It is the magnitude and timing–but not the direction–of the market move that has surprised us. Since the fall, late-cycle signals were shining. We have been recommending that investors reduce equity risk during market rallies and extend duration in high-quality fixed income. With the benefit of hindsight, that was the right approach.

As we look ahead to 2019, caution best describes our market outlook. We expect investors to continue to shift their focus. The tailwinds of above trend economic activity and fiscally supported earnings growth shift to the headwinds of central bank tightening, trade concerns, political discord, slowing economic activity and negative earnings revisions. Volatility has increased, and with rising recession probabilities, de-risking is natural. That said, the de-risking that we thought would occur over the next four quarters happened, instead, over the past four weeks. 

As Michael Cembalest said in Bear Market Barometer, “for the first time in many years, markets are now pricing in pessimism instead of optimism.” We couldn’t agree more. Given recent market volatility, we nuance our outlook across both fixed income and equities.

In fixed income, high-quality, longer-term bonds are still an important portfolio ballast, especially for those clients that have not repositioned in acknowledgement of late cycle. During Q4 2018, the S&P 500 declined about 18%, while 10-year Treasuries returned about 5%. That is insulation at work. Yields are lower now than they were just four weeks ago, but given that we expect volatility to remain elevated, we continue to advocate deploying the late-cycle playbook, including adding to high-quality, longer-term bonds as the yield curve flattens.

In equities, at 14x earnings, and with over 90% of S&P 500 companies trading below their 200-day moving average, we would add risk at these levels. That is not to say risks have abated; rather, investors are now being fairly compensated to assume the spectrum of risks. While year-end dynamics, such as low liquidity and trade volume, are clearly still at play, importantly, by no means is this a recommendation to take on excessive risk. Rather, we acknowledge that many of the equity hurdles we expected in 2019 seem less challenging at these levels. In our Chief Investment Office (CIO) team-managed multi-asset portfolios, as portfolio equity allocations have drifted lower, we have made the active decision to buy U.S. equities in order to rebalance back to current tactical weights. The CIO team believes equities will outperform fixed income in 2019 and remains comfortable with the existing equity overweight across multi-asset portfolios.

If you missed our live call with David Frame, Clay Erwin and Tom Kennedy discussing our most updated market and investment views on December 31, you can access the replay now.

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