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By Bruce Herring, CFA®,* President, Strategic Advisers, Inc.
In 2017, most of the world’s major economies, including the United States, remained in expansion. Against this favorable backdrop, global corporate earnings rose, and stock prices generally followed suit. For the year as a whole, most major stock markets around the world generated returns of over 20%.1 In fact, international stocks outpaced U.S. stocks for the first time in five years. Meanwhile, bond markets registered gains for the year, as U.S. interest rates ended the year close to where they began. Despite numerous investor concerns, ranging from debates in Washington to rising tensions with North Korea, stocks were unusually calm last year, experiencing just a few muted periods of volatility.
Throughout the year, the U.S. economy continued to expand, supported by low interest rates, strong business and consumer confidence, and a healthy labor market. As the mid-cycle phase of the business cycle continues to mature, we are monitoring a number of indicators, such as wage growth and inflation. Although these have historically been associated with late-cycle expansions, they are generally positive for stock investments. However, during the late-cycle phase we would also expect to see more modest corporate profit growth. Fortunately, despite the fact that the labor market continued to tighten, both wage growth and inflation remained low in 2017, supporting higher profit margins for U.S. businesses, and rising stock markets. Nonetheless, we will carefully monitor the U.S. economy for any changes in the pace of its growth.
Lastly, the Tax Cuts and Jobs Act, which passed in late December, includes provisions to lower corporate taxes. We believe that these cuts could provide a modest boost to corporate earnings and the U.S. economy as a whole. Given this backdrop, we continue to broadly favor stocks over bonds in most managed accounts.
Stock markets steadily marched higher in 2017, as volatility was extremely low. To put this in perspective, for the first time in its history, the S&P 500 Index finished the period with positive total returns for all twelve months of the year. Additionally, there were only 8 days when the index closed up or down by more than 1%—the fewest such days since 1964. Given how unusually calm markets were in 2017, we believe investors should not be surprised if this year sees more stock market volatility.
The stock market’s steady upward trajectory over the past year was led by growth-oriented segments of the market, including technology stocks, which gained nearly 40%3 last year. Meanwhile, value stocks did not fare as well, given that investors largely favored companies with strong earnings growth prospects instead.
Throughout the year, the strength of the domestic stock market provided us multiple opportunities to rebalance and reposition most client accounts. Additionally, we maintained an emphasis on both quality and growth-oriented stock investments. Conversely, we had less investment exposure to defensive, dividend-focused strategies, which are less attractive due to higher valuations, and could be challenged in a rising-interest-rate environment.
Overseas, international stock returns generally exceeded those in the United States. In developed markets, like Europe and Japan, accelerating economic growth was powered by improving business conditions, government spending, and accommodative monetary policy. Additionally, emerging market stocks produced some of the strongest gains in 2017. They were led by China and India, which benefitted from stable commodity prices and strong global trade.
Most client accounts benefited from these trends due to an emphasis on international investments within client stock allocations. We also modestly added to emerging market stock investments where appropriate during the year. Over the long term, we believe that emerging market stocks can provide value within your diversified managed account. In our view, they are likely to experience strong economic growth, supported by positive demographic trends.
The U.S. Federal Reserve (Fed) raised interest rates once again in December. Although this was the third Fed interest rate hike of the year, 10-year Treasury rates were little changed at the end of 2017 from where they began. This led to investment-grade bonds returning 3.5%5 for the period. Meanwhile, high-yield bonds delivered 7.5%6 on the year, reflecting healthy U.S. corporate balance sheets and a U.S. economy on sound footing.
Over the course of the year, we incrementally reduced the level of high-yield bond exposure within most client accounts in order to appropriately manage their level of risk. This action, coupled with a slightly higher tilt toward investment-grade bonds, reflects our goal of maintaining a diverse mix of bond investments within your managed account.
In 2017, alternative investments collectively posted positive returns. International real estate investments were the strongest performers, generating returns in excess of 25% for the year. Elsewhere, despite strong gains in oil prices, more diversified commodity funds were hampered by negative returns within agriculture. Conversely, funds focused on specific commodities, such as precious metals, including gold, performed well. Finally, multi-strategy, absolute return and long-short credit funds generally produced solid single-digit returns on the year, which is consistent with our expectations. We continue to believe that alternative investment strategies play an important role in diversifying your portfolio as their performance typically moves in different directions than traditional stock and bond investments, through most market environments.
* 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 and MSCI® ACWI (All Country World Index) ex USA Index (net MA tax).
2 Dow Jones U.S. Total Stock Market Index.
3 As measured by the technology sector of the S&P 500® Index
4 MSCI® ACWI (All Country World Index) ex USA Index (net MA tax)
5 Bloomberg Barclays U.S. Aggregate Bond Index.
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.