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By Bruce Herring, CFA®,* President, Strategic Advisers, Inc.
The third quarter of 2017 saw strong stock market returns, with international stocks outpacing U.S. stocks. Bonds also gained during the period. Although geopolitical tensions and tragic natural disasters likely weighed on the minds of many investors, the U.S. economy remained on solid footing. In fact, global economic growth continued to drive corporate earnings higher around the world.
Abroad, stock markets in Europe and Japan advanced, but performance was even stronger in emerging-market countries, like China and Brazil. As for bonds, long-term interest rates rose modestly, even as the Federal Reserve (Fed) left short-term interest rates unchanged in September. Investment-grade bond performance was incrementally positive, while high-yield bond returns were even higher.
In our previous letters, we have communicated that we are vigilantly watching for signs of the late cycle phase in the U.S. economy. A few key signs of late cycle include higher inflation and rising interest rates. Although we have begun to see the Fed slowly raise interest rates more recently, inflation has remained low.
For most investors and consumers, this is often a positive development. First, it indicates that the current economic expansion that we are experiencing could last longer, as interest rates will likely be slow to rise. Second, for consumers, low inflation means that the prices they pay for items on a daily basis are either rising more slowly or falling. For example, increased competition has led to lower prices on many cell-phone plans.
Thus, we believe that low levels of inflation could continue to support a healthy U.S. economy, and provide a positive backdrop for stocks.
Within the U.S., strong corporate profits continued to drive domestic stocks higher. It is important to note that this positive performance was against a backdrop of escalating political rhetoric between the U.S. and North Korea, as well as the impacts of Hurricanes Harvey, Irma, and Maria. During this period, short-term market volatility increased and markets declined. Yet, they finished higher than where they began. This underscores the importance of remaining invested, as periodic declines are normal for stock markets.
For example, Hurricane Harvey’s flooding and destruction affected the city of Houston, home to a significant amount of the country’s oil refineries. However, this did not meaningfully change the pace of economic growth for the entire U.S. economy.
Given that the U.S. economy remains in a mature mid-cycle environment, we have continued to emphasize stocks over bonds in most client accounts. We have also emphasized growth- and quality-oriented stock funds, while investing less in defensive, dividend-focused strategies. Finally, we took advantage of the strength in domestic stocks this quarter by rebalancing and repositioning investments as markets continued to rise.
Outside the U.S., international stocks continued to gain traction. Developed international stock markets, such as those in Europe and Japan, have continued to benefit from upward trends in manufacturing and business activity, as well as consumer confidence. Furthermore, central banks in these regions have maintained policies to support growth. Improving growth in China bolstered many emerging market stocks. Meanwhile, higher commodity prices aided markets like Brazil.
During the quarter, we modestly increased our allocations to emerging market stock funds. We believe the economic and earnings outlook remains positive for these regions.
Despite the Fed announcing plans to unwind its balance sheet, with inflation remaining subdued, interest rates rose only slightly during the quarter. This allowed for positive returns of 0.9%3 for investment-grade bonds, while high yield bonds gained 2.0%4.
This environment of slowly rising interest rates favors the diversified mix of bond investments in your account. More specifically, owning bonds that are less sensitive to changes in interest rates, such as corporate bonds or high yield bonds, can help reduce the impact of higher interest rates on your bond allocation.
Higher global stock and bond market performance in the third quarter aided a number of alternative investments, particularly commodity and natural resource focused strategies, as well as an international real estate fund. Following a period of largely disappointing performance early in the first half 2017, commodity and natural resource investments rebounded given higher oil prices and improving growth in China, which has continued to influence global commodity prices. We maintain exposure to alternative investment strategies in your account based on their ability to help provide differentiated sources of returns during certain phases of the business cycle when compared to more traditional stock and bond funds.
* 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 Bloomberg Barclays U.S. Aggregate Bond Index
4 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 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.