We entered 2018 with a significant overweight to risk assets but steadily pared that back to neutral as risks increased around the outlook for growth and monetary policy. The Fed's actions and messaging will be an important marker for the 2019 outlook, as it will help us better gauge whether the Fed will raise rates more than the economy or markets can withstand. The Fed has raised rates by two full percentage points so far this cycle, while the European Central Bank and Bank of Japan haven't moved their policy rates at all. The resulting 10% rise in the dollar this year has pressured emerging markets and tightened financial conditions in the US, which could improve should the Fed choose to take a more patient route in 2019.
The Fed needs to balance their desire to normalize interest rates and increase their dry powder for the next downturn with the risk that further rate increases imperil the economic expansion, 2018 was marked by acceleration in the US and deceleration in Europe and Asia. This has the potential to shift in 2019, as growth in the US is moderating, and the slowdown in Europe and Japan could start to reverse. The typical signs of the end of the business cycle-- surging wages and commodity prices-- aren't present and support the view that the economic expansion will continue through 2019.
Additionally, China's stimulus efforts should also support growth in the second half of 2019, although trade problems could end up offsetting these gains. We continue to favor US high yield bonds in this environment, where we expect them to perform well in a risk-on environment. But they should also provide some downside protection if the environment turns more hostile.
We think concerns over high-yield credit quality are overblown, as high-yield issuers are currently reporting cycle-high profit margins and cycle-low amounts of leverage. Overall, an investor's most important objective should be to carefully align their assets with their long-term goals. Having a portfolio reserve of cash and investment-grade bonds helps ride out inevitable market volatility such as that experienced during the market's recent 10% decline. Having this liquidity reserve in place increases the odds of sticking with the investment plan that was originally designed to best meet your goals.