By John Spear, CFA
USAA Mutual Funds Chief Investment Officer
Markets began 2018 as a continuation of 2017, only better. Buoyed by strong earnings growth and December’s federal tax cuts, the Standard & Poor’s (S&P) 500 had shot up more than 7 percent by late January. Record highs were set 14 times in the first 18 trading days of the year. Investor optimism seemed to know no bounds.
Then inflation fears emerged and volatility came roaring back. The ride down for stocks was far faster than the ascent. Within a handful of sessions, the S&P had slid more than 10 percent. Global stocks also tumbled and bonds sold off because of the inflation worries. By late February, the yield on the 10-year Treasury was just under 3 percent, a level not seen in four years.
Adding to the turbulent conditions in March were escalating concerns about a global trade war as well as faster interest-rate hikes. Big technology names dragged stocks down after several high-profile missteps in their handling of private user data.
Most key asset classes finished the quarter in negative territory on a total-return basis. U.S. large caps and small caps lost 0.8 percent and 0.1 percent, respectively, while non-U.S. developed equities fell 1.4 percent, U.S. aggregate bonds dropped 1.5 percent and the 10-year Treasury slipped 2.4 percent. Exceptions to the downward slide were emerging-market equities and gold, both of which gained 1.5 percent for the three-month period.
Volatility is back
Until late January, stock volatility had been largely repressed for nearly two years. That prolonged calm ended when macro factors that had been viewed as positives – synchronized global growth and the federal tax cuts – were suddenly seen as inflation fuel that could push the Federal Reserve to raise interest rates faster than expected.
Despite the worries, actual inflation appears contained. The Fed’s preferred measure has consistently fallen short of its 2 percent target for nearly a decade, with the latest data (from February) showing prices rising at a 1.6 percent pace.
The macro environment continues to be favorable for companies, even though valuations are on the rich side. Earnings growth forecasts have been rising in recent months, and revenue growth expectations are solid. The prospect of top- and bottom-line gains have supported corporate bonds.
Concerns about inflation and a more aggressive Fed pushed up Treasury yields (yields rise as bond prices fall), but the market has been fairly orderly. As long-term, income-oriented investors, we welcome higher interest rates – over time, a bond’s coupon payments account for the vast majority of its total return.
Forecasting the Fed
The Fed raised short-term interest rates by 0.25 percent at its late-March meeting. – This was the sixth such increase since the current tightening cycle began in late 2015.
Right now, the consensus is that the Fed will match 2017 by approving three rate hikes this year. The latest numbers show modest growth for both economic growth and inflation – a continuation of this trend would likely allow the Fed to keep to its cautious pace on rates.
The economy has been growing for nearly nine years now, the second longest expansion in the post-World-War-II era. The current bull market for stocks has run for roughly the same period, with both being aided by very low interest rates.
Stocks could be disrupted if the Fed tightens monetary conditions too quickly. A rate hike would also likely affect bond investors, given the inverse relationship between bond prices and yields.
The economy’s slow growth since 2009 may indicate that we’re not as close to the end of the current economic cycle as many fear, and upward revisions in 2018 corporate earnings may indicate that stocks still have more upside ahead.
The USAA asset allocation portfolios are currently neutral on equities and fixed income.
Within equities, we maintain a full overweight on non-U.S. developed markets, with a slightly larger allocation to Japan than Europe. Japan is one of the cheaper regions on a valuation basis, and we see better prospects for profitability. The stronger yen has hurt equities a bit, but we have used periods of weakness as opportunities to add to our position.
We also have a full overweight to emerging markets based on relative valuation and earnings growth potential. In our view, fears of a global trade war – which would likely have a harsh impact on emerging markets (EMs) – are overblown. Our value tilt leads us to less exposure to the EM technology sector, where valuations are uncomfortably high, and more exposure to underappreciated sectors like industrials, financials and energy.
