Looking Ahead- Q2 2017
2017 began on the heels of a fairly euphoric move in the U.S. markets following the election of President Trump and the expectations for a meaningful bump in growth on the back of Republican-sponsored fiscal stimulus in the form of spending packages and tax reform plans. Underlying these stimulus expectations, however, was a steady improvement in economic data beginning in August of last year, and that supported the markets through the end of the first quarter, even as the risks of disappointment on the legislative landscape increased. Indeed, as we look forward to the rest of the year, it is difficult to determine how effective the Republican held Congress will be, given the different factions currently vying for an opportunity to create the legislative agenda. In addition, President Trump has several items on his docket, including a border wall, that don’t necessarily fit neatly into that agenda.
With that said, for U.S. equities, we are most positive on the financial, energy, and technology sectors, and our portfolio managers and research analysts are looking to any potential pullbacks as opportunities to add exposure in those sectors. In addition, our team is monitoring our exposure to a negative reaction which could result from a meaningful delay in tax reform here in the U.S. In the shorter term, we are focusing on the alignment of sentiment with underlying data, as unsupported exuberance, particularly on the consumer front, could indicate that we have reached a cyclical peak. With valuations at lofty levels and heightened political uncertainty, along with typical seasonal pressures, we acknowledge that pullback of 5-10% in the coming months is a reasonable possibility, but we remain constructive on U.S. equities despite that risk.
Internationally, our view is that the opportunity has improved over the last several months. While we adopted a more cautious stance last summer following the Brexit vote in the U.K., strengthening economic data in Europe, along with continued support for Prime Minister Shinzo Abe and the Bank of Japan’s policies has provided us with further comfort that gains in developed international stocks could be forthcoming, despite the uncertainty associated with the U.K. situation. In addition, while the Federal Reserve is clearly moving to raise interest rates, which should result in a stronger U.S. dollar, stronger global growth expectations appear to be offsetting those concerns, as assets are flowing to emerging markets equities (and debt, for that matter). We remain overweight in this asset class, despite strong returns over the last several quarters, given more favorable current account balances and relatively reasonable valuations.
Within fixed income, we have been positioning our portfolios over the last year in response to both our expectations for higher rates in the future, as well as our acknowledgment that we are likely entering the later stages of the current cycle; as such we are slightly underweight bonds relative to equities. Within our taxable bond portfolios, given the strength of the economy and corporate balance sheets, our fixed income portfolio managers and analysts still favor an overweight to credit and corporate bonds, and in certain cases, we are selectively incorporating bonds of modestly lower credit quality as those opportunities are presented. From a duration standpoint, the team is allowing duration to drift a bit shorter compared to the relevant benchmarks, as the risk of higher rates has materially increased. For our municipal bond portfolios, we maintain a positive outlook on municipal credit, although issuer selection continues to be important. We are taking a neutral duration stance, still maintain an up-in-quality bias and are getting extra yield by buying callable structures. As for high yield, we are neutral in our allocation to high yield bonds, both corporate and municipal. Returns have been strong, and while we acknowledge that low interest rates have created a potential for refinancing pressures in the coming years, we believe the yield afforded offsets that risk at this juncture.
Finally, we still believe there exists an opportunity to invest in areas which show positive correlation to inflation in the near to mid term, despite the pressure experienced by these areas in the first quarter. In particular, we believe commodities and natural resource equities should benefit from such an environment, particularly if energy demand strengthens on the back of global demand; we also like global exposure to the real estate market.
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