As the booming business cycle begins to run its course, advisors should begin talking with clients who have fixed-income holdings about an expected period of heightened risk and market volatility.
"Most of the conversation that advisors need to have with their clients is to prepare them [that in] the not too distant future there will be a recession," says Brent Schutte, chief investment strategist with Northwestern Mutual Wealth Management in Milwaukee.
"As you move toward the end of a cycle in general, risk increases, and it increases across the board," he says. "I do believe that investors are going to have to stomach additional volatility."
Advisors should view the turbulence that markets experienced in February as a harbinger of things to come, says Samuel Miller, senior investment strategist at Signature Estate & Investment Advisors in Los Angeles.
That event, rather than the strong 2017 that investors enjoyed, is more likely to resemble what the near future will look like, but that is no cause for panic, he says.
"We have been reminding our advisors at every opportunity that the unusually low volatility of 2017 was very much an anomaly and to expect markets to normalize going forward," Miller says. "The uptick in volatility in early February is likely here to stay and is completely normal for healthy markets."
Schutte notes that the Federal Reserve's continuing moves to raise rates will exacerbate the risk environment, but he urges against a knee-jerk reaction to chase high-yield bonds or junk bonds in fixed income.
"I do in general agree that people can get lulled to sleep by lack of volatility, and it can cause them to take risks they otherwise wouldn't take," he says.
"I want investors to be careful in the fixed-income [market] stretching for yield," Schutte says. "You need to prepare them for the fact that risk is going to be rising, so they don't do the emotional thing when it happens."
In particular, Schutte worries that investors have grown accustomed to chasing yield in their fixed-income strategies in recent years, to the point where they have been pursuing increasingly risky positions. If advisors and investors continue in that vein, he is concerned that they will fail to insulate themselves from an upcoming wave of volatility.
"I fear that people are taking equity risk," Schutte says. "Their fixed income is not set up in a way that would hedge against that if equities go wrong."
Apart from the normal run of the economic cycle, Miller points out that 2018 also happens to be a midterm election year, when markets typically fare the worst and see "larger corrections due to increased policy uncertainty."
"The average S&P 500 decline in midterm election years is 18%, so using the past as a guide, we may be in for more volatility between now and year-end," he says. "On the bright side, midterm election sell-offs have historically proven to be excellent buying opportunities."
This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising.