Investment Commentary

Market Recap

The second quarter proved to be another strong period for global stock markets. Large-cap U.S. stocks gained 3.1%. Growth stocks continued to outpace Value stocks, suggesting that a strong economic recovery could be six to nine months out. Developed market international stocks rose 6.4%, with European stocks jumping 8.4% and emerging market stocks rising 3.4% during the quarter.

Core bonds also delivered solid returns, with the Barclays US Aggregate Bond TR USD (Price) rising 1.45% for the quarter. (Higher bond prices correspond to lower bond yields.) The yield curve “flattened” considerably, with the spread between the 10-year and 2-year Treasury yields ending the quarter near a post-2008 low.
The widely-followed VIX index—an indicator of the S&P 500’s expected 30-day volatility—fell to a 23-year low in early May…and the VIX finished at its lowest level ever at quarter’s end. Yet the calm was briefly interrupted during the last few days of June. Global stock and bond investors were rattled by comments from the heads of the European Central Bank and the Bank of England. Their comments suggested that they may be considering tapering off their bond buying policies, along with a move to start to raise interest rates. Investors were further jolted by Fed Chair Janet Yellen’s statement that “by standard metrics, some asset valuations look high.” In response, bond yields quickly spiked higher, causing currency markets to experience large swings. Nevertheless, at quarter-end the S&P 500 was only about 1% below its all-time high.

Economic and corporate fundamentals still look mostly solid, and investors expect the second quarter earnings season to continue the strong growth trends exhibited so far in 2017. Consequently, we continue to view exogenous risks—from central banks and geopolitics—as posing the most likely near-term threats to markets.

Investment Environment
The U.S. stock market’s calm ascendance seems to fly in the face of ongoing political uncertainty and geopolitical tumult, including tensions with North Korea, Syria, terrorist attacks in Europe, cyber attacks in the United States, and widening investigations of President Trump and members of his administration and election campaign staff. Each day seems to bring a new headline with something else to worry about.

The high level of complacency we’ve seen leaves stocks particularly vulnerable to a negative surprise. Valuation risk is high. It offers no margin of safety in the event that the optimistic scenario currently baked into valuations doesn’t play out.

When investors are worried about the economy or other macro risks they typically put their money into safe-haven assets such as Treasury bonds. While there are plenty of things to worry about in the world, that doesn’t seem to be what is driving core bond prices this year, given the accompanying low volatility and strength of riskier asset classes. 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. For example, the core Consumer Price Index (CPI) dropped to a year-over-year rate of 1.7% in May, down from 2.3% in January. Inflation is the enemy of bondholders. So in that regard, the drop in bond yields and rising core bond prices follows suit.

The equity market, on the other hand, likes neither too little inflation nor too much inflation—similar to Goldilocks and her porridge. So stock investors have had plenty of reasons to propel prices higher: Inflation is lower but still in the ballpark of the Fed’s 2% target. The global economic recovery is ongoing and S&P 500 company earnings are rebounding; and global central banks, including the Fed, are not seen as becoming too aggressive in tightening monetary policy any time soon.

Macro Strategies
We think it is prudent to construct portfolios that are prepared for, and have resilience 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) due to their risk-mitigating properties in the event of a recession or other shock. We have also been able to increase total returns through our meaningful exposure to other more flexible and opportunistic fixed-income funds (non-traditional, unconstrained and strategic income funds). These investments may also provide some added protection against rising interest rates and inflation as they move between floating rate bank loans, (many with five-year maturities) and intermediate term core bonds. A partial allocation to high yield bonds is typically also held in these funds and often results in enhanced yields, albeit with greater credit risk exposure.

On the equity side of the portfolio, we see good opportunities outside of the United States. We see strong potential for both improving earnings growth and higher valuations—leading to relatively attractive expected returns. As a result, we are increasing our weighting to funds that hold both European and emerging-market stocks.

Overall, many of our portfolios are tilted towards slightly higher than normal equity risk exposure, in part because of the potential of the Trump administration’s pro-growth fiscal stimulus, including lower tax rates and deregulation. However, most of the modest market reversals we’ve seen so far this year are related to a potential unwinding of the so-called Trump trade. This is shorthand for the market’s almost knee-jerk reaction (that soon became consensus) that Trump’s election and the Republican sweep of Congress would herald a period of inflation, unleashing the U.S. economy’s “animal spirits.” Instead, as the Trump administration has gotten bogged down in a myriad of other issues, with little progress on the economic front, confidence in that scenario has, at times, diminished.

Summing Up Our Positioning and Outlook
Our positioning is generally driven by our big picture perspective. We think the odds favor a continuation of the ongoing mild global economic recovery we’ve witnessed so far this year. In particular, we believe there is still more room to run regarding the outperformance of foreign stocks given their superior valuations and earnings growth potential versus the U.S market.

Our base case scenario should also be beneficial for our unconstrained and strategic non-core fixed-income funds. That doesn’t mean there won’t be market volatility in response to day-to-day news flow and unexpected events, whether negative or positive. Central bank policy, as usual, could trigger volatility. European and Japanese central banks, on balance, seem more likely to retain their accommodative monetary policies. In the United States, the Fed is poised to continue to gradually hike rates—once more this year and three times next year.

Conclusion
It is difficult or impossible to consistently and accurately time short-term swings in markets or inflection points in market cycles. The false belief that they can be timed often leads to performance-chasing, whipsawing in and out of markets (selling low and buying high), and ultimately disappointing investment results. When investors are aligned on one side of a trade and the consensus is strongest, it is often a time when a trend has the greatest potential to reverse course.
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 and growth—not on transitory macro events or on who occupies the White House. Generally, investors have been well served by not reacting to every domestic political development or geopolitical event, and resisting the urge to sell their stock positions. Having a disciplined investment process and a focus on the long term are essential ingredients to best achieve your financial objectives.
Warm Regards,
Barry Dampf