat or even negative returns in the value of their bond funds. However, know that fixed income serves as an important source of diversification, so despite the current tepid outlook for bond prices, it’s important to have sufficient exposure to this asset class. A reasonable level of fixed income exposure will help reduce volatility in portfolios if the stock market hits another air pocket.

Your particular asset allocation strategy reflects a combination of current market conditions, near and mid-term liquidity needs, and optimized risk-adjusted returns for various types of economic outlooks.