Stock markets soared around the world in 2017 as global economic growth improved and investor confidence strengthened. Interest rates generally remained low, helping keep markets calm despite ongoing worries that political uncertainty or unexpected events would trigger disruptions. But rising optimism and five years of above-average U.S. stock market returns are two key reasons investors need to put away their rose-colored glasses and set realistic expectations for the years ahead.

 

The outlook for 2018 depends on the answers to three key questions:

 

1. Will the global bull market continue?

We think the answer is yes. Global stocks should continue to rise in 2018, helping international stocks outperform U.S. stocks for a second year. Improving global economic growth and rising corporate earnings are the food that feeds the bull market and spurs it higher, but expect its pace to slow from a trot to a walk with a few likely stumbles. Solid job growth and higher business investment should continue to support modest U.S. economic growth. 

 

Actions to help prepare for a slower bull market

Increase your allocation to broad-based international equity investments as needed. We think their long-term expected returns are higher than those of U.S. stocks because they have lower valuations, higher dividend yields and higher expected earnings growth rates. Emerging-market stocks were one of the best-performing asset classes in 2017, and they could continue to benefit from global growth.

 

2. How much will interest rates rise?

We expect U.S. interest rates to rise modestly in 2018. As long as inflation doesn’t jump sharply and significantly above 2 percent, the Federal Reserve should remain patient and cautious, raising rates slowly throughout the year. Slowly rising short-term rates, still-low inflation and continuing stimulus policies by foreign central banks can help restrain increases in long-term rates as well. 

Actions to help prepare for slowly rising interest rates:

Add investment-grade bonds as needed. Own a variety of maturities and sectors with enough in short-term cash and fixed income to cover current spending.

Reduce your allocation to high-yield bonds as needed. The additional rate, or spread, to compensate for the higher risk of high-yield bonds is currently well below average. We think investors aren’t being compensated adequately.

Reduce your allocation to international bonds as needed. As the value of the dollar declined in 2017, international bonds performed better than expected, making them more likely to under-perform when foreign interest rates rise. 

 

3. What could trigger higher volatility?

Rising interest rates, elevated political uncertainty, a shift in sentiment or unexpected changes in fiscal, monetary or trade policies are all possible reasons for stock market pullbacks. Historically, stocks drop by 10% or more (called a correction) about once a year. Fortunately, it’s been almost two years since the last correction, but we think it’s prudent to prepare for a return to normal volatility in 2018.

 

Actions to help prepare for higher volatility:

Rebalance to an appropriate mix of stocks and bonds if needed, since investment-grade bonds can help reduce portfolio volatility during stock market pullbacks.

Improve the diversification of your portfolio if needed with a wider variety of asset classes that tend to perform differently over time.

Have a little extra cash to take advantage of pullbacks.

 

Less rosy returns

We think it’s realistic to expect further gains in global stocks, modest interest rate increases and more volatility. Staying patient, disciplined and invested will be critical. But after above-average U.S. stock market returns for several years, realistic investors also need to incorporate lower expected long-term rates of return into their strategies.

Expect lower large-cap stock returns. Over the past five years, S&P 500 returns have averaged more than 15 percent per year – that’s twice as much as we expect long-term. In the past, above-average stock market valuations were followed by below-average long-term returns, as the chart shows. We expect international stock returns to be higher than U.S. returns, helping improve the outlook for well-diversified portfolios.

Expect low fixed-income returns. As interest rates rise slowly, bond prices are likely to slide lower, reducing returns on fixed-income investments. U.S. bond returns were 2.1 percent per year over the past five years, similar to our outlook for the next 10 years.

Adjust your mix. The mix of U.S. stocks, international stocks and bonds that’s right for you depends on your comfort with volatility and long-term financial goals. Your financial advisor can partner with you to review your risk tolerance and evaluate your entire financial position, and then help you decide if you should make some adjustments.

In 2017, investors were pleased to view the world through rose-colored glasses, created by double-digit stock market returns and calm markets. We think you need to remove them for a more realistic view of 2018 and beyond, preparing for more volatile markets and lower returns.

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