By Bob Landry, CFA, Chief Investment Officer, USAA Investment Management Company
At the halfway mark of 2017, the dominant market themes are the same as when the year started – the Trump economic plan and the Federal Reserve’s decision-making. And just like back then, questions are plentiful nowadays and clear answers remain scarce.
An optimistic vision of economic growth under Trump lifted asset prices in the months following the November election. Investors rushed to position themselves for major tax cuts, regulatory rollbacks and an infrastructure boom. Over the past eight months, some regulatory actions have been taken, but the rest is still in the promise phase.
Now the big question we and others are asking is “Which of the big targets is hittable, and when?” There’s been talk about taxes and infrastructure – if that talk starts to look like it could turn into action that lifts the economy, some of that post-election optimism could return.
The uncertainties have not affected the buoyancy of U.S. large caps so far in 2017 (Figure 1), though small-cap stocks that soared immediately after the election have come back to earth. International equities have fared better, while soft oil and metals prices have dragged down commodities.
FED DIRECTION: Signs of a weakening economy – first-quarter GDP growth came in at a paltry 1.2%, and inflation is ebbing – have spurred questions about the Fed’s future direction.
Policymakers raised short-term interest rates in June; it was the fourth increase in the slow tightening cycle that began in December 2015. The Fed also announced it will gradually trim the $4 trillion-plus now held on its balance sheet.
Where do we go from here on rates? The Fed says it will hike again before year-end to head off any inflationary pressures during a period of near full employment. Based on current yields, however, the bond market appears unconvinced. The 10-year Treasury’s yield has tumbled from 2.6% to around 2.2% in the past few months as investors respond to softening economic data.
The Fed clearly wants to stay on pace with its slow tightening, but if mediocre data persists, a late 2017 rate increase may be delayed. The Fed has tended to play it safe during the long, grinding recovery that began in 2009. This scenario would support asset prices, and it would also fit our “low-ish for longer” outlook on rates.
GROWTH > VALUE: U.S. stocks continued their strong performance, with the Standard & Poor’s 500 index further stretching already rich valuations in a low-volatility environment. Sharper-than-expected earnings growth contributed to the equity exuberance.
Growth-oriented sectors of the S&P are leading the way, as investors take on more risk in pursuit of decent returns in a slow economy. Technology, health care and consumer discretionary are at the top of the leader board. At the other end are energy, telecom and financials – value sectors that typically fare better when GDP growth is stronger.
Value turned in a strong 2016, but this year it has reverted to the weak-growth trend that has dominated the past decade. In our view, the lack of clarity on economic policy issues coming out of Washington is certainly contributing to value’s vast underperformance in 2017. That said, value sectors that serve as bond substitutes are mostly doing OK – these include utilities and consumer staples.
MOVING OVERSEAS: Equities in non-U.S. developed markets (DM), most notably the eurozone, and emerging markets (EM) are catching a tailwind generated by economic growth and improving corporate fundamentals.
Through the first six months of 2017, both DM and EM stocks were up by double digits, well ahead of the performance of the S&P 500. And because those asset classes have not enjoyed the same sort of multi-year returns as U.S. equities, their relative undervaluation compared to U.S. stocks (Figure 2) enhances their appeal.
Risks are down, but not completely gone. For DM, there are still open questions about bad debt at big European banks and we worry a bit that a volatility spike in U.S. stocks could be contagious. For EM, a revived U.S. dollar could hurt, as could changes to U.S. trade policy.
The top contributors to the UMP portfolios in the second quarter were our exposure to non-U.S. developed markets and U.S. fixed income.
As we discussed above, the brightening trend for GDP growth (albeit from a low base) and corporate results, combined with attractive relative valuations, largely defines the opportunity we see in developed markets.
International stock rallies have been known to last for years, so once we were confident that underlying conditions could be sustainable, we swapped expensive assets for cheap ones by trimming our tactical allocation to U.S. large-cap stocks and adding to developed markets. Our exposure to value stocks was a headwind for U.S. large cap performance.
Our fixed-income tilt toward credit has been a major driver of UMP returns over the past year. Over that time, spreads to comparable Treasury bonds have tightened significantly – this suggests they may not be as meaningful going forward.
We believe, however, that corporate bond prices – particularly high yield -- may be resilient.
Higher revenue and earnings for U.S. companies stand to reduce default risks and rock-bottom Treasury yields continue to push income investors toward credit. In addition, lower inflation could stay the Fed’s hand on a second-half rate bump, but if the Fed opts to act, high yield’s low correlation to Treasuries make the asset class less sensitive to interest rate changes.
Our allocations to U.S. small cap stocks and alternatives were positive on an absolute basis in 2Q, but they underperformed stocks and thus detracted from our relative performance. It’s worth a reminder that alternatives were added to the UMP portfolios as diversifiers because of their low correlation to other asset classes – they would be expected to lag in a robust environment for equities.
As always, our advice to members is to remain focused on the long-term investment plan that you have put so much thought into. For those UMP shareholders who may be uneasy about market risk in general or have concerns about current asset-class allocations, we recommend consulting with a USAA advisor.
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.
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