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Quarterly Investment Review

A message from the Investment Management Team of Strategic Advisers, Inc.

By Brian Enyeart, CFA®,* President, Strategic Advisers, Inc.

Q1: Key Points during the Quarter

  • CONTINUED GLOBAL EXPANSION
    Although markets were volatile, stock and bond returns were down only slightly for the quarter, while most of the world’s largest economies continued to experience growth.
  • UNITED STATES STILL IN MATURE MID-CYCLE
    U.S. economic expansion continued, driven by consumer and business confidence, and by a healthy labor market.
  • INFLATION, GLOBAL TRADE CONCERNS DROVE VOLATILITY
    Concerns around inflation and global trade led to volatility in stocks and bonds.

Despite volatility, synchronized global growth continued

Global stock and bond markets were challenged by concerns around inflation and global trade during the first quarter. Despite these near-term concerns, the global economy experienced positive growth, supported by relatively low interest rates, strong labor markets, and higher corporate profits. Nonetheless, stocks finished nearly flat through the end of March. In fact, both U.S. and international stocks are down about 1%1, 2 so far in 2018. Yet both are still positive over the last 12 months. In fact, international stocks have performed better than U.S. stocks over this time. As for bonds, they have lost some value this year, as inflation concerns have driven interest rates slightly higher. However, bonds too have added value for investors over the course of the past year.

Mature mid-cycle despite a slight pick-up in inflation

Last year, inflation slowed and interest rates remained largely unchanged, helping keep the U.S. economy in mid-cycle expansion. So far this year, measures of inflation have moved higher to a degree, as have interest rates. Going forward, we would expect both to gradually drift higher. Historically, this has been common as the U.S. economy matures. Yet so far, we still feel that the U.S. economy is experiencing a healthy mid-cycle expansion. Positive consumer and business sentiment, a strong job market, and relatively low interest rates are all supporting this economic growth.

As inflation gradually accelerates and interest rates edge higher, we believe the economy will, in time, enter a late-cycle expansion. For now, though, with the U.S. economy still going through a healthy expansion, we continue to favor stocks over bonds in most managed accounts.

Domestic stocks fell 0.6%1

Following a period of solid double-digit performance last year, the first quarter of 2018 saw the U.S. stock market finish lower. Investors experienced notable periods of volatility due to concerns with inflation and global trade, as well as with some company-specific issues affecting a few widely held technology stocks. Still, technology companies as a whole proved to be one of the better-performing segments of the market early in 2018. Larger-company stocks retreated more so than smaller-company stocks, while a predominantly favorable earnings environment bolstered the returns of growth stocks relative to value stocks.

Within your managed account, we continue to emphasize growth-oriented and quality stock investments over dividend-focused and defensive strategies, which have historically lagged in periods of rising interest rates.

International stocks declined 1.1%2

Outside the United States, stock performance as a whole was negative during the quarter, as concerns around inflation and global trade affected those markets as well. Developed international markets generated returns that trailed domestic stocks, while emerging-market economies fared better, advancing 1.5%3.

Throughout 2017, we incrementally added exposure to emerging-market stock funds, which helped most client accounts in the first quarter of 2018. We also continue to maintain higher exposure to developed international stock investments. We believe that most such economies are earlier in the business cycle compared with the United States, offering opportunity for further growth.

Rising interest rates weighed on bonds

Under the leadership of new chairman Jerome Powell, the Federal Reserve continued along the path of gradually raising short-term interest rates in the first quarter. Additionally, growing inflation concerns led to higher intermediate-term interest rates, which resulted in investment-grade bonds dropping 1.5%4 for the period. High-yield bonds also fell, sliding 0.9%5. Despite the fact that the U.S. economy continues to grow and corporations have maintained healthy balance sheets, the high-yield bond market was not immune to broader market concerns around inflation and global trade.

As for positioning within bond investments, over the last year, we took the opportunity to reduce high-yield bond exposure. This was based on our view that the performance of high-yield bonds has historically been more challenged as economic growth matures. Finally, since we believe that interest rates will continue to rise at a measured pace, we continue to hold a diverse mix of bonds in your account. Some of these bonds are less sensitive to changes in interest rates, which can help reduce the impact of higher rates on your bond investments. However, we still expect these bond funds to generate modest gains over time and, more importantly, provide stability to client accounts during most periods of market volatility.

Mixed extended asset class performance

In the first quarter of 2018, alternative investments returns were mixed. Against a backdrop of increased market volatility, when both stock and bond investments declined slightly, investments such as gold performed well. Favorable merger and acquisition market activity helped one event-driven alternative investment strategy also produce strong gains. Additionally, long-short credit funds notched incremental gains to begin the year as well. Real estate investments had mixed results: while domestic real estate investment returns declined, the performance of global real estate investments was effectively flat during the period. For the long term, we continue to believe that alternative investment strategies play a vital role in diversifying your portfolio, given that their performance has historically moved in different directions than traditional stock and bond investments.

GLOBAL TRADE UNCERTAINTY

Over the past few months, the current administration has engaged in a number of discussions on global trade. For example, there have been announcements regarding tariffs on steel and aluminum imports, and on broad trade with China, to name a few. Yet, many of these discussions are ongoing, and few concrete actions have taken place in these areas. For our part, we will continue to monitor these developments. However, we will only adjust your account as needed, once trade policies become more definitive. In the meantime, we will continue to follow our approach of investing client assets for the long term, and using our analysis of the U.S. business cycle to position accounts over time.

VOLATILITY AND REBALANCING

While market volatility can be disconcerting for some investors, it is a normal part of how markets behave over time. Additionally, volatility can provide opportunities to rebalance client accounts. For example, when stocks declined from late January into February, we took advantage of this by increasing stock fund exposure in most client accounts. As markets rebounded in the weeks that followed, we were able to reduce stock allocations and reinvest those gains into bond funds. This discipline in the face of market shifts is vital to keeping your investments aligned to your longer-term financial goals.

POTENTIAL IMPLICATIONS OF CORPORATE TAX REFORM

The U.S. corporate tax rate is slated to fall from 35% to 21% in 2018. This should allow businesses to keep more of their earnings. Thus, although U.S. earnings were already projected to rise in 2018, they may now grow at an even faster pace. This has the potential to boost stock prices and dividends. Furthermore, the lower tax rate could encourage businesses to invest more capital and resources within the United States. This could lead to modestly higher growth across the U.S. economy, including more job opportunities and higher wages for U.S. workers.

WHAT WE ARE WATCHING IN 2018

Although wage growth and inflation remained modest in 2017, we will be intently watching for any acceleration in these trends. First, while some wage growth can be good for U.S. workers and the economy, very fast wage growth can lead to slower profit growth for business owners. Similarly, high levels of inflation have historically prompted the Fed to raise interest rates, which can discourage borrowing by consumers and businesses. Both of these factors have the potential to lead to slower U.S. economic growth. As a result, they are important indicators that we will monitor this year.

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