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Rebalance and Re‐evaluate Risk Tolerance: 2017 was a very good year for stocks, with most equity markets returning over 20% and emerging markets up a meteoric 38%. With this rise, there is a tendency to potentially overweight equities or shun risk‐mitigating investments. However, investors should be careful to avoid Recency Bias, a cognitive bias that causes people to more prominently recall and emphasize recent events than those that occurred in the past. If you are overweight equities versus your policy, you should consider rebalancing. Over the past 20 years, the average drawdown in the S&P 500 during any calendar year is 15%. However, many investors have forgotten about this kind of drawdown given we have not experienced that kind of volatility since 2011.
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Overweight International Equities versus the US versus Strategic Target Even though international equities (MSCI ACWI ex‐US) outperformed US equities (S&P 500) during 2017, we don’t think it’s too late to tilt your equity allocation toward international stocks compared to your strategic policy. The US currently makes up 52% of the MSCI All Country World Index. Valuations appear more attractive overseas and earnings in the US are at all time highs while earnings in Europe and emerging markets are both below previous peaks.
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Tilt Toward Active Management and More Broad Mandates While bull markets don’t die of old age, the 105 months of the current bull market have left some regions and sectors more overvalued than others. Passive Index funds tend to do a good job of keeping up with increasing markets, but because they are normally based on market capitalization, they don’t discriminate against overvalued securities. Therefore, at this point in the cycle, we feel it would be prudent to add to active management at the margin. Likewise, the broader the active manager’s mandate, the better. For example, a global all‐cap equity manager has many more options to find value than a US large‐cap manager.
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Have an Inflation Action Plan Inflation has been stubbornly low over the past decade and much of the world’s central banks’ policies have been aimed at avoiding deflation and trying to hit their stated inflation targets (2% in the US). While we don’t anticipate an immediate spike in inflation, there are several indicators worth monitoring:
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Unemployment in the US has fallen from 10% in 2009 to 4.1%. The Federal Reserve generally considers an unemployment rate near 5% as “full employment”. This tightening labor market has yet to lead to a jump in wage growth, but could push it higher.
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The 10‐year breakeven rate, the difference between the yield of a nominal bond and an inflation‐linked bond, recently climbed back above 2%, indicating that investors expect inflation to be about 2% over the next 10 years.
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Beware of Growing Fixed‐Income Duration Now that the Fed is expected to increase rates three times during 2018, some market participants are predicting that it may finally lead to higher rates on bonds. Falling yields over the past decade have caused an increase in the duration of most bond indices. While we expect upward pressure on longer‐term bonds to be limited due to low rates globally, it is prudent to monitor your bond portfolio’s duration (sensitivity to a change in interest rates) and make sure it hasn’t increased with the duration of the index it is being measured against. For example, the duration of the Bloomberg Barclays US Aggregate Bond Index has grown to 6 years as of December 2017 from near 4 years a decade ago. The index’s average duration over the past three decades has been 4.8 years.
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