From the Desk of the CIO
A maturing investment cycle brings its own challenges but also opportunities for investors who can proactively respond to a shifting financial environment.
It’s certainly been an eventful start to the year for global financial markets. Though the first quarter ended with major developed equity market indices down only slightly, those numbers mask a very turbulent period in which stock prices were whipsawed. Bonds also experienced gyrations, with the yield on the 10-year Treasury moving from 2.41% at the start of the quarter to a peak of 2.95% before ending at 2.74%.
Indeed, the biggest story of 2018 so far has been the return of market volatility, following a year and a half in which stock prices rose essentially without interruption and investors seemed impervious to any hint of bad news. That has changed as markets, despite still-favorable economic conditions, have begun to grapple with a number of concerns, including rising trade tensions and the possibility that firming inflation might lead to more aggressive Fed policies.
After an extended period of extraordinary calm, investors can be forgiven for forgetting that volatility spikes in the capital markets are not unusual even in the best of times. In fact, the recent pullback has been well within the normal range of annual market movements. On average, the S&P 500 has experienced a decline of 10% or more in almost half of the calendar years since 1980. In all but six of those instances, the market ended the year in positive territory.
As investors, we believe the most important thing to keep in mind is that bear markets outside recessions are rare and that the outlook for the economy, and especially corporate profits, continues to be quite positive. Already, strong earnings growth will likely see a significant boost in 2018 due to recently enacted tax cuts, and we estimate that average overall earnings per share for the S&P 500 could rise 13% to 15%. History has shown that corporate profits are usually the most influential driver of stock prices. Meanwhile, valuations have also become a bit more attractive.
For much of this long-running bull market, equities have been in a sweet spot. Interest rates and inflation have stayed low while economic and earnings growth prospects have been good. This has given investors the confidence that expected stock returns would be superior to those of bonds and other investments. We don’t think we have moved beyond this sweet spot just yet, but financial markets do seem to be coming to terms with the idea that things are beginning to change. The investment landscape is growing more challenging and will likely become more volatile as investors adjust to a more typical late-stage expansion environment that includes higher inflation, rising interest rates, and less accommodative monetary policies.
Already this year, we have seen greater return dispersion across and within asset classes. None of this means there are not more worthwhile gains ahead for investors, but it does highlight the value of active management and the need to become more selective. Beginning in 2017, both our equity and fixed income research teams made deliberate risk-mitigating portfolio decisions. These decisions have helped fortify client portfolios to weather the turbulence we are experiencing while still leaving them well positioned to take advantage of an investment outlook that remains positive.
Within equities, we have carefully and methodically lowered our risk exposure. Today, our emphasis is more on quality companies and less on cyclical earnings growth. In our equity income strategy, we have reduced exposure to rate-sensitive sectors like utilities and are focusing on companies that can consistently and predictably grow their dividends, which we feel can offset some of the effects of rising rates and help drive our longer-term total returns.
More changes are likely to come as we continue to digest the maturing nature of the cycle. A maturing investment cycle brings its own challenges but also opportunities for investors who can proactively respond to a shifting financial environment. Our relationship with you is very important to us. If there is something you would like to discuss, please contact your advisor or portfolio manager. If I can be of assistance to you, please contact me directly at firstname.lastname@example.org.