Many investors breathed a sigh of relief as 2015 came to a close. It was a difficult year for most asset classes, with both equities and bonds broadly producing flat-to-negative returns. A traditional 60/40 portfolio (for this simple example we assume 60% Russell 3000 Index / 40% Barclays U.S. Aggregate Bond Index), which averaged a 12.5% annualized return from 2009 to 2014, returned just 0.5% in 2015. In fact, it mattered little whether an investor had a conservative, moderate or aggressive allocation in 2015, as returns were bunched closely together (see below table). Low returns combined with multiple bouts of elevated volatility resulted in a challenging year indeed for asset allocators.
Despite a difficult 2015, we see a favorable backdrop for risk assets in the short-to-medium term. While the Fed recently embarked on a rate normalization cycle, monetary policy remains extremely accommodative from a global perspective. A less-reported but important story is that fiscal policy is again contributing positively to the gross domestic product (GDP) in the U.S. and has become less restrictive in the eurozone, partially due to the immigration crisis. Additionally, expectations for global growth have been lowered so much that it wouldn’t take too much to surprise on the upside.
Of course, it is never too difficult to identify downside risks to our central view. For 2016, these include: an overshoot of commodity prices, emerging market capital outflows, a China slowdown or disorderly equity market/currency adjustment and escalating tensions in the Middle East. Of these potential risks, China gives us the most concern. Markets have started the year very skittish, with concerns over Chinese data, and the uneven policies from the Chinese government with respect to the renminbi and the equity market. While we are concerned about these “tail risks,” we feel that ultimately investors will be rewarded for their patience in this environment.
We retain our modest overweight to risk assets and will look to tactically adjust strategy if we see opportunities created by continued instances of elevated volatility. As equity valuations are fair, core bonds are significantly overvalued, and global economic growth remains relatively slow, investors may need to lower their expectations for returns going forward.