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Don’t Expect a Market Encore

The stock market has gotten off to a strong start, but that doesn’t mean investors should expect a repeat of 2017, one of the best years historically for global equity performance. The absolute returns were remarkable in every major region last year. The S&P 500 rose 22%, the MSCI All-Country World Index gained 25% and the MSCI Emerging Markets Index soared 38%.

Rarely have we seen such breadth across sectors. Though technology stocks dominated the headlines, investors didn’t need to own any tech stocks to do well last year. Bonds did well, too, even though stronger-than-expected global economic growth is typically a headwind for fixed income securities. Seven-to-10-year U.S. Treasuries returned a little more than 2%, and U.S. investment grade fixed income was up 6.4%.

U.S. high yield bonds earned a 7.5% return, but their relative performance disappointed later in the year. We believe we are in a classic late-cycle economy when high yield usually starts to underperform both investment grade and equities. As such, we downgraded high yield last summer close to the highs and are now removing it completely from our asset allocation recommendations.

What should we expect in 2018? I’m not forecasting a recession, but I do think markets will be more volatile and gains won’t be as robust as some investors may expect.

While we believe that U.S. and non-U.S. earnings will likely rise in 2018, the growth rate will likely peak in the first half. We also believe that financial conditions will tighten this year. Last year, many investors were pessimistic about the market, keeping cash on the sidelines that could be invested to fuel the market’s rise. We can no longer say that investor sentiment and positioning is muted. In fact, there are now signs we may have entered into the “euphoria” stage of this bull market.

This doesn’t necessarily mean the bull market is over, because this stage can last awhile. It does mean, however, that whatever potential upside is left is likely to be more speculative and thus higher risk and lower quality than what we had in 2017.

To our surprise, we hear many strategists and commentators suggesting that the risk is lower because of the tax cut, and earnings are set to go up in 2018. However, the tax situation is a “known known” at this point and one of the reasons why U.S. equities did so well in 2017. Be wary of comments that tax reform has not yet been priced in.


Passing the Baton

Perhaps ironically, we find some comfort that our more muted outlook for 2018 seems almost as out of consensus as our bullish view was at this time last year. Morgan Stanley Wealth Management’s Global Investment Committee, a group of seasoned market professionals who provide investment ideas to our Financial Advisors to help clients build their investment portfolios, recently made three shifts to its tactical asset allocation models for 2018.

First, we think that global markets will outperform U.S. markets in 2018 and beyond. In particular, Europe and Japan offer lower valuations and potentially faster earnings growth. They are earlier in their economic cycles than is the U.S.

Also, we are no longer recommending a currency hedge for Japanese equity positions, which is a change from our long-standing recommended 50% currency hedge. We believe that emerging market equities will do okay in 2018 but lag behind Europe, Japan and maybe even the U.S. in the first half.

Finally, we urge extreme caution with high yield bonds. Stocks have tended to do better than high yield late in the economic cycle and we think late-cycle dynamics have become even more evident lately. Look instead at short-term fixed income, such as two-year Treasurys, taxable investment-grade bonds, or high-quality municipal bonds.

Normalization Means More Normal

While global equity and credit markets performed exceptionally well in 2017 in absolute terms, the risk-adjusted returns were even better considering the extraordinary breadth and low volatility. The biggest market correction was only 3%. That might seem surprising, given the numerous geopolitical shocks, not to mention a contentious U.S. political climate.

To us, this just speaks to how powerful the synchronous global expansion has been and our view that the business cycle trumps politics. We also think that investors underestimated the positive impact of stronger fiscal support on equity market valuations, given still-low interest rates.

As monetary policy continues to normalize, financial conditions tighten and positive surprises wane, global markets should also normalize. During the past 38 years, a correction in any given year has averaged 14%, with a median of 10%. Therefore, investors should be prepared for at least one, if not a few, 10% corrections in U.S. and global equities in 2018.

Asset class and index data sourced from Bloomberg.

Index Definitions

MSCI All Country World Index: The Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global developed and emerging markets.

MSCI Emerging Markets IMI: This index captures large, mid and small cap representation across 21 emerging market countries.

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

Risk Considerations: 

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.

Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT).  Typically, state tax-exemption applies if securities are issued within one's state of residence and, if applicable, local tax-exemption applies if securities are issued within one's city of residence.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Smith Barney LLC retains the right to change representative indices at any time.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. 

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