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Quarterly Investment Review

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

By Bruce Herring, CFA®,* President, Strategic Advisers, Inc.

Q3: Key Points during the Quarter

  • SYNCHRONIZED GLOBAL EXPANSION: Economic growth around the world led to gains in stocks and bonds.
  • POSITIVE GROWTH & LOW INFLATION: We continued to emphasize stocks over bonds in most client accounts, due to the mature mid-cycle phase of the business cycle and low inflation.
  • MARKETS REMAINED STEADY: Despite geopolitical concerns and devastating natural disasters, markets did not see prolonged periods of volatility.

Market Summary: Global economy continued to grow despite geopolitical tensions

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.

Business Cycle: Inflation held in check, mature mid-cycle continues

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.

Domestic stocks rose 4.6%1

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.

International stocks up 6.2%2

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.

INFLATION & THE BUSINESS CYCLE

Given the importance of inflation and interest rates to the U.S. business cycle, we continuously watch for changes to drivers of inflation. This includes higher wages or increasing commodity prices.

Higher levels of inflation can prompt us to make incremental adjustments to your portfolio. For example, this could entail increasing allocations to commodities or inflation-protected bonds.

FED BALANCE SHEET UNWIND — What does it mean?

As part of its response to the U.S. economic slowdown and housing crisis in 2008, the Fed had been purchasing Treasury and mortgage bonds.

Their goal was to keep borrowing costs low for both businesses and consumers. In turn, this helped to stimulate the U.S. economy through increased spending and borrowing. In doing so, the Fed’s balance sheet grew to $4.5 trillion.

As the economy has since largely recovered, the Fed feels that this extraordinary stimulus is no longer needed.

In September, the Fed announced that it would begin trimming its balance sheet by parting ways with some of the bonds that it owns. It has also signaled that it plans to carry out this reduction at a gradual and measured pace, over the course of many years.

As such, we believe the impact on U.S. interest rates and the bond market should be minimal over time.

Bonds continue to advance

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.

Positive returns from extended asset classes

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.

INFLATION & THE BUSINESS CYCLE

Given the importance of inflation and interest rates to the U.S. business cycle, we continuously watch for changes to drivers of inflation. This includes higher wages or increasing commodity prices.

Higher levels of inflation can prompt us to make incremental adjustments to your portfolio. For example, this could entail increasing allocations to commodities or inflation-protected bonds.

FED BALANCE SHEET UNWIND — What does it mean?

As part of its response to the U.S. economic slowdown and housing crisis in 2008, the Fed had been purchasing Treasury and mortgage bonds.

Their goal was to keep borrowing costs low for both businesses and consumers. In turn, this helped to stimulate the U.S. economy through increased spending and borrowing. In doing so, the Fed’s balance sheet grew to $4.5 trillion.

As the economy has since largely recovered, the Fed feels that this extraordinary stimulus is no longer needed.

In September, the Fed announced that it would begin trimming its balance sheet by parting ways with some of the bonds that it owns. It has also signaled that it plans to carry out this reduction at a gradual and measured pace, over the course of many years.

As such, we believe the impact on U.S. interest rates and the bond market should be minimal over time.

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