Strong upward momentum in metals with down moves in bonds and dollar - Good potential for the start of the year

There were some trend surprises in markets near the end of the year; the upward price movement in both precious and base metals and the weather shock in natural gas market and to a lesser extent oil product markets. The question for the beginning of the year is whether these trends will only be short-term in nature. Strong price spikes, especially weather related, are often reversed.

Both base and precious metal sectors were up across the board and have moved through short-term, intermediate, and longer-term trend signals. While base metal trends have been building on the economic growth story, the gold and precious moves were somewhat unexpected even with the talk of higher inflation.

Bond prices have been moving lower across most global markets based on the combination of higher economic growth, higher expected inflation, and expectations of central bank policy normalizations and unwinds. Equity trends have been mixed. The US equity markets continued to trend higher, but European stock indices have moved in the opposite direction. Japan equity prices are above our trend measures but the overall slopes for these trends are flat.

We have added a column to our trend table which shows the asset class trend direction from previous month to allow investor a quick visual on trend changes over the month. At this time, early indications suggest that there will be profitable trend opportunities for January. 

60/40 global blend tells a similar story to US - 2017 was exceptional - A normal year may be closer to 1/2 of the return

The 60/40 stock/bond combination generated an exceptional year for many investors. Although a 60/40 combination is a simplified version for the portfolio that many investors hold, it is a good representation of the general asset class mix without any accounting for alpha and manager selection. For international investors, we ran a similar 60/40 combination of the MSCI World and Citi WGBI index of world sovereign bonds. 

As expected, this mix also generated double-digit returns in 2017 even with the lower global rates. The average return for this combination was 8.1% and the median was 11.23% for the last 30 years. Yet, these averages do not represent what an investor may receive in 2018.

To get even the average return, investors will either need to do better than the consensus expected return of around 6% (from Bloomberg survey for US stocks) and receive a strong positive bond return even with many yields at sub-zero levels outside the US. Rates will have to go lower even while there is talk of central bank normalization outside the US.

Stock/bond portfolio exceptionalism usually leads to the following year being more "normal". Every year where there have been 15% portfolio returns has been followed by lower portfolio returns although not negative. Negative portfolio returns require a recession which is unlikely in 2018. Nevertheless, the need for many global investors is to match an expected return around actuarial assumptions and not just a positive return. Those expected returns are around 7%.

Expected performance suggest a story that better returns for next year will be more likely driven by holding non-traditional asset classes, finding strong alpha generators that can offset diminished beta returns, or strategies that can move across asset classes to take advantage of changing beta returns. Simple variations around a 60/40 theme will not be enough for return-demanding investors. 

Managed futures up for month and positive for the year even in a risk-on world

Much has been made about the value of managed futures during periods of market crisis, but there are also some other regularities that have been found for this strategy that can help with understanding performance. 

A breakdown of the investment environment between risk-on and risk-off periods will find that managed futures does better when the environment is classified as risk-off and does less well when the environment is risk-on. There are a number of indicators which can help define these periods including volatility, credit spreads, and direction of certain asset classes. In a risk-on world, equities will do well as investors will demand lower premiums and hold more risky assets. In this environment, it does not pay to diversify or to manage position exposure to volatility. 2017 turned into a risk-on environment that did not play to the strengths of active management of risk.

Managed futures generated gains of approximately 2.5% for the SocGen CTA index in 2017. The returns for managers who either had a short-term focus, a long-term low turn-over emphasis, or some multi-model   strategy did better than this average. Focused intermediate-term trend managers generally fell below the index average, as diversification and active position management were not rewarded. Holding a diversified basket of selective strategies did allow for better upside.

Do you really want to live with a 60/40 allocation in 2018? - Follow the numbers and you will likely underperform

Numbers and statistics are a funny thing. They usually don't lie and are not fake. You can misinterpret them, but numbers tell a story and it is the job of the investor to either accept the story or come up with an alternative. 

For many investors, there has been a strong adherence to the 60/40 mantra. The mantra says that 60/40 will protect an investor in a downturn and provide strong risk-adjusted returns in all environments. There can be variations on this theme, but 60/40 has often served as the core allocation for many investors. For 2017 this portfolio combination was again a winner.  The 60/40 SPY/AGG (using index total returns) combination generated a return of 13.74% in 2017 which was above the average of 9.86% for the last 30 years.

It is natural to keep with this winning strategy, but it might be good to run some scenarios to see what you will need in 2018 to generate the long-term average annual return for a 60/40 combination. Do not expect a repeat of 2017. 

We used the average forecast for 2018 equity returns (SPY) from a Bloomberg survey as a base equity number and worked backwards to calculate the returns necessary from the AGG index to generate the average annual 60/40 return over the last 30 years.  In this case, the Aggregate index would have to generate over 15% next year. That is unlikely to happen. It would be over 2 times the average AGG return and just under 2 standard deviations from the average over the last 30 years. This return would be without the help of the higher currents yields over the last 30 years. 

Even with the expected SPY returns, just to generate a 6% return for the 60/40 portfolio would require a significant decrease in rates since yields are so low. To get the average return for a 60/40 portfolio, equities will have to exceed the high end of the SPY estimates from analysts and the Aggregate bond index will have be close to its average return of 6.5%. Even to reach expected portfolio returns of 7% will require above average returns in equities and a positive return year for bonds. Most of these scenarios are not likely. 

One of the only likely scenarios for better returns is for asset allocation adjustments based on strategy diversification focused on absolute return. This means high alpha strategies or dynamic beta strategies that can exploit moves in equities and bonds regardless of their market direction. If you want to beat your target return and the 60/40 average, you will need to look outside the usual asset allocation box.