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Quarterly Investment Review

A message from the Investment Management Team of Strategic Advisers LLC

By Brian Enyeart, CFA®,* President, Strategic Advisers LLC

Q3: Key Points during the Quarter

  • POSITIVE GLOBAL GROWTH
    Accelerating growth in the United States drove domestic stocks higher while investment-grade bond returns were essentially flat. Overseas, stocks also gained, but to a lesser extent, due to slower growth and trade tensions.
  • U.S. ECONOMY MATURING
    The U.S. economy continued to mature, with positive economic growth leading to a tighter labor market and incrementally higher interest rates.
  • EARNINGS OUTLOOK REMAINS POSITIVE FOR GLOBAL STOCKS
    Although international stocks have not kept pace with U.S. stocks this year, their earnings outlook and valuations remain attractive.

Global Expansion Continued

Domestic stocks posted strong gains against an economic backdrop that continued to benefit from:

  • robust corporate earnings
  • strong consumer confidence
  • lower corporate tax rates

International stock markets also moved higher, but not as much as their U.S. counterparts, due to investor concerns over:

  • global trade tensions
  • slower economic growth in some regions
  • specific issues for countries such as Turkey and Argentina

While international stock markets have not kept pace with the United States of late, we still firmly believe that they offer opportunities for growth in the long run. They can also provide diversification benefits for investors.

Lastly, investment-grade bond returns were nearly flat despite the fact that interest rates rose, reflecting a strong economic backdrop and a slight pickup in inflation.

U.S. Business Cycle Becoming More Mature

Even as the United States continues to experience positive economic expansion, we are seeing some signs of a maturing business cycle, including:

  • a tighter labor market
  • modestly higher inflation
  • gradually rising interest rates

Therefore, we expect U.S. growth to moderate over time. This kind of environment can still support positive returns for stock and bond investments, though at more modest levels. As a result, we continue to broadly emphasize stocks over bonds within most managed accounts.

Domestic stocks gained 7.1%2

U.S. stock markets rose for the second consecutive quarter, propelled by strong corporate earnings growth. In a reversal from the prior quarter, however, large-cap domestic stocks outpaced the stocks of smaller companies. Domestic corporations continue to perform well amid accelerating revenues and record-high stock buybacks. Broad economic strength aided both health care and industrial stocks, making them the leading performers during the period with both posting double-digit gains. Consumer discretionary stocks continued to provide strong returns this year, as consumer confidence reached levels not seen since the year 2000 and businesses saw increases in consumer spending. Within U.S. stock funds, we continue to emphasize growth-oriented stocks rather than value and more defensive investments, such as dividend-focused strategies.

International stocks rose 0.7%4

International stock markets as a whole were up modestly compared to the United States. Developed markets posted incremental gains as global manufacturing activity and economic growth slowed, but remained positive. Emerging-market stock performance fell 1.1%,1 due to global trade and country-specific concerns. For example, Chinese stocks experienced weakness as the Chinese economy saw slower economic growth. Meanwhile, Turkey and Argentina each grappled with issues related to their respective level of national debt.

We still believe that international stocks play an important role in your managed account.

In the short term, the corporate earnings of international stocks are projected to grow. Additionally, their valuations remain reasonable compared to domestic stocks. Longer term, our research shows that a portfolio consisting of both domestic and international stocks can help provide smoother returns and a more balanced level of risk than investing in domestic stocks alone. That’s because there are thousands of companies outside the United States with a wide array of growth opportunities. Within international stock funds, we continue to favor holdings that emphasize growth, as well as small and mid-sized companies.

Bond returns largely flat

The U.S. economy exhibited broad strength during the quarter, which led to a small uptick in inflation. Meanwhile, the Federal Reserve (Fed) maintained its path of interest rate hikes with the third such increase of the year in September. This led to higher interest rates but nearly flat returns for many bond investors. Investment-grade bonds finished the period with extremely small gains. More risk-oriented bond investments, such as high yield, gained 2.4%.5 One benefit of higher interest rates is that short-term bonds have started to generate better returns, having gained 1.3%6 year-to-date.

In early September, we modestly increased investment-grade bond fund holdings in most Portfolio Advisory Services client accounts. At the same time, we reduced exposure to short-term investments. We made these changes because higher-quality bond fund investments have historically fared better during more mature stages of U.S. economic growth. Also, we believe that in today’s slowly rising interest rate environment, it is important to have a diversified mix of bond investments in your account. For example, high-yield bond funds are less sensitive to changes in interest rates. Owning these types of investments can help reduce the impact of higher interest rates on your bond allocation.

Slightly Negative Returns Driven by Commodities

During the quarter, the portfolio’s alternative investments saw modest losses, mostly due to the performance of commodity positions. Most commodities traded lower over the last three months as a strong U.S. dollar and concerns about international trade were both headwinds to commodity prices. On the other hand, several alternatives strategies delivered positive returns for the quarter. Domestic real estate investments also produced modest gains, as demand for commercial real estate persisted amid healthy U.S. economic activity and employment growth. Over 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

OUTLOOK ON EMERGING MARKET STOCKS

Emerging market stocks have lagged their U.S. and international counterparts this year, falling 7.7%1 so far in 2018. Headlines around China, Turkey, and Argentina, among others, may leave some clients concerned about investing in this region. In our view, however, emerging market stocks remain a compelling investment. We believe there are several long-term trends likely to help emerging market stocks. For example, these countries typically have young and growing work forces, which can help spur economic growth. They also are home to a growing middle class, whose spending power can allow them to consume both local goods and imports from the rest of the world, including the United States. Given these powerful demographic trends, we remain confident that emerging market stocks can provide both growth and diversification in your managed account.

Updates in Tax-Sensitive Accounts

  • In an effort to improve after- tax returns, we were able to harvest tax losses across certain investments, such as emerging- market stock and global bond funds. We were also able to periodically rebalance client accounts where appropriate.
  • (We made a small shift out of frontier market funds to areas where we have greater confidence within the international stock arena.)
  • (Investment-grade municipal bond performance fell 0.2%3 in the third quarter, due to marginally higher U.S. interest rates. The environment for municipal bonds remains favorable, however, with strong investor demand and a positive U.S. economic backdrop that resulted in increased tax receipts for towns and states.)

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