We are underweight on U.S. large cap and small cap stocks, as expected returns stand to be lower than other regions given higher relative valuations. We are also slightly underweight on credit (corporate bonds), as we see an imbalance between risk and expected returns.
As always, we advise members investing for the long term to expect the unexpected and not get swept up in short-term market moves. Our consistent advice is to remain focused on the long-term investment plan you have put so much thought into. For those uneasy about market risk in general, or with concerns about too much exposure to specific asset classes, we recommend consulting with a USAA advisor.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are suited for you based upon your individual goals, objectives, risk tolerance and time horizon.
Investing in securities products involves risk, including possible loss of principal.
This material is provided for informational purposes only by USAA Asset Management Company (AMCO) and/or USAA Investment Management Company (IMCO), both registered investment advisors. The material is not investment advice and is not a recommendation, an offer, or a solicitation of an offer, to buy or sell any security, strategy or investment product. The views and opinions expressed in the material solely reflect the judgment of the authors, but not necessarily those of AMCO, IMCO or any affiliates as of the date provided and are subject to change at any time. All information and data presented herein has been obtained from sources believed to be reliable and is believed to be accurate as of the time presented, but AMCO/IMCO does not guarantee its accuracy. The information presented should not be regarded as a complete analysis of the subjects discussed. Any past results provided do not predict or indicate future performance, which may be negative. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of AMCO/IMCO and USAA.
Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.
The fixed income securities are subject to price volatility and a number of risks, including interest rate risk. Interest rates and bond prices move in opposite directions so that as interest rates rise, bond prices usually fall and vice versa. Interest rates are currently at historically low levels. Fixed income securities also carry other risks, such as inflation risk, liquidity risk, call risk, and credit and default risks. Lower-quality fixed income securities involve greater risk of default or price changes. Securities of non-U.S. issuers generally involve greater risks than U.S. investments and can decline significantly in response to adverse issuer, political, regulatory, market and economic risks. Fixed income securities sold or redeemed prior to maturity may be subject to loss.
Asset allocation does not protect against a loss or guarantee that an investor’s goal will be met.
Investments in foreign securities are subject to additional and more diverse risks, including but not limited to currency fluctuations, market illiquidity, and political and economic instability. Foreign investing may result in more rapid and extreme changes in value than investments made exclusively in the securities of U.S. companies. There may be less publicly available information relating to foreign companies than those in the U.S. Foreign securities may also be subject to foreign taxes. Investments made in emerging market countries may be particularly volatile. Economies of emerging market countries are generally less diverse and mature than more developed countries and may have less stable political systems.
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
Gold is a volatile asset class and is subject to additional risks, such as currency fluctuation, market liquidity, political instability and increased price volatility. It may be more volatile than other asset classes that diversify across many industries and companies.
Standard & Poor’s 500 Index and S&P are registered trademarks. The S&P 500 Index is an unmanaged index of 500 stocks. The S&P 500 focuses on the large cap segment of the market, covering 75% of the U.S. equities market. S&P 500 is a trademark of the McGraw-Hill Companies, Inc.
USAA means United Services Automobile Association and its affiliates. Financial advice provided by USAA Financial Advisors, Inc. (FAI), a registered broker-dealer, USAA Investment Management Company (IMCO), a registered broker-dealer, and for insurance, USAA Financial Planning Services Insurance Agency, Inc. (known as USAA Financial Insurance Agency in California, License # OE36312). Investment products and services offered by IMCO and FAI. Life insurance and annuities provided by USAA Life Insurance Co., San Antonio, TX, and in NY by USAA Life Insurance Co of New York, Highland falls, NY. Other life and health insurance from select companies offered through USAA Life General Agency, Inc. (known in CA (license #0782231) and in NY as USAA Health and Life Insurance Agency). Banking products offered by USAA Federal Savings Bank and USAA Savings Bank, both FDIC insured. Trust services provided by USAA Federal Savings Bank.
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