*Articles and content provided by SigFig Wealth Management, LLC.
The reasons for holding a diversified portfolio are clear; we know with some certainty that each year, some asset classes will shine, while others decline. Of course, we would love to invest only in the winning asset classes, but no one knows which will win, lose, or run sideways. In an effort to maximize our returns while managing risk, we spread our investments across the available assets.
Even when we understand the logic and the mathematics of long-run performance, it is still difficult to stay disciplined when a familiar asset class outpaces the disciplined, diversified approach. Why shouldn’t we change course and invest in the single asset class that is currently outperforming our diversified, long-run strategy? In spite of our experience and rational investment philosophy, the lure of recently better performance is strong.
One thing modern portfolio theory doesn’t take into account is the risk that our human, emotional self overrides the logical, rational self — to the detriment of our portfolio. It is up to investors to remain focused and committed to maximizing long-term performance, while keeping risk manageable.
For U.S. stocks, mixed signals continue
Over the last six months, U.S. equities outperformed international developed and emerging markets, but that’s not to say that U.S. stocks were great investments. After several years of relentless upward momentum, the S&P 500 flatlined for the last few months; nearly all the positive year-to-date returns came during the month of February alone. Even as its trajectory stalled, the S&P 500’s increased volatility is noteworthy, but not immediately alarming, as it is now closer to historical norms (the previous few years had relatively low volatility).
Our view is that the general pattern speaks more to multiple divergent views among market players on where the U.S. economy is going. As the United States enters a new phase of a global economy with many dimensions in flux, there is value in the absence of a single dominant view about the future. For example, historically, the United States has been a net importer of oil and generally benefited when gas prices were low, but as U.S. production increased over the last decade, declines in oil prices now bring some negative consequences to oil producers and energy employment in the Midwest.
(S&P 500 Index performance for the six months ending August 20, 2015)
Continued anticipation of a rate hike
For the better part of five years, markets have been waiting for the Federal Reserve to start lifting interest rates off the ground floor. As anticipation mounts, U.S. bonds pulled back from their early 2015 highs, suggesting bond markets are already pricing in a rate increase.
(Six-month performance chart, ending August 20, 2015, of AGG, an ETF tracking the Barclays Aggregate Bond Index)
The recent minutes of the Federal Reserve Open Market Committee note that labor markets are improving (unemployment is down to 5.3%) and inflation remains below their 2% target. Polled economists are leaning towards a September interest rate liftoff date over December, though we remain skeptical of a September hike. The economy continues to improve on the back of 2.3% GDP growth in the second quarter of 2015, but there is little evidence of overheating or inflation pressure. China’s recent currency devaluation will continue pressure on our trade deficit. Moreover, Fed Chairwoman Janet Yellen’s dovish stance on rates – she prefers to keep interest rates low to spur economic growth while risking a higher chance of inflation – makes her likely to push to extend the current low-rate environment until the end of the year. If the Fed acts in September, we can interpret that action as signaling the Fed’s belief that the economy is sufficiently strong to weather any negative consequences of tightening monetary policy.
What is going on overseas?
The last several months have not been kind to developed international markets. It is easy to point at the Greek crisis for a reason why European markets struggled, but that is only part of a bigger story. Questions remain about the viability of a single currency union, with Germany and other major economies’ outsized role in driving economic policy, and this continues to hamper European growth. Across the continent, European government austerity policies have had terrible consequences for growth: eurozone expansion fell to 0.3% last quarter, following two quarters of just 0.4% growth. The one bright spot in developed markets, Japan, has enjoyed substantial gains–up almost 16% in the last six months–even as its economy contracted 1.6% in the second quarter.
(Six-month performance chart, ending August 20, 2015, of EFA, an index fund tracking the MSCI Developed Markets Index.)
China’s performance depends on the timeframe
Most frustrating for globally diversified investors has been the abysmal performance in emerging markets. Led by China and declines in commodity prices, these markets slid nearly 15% over the last six months. China’s main Shanghai Index is off 25% since its June heights, but consider the entire run-up in values over the last year. Even though it just lost a quarter of its value, the Shanghai Index is still up 72% over twelve months.
Where should globally diversified investors go?
Even as it seems like all markets are flat or falling, a globally diversified investor should be asking this question: What, if anything, about the current environment and future prospects for growth changes our view about the long run? Our view is that there is little in the recent past and little on the immediate horizon to shift our opinions about the long run. International markets are risky, emerging markets especially, but they comprise the vast majority of the world’s resources, consumers, and long-run growth opportunities. Locally, the U.S. economy is building on its recent growth and a Fed rate increase should reinforce positive inference about the state of the economy–solid growth in prospects, earnings, and labor market tightening. Inflation continues to appear low in the short and long term. Divergence in market views reflects a better, more balanced outlook about the long-run future. On the whole, our stance continues to be that a broad, globally diversified, risk-appropriate portfolio will serve the needs of the long-run investor.