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By Brian Enyeart, CFA®,* President, Strategic Advisers LLC
Domestic stocks posted strong gains against an economic backdrop that continued to benefit from:
International stock markets also moved higher, but not as much as their U.S. counterparts, due to investor concerns over:
While international stock markets have not kept pace with the United States of late, we still firmly believe that they offer opportunities for growth in the long run. They can also provide diversification benefits for investors.
Lastly, investment-grade bond returns were nearly flat despite the fact that interest rates rose, reflecting a strong economic backdrop and a slight pickup in inflation.
Even as the United States continues to experience positive economic expansion, we are seeing some signs of a maturing business cycle, including:
Therefore, we expect U.S. growth to moderate over time. This kind of environment can still support positive returns for stock and bond investments, though at more modest levels. As a result, we continue to broadly emphasize stocks over bonds within most managed accounts.
U.S. stock markets rose for the second consecutive quarter, propelled by strong corporate earnings growth. In a reversal from the prior quarter, however, large-cap domestic stocks outpaced the stocks of smaller companies. Domestic corporations continue to perform well amid accelerating revenues and record-high stock buybacks. Broad economic strength aided both health care and industrial stocks, making them the leading performers during the period with both posting double-digit gains. Consumer discretionary stocks continued to provide strong returns this year, as consumer confidence reached levels not seen since the year 2000 and businesses saw increases in consumer spending. Within U.S. stock funds, we continue to emphasize growth-oriented stocks rather than value and more defensive investments, such as dividend-focused strategies.
International stock markets as a whole were up modestly compared to the United States. Developed markets posted incremental gains as global manufacturing activity and economic growth slowed, but remained positive. Emerging-market stock performance fell 1.1%,1 due to global trade and country-specific concerns. For example, Chinese stocks experienced weakness as the Chinese economy saw slower economic growth. Meanwhile, Turkey and Argentina each grappled with issues related to their respective level of national debt.
We still believe that international stocks play an important role in your managed account.
In the short term, the corporate earnings of international stocks are projected to grow. Additionally, their valuations remain reasonable compared to domestic stocks. Longer term, our research shows that a portfolio consisting of both domestic and international stocks can help provide smoother returns and a more balanced level of risk than investing in domestic stocks alone. That’s because there are thousands of companies outside the United States with a wide array of growth opportunities. Within international stock funds, we continue to favor holdings that emphasize growth, as well as small and mid-sized companies.
The U.S. economy exhibited broad strength during the quarter, which led to a small uptick in inflation. Meanwhile, the Federal Reserve (Fed) maintained its path of interest rate hikes with the third such increase of the year in September. This led to higher interest rates but nearly flat returns for many bond investors. Investment-grade bonds finished the period with extremely small gains. More risk-oriented bond investments, such as high yield, gained 2.4%.5 One benefit of higher interest rates is that short-term bonds have started to generate better returns, having gained 1.3%6 year-to-date.
In early September, we modestly increased investment-grade bond fund holdings in most Portfolio Advisory Services client accounts. At the same time, we reduced exposure to short-term investments. We made these changes because higher-quality bond fund investments have historically fared better during more mature stages of U.S. economic growth. Also, we believe that in today’s slowly rising interest rate environment, it is important to have a diversified mix of bond investments in your account. For example, high-yield bond funds are less sensitive to changes in interest rates. Owning these types of investments can help reduce the impact of higher interest rates on your bond allocation.
During the quarter, the portfolio’s alternative investments saw modest losses, mostly due to the performance of commodity positions. Most commodities traded lower over the last three months as a strong U.S. dollar and concerns about international trade were both headwinds to commodity prices. On the other hand, several alternatives strategies delivered positive returns for the quarter. Domestic real estate investments also produced modest gains, as demand for commercial real estate persisted amid healthy U.S. economic activity and employment growth. Over 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
* 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 MSCI® Emerging Markets Index (Net MA tax)
2 Dow Jones U.S. Total Stock Market Index
3 Bloomberg Barclays Municipal Bond Index
4 MSCI® ACWI (All Country World Index) ex USA Index (Net MA tax)
5 Bank of America Merrill Lynch U.S. High Yield Constrained Index
6 Bloomberg Barclays U.S. 3 Month Treasury Bellwether 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 (Net MA tax) is a market capitalization-weighted index that is designed to measure the investable equity market performance for global investors in emerging markets.
The Bank of America (BofA) Merrill Lynch U.S. High Yield Constrained Index is a modified market capitalization—weighted index of U.S. dollar—denominated, below-investment-grade corporate debt publicly issued in the U.S. 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 U.S. or a Western European nation. The FX-G10 includes all Euro members, the U.S., 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 U.S. High Yield Index but caps issuer exposure at 2%.
Bloomberg Barclays U.S. 3 Month Treasury Bellwether Index is a market value-weighted index of investment-grade fixed-rate public obligations of the U.S. Treasury with maturities of 3 months, excluding zero coupon strips.
The Bloomberg Barclays Municipal Bond Index is an unmanaged, market value–weighted index of investment-grade municipal bonds with maturities of one year or more.
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.