The only constant is change. Artificial intelligence took massive leaps forward. Bank failures made a comeback. Moody’s downgraded US debt. Summer came and went with record temperatures making July the hottest month on record. Phew. And change hasn’t stopped there: financial markets have been no different. The S&P 500 is up 17% through August (versus down -20% last year); the tech-heavy Nasdaq is up a whole 34% this year (versus down -33% last year); and inflation is now down to an annual 3.2% (versus 8.5% this time last year).

As markets change, so do our assumptions around long-term expected returns. We don’t try and predict markets, but we do perform an annual review of our capital market assumptions — 10-20 year forecasts of how different asset classes could perform based on global economic, monetary, and political conditions. Each year’s review includes active discussions and healthy debates among the Ellevest Investments team to determine whether market change is: 1) material and 2) requires action. In some years, we finish our capital market assumptions review and make little change to our forecasts. In others, we make more active adjustments to our portfolios. 

This year is one of those active adjustment years. The team agreed that there’s been meaningful, fundamental change — the biggest being interest rates, which have moved to their highest level in over 20 years (chart below). Let’s dive into what this means for our forecasts and how we’re positioning portfolios for this new environment.

A Higher Cost of Capital

Almost everyone’s felt the impact of higher interest rates at this point. Mortgage rates, credit card rates, auto loans, have all become more expensive. For companies, this means higher borrowing costs and lower earnings. Within equities, companies in the small-cap value asset class are among the most impacted. So, that’s where we’re making a reduction in our portfolios.

Here’s a peek into our reasoning: The small-cap value asset class represents smaller, more economically sensitive sectors (think: banks, energy) which not only have to deal with the slowdown in economic growth from higher interest rates, but also, due to their size, aren’t equipped as well as their larger counterparts to weather the storm. They’ve performed well over the last three years, but going forward, may face more challenges.

Additionally, the types of companies represented within small-caps as a group have changed. Due to reasons like higher regulatory costs and easier access to private capital, companies have been staying private for longer. Not only are fewer companies going public, but the really successful ones also bypass their entry into the small-cap world by growing past the $2 billion threshold for inclusion. All this impacts the size, breadth, and quality of companies available in the small-cap segment in public markets. 

Falling inflation

Another outcome of higher interest rates? Falling inflation. Inflation has fallen — by a lot.  Yes, it’s still higher than pre-pandemic levels. But 3.2% is a lot closer to 2% than the 9% peak we saw last year (see below). There are still segments within inflation, like housing costs, that still need time to normalize. But progress has been made and it seems like the worst is behind us. That’s why we’re reducing our TIPS exposure (Treasury Inflation-Protected Securities), which was used as an inflation hedge within some fixed-income portfolios. These securities trade based on future expectations for inflation, which have also come down a lot. TIPS played an important role in portfolios over the last few years, but our assumptions point to a better picture for inflation going forward with less of a need for TIPS exposure. 

The need for Private Alternative Investments

Finally, the last major outcome from our review of capital market assumptions is higher correlations across public market asset classes. We’re seeing this across the board, from both the assumptions we rely on and from larger asset managers in the industry. Larger asset managers like BlackRock and JP Morgan also discuss this phenomenon. The bottom line: Higher correlations within public markets increase the need for private alternatives, with no or low correlation with stocks and bonds for higher diversification within portfolios.

Investing is not a set-it-and-forget-it exercise. Regular rebalancing is key in a long-term investment plan to keep you close to your target asset allocation, aka one optimally diversified for you. But so is revisiting assumptions when markets and key factors driving the economy have changed. At Ellevest, we do that heavy lifting for you and determine what portfolio adjustments, if any, should be made to help keep you on track to achieve your financial goals.

If wealth management sounds right for you, learn more about Ellevest’s Private Wealth Management and our team of financial advisors.

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