Looking Ahead - Q1 2017
As intimated in our commentary last quarter, the global economy, and in turn, the equity and fixed income markets, experienced a pattern of fits and starts in 2016, which created an environment of volatility and uncertainty, but also yielded opportunities for investors. U.S. and emerging markets equities, high yield bonds, and commodities all generated solid returns, and there are tailwinds for this performance to continue. With that said, there are certainly some concerns worth noting, and we remain mindful of the considerations outlined below as we allocate for your portfolios.
Within U.S. equity markets, there is much enthusiasm around the potential trifecta of lower taxes, looser regulation, and increased fiscal spending, and this has created an assumption among investors that recent gains are almost entirely due to the Trump effect. While we have seen a sharp sector rotation since November here in the U.S., this rotation was already underway before the election. The expectations ascribed to what could be accomplished by the Republicans only helped to accelerate the moves. In addition, much of this rotation – to areas like financials, energy, and industrials, and away from consumer staples, utilities, and health care – can also be attributed to the improvement in global economic data over the last several months, which should translate to stronger growth.
While we are optimistic around the potential for U.S. equity markets to post positive returns in 2017, we acknowledge several factors that could create the catalyst for a correction at some point during the year. Valuations are certainly not cheap at current levels, and any combination of disappointing earnings growth, lack of movement on increased fiscal spending, or indications of an acceleration of Fed rate hikes could derail the current uptrend, albeit over a short-term period. We are careful to balance the near- to mid-term pressure on defensive stocks with an appropriate overall portfolio position, and we acknowledge that while the more cyclical parts of the market have experienced meaningful gains over the past several months, we believe the current rally could be maintained in these names, and have continued to identify options in these sectors.
Within international markets, there has been some easing of concerns around a near-term banking crisis, and thus financial stocks (and bonds) have stabilized. Economic data, too, has proven resilient, and trends in both the U.K. and the Eurozone have been broadly positive as it relates both to business demand and consumption. However, the relative attractiveness of international developed stocks still lies in their valuations, which are lower than U.S. stocks. Our view is that the catalyst to realize gains in these stocks is a meaningful upturn in economic growth, and the outlook for that in the near term is muddy. As a result, we prefer domestic stocks over international developed names at this juncture. The case for emerging markets equities is admittedly more complex. While a strong U.S. dollar creates pressure on emerging market currencies, particularly those with current account deficits, an improvement in the overall growth of developed economies would likely have an outsized impact on these more export-driven countries. For now, we believe the relative opportunity still exists, and as such, we remain overweight in the asset class.
Within fixed income, the Fed is now engaged, and the pace and timing of interest rate hikes is likely to hinge on the desire to balance the opportunity for an acceleration of growth with the reality of inflation. As long as global central banks outside the U.S. remain accommodative, demand for U.S. Treasuries will remain, given the yield differential. With that said, it is unlikely that this demand can fully offset the shift in the yield curve which is now occurring on the unwinding of an extended period of easy monetary policy. Despite these pressures, our concerns are focused more on credit quality than maintaining a short duration posture, and as such we are continuing to migrate our portfolios closer to their appropriate benchmarks, while improving the overall quality. Within the high yield space, we believe traditional corporate bonds are somewhat expensive following last year’s superior performance, and are beginning to shift this exposure to floating rate bonds, which are better insulated from rising rates, but still offer higher yields than their high quality counterparts.
Finally, we believe an opportunity exists to invest in areas that show positive correlation to inflation in the near to mid term. In particular, we believe commodities and natural resource equities should benefit from such an environment, along with portions of the real estate market. We prefer to remain diversified globally in that asset class.
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