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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.

Q2: Key Points during the Quarter

  • GLOBAL STOCKS, BONDS ADVANCED: Global stocks and bonds continued to build on gains in the first quarter, amid improving worldwide economic strength.
  • U.S. ECONOMIC GROWTH CONTINUED: The U.S. economy continued to grow as we watch for signs of an eventual shift to late-cycle expansion.
  • INVESTORS BENEFITTED FROM CALM MARKETS: Despite headlines from Washington and abroad, patient investors saw steady gains.

Market Summary

The last several months saw global stocks and bonds steadily rise in value. Many economies continued to grow and corporate earnings moved higher. It appears markets ignored political headlines from Washington and Europe, focusing instead on positive economic developments. Looking overseas, international stocks outpaced U.S. stocks. Economic growth has continued to improve in these regions, as does the outlook for corporate earnings. European stocks led the way, supported by low interest rates and other pro-growth policies. Emerging market stocks also saw a strong quarter, especially in Asian regions.

As for investment-grade and high yield bonds, their returns were also positive, but more modest than stocks. Although the Federal Reserve (Fed) raised short-term interest rates in June, longer-term interest rates fell slightly during the last few months. This was due, in part, to lower inflation expectations by investors.

Business Cycle: Closely watching labor, wages & pro-growth policies

Although the U.S. economy expanded in the second quarter, we have been monitoring labor markets and new pro-growth policies. On the labor front, job openings are plentiful and weekly unemployment claims are near 45-year lows. Healthy labor markets and low unemployment rates have historically spurred faster wage growth and higher inflation. These pressures can weigh on corporate earnings as rising inflation and employee costs shrink profits. So far in 2017, wages have been slow to rise and inflation is stable. However, should wages rise at a faster pace, we would expect a more challenging environment for stocks. Shifting to new pro-growth policies, the possibility for tax reform and deregulation occurring in 2017 has fallen significantly. This does not mean they will not occur, but it is likely that the pace will be much slower than originally anticipated following the U.S. election. This could change should more constructive policy debate resume in Washington.

Domestic stocks grew 3.0%1

Despite the lack of pro-growth policy progress in Washington, U.S. stock markets continued to move higher. They were bolstered by a positive economic backdrop and improving corporate earnings. Growth areas of the market did well, while energy, telecom, and small-company stocks lagged.

Within most client accounts, we are still emphasizing stocks over bonds. Our positioning favors stocks in areas like technology and banking, which typically perform well when the economy grows. Conversely, we have less exposure to defensive, yield-oriented stocks, such as utilities and telecoms, as these could struggle if interest rates head higher.

MANAGING THROUGH THE BUSINESS CYCLE

At Strategic Advisers, we believe that there are strong relationships between phases of the business cycle and investment performance.

For example, stock investments have historically performed better than bonds during periods of economic expansion. Using rigorous research to determine where we are in the U.S. business cycle helps us maintain our investment conviction in the face of short-term headlines and changing market conditions.

POLICY, NOT POLITICS

The stability of stock returns in recent months is a stark contrast to daily news stories about controversy in Washington, D.C., elections in Europe, and sadly, worldwide terrorist attacks. For the most part, the markets seem to have ignored these headlines and remained focused on improving global growth and higher corporate earnings.

Remaining focused benefits our clients, as we believe there is a strong connection between the pace of economic growth and the direction of stocks and bonds. In fact, we believe the backdrop for stocks remains positive, given the slowly growing economy. We also think it is important to stay calm and disciplined amid negative headlines.

Internationals stocks up 5.9%2

Looking overseas, stocks have also moved higher. This was driven by accelerating corporate earnings and improving economic conditions. As a result, international stocks have outpaced U.S. stocks in 2017. In fact, manufacturing remains robust and unemployment rates continue to fall. Additionally, exceptionally low interest rates aimed at boosting borrowing and spending remain in place. With this backdrop, the outlook for international stocks seems to be bright. Finally, corporate earnings for international stocks are expected to grow at a faster pace than U.S. stocks for the rest of 2017.3

International stocks are also more attractively valued than U.S. stocks. Furthermore, international stocks—especially emerging market stocks—have historically seen strong performance when the U.S. shifts to late cycle expansion. Thus, we have a small bias toward international stocks in client accounts. We also remain diversified across many regions, countries, and sectors.

Bonds perform modestly well

Bonds performed modestly well in spite of the Fed’s third interest rate increase since December, long-term interest rates fell slightly over the last few months. This fueled returns of 1.5%4 for investment- grade bonds, and 2.1%5 for high yield bonds. Based on the market’s muted reaction to rate hikes, most investors likely viewed the Fed’s actions as a positive reflection of U.S. economic growth.

Nonetheless, we believe that the likely path ahead for interest rates is a slow, gradual rise over time. As such, we continue to hold a diverse mix of bonds in client accounts to help temper the effects of higher interest rates. This is because some bonds are not as sensitive to changes in interest rates. For example, bonds issued by U.S. corporations are generally less sensitive to interest rate changes than U. S. Treasuries. As a result, we have a greater emphasis on corporate bonds in client accounts, and less exposure to U.S. Treasuries.

Extended asset class returns varied

The improving global growth backdrop also helped deliver positive performance for many alternative investments. Real estate, long/short, and absolute return investment strategies performed the best during the second quarter whereas multi-strategy funds were more mixed. Commodity and natural resource investments came under pressure as oil prices declined amid supply and demand imbalances. This weakness provided an opportunity to incrementally increase exposure to commodity and real asset investments. Overall, we firmly believe that alternative investment strategies play a vital role in diversifying your portfolio given that their performance over time often moves in different directions than traditional stock and bond investments.

MANAGING THROUGH THE BUSINESS CYCLE

At Strategic Advisers, we believe that there are strong relationships between phases of the business cycle and investment performance.

For example, stock investments have historically performed better than bonds during periods of economic expansion. Using rigorous research to determine where we are in the U.S. business cycle helps us maintain our investment conviction in the face of short-term headlines and changing market conditions.

POLICY, NOT POLITICS

The stability of stock returns in recent months is a stark contrast to daily news stories about controversy in Washington, D.C., elections in Europe, and sadly, worldwide terrorist attacks. For the most part, the markets seem to have ignored these headlines and remained focused on improving global growth and higher corporate earnings.

Remaining focused benefits our clients, as we believe there is a strong connection between the pace of economic growth and the direction of stocks and bonds. In fact, we believe the backdrop for stocks remains positive, given the slowly growing economy. We also think it is important to stay calm and disciplined amid negative headlines.

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