By The Advocates
Investment Mission Statement (IMS): To accomplish your life goals by earning a consistent, long-term rate of return in excess of inflation as required in your wealth plan.
As we look back over the first half of the year, one of the most notable items is how steadily markets have risen, despite ongoing political uncertainty and geopolitical tumult. In reality, this is the way the stock market should behave. We believe this serves as a good reminder that over the long term, financial assets are priced and valued based on their underlying economic fundamentals—yields, earnings, growth—not on transitory macroeconomic or political events.
Economic and corporate fundamentals largely still look solid, and investors are pricing in expectations that the second quarter earnings season will demonstrate a continuation of the strong growth trends exhibited so far in 2017. Inflation is lower, but still in the ballpark of the Federal Reserve’s 2% target. And global central banks, including the Federal Reserve, are not seen as becoming too aggressive in raising rates and tightening monetary policy any time soon.
From a big picture perspective, we think the odds favor a continuation of the ongoing mild global economic recovery we’ve witnessed this year. That should be broadly supportive of riskier assets, such as stocks and corporate debt. In particular, we believe there is still more room to run for foreign stocks versus the U.S. market, given their more attractive valuations and earnings growth potential, even after their strong performance in the first half of the year.
Specific to Europe, the European Central Bank recently increased its economic growth forecasts for the eurozone for this year and next. Across the bloc, banks are largely well capitalized and ready to lend, and unemployment has fallen to multiyear lows. Worries over deflation also seem to be subsiding as inflation has begun to pick up. And as the overall economy recovers, so do company finances. Corporate profits have been surprising to the upside. In response, analysts’ forecasts for corporate earnings growth have increased from the single digits to the double digits, and we are seeing more and more Wall Street strategists recommending an overweight to foreign stocks: a position we have held for a while in our portfolios. These actions and views can feed on themselves in a virtuous circle—as more money flows into these asset classes, it can boost prices and returns, attracting yet more inflows and driving prices higher. While European stocks continue to trade at attractive valuations relative to U.S. stocks, we will be closely watching this market as more investors seek to take advantage of this opportunity.
Ultimately, our asset class weightings—and, specifically, our willingness to take on equity risk—rest on our assessment of the 5 to 10 year return potential for each asset class as well as the objectives and risk threshold of each portfolio. These are our foremost, and ongoing, considerations as we manage our portfolios and work with our clients to help achieve their goals.
Within our portfolios, we look to bonds for protection, capital preservation, and a regular income stream. As interest rates rise, and assuming the global economy stays on its current growth trend, we expect returns for core, investment-grade bonds to remain low. However, we anticipate returns for high-quality floating-rate loan funds will far exceed those for core bonds.
We also continue to see long-term value from exposure to stabilizer strategies. While this has been a headwind to overall portfolio performance during extended periods of stock market gains, we continue to believe they are an important source of diversification, offering solid return potential and portfolio volatility reduction.
Looking ahead, we know there will inevitably be shorter-term market surprises, including negative ones. Given the high level of complacency we’ve witnessed in the markets so far this year, we think stocks are particularly vulnerable to a negative surprise. This is why it’s more important than ever to take a long-term investment view when it comes to positioning our portfolios. While there has seemed to be little need for diversified portfolios over the past eight years of a raging U.S. equity bull market, history teaches that this cycle will turn too and the portfolio benefits of strategies like stabilizers and floating-rate loan funds will then be apparent.
Asset Class Changes:
On May 25th we hit a Trigger Point when the S&P 500 rose above 2,411 and we incrementally decreased your exposure to Large Cap US Stock. The 2,411 mark represented a figure that, at the time of the trigger, put the S&P 500 as one of the 10 most expensive (i.e. over-priced) in it’s history (i.e. since 1950). This puts us at our minimum weighting for Large Cap US Stocks. The proceeds were used to establish a position in Floating-Rate Loans; a further definition is below.
What are they? Floating-rate loans are debt obligations issued by banks and other financial institutions that consist of loans made to companies. They are called “floating rate” securities because the interest rates on the loans adjust at regular intervals to reflect changes in short-term interest rates as tracked by commonly accepted measures such as LIBOR (London Interbank Offered Rate). The companies that issue bank loans for financing generally lack investmentgrade credit ratings. Indeed, many corporations issue both bank loans and high- yield bonds. Whereas high-yield bonds are usually unsecured, bank loans are typically secured by the issuer’s assets, such as property, equipment, or rights to inventories or receivables. In this way, floating-rate bank loans have a senior position in the firm’s capital structure and are considered Senior Secured Debt.
Why do loans have less interest-rate risk than bonds? The biggest difference between bank loans and traditional, fixed-rate bonds involves how each reacts to interest-rate changes. Bond prices move inversely to interest rates: When interest rates rise, bond prices fall, and when rates fall, bond prices rise. With floating-rate loans, there is a different outcome: Their coupons adjust by increasing to the higher-rate scenario, and the resulting higher income makes the security more valuable. Even though a loan’s price should fall as rates rise, the price does not fluctuate in the typical manner because the additional interest earned makes the security worth more. In addition, rates and loan prices typically increase during periods of strong economic growth, conditions that help to reduce the perceived credit risk of bank loans. With these characteristics, loans can help diversify a portfolio that favors traditional, fixed-rate bonds. Loans can help protect against rising interest rates, which typically have an adverse impact on fixed-rate bonds.
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