When we think about our outlook for 2018, we look for themes that can help us reduce risk and boost return potential — and we’re always on the lookout for blind spots that can pose an unexpected threat. The foundation of our process is the development of capital market assumptions — long-term forecasts for the behavior of different asset classes. Our expectations for returns, volatility and correlation serve as guidelines for our long-term, strategic asset allocation decisions.
Given our capital market assumptions, there are two main challenges we believe investors will need to navigate in 2018 (lower returns, higher volatility).
Where are the potential blind spots?
When equity markets experience the type of extended rally that we’ve seen over the past nine years, it’s very easy for investors to lose sight of the value of diversification. Not just among equities, fixed income and commodities — which is critical — but within each asset class as well.
For example, in many of the portfolios that we analyze for our clients, we see significant exposure to credit and reduced exposure to duration within fixed income allocations. Because credit exposure has a higher historical correlation with stocks, this has led to equity-like exposure in a fixed income portfolio and removes the component of fixed income — duration — that is expected to provide a diversification benefit in periods of stress for stocks.
Another blind spot that we see is the use of alternatives. Alternative strategies by definition are designed to provide diversification, specifically during market stresses, and clearly investors in alternatives have waited a long time for this to pay off. However, given our market expectations, there may not be a more important time to own alternatives than now, when we believe the market could eventually shift from a late expansion stage to early contraction.
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