It is widely reported that for much of the past decade, U.S. investors have enjoyed strong returns in balanced portfolios. When looked at in historical context, it becomes apparent that “strong returns” is actually an inadequate description. A balanced portfolio of 60 percent U.S. equities/40 percent 10-year U.S. treasuries has now gone just over nine years without a 10 percent drawdown in real terms, which has eclipsed the previous record set in the roaring 1920s. While returns have not been as strong as they were then, at 11 percent per annum versus 19 percent, many investors are now questioning how much longer there is left in this cycle.
U.S. equity markets have been in a trading range since the correction seen in the first quarter but have outperformed international equity markets. There is no shortage of so-called “known unknowns” out there presenting risks to markets, primarily the threat of rising protectionism, stress in a number of Emerging Market economies and political risk in Europe. However, strong corporate earnings are behind the U.S. market’s relative resilience to these risks. Earnings expectations for the S&P 500 are tracking at 19 percent year-over-year this quarter and although there is clearly a boost from lower tax rates here, it is important to note that expectations are still being revised up. While the upward revision is only small, on average over the last decade earnings are revised down around 5 percent during a quarter, so fundamentals are well supported. It is the price/earnings (P/E) ratio side of the equity equation that is more tricky and providing some volatility.
The phrase “goldilocks” was coined in the mid to late 1990s to describe an economy with well-balanced growth and therefore one not creating any meaningful inflationary or deflationary pressures. More recently, the phrase has been used to describe the environment for asset prices rather than the real economy. While the economic backdrop has been reasonable, it is hardly news that productivity has been weak since the financial crisis. Without productivity growth, it is very difficult to have low inflation, strong corporate profitability and higher wages. Essentially, you can have two out of the three.
The goldilocks environment for risk assets has been supported by strong corporate profits (equities) and low inflation (bonds). However, with unemployment now at 3.8 percent and a fiscal stimulus when we are well below almost all measures of full employment, the balance between the three variables is getting more challenging for both bonds and equities. The relationship between unemployment and wages/inflation is the subject of much debate, but what is important from an investment perspective is that wages are growing faster than productivity. Said simply, as wages and inflation pick up the cost of weak productivity is shifting from labor to fixed income investors, and higher bond yields usually lead to lower P/E ratios and, eventually, the end of the cycle.
In the near term, equity markets are facing the challenge of pricing risks emanating from predominantly political origins. After successfully passing the Tax Reform and Jobs Act, President Donald Trump has turned his focus to trade. In an age of globalization, the interconnectedness of global finance and supply chains makes this an incredibly complex area. However, the overriding principle is that less global trade means less overall wealth creation. The issue is and has always been one of fair trade and a necessary focus on the distribution of the beneficiaries. There is clearly a risk that negotiations could spiral out of control, but we should all hope that economic sense prevails and it is remembered that no one can win a trade war, but everyone can win in a constructive trade negotiation.
From an investment perspective, the environment, no doubt, is getting more challenging. With equity valuations above their long-term averages and bonds providing less diversification benefits than they have done historically, the likely result is higher volatility and lower risk-adjusted returns. To be sure, there are many possible underlying strategies beyond a passive 60/40 portfolio, and this is particularly the case in Fixed Income and Alternatives, where active management remains as important as ever. Overall, it is hard to escape the conclusion that the goldilocks period for asset prices is probably over, even though the U.S. economic cycle, and quite possibly also equities, have further to run.