By: John Spear, CFA, USAA Mutual Funds Chief Investment Officer
After a relatively calm July and August, the final month or so of the third quarter was anything but.
Two powerful hurricanes smashed into Texas and Florida within a two-week period, leaving behind up to $150 billion in damage. Nuclear-armed North Korea provocatively launched a couple of missiles over Japan – this prompted retaliatory threats from President Trump. Venezuela, a key U.S. oil supplier, moved closer to dictatorship. Another Islamic State terror attack in London, a major earthquake in Mexico, and the list goes on.
These types of natural and man-made events have, in the past, often kicked up market volatility. But this time through, stocks barely flinched. In fact, while Hurricane Harvey was dropping four feet of rain on Houston, the Standard & Poor’s 500 started a rally that lifted the large-cap index over the 2500 mark for the first time.
The S&P 500 finished the third quarter at an all-time high – the index’s 4.5% total return during the period brought its year-to-date performance to 14.2%. International stocks also rose with returns in U.S. dollar terms being amplified by further greenback depreciation.
The yield on the 10-year Treasury dipped close to 2% in early September, but clearer prospects of more Federal Reserve tightening spurred a bond selloff that lifted yields. The price of West Texas oil kicked up nearly 10% after the hurricanes, while gold peaked above $1,350 an ounce in early September before giving back most of its 3Q gain by month end.
RISK-ON AND RISK-OFF
On the face of it, the past quarter was unusual across asset classes, with U.S. stocks finishing in record territory and strong bond prices for most of the period before a late-quarter fade triggered by Fed intentions and tax-reform talk.
Equities appeared to be propelled by a pair of key trends: stronger year-on-year earnings growth at the corporate level, plus evidence of synchronized global GDP growth for the first time in several years. The latter trend suggests that companies could sustain or even accelerate their profitability in the coming quarters.
Projected year-on-year U.S. earnings growth rate for 3Q is in the high single digits, and it’s even higher in overseas stock markets. This is one of the key reasons why we favor international developed and emerging markets.
Bond demand can be traced back to the same interlocking sources: the relentless global quest for current income, so-so economic data and expectations that the Fed will continue to move slowly on interest rates. Default risk on corporate bonds remains low given the solid profit growth trend for stocks – this has supported credit and will likely continue to