Second Quarter 2017 Key Takeaways
The second quarter proved to be another very strong period for global stock markets. Larger-cap U.S. stocks gained 3.1%, developed international stocks rose 6.4% and emerging-market stocks rose by 3.4%.
This makes 2017 stock performance even stronger. Larger-cap U.S. stocks have surged 9.3% year to date, while international indexes are each up in the mid-teens. As international stocks continue to lead the way, our portfolios have strongly benefitted from their overweight to these areas, especially our European and emerging-market stock exposures.
While markets show very little “on the surface” volatility, we have seen very strong changes in the market on the sector level, a process which started in Feburary. After 12 months of outperformance over growth stock sectors, value stocks underperformed by double digits the last five months. This rotation happened with very little disturbance to the overall market—a very positive signal in our view.
Core bonds also delivered solid returns, rising 1.5% for the quarter. (Higher bond prices correspond to lower bond yields.) The yield curve “flattened” considerably, with the difference between the 10-year and 2-year Treasury yields ending the quarter at close to a post-2008 low.
In aggregate, the flexible bond funds we hold in place of a ”traditional” fixed-income portfolio again outperformed the core bond index for the quarter and year-to-date. Global bonds also delivered modest gains that out-paced the bond benchmark.
Economic and corporate fundamentals largely still look solid, and investors expect the second quarter earnings season to demonstrate a continuation of the strong growth trends exhibited so far in 2017. From a big picture perspective, we think the odds favor a continuation of the ongoing mild global economic recovery we’ve witnessed so far this year. That should be broadly supportive of riskier assets, such as stocks and corporate debt. In particular, we believe there is still more room to run for foreign stocks versus the U.S. market, given their more attractive valuations and earnings growth potential, even after their strong performance in the first half of the year.
The past quarter and first half of the year were characterized by historically low stock market volatility and the strong performance of both stocks and bonds. In this quarter’s commentary, we attempt to explain these phenomena, some of which may seem contradictory. We also reiterate that, given the lack of market volatility, we have not made any changes to client portfolios. But we remain alert to–and positioned to address–the high level of uncertainty in global financial markets and the geopolitical environment today.
Second Quarter 2017 Investment Commentary
As we look back over the past quarter and first half of the year, a few things stand out. Overall stock market volatility remained extremely low, despite significant domestic political uncertainty and unsettling global and geopolitical events. Both risky assets (stocks) and defensive assets (core bonds) performed very well. And the period was marked by some significant market trend reversals from the previous year.
The S&P 500’s actual realized volatility recently fell to near its lowest level in the past fifty years, according to a recent Goldman Sachs report, while the S&P 500 Index continued to hit all-time highs. The U.S. stock market’s calm ascendance seems to fly in the face of ongoing political uncertainty and geopolitical tumult. Each day seems to bring a new headline concerning something else to worry about.
That said, maintaining a degree of steadiness is a valuable attribute of successful long-term investors. Global risks always exist and unexpected events inevitably happen, causing markets to fall no matter their valuation. The world and financial markets have faced numerous negative shocks over the decades, but the broad economic impacts have ultimately proved transitory. Over the long term, financial assets are priced and valued based on their underlying economic fundamentals—yields, earnings, growth—not on transitory macro events or who occupies the White House. Therefore, we believe it is beneficial for investors not to react to every domestic political development or geopolitical event with the urge to sell their stocks nor get overly excited and jump into the market on some piece of news they view positively. We don’t think refraining from such short-term trades is complacency—if the choice is supported by a sound decision-making framework. Having a disciplined investment process and a focus on the long term are essential to best achieve your financial objectives.
It may seem somewhat surprising or contradictory that both global stocks and defensive core bonds have performed well. Treasury bond prices typically rise when people are worried about the economy or other macro risks, but that doesn’t seem to be what is driving core bond prices this year given the low volatility and strong performance of riskier assets. Rather than fears of an impending macro shock, it seems the bond market is responding largely to the recent declines in inflation and inflation expectations (inflation is the enemy of bondholders).
The equity market, on the other hand, likes neither too little inflation nor too much. So stock investors have had plenty of reasons to propel prices higher: inflation is lower but still in the ballpark of the Federal Reserve’s 2% target. The global economic recovery is ongoing. S&P 500 company earnings have rebounded the last four quarters. And global central banks, including the Fed, are not expected to aggressively tighten monetary policy any time soon.
