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By Brian Enyeart, CFA®,* President, Strategic Advisers, Inc.
Domestic stocks advanced over the last few months, supported by a healthy U.S. economy and rising corporate profits. However, stock markets did experience some volatility, driven by global trade uncertainty and other geopolitical concerns. Meanwhile, international stocks fell slightly during the quarter. While economic growth overseas remains mostly positive, there were signs of some slowing in key regions, such as China. Nonetheless, over the last 12 months, international stocks have delivered solid gains for investors. Finally, bond performance declined because of a modest uptick in interest rates, which was a reflection of a healthy U.S. economy. As a result, some inflation measures moved slightly higher.
We believe that the United States is in a mature phase of economic expansion. Strong corporate earnings, high levels of business and consumer confidence, and a healthy labor market are all supporting growth. However, in our view, this level of economic activity is likely to moderate over time. Factors such as Federal Reserve (Fed) and other global central bank policies, in addition to ongoing global trade developments, have the potential to affect economic activity around the world. In spite of these potential concerns, our view is that the economic environment remains largely positive for most countries. Thus, we continue to emphasize stocks over bonds within most managed accounts.
U.S. stock markets rebounded in the second quarter after beginning the year nearly flat. Strong corporate earnings helped limit the impact of recent volatility caused by trade negotiations and geopolitical concerns. That being said, while we do not expect an all-out trade war, we are monitoring the potential impact of tariffs on U.S. multinational corporations, given that nearly half of the revenues of companies in the S&P 500® Index come from overseas. Trade uncertainty actually helped stocks of smaller U.S. companies gain 7.8%2 for the period, as such stocks typically rely less on international sales to be profitable.
We modestly repositioned the domestic stock fund exposure in most client accounts during the quarter. This included shifting some large-cap domestic stock investments to those that have a smaller-company focus. Additionally, our tilts toward growth- over value-oriented stock investments remained in place and added to returns in the last few months.
Overseas, stock markets were hampered this past quarter by global trade concerns, slowing industrial activity across key regions like China, and a strong U.S. dollar. While performance in developed international markets, such as Europe and Japan, failed to keep pace with the United States, it was emerging-market economies that bore the brunt of the decline, retreating 7.9%.4 Political turmoil weighed on returns in countries like Brazil and Turkey. Other emerging markets like China and India also fell, but considerably less because of government efforts aimed at providing economic stability.
We modestly lowered international stock fund exposure in most client accounts during the quarter. This is because the U.S. dollar strengthened in recent months, which can weigh on international stock returns when translated back into U.S. dollars. The strong dollar was driven by the positive pace of U.S. economic growth versus many other global economies, as well as by higher interest rates. Despite this small reduction in exposure to international stock investments, we believe that they offer long-term growth opportunities for investors and remain a key component of your account.
The Fed’s second interest rate hike of 2018 took place in mid-June, and measures of inflation also moved slightly higher over the last few months. This resulted in higher interest rates for the quarter and a small decline of 0.2%5 for investment-grade bond investments. However, high-yield bonds advanced 1.0%,6 as strong earnings supported corporate balance sheets.
Throughout the quarter, we repositioned some of the bond investments within your account to increase exposure to investment-grade bonds. Higher-quality bond investments can provide stability to a portfolio during periods of stock market volatility, which can be more common during mature stages of U.S. economic growth. Additionally, we strive to maintain a diverse mix of bond investments within your managed account, as certain types of bonds fare better than others in a rising interest rate environment. Finally, while rising rates can weigh on bond prices in the short term, the higher interest payments they provide over time can actually benefit long-term investors.
Consistent with their diversification qualities and differing objectives, the portfolio’s alternative investments had varied performance during the quarter. Positions in both domestic and international real estate investments generated strong gains for the period. More specifically, domestic real estate investments benefitted from continued underlying strength in the economy. A backdrop of higher oil prices helped those funds with more exposure to natural resource companies within the energy segment of the market. Conversely, commodity funds that own a broad-basket of investments, including industrial metals and agriculture, posted weaker returns due to higher supply as well as questions regarding overseas growth. Finally, certain multi-strategy and market neutral funds that seek to identify and invest in market trends within global bonds and commodities had more challenged returns given market instability in these areas during the period. Over time, we continue to 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 Stock Market Index.
2 Russell 2000 Index.
3 MSCI® ACWI (All Country World Index) ex USA Index (net MA tax).
4 MSCI® Emerging Markets Index. 5 Bloomberg Barclays U.S. Aggregate Bond Index.
6 Bank of America Merrill Lynch U.S. 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 Russell 2000 Index is a market capitalization–weighted index designed to measure the performance of the small-cap segment of the US equity market. It includes approximately 2,000 of the smallest securities in the Russell 3000 Index.
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 S&P 500 Index is a market capitalization—weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
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 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%.
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.