Has the volatility this year been a surprise to you?
Since early February, investors have seen more downside in equity prices than in all of 2017. But, this year's volatility was not a surprise to us. We had been expecting volatility to pick up from last year's historically low levels, and the good news is that pullbacks can actually be healthy for markets. Higher levels of volatility can signal building risks, particularly late in business cycles. These risks can alter the risk-reward balance in portfolios.
However, we believe positive feedback loops continue to promote expansion as the rebound in corporate profits and sentiment should prove more durable in promoting broad-based upturns in business spending and continued hiring through the remainder of 2018 and into 2019. To put it succinctly, late cycle doesn't mean end of cycle—and that difference has investment implications.
For example, the increased volatility in commodities, oil in particular, was prompted by geopolitical uncertainties in the Middle East, stronger global oil demand, and OPEC's unusually disciplined production cuts, all of which have pressured oil prices higher.
Additionally, currencies have been more volatile this year—foreign exchange markets price in the divergence between rising U.S. interest rates and the low rates that persist in Europe, Japan, and other developed markets.
Where do you see growth opportunities the remainder of the year?
While the U.S. equity markets got ahead of themselves in January, we think earnings will continue to rise in an environment of steady economic growth and modestly rising inflation and interest rates. That should support higher U.S. equity prices by year end.
From a global standpoint, we favor U.S. equities over developed and emerging markets. In fixed income markets, even gradually rising inflation and interest rates make long-term bonds less attractive than short-term instruments.
In comparing bonds across countries and regions, we favor the U.S. over local-currency developed markets for two primary reasons—U.S. yields are more attractive and we anticipate volatility in the currencies market.
Where would you rather not take risk?
We would also be cautious on lower-rated areas of fixed income. At current valuations, we believe that high-yield debt offers limited upside potential and meaningful downside risk. To lessen overall portfolio risk, we suggest moving up in credit quality by reducing exposure to high yield bonds and investing in shorter-term high-quality corporate debt.
We would also avoid commodity markets, where we still see too much available supply. This indicates that investors likely will see price declines as the year progresses.
For more information, download our Wells Fargo Investment Institute 2018 Midyear Outlook Report: Late Cycle Doesn't Mean End of Cycle.