In the short term, both markets may be “right.” But the current state is not sustainable for very long—something has to give. The Fed holds a big key as to how things might play out: will it tighten too much, too little, or manage it just right? Nobody knows, but based on history, we wouldn’t put all our chips on any single scenario. Potential changes to fiscal, tax, and regulatory policies are also big unknowns.
A final observation: several of the market trends and consensus market views we highlighted at the start of the year have reversed (again):
- European stocks are beating U.S. stocks by a wide margin.
- The U.S. dollar is down (about 6%).
- Treasury yields are down.
- Oil prices have plunged 20% from their recent highs.
- Growth stock indexes are crushing value indexes.
- Larger caps are beating smaller caps.
- Emerging-market stocks are outperforming U.S. stocks.
The recent market shifts only reinforce the point we made then. We don’t think anyone can consistently and accurately time short-term swings in markets or inflection points in market cycles. It is when “the experts” are overwhelmingly aligned on one side of a trade and the consensus is strongest that a trend will continue, that it actually has the most potential to reverse.
In general, we agree with Warren Buffett who recently said, “If you mix your politics with your investment decisions, you’re making a big mistake.” We made no changes to our portfolio positioning when Trump was elected, focusing instead on the significant uncertainty around the actual implementation of his policies. And that’s not to mention the highly uncertain timing and magnitude of their ultimate economic and financial market impacts. Therefore, the unwinding of that narrative this year hasn’t led us to make any portfolio changes. We still believe, as we did last summer, that the most likely outcome for the global economic environment would be more growth, higher interest rates and higher inflation. So far, we have seen higher growth and higher short-term interest rates, but higher inflation has not yet taken hold.
We think it is prudent to construct portfolios that are prepared for, and are resilient to, a range of potential outcomes. As a result, in our balanced portfolios, we maintain some exposure to core bonds, despite very low current yields, because of their risk-mitigating properties in the event of a recession or other shock. But given core bonds’ paltry yields and unattractive longer-term (five-year) return prospects, we maintain meaningful exposure to other more flexible and opportunistic fixed-income funds as well as global bond funds. These investments have provided protection against rising interest rates and will provide protection against inflation.
Our positions in flexible bond funds have performed well this year and (again) added value versus the core bond index. Meanwhile, our tactical position in global bond funds generated modest gains. This combination of funds has led us to out perform the bond benchmark both last year and this year.
Based on our analysis of valuations and longer-term earnings fundamentals—even setting aside any near-term political or geopolitical risks—U.S. stocks present lower expected returns over our five-year tactical investment horizon then history would expect. Valuation risk is high and offers no margin of safety in the event the optimistic scenario currently baked into valuations doesn’t play out. Therefore, we are underweight to U.S. However, we should add that we don’t see any particular near-term trigger for a sharp market decline.
Outside of the United States, we see strong potential for both improving earnings growth and higher valuations—leading to relatively attractive longer-term expected returns. We have a moderate overweight to international stocks and a significant overweight to emerging-market stocks.
We believe the outperformance of foreign stocks still has “room to run” given their superior valuations and earnings growth potential versus the U.S market. Even with their strong performance so far this year, our longer-term return expectations continue to favor International/Europe and emerging markets compared to the United States.
Foreign stock markets are also seeing increasingly positive investor sentiment and strong cash inflows. More than $12 billion has flooded into U.S.-domiciled European stock funds and ETFs this year, reversing 13 consecutive months of net outflows prior to that. Year-to-date inflows into emerging-market stock funds are close to $30 billion.
Momentum seems to be shifting in favor of foreign stocks. We are seeing more and more Wall Street strategists recommend an overweight to International/European and emerging-market stocks: a position we have held for a while. This can feed on itself in a virtuous cycle—as more money flows into these asset classes, it can boost prices and returns, attracting yet more inflows and driving prices higher.
Our lower-risk liquid alternative strategies are performing well in absolute terms, and they have had strong performance vs. fixed income this year. We continue to benefit from diversification across multiple managers and approaches within the category.
Putting It All Together
We don’t expect a recession in the near term, but we remain alert to and positioned to meet the high level of uncertainty that characterizes both global financial markets and the current geopolitical environment. We maintain exposure to assets—core bonds in particular—that should generate positive returns in the event of a recession and a bear market in stocks. In addition, our lower-risk alternative strategies should perform pretty well in most scenarios, and we are confident they have much less downside risk than equities. Over the longer term, they also provide attractive risk-adjusted return potential and valuable diversification to the overall portfolio. While there has seemed to be little need for such strategies over the past eighteen months of a rising U.S. equity market, history teaches that this cycle will eventually turn and the portfolio benefits of these alternatives will then be apparent.