The Goldilocks investment environment may be coming to an end. What does that mean for portfolios?
Everyone knows the famous story of Goldilocks. A little girl goes for a walk in the forest and enters a home where she finds three bowls of porridge. The first bowl is too hot, the second too cold, but the third one is just right, so she eats it all up.
In 2017, similarly, investors found themselves in an environment that was ‘just right’. Global synchronized growth took hold. Nearly every economy grew, some at its fastest pace since the financial crisis, while others exited recessions. Despite the dramatically improved economic environment, inflation remained non-existent. So, despite record-low interest rates, central banks could maintain their dovish tone – with some even cutting rates.
Risk assets certainly benefited. The 10-Year Treasury traded between 2% and 2.6%1 – a very narrow range. Stocks returned 21.8% with the second lowest volatility on record.2 The S&P 500 declined by more than 1% on only eight occasions. In the end, it was one of the highest quality years on record. Bonds and stocks worked together, with a low risk of shock.
A too-hot economy is hard to characterize. It exhibits many qualities – more economic activity, more hiring, and more strain are among them, but the recent rise in inflation visible in wages and CPI is most telling.
Signs Inflation (and the Economy) May Be Approaching a Boil:
- U.S. economy near full employment
- Productivity growth low
- A cheap dollar
- Global output gap rapidly closing
- Even more fiscal stimulus in the pipeline
Inflation Is Bad for Both Stocks and Bonds
Inflation erodes the purchasing power of a bond’s future cash flow. Therefore, when inflation expectations rise, investors require a greater yield for their investment. Any rise in inflation is bad for bonds.
Equities are less impacted, at first, by inflation. Inflation increases a firm’s cost to borrow (as the Fed raises rates), while also reducing the future value of earnings in today’s dollars. For now, a little inflation is okay for stocks, but as inflation rises significantly investors may be less willing to pay today’s prices for tomorrow’s (less valuable) earnings.
If inflation concerns continue to linger, we may be entering a period where both stocks and bonds move together. These scenarios reduce the effectiveness of a diversified portfolio of stocks and bonds and can be very painful for investors.
Inflation remains at moderate levels, the economy remains on very solid footing, and earnings are in an upward trend. As such, we prefer equities to fixed income. We recognize that the end of Goldilocks likely means more inflation and more volatility. Investors concerned about the regime change may want to consider adding alternative investments or commodities to their portfolio where appropriate.
1. Based on the 10-Year U.S. Treasury Yield, 12/31/16 – 12/30/17.
2. Based on the S&P 500 Total Return Index, 12/31/16 – 12/30/17
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Alternative investments are speculative, not suitable for all clients, and intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment.
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Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. Index results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index.
The Standard & Poor’s 500 Index (S&P 500) is one example of a total return index. The total return indexes follow a similar pattern in which many mutual funds operate, where all resulting cash payouts are automatically reinvested back into the fund itself.
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