Many investors have become vulnerable to the risk of overconcentration in U.S. markets due to the strength of the U.S. stock market and currency during the past few years, Joe Davis, chief economist at U.S.-based mutual fund and exchange-traded fund (ETF) giant Vanguard Group told a Florida conference Monday.
“Investors’ positions have become more concentrated as they tend not to rebalance,” he told ETF.com‘s Inside ETFs conference. He suggested that advisors can play a valuable role in helping them rebalance regularly.
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Davis said in an interview that by failing to rebalance, most investors miss the opportunity to buy into undervalued areas, while the overvalued areas in which they are overweight as a result of market gains are vulnerable to correction. Investors have a habit of going with momentum and adding to positions when markets are high and selling when they are low, he said. They therefore fail to achieve the long-term performance shown by markets.
Vanguard has conducted research that found advisors can add as much as 3% to a client’s average annual return by maximizing best financial planning practices such as helping clients select an appropriate asset allocation, implementing the plan using low-cost investments, limiting deviations from the pre-set allocation targets and concentrating on behavioural coaching to help clients stay the course and make tax-efficient choices.
He said there is an opportunity for advisors to assist clients in rebalancing even when it doesn’t “feel” like the right thing to do at the time. He counseled that it is important to rebalance asset allocations to include diversified exposure to more attractively priced markets outside the North America, particularly Europe and Asia. He says investors have been discouraged by slowdowns in Europe and Asia and weakening currencies, but the challenge is have the fortitude to look beyond the current headlines.
“It’s important to look at valuations and the price being paid for growth,” he said.
In his formal talk, he said the biggest economic risk the world currently faces is deflation.
“During the next 10 years every economy in the world is expected to grow at a lower rate than in the past decade,” he told the conference. “Low growth will be the key trend of the next decade, and that has profound implications with respect to interest rates and equity markets, and also has political ramifications.”
Davis says growth will be slower in both developed and emerging markets, and it will dwindle even lower in time.
“If this is the future, the best performing asset class may be a 35-year bond,” he said.
Japan has been experiencing tepid growth marked by mild deflation for the past 30 years, Europe is at risk of falling into similar stagnation and China will move closer to 5% annual growth from the current 7%, he said.
Meanwhile, the U.S. has the best chance it has had in years of hitting a 3% annual growth rate in 2015. He says the U.S. is showing momentum relative to the past few years since 2008, with business confidence increasing, jobs growing and “animal spirits rising.” Lower oil prices are good for the 70% of the economy that consumes energy, he says, rather than the 1% that produces the commodity.
“The question is whether the U.S. economy can remain resilient in a world where Europe and Japan may be facing stagnation and not raise rates for a decade,” he says.
Meanwhile, he says the stock and bond markets are indicating disparate views. The bond market is pricing in stagnation and pushing down yields, but the U.S. stock market has been strong for a few years indicating an improvement in growth expectations. Due to high stock valuations, he is “guarded, but not bearish” about the outlook for the U.S. stock market in 2015.
During the next five years, he expects modest returns of 3% to 6% for a balanced portfolio of 60% stocks and 40% bonds. This compares to an average of 9.8% for the past 30 years and 7.3% for 2014.
Although many forecasters are expecting the U.S. federal reserve to raise interest rates some time in 2015, Davis said the strong U.S. dollar may stop that from happening, as officials may want to limit further strength.
“The biggest potential surprise may not be that interest rates will rise, but that they may not rise at all,” he said in an interview after his address. “It’s a wild card. There is limit to how far the U.S. dollar can appreciate before leading the Fed to pause or forestall a rate increase.”
Editor’s note: For more insight on how the economy and investments will perform in the year ahead, read “Outlook 2015” in the Mid-January 2015 issue of Investment Executive.