After a strong first quarter of 2017, the second quarter was even better, particularly for non-US equities that played catch-up to the steady upward move in US stocks. While leadership within stocks has oscillated between cyclical and defensive sectors, volatility has primarily been a function of political noise rather than economic or earnings uncertainty, both of which have beat expectations.
During the quarter, bond prices rose as interest rates declined, partially unwinding from the spike in yields immediately following the election. We have now experienced two quarters of bond price appreciation following a very tough 4th quarter last year. Overall, bond returns in 2017 are up about 2.5%, a pace the second half of the year is unlikely to sustain. Interest rates appear to be headed higher through the remainder of the year, which will be a headwind for bond returns. The best performing bond sector during the quarter was Emerging Markets Debt, up almost 2%. This sector has had a big recovery from its 2015 lows and still sports an attractive 5.5% yield. However, valuations approaching historic peaks argues for caution.
Globally, economies are syncing up and appear to be accelerating. The US has led the world in growth since the financial crisis of 2008, while most of the rest of the world floundered. Fortunately, major economies like Japan, China and Europe are showing real signs of strength. This pick-up, alongside local stock market valuations that are in some cases very attractive, make non-US stocks compelling. For the quarter, developed international stocks (mostly Europe, UK and Japan) performed best, up 7.4%. US Small Cap lagged, up only 2.5%, as political challenges seemed to reduce the likelihood of tax reform that would be so beneficial to the group. We continue to be overweight this part of the market based on small company leverage to a continued good economy, as well as benefits of lower taxes and regulation which disproportionately benefit them.
Risk in the market appears to be rotating away from politics (Brexit, Trump election, Trump impeachment talk, French elections, etc.) and back to central bank policy which dominated the market for most of the last eight years. The Fed is continuing down the path of higher short-term rates, albeit at a very slow pace, and unwinding some of the asset purchases made earlier in the cycle. Both of these activities could ultimately slow the economy but that prospect appears to be further down the road. Net monetary policy on a global basis continues to be net accommodative which markets like. The day will come when Europe, Japan, UK and China will catch up to the US and need to move toward tightening, and when that happens, market volatility is likely to pick up, but we don’t seem to be there yet.
2nd Quarter 2017 Performance
- Stocks globally were up (↑4%). International Developed (↑6.4%) and International Emerging (↑5.0%) outperformed the global benchmark while US Large Cap (↑2.9%) and US Small Cap (↑1.5%) lagged.
- Looking ahead, stocks have tended to have a good second half of the year when the first half returns are above-average, as they have been in 2017.
- Lower long-term interest rates pushed bond prices higher in the 2nd quarter. In addition, credit spreads tightened during the quarter on corporate and emerging markets sovereign debt further buoying returns.
- Looking forward, bond returns in the second half of the year are unlikely to match the gains achieved year-to-date due to continued Fed rate hikes and still strong economic activity putting a floor on inflation expectations.
- Alternatives were flat this quarter. The culprit was poor performance from MLPs which were down (↓8%) in the quarter, after exceptional performance in 2016. Even though they are only 10% of the alternatives allocation, they are the riskiest part of the alternatives portfolio. Without them, alternatives would have been up about (↑1%).
- Year-to-date, alternatives are up about (↑2%), slightly behind the pace needed to achieve our long term annual return goal of (↑5-7%). They are up (↑6.9%) over the past 12 months.
- From a risk perspective, alternatives look more like bonds than stocks, but with much better outlook for returns.
- Alternatives tend to have their best relative performance when stocks are flat-to-down which made this quarter difficult.
- Looking forward, Fed policy normalization reintroduce volatility with 10-20% corrections every year or so, which will make the benefits of owning alternatives more apparent.
Royce W. Medlin, CFA, CAIA
Chief Investment Officer