While the 24-hour news cycle careened from one potential political crisis to the next, from North Korea, to the Affordable Care Act repeal, to Supreme Court changes, and finally to tax reform, volatility in the equity markets remained subdued, and the pace of the upward climb continued throughout 2017. Indeed, with economic data steadily improving, corporate earnings growing, and the consumer feeling optimistic about the future – particularly given the strong employment backdrop – there was little reason for investors to de-risk portfolios during the year, and equities enjoyed positive flows. Of course, there has been growing concern around equity valuations (how many all-time highs can we enjoy?) but with interest rates rising and bonds the inferior near-term option, asset allocation seems destined to continue to favor stocks.
With that said, we remain overweight equities versus bonds, a position we have maintained for the past several years. Within U.S. equities, our portfolios remain positioned to take advantage of both reflation and rising rates, with a nod towards the potential positive benefits of tax reform. We favor more cyclical parts of the market such as technology, energy, and financials, as well as select industrial names. We also favor large caps over small caps, given the later stage of this economic cycle.
Drilling down on our sector positioning, while we acknowledge that technology names have performed well, we believe that current valuations in the sector are closer to fair value than in other parts of the U.S. market, and that the repatriation of overseas cash could create greater opportunities for growth. Financials stand to benefit from higher interest rates, and small to mid-size financial companies are likely to enjoy a lower effective tax rate in the years ahead. Energy stocks, which experienced a disappointing year in 2017, should benefit from the current trends in oil’s supply-demand relationship, and we are considering carefully the best way to expose our portfolios to that space. Conversely, we have continued to move more underweight to areas such as consumer staples and utilities, with the latter being one of the few sectors which could actually be disadvantaged near term by the changes in tax law.
As in 2017, our team is positive on international developed equities going into 2018, even with strong gains posted last year. While much of the narrative over the last several years has been focused on the rebirth of the European economy following the sovereign debt crisis, there have been improvements as well in Japan that are worth noting. A concerted effort to bring about inflation, and jumpstart real consumption, is showing signs of success, and this catalyst could lead to value creation in Japanese stocks, which have been long accused by investors of being value traps. The situation in the United Kingdom is admittedly more uncertain, given the ongoing Brexit negotiations, but the U.K. economy is stable and the Bank of England has shown it is willing to take its cues from the economy, tightening policy even amidst the uncertainty. We are constructive on emerging markets equities as well, as the global growth trend, a stable U.S. dollar, and steadied commodity prices all point towards continued gains in these names.
As noted above, we remain underweight bonds versus equities. Within our taxable bond portfolios, the team continues to favor corporate bonds, although issuer selection is becoming even more important with increased M&A and volatility expected in 2018. From a duration standpoint, our corporate bond portfolios are slightly shorter than the relevant benchmarks, with the feeling that risk is still skewed towards higher rates. We believe selecting BBB and split-rated bonds in appropriate sectors will still be an effective way to add yield and performance in 2018. For our municipal bond portfolios, our overall outlook on credit quality remains strong – the well-publicized pockets of weakness notwithstanding. From a duration standpoint, portfolios are typically close to neutral when compared with the benchmark, and the team is focusing on higher quality credits, instead earning additional yield by adding callable bonds to portfolios. An increase in yields or cheapening in the municipal bond sector will generally be treated as an opportunity to add duration to portfolios and lock-in attractive tax-exempt yields for future years.
Finally, investors who sought refuge in commodities over the past several years as an inflation hedge are finally beginning to see a light at the end of the tunnel. Crude prices have stabilized and moved higher, as have precious and industrial metals, which have benefited on improved demand. REITs, as could be expected, have lagged the gains of the broader market from a total return perspective, but we have maintained exposure, albeit underweight to our long-term strategic allocation, due to the incremental yield advantage offered by these names.
Q1 2018 – Economic and Market Perspective
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