Fidelity Viewpoints 5: last days of summer

Markets continue to grind higher in the dog days of summer, but subtle winds of change could be brewing.

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The summer kicked off with another wave of volatility as Brexit (the U.K. vote to leave the European Union) rocked global stocks in late June. Since then, markets have responded well; major indexes, including the S&P 500 and MSCI World Index, hit or are within reach of all-time record highs.

Fidelity’s Asset Allocation Research Team continues to think the business cycle backdrop in the U.S. is a mid-cycle expansion phase. But with a Fed rate hike possible later this year, long-term investors should be careful about wading into lower-quality bonds in search of higher yields. And, even though summer is not officially over yet, it’s not too early to start thinking about year-end tax planning moves.

Here are five themes, recently highlighted in Viewpoints, to consider at September’s outset.

1. Which way for stocks?

Will stocks continue to make new highs, move sideways, or is there a bear lurking in fall’s shadow? Jurrien Timmer, director of global macro at Fidelity, sees five possible paths forward, ranked from most likely to least likely:

  • More of the same—Global growth could continue to be slow and inflation (i.e., a general rise in prices) will remain low, creating a slow grind higher for stocks, as has been the case for the better part of the past two years.
  • Deglobalization—Brexit could be the first domino to fall, leading to less global economic dependence (i.e., deglobalization), lower economic growth, and a slight increase in inflation. Companies with the ability to raise prices more easily than their competitors would best endure this scenario.
  • Bond bubble—If rates fall even lower than they are now, this could lead to a continuation of an unsustainable rally in bond proxies (i.e., low volatility, high-dividend-paying stocks within historically defensive sectors like consumer staples, utilities, and real estate).
  • Recession—An extremely unlikely possibility remains that company earnings will decline further, resulting in a global recession of some magnitude. However, most of the major world economies appear to be doing OK for the moment and earnings appear to be stabilizing of late.
  • Inflation boom—Another extreme, but unlikely, possibility would be stocks riding higher a substantial increase in inflation.

Read Viewpoints: “Five scenarios for stocks

2. Bond update

It’s been an unusual year for bond investors. Bonds have risen alongside stocks, an atypical circumstance over any extended period of time, as global central banks have injected a lot of stimulus to spur economic growth. The global market value of bonds has jumped by $2.5 trillion this year, according to Bank of America Merrill Lynch data.

Tom DeMarco, CFA®, a market strategist in Fidelity Capital Markets’ fixed income division, thinks yields may remain lower for longer. DeMarco thinks opportunities in the bond market may reside in both investment-grade and high-yield names that offer predictable cash flows and a strong ability to pay their debts. However, DeMarco suggests that long-term investors should be very careful about wading into lower-quality bonds that may be tempting to some investors because of these bonds’ relatively higher yields.

Read Viewpoints: “Bond check-in: unusual times

3. Business-cycle backdrop

Fidelity’s Asset Allocation Research Team continues to think that the business cycle backdrop in the U.S. is a mid-cycle expansion phase—with some signs suggesting an eventual transition to the late stage (see the chart below).

However, Fidelity’s latest business-cycle update suggests there may be some changes afoot. For instance, inflation could rise in the near term, due in large part to firming oil prices, wage growth, and service prices. And, while high-quality bonds are still a necessary component of a diversified portfolio, there could be cyclical and secular risks at these yield levels that suggest a more difficult return profile ahead for some bonds.

Read Viewpoints: “August business cycle: stocks high, yields low?

4. Stay diversified

No matter what’s ahead for the market, a tried-and-true strategy to roll with the tide is through diversification. It won’t ensure gains or guarantee against losses, but diversification may provide the potential to improve returns for the level of risk you’ve chosen based on your goals, time horizon, and tolerance for volatility. Determining and maintaining an appropriate asset mix is core to achieving diversification.

Here are three ways to make sure you are diversified:

  1. Know your target mix—Choose a mix of stocks, bonds, and short-term investments that match your goals and risk tolerance.
  2. Review your investments regularly—Monitor your investments, either on your own or with the help of an investment professional.
  3. Rebalance as needed—Rebalancing can entail a variety of strategies. Regardless of the approach you take, be sure to do it in a way that keeps your portfolio diversified within each type of investment.

Read Viewpoints: “Guide to diversification

5. Taxes all the time

While the April tax filing deadline is eight months away, one way you can potentially enhance your after-tax returns is to ensure you are managing your investments in as tax-efficient a manner as possible.

There are many different types of tax-aware plans worth considering that may help you achieve this objective, including plans that focus on retirement, education, health care, and child care. For example, you might consider taking advantage of “free” money with matching 401(k) contributions from your employer. Also, if you are already in retirement, it can help to have both taxable income and nontaxable income sources because it offers the flexibility to take withdrawals from different accounts in order to help reduce overall taxes.

Remember: The specific action you choose should align with your financial goals and situation, and you may want to consider consulting a tax professional before making any decision.

Read Viewpoints: “Are you getting all the tax benefits you can?” and “Manage your tax brackets in retirement”

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