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By Brian Enyeart, CFA®,* President, Strategic Advisers, Inc.
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.
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.
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.
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.
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.
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.
* 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 MSCI® ACWI (All Country World Index) ex USA Index (net MA tax).
3 Bloomberg Barclays U.S. Aggregate 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.
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 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%.
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.