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By Bruce Herring, CFA®,* President, Strategic Advisers, Inc.
The last several months saw global stocks and bonds steadily rise in value. Many economies continued to grow and corporate earnings moved higher. It appears markets ignored political headlines from Washington and Europe, focusing instead on positive economic developments. Looking overseas, international stocks outpaced U.S. stocks. Economic growth has continued to improve in these regions, as does the outlook for corporate earnings. European stocks led the way, supported by low interest rates and other pro-growth policies. Emerging market stocks also saw a strong quarter, especially in Asian regions.
As for investment-grade and high yield bonds, their returns were also positive, but more modest than stocks. Although the Federal Reserve (Fed) raised short-term interest rates in June, longer-term interest rates fell slightly during the last few months. This was due, in part, to lower inflation expectations by investors.
Although the U.S. economy expanded in the second quarter, we have been monitoring labor markets and new pro-growth policies. On the labor front, job openings are plentiful and weekly unemployment claims are near 45-year lows. Healthy labor markets and low unemployment rates have historically spurred faster wage growth and higher inflation. These pressures can weigh on corporate earnings as rising inflation and employee costs shrink profits. So far in 2017, wages have been slow to rise and inflation is stable. However, should wages rise at a faster pace, we would expect a more challenging environment for stocks. Shifting to new pro-growth policies, the possibility for tax reform and deregulation occurring in 2017 has fallen significantly. This does not mean they will not occur, but it is likely that the pace will be much slower than originally anticipated following the U.S. election. This could change should more constructive policy debate resume in Washington.
Despite the lack of pro-growth policy progress in Washington, U.S. stock markets continued to move higher. They were bolstered by a positive economic backdrop and improving corporate earnings. Growth areas of the market did well, while energy, telecom, and small-company stocks lagged.
Within most client accounts, we are still emphasizing stocks over bonds. Our positioning favors stocks in areas like technology and banking, which typically perform well when the economy grows. Conversely, we have less exposure to defensive, yield-oriented stocks, such as utilities and telecoms, as these could struggle if interest rates head higher.
Looking overseas, stocks have also moved higher. This was driven by accelerating corporate earnings and improving economic conditions. As a result, international stocks have outpaced U.S. stocks in 2017. In fact, manufacturing remains robust and unemployment rates continue to fall. Additionally, exceptionally low interest rates aimed at boosting borrowing and spending remain in place. With this backdrop, the outlook for international stocks seems to be bright. Finally, corporate earnings for international stocks are expected to grow at a faster pace than U.S. stocks for the rest of 2017.3
International stocks are also more attractively valued than U.S. stocks. Furthermore, international stocks—especially emerging market stocks—have historically seen strong performance when the U.S. shifts to late cycle expansion. Thus, we have a small bias toward international stocks in client accounts. We also remain diversified across many regions, countries, and sectors.
Bonds performed modestly well in spite of the Fed’s third interest rate increase since December, long-term interest rates fell slightly over the last few months. This fueled returns of 1.5%4 for investment- grade bonds, and 2.1%5 for high yield bonds. Based on the market’s muted reaction to rate hikes, most investors likely viewed the Fed’s actions as a positive reflection of U.S. economic growth.
Nonetheless, we believe that the likely path ahead for interest rates is a slow, gradual rise over time. As such, we continue to hold a diverse mix of bonds in client accounts to help temper the effects of higher interest rates. This is because some bonds are not as sensitive to changes in interest rates. For example, bonds issued by U.S. corporations are generally less sensitive to interest rate changes than U. S. Treasuries. As a result, we have a greater emphasis on corporate bonds in client accounts, and less exposure to U.S. Treasuries.
The improving global growth backdrop also helped deliver positive performance for many alternative investments. Real estate, long/short, and absolute return investment strategies performed the best during the second quarter whereas multi-strategy funds were more mixed. Commodity and natural resource investments came under pressure as oil prices declined amid supply and demand imbalances. This weakness provided an opportunity to incrementally increase exposure to commodity and real asset investments. Overall, we firmly believe that alternative investment strategies play a vital role in diversifying your portfolio given that their performance over time often moves in different directions than traditional stock and bond investments.
* The CFA designation is offered by the CFA Institute. To obtain the CFA charter, candidates must pass three exams demonstrating their competence, integrity, and extensive knowledge in accounting, ethical and professional standards, economics, portfolio management, and security analysis, and must also have at least three years of qualifying work experience, among other requirements.
1 Dow Jones U.S. Total Market Index
2 MSCI® ACWI (All Country World Index) ex USA Index (net MA tax)
3 Fidelity Investments (AART), as of 1/31/17.
4 Bloomberg Barclays U.S. Aggregate Bond Index
5 Bank of America Merrill Lynch US High Yield Constrained Index
Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.
Past performance is no guarantee of future results.
Diversification cannot ensure a profit or guarantee against loss.
Indexes are unmanaged. It is not possible to invest directly in an index.
The views expressed in the foregoing commentary were prepared by Strategic Advisers, Inc., based upon information obtained from sources believed to be reliable but not guaranteed. This commentary is for informational purposes only and is not intended to constitute a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The information and opinions presented are current only as of the date of writing without regard to the date on which you may access this information. All opinions and estimates are subject to change at any time without notice.
Alternative investment strategies can invest in securities that may have a leveraging effect (such as derivatives and forward-settling securities), which may increase market exposure, magnify investment risks, and cause losses to be realized more quickly. These strategies may invest in commodity-linked investments, which may be more volatile and less liquid than the underlying instruments or measures. The commodities industry can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions. Short positions pose a risk because they lose value as a security’s price increases; therefore, the loss on a short sale is theoretically unlimited.
Securities indexes are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Benchmark returns assume the reinvestment of dividends and interest income. Investments cannot be made directly in a broad-based securities index.
The Dow Jones U.S. Total Stock Market Index is a float-adjusted market capitalization–weighted index of all equity securities of U.S. headquartered companies with readily available price data.
The MSCI ACWI (All Country World Index) ex USA Index (net MA tax) is a market capitalization-weighted index designed to measure the investable equity market performance for global investors of large and mid-cap stocks in developed and emerging markets, excluding the United States.
The MSCI Emerging Markets Index is a market capitalization-weighted index of equity securities of companies domiciled in various countries. The index is designed to represent the performance of emerging stock markets throughout the world and excludes certain market segments unavailable to U.S. based investors.
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based, market-value-weighted benchmark that measures the performance of the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. Sectors in the index include Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS.
The BofA Merrill Lynch US High Yield Constrained Index is a modified market capitalization–weighted index of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch). The country of risk of qualifying issuers must be an FX-G10 member, a Western European nation, or a territory of the US or a Western European nation. The FX-G10 includes all Euro members, the US, Japan, the UK, Canada, Australia, New Zealand, Switzerland, Norway and Sweden. In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule and at least $100 million in outstanding face value. Defaulted securities are excluded. The index contains all securities of The BofA Merrill Lynch US High Yield Index but caps issuer exposure at 2%%.
Stock values fluctuate in response to the activities of individual companies and to general market and economic conditions.
Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.
Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
In general, the bond market is volatile, and fixed income securities carry interest-rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
Investments in smaller companies may involve greater risk than those in larger, more well-known companies. Because of their narrow focus, sector funds tend to be more volatile than funds that diversify across many sectors and companies.