We have consistently held to the thesis since 2007 that the Balrog down in the deep has always been deflation. With U.S. quantitative easing behind us and the first hike of 5 (4 to come in 2016) completed in December, interference in market price discovery has been reduced. The initial reaction has been a strong bid in defensive sectors, areas that are showing positive absolute and relative strength.
The key during the next year will be to ensure a “barbell” approach to risk by adjusting the balance of asset and sector allocations. Defensive holdings, such as longer-dated bonds, utilities, consumer staples and infrastructure for example, will provide portfolios with a stable, trending core while more pro-cyclical areas such as energy, industrials and technology need to be strong individual securities (sector outliers) or the sectors must be bought on weakness. Spreading out risk in this way, combined with active management, will support decent absolute returns one year from now.