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THIS ISSUE:

From the Desk of

GARRETT D'ALESSANDRO, CFA, CAIA, AIF®

Equities had an outstanding year in 2017. Returns were high across the U.S., Europe, and Asia (see chart), while volatility remained at record lows. Equities in particular registered some of the best performances in recent memory as the top 30 global stock markets all posted gains, most of them in double digits. Corporate and government bonds around the world enjoyed moderate returns, as did many commodities.

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As we go forward in 2018, most of the positive developments that drive financial markets remain in place, including improving global growth, benign inflation, low interest rates and strong corporate profits. While future stock returns will likely be moderate, there are worthwhile gains ahead in equity markets and select credit opportunities in fixed income. This year will likely have more volatility as well as more moderate returns. Given current valuations levels, if history is a reliable guide, equities are likely to generate lower overall annual returns during the next several years.

On the positive side, the world economy looks set for its best back-to-back years of growth in more than a decade, and there are few obvious clouds on the horizon (see chart). A rise in corporate profits has helped revive capital investment, while strong labor markets and relatively low inflation are fueling consumer spending. This has lifted confidence, creating a positive feedback loop where the pickup in global GDP and better financial conditions are further boosting spending and investment. Meanwhile, inflation shows some signs of moderate acceleration and, while central banks have thus far been patient as they seek to normalize monetary policy, the Federal Reserve has said it will raise interest rates 3-4 times in 2018.

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In the U.S., the expansion is on track to soon become the second-longest in post-war history and, despite its advanced age, fundamentals remain good (see chart). The unemployment rate has reached its lowest level in 17 years, confidence is high, and business surveys support continued economic expansion. We expect recently passed tax cuts to provide an additional modest boost to GDP growth over the next several quarters.

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Investors – as they should be – are clearly focused on this positive outlook. After three years of modest growth, the upturn in the world economy has fueled an impressive recovery in corporate profits, which should help extend the long-run bull market for another year. What's been remarkable about the recent rally is how low volatility has been (see chart). While many investors expected more turbulence last year due to Washington politics, European elections, or conflict with North Korea, the market has largely shrugged off all negative news. Indeed, 2017 was the first calendar year without a single negative month in the history of the S&P 500. However, we expect more volatility ahead.

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From the perspective of the past year, with broad global economic growth, solid corporate fundamentals and attractive financial conditions, these low levels of volatility appear justified. However, the expectations bar is now set quite high and growing market enthusiasm means that equities are fully valued. This suggests that future returns will be lower and also subjects investors to potential shocks and unexpected shifts in policy going forward. At 14 months and counting, we are in the longest period in S&P 500 history without a correction of 3% or more, but we do expect a correction in 2018.

Given all of this, our advice for investors is to stay invested while lowering expectations and preparing for choppier markets. Global economic growth will likely continue to lift earnings and power the bull market higher. However, we appear to be entering the later stages of the market cycle, and investors should remain disciplined. The final stages of a bull market can be rewarding, but last year's impressive gains are unlikely to be repeated, and investors should expect more moderate returns in 2018.

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 Read the next article in the series: U.S. Economy on a Roll, but There Are Caveats

Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors, as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

Concentrating assets in the real estate sector or REITs may disproportionately subject a portfolio to the risks of that industry, including the loss of value because of adverse developments affecting the real estate industry and real property values. Investments in REITs may be subject to increased price volatility and liquidity risk; concentration risk is high.

Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy, and market risk. Investors in MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Income Tax).

There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed-income securities and during periods when prevailing interest rates are low or negative. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in below-investment-grade debt securities, which are usually called “high yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

Investments in emerging market bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging market bonds can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk. Past performance is no guarantee of future performance.

Index Definitions

The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a nongovernmental organization, which determines the value of the index from the values of ten key variables.

The Goldman Sachs Financial Conditions Index (GSFCI) is a weighted sum of a short-term bond yield, a long-term corporate yield, the exchange rate, and a stock market variable.

The Standard & Poor’s (S&P) 500 Index represents 500 large U.S. companies. The comparative market index is not directly investable and is not adjusted to reflect expenses that the SEC requires to be reflected in the fund’s performance.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.