State of the Markets
Welcome to the 2nd half of 2018. While the first quarter was volatile but resulted in relatively flat returns, the second quarter has seen some divergence across asset class performance. U.S equities are positive for the quarter and year-to-date. International and Emerging Markets have experienced declines related to currency movements and the possible negative affect of tariffs. Despite this divergence of returns across the world, the global equity market represented by the MSCI All Country World Index (MSCI ACWI) remains relatively flat for the quarter and for year.
The total returns for major asset classes are below.
Diversification is Still Your Friend
From our perspective, there are two main components of diversification. The first is blending together the high-growth investments with assets that can reduce volatility and bring stability to the overall portfolio. This relatively simple blend of growth assets with high quality bonds reduces the overall expected return but can actually increase the liquidity and long-term sustainability of a portfolio, which is critical for matching a portfolio to individual planning needs.
The second component of diversification has to do with making sure the growth portion of the portfolio is not overly concentrated in any particular country, industry, or sector or subject to idiosyncratic risk. This can be done by owning a number of different asset classes – U.S. Equity, International Equity, Emerging Markets Equity, and Real Assets. Over the long-term these assets may have similar return profiles but are likely to follow different paths to achieve them. This level of diversification provides two benefits to the overall investment experience. First, the fact that different growth assets are uncorrelated brings down the overall volatility of the portfolio, which again increases long-term sustainability. Second, a diversified portfolio ensures that you always have exposure to what is doing well while reducing the risk of being overexposed to any asset class that is performing poorly.
This means that a diversified portfolio will always have winners and losers. This can be especially frustrating when the winning asset class over the last decade happens to be the same one headlined in the newspaper every day – U.S. Equity represented by the S&P 500. This shines the spotlight on those elements of a portfolio that are lagging and makes one question the value of diversification. It is worth noting that this not the first time that the S&P 500 has had a period of exceptional performance, leading many to believe that other asset classes are not worth owning. However, a look at market history may lead to a different conclusion.
The chart above illustrates the returns of the growth asset classes represented by applicable indexes. (Bonds are excluded from the illustration as they are not relevant to this commentary.) Each column represents a five-year annualized return beginning in 1993 and ending in 2017, sorted by performance from highest to lowest. The column to the far right represents the annualized returns for each asset class over the entire 25-year period. The grey blocks represent a Diversified Growth Portfolio holding all the individual asset classes in a hypothetical allocation that simplistically represents a diversified portfolio.
There are several takeaways:
- Performance of growth assets ebb and flow. Each asset class has had periods of good performance and bad performance across these rolling five-year periods.
- Periods of good performance are often followed by periods of poor performance and vice versa.
- Despite the very distinct return paths of each asset class, the 25-year annualized returns are remarkably close.
- The Small Value asset class had the best overall performance even though it was never the top performer in any five-year period.
- The Diversified Growth Portfolio was never a winner or a loser but held a consistent position in the middle of the spectrum of returns.
- The Diversified Growth Portfolio also had a positive performance in each five-year period and delivered a respectable annualized return close to the top performers with less overall volatility.
What will the next five years look like?
Returns over the last five years have been decent for all growth asset classes and exceptional for some. While market returns can’t be predicted, we have faith that mean reversion is a consistent driver of long-term market activity. This means that eventually the roles of winners and losers are likely to swap places as they have in the past.
The reversion to the mean is driven by asset classes coming in and out of favor and moving from undervalued to overvalued. It is not surprising that some of the asset classes that have performed poorly recently also have attractive valuations – MLPs yield 7.6%, global infrastructure 6.0%, and global real estate 4.4%. Emerging Markets and Developed International are also trading below their historical average valuations (all according to JP Morgan).
The trade war with China has escalated as the administration implemented tariffs on over $200B of Chinese imports. China is contemplating a response, but this will eventually lead to trade negotiations that will hopefully benefit all sides. In the meantime, this game of brinkmanship has created uncertainty for investors and the markets.
Let’s put the scope of tariffs and trade in perspective. According to the Census Bureau, last year the U.S. imported $506B from China and exported $130B leaving a deficit of $376B. The value of our exports to China (which is the number at risk should China stop importing from the U.S.) represent about 0.5% of our GDP. The cost to the U.S. of implementing the tariffs represents about 0.16% of GDP. These numbers certainly affect some companies and industries more than others but any potential outcomes from this situation are already priced into the markets and unlikely to have a meaningful impact on long-term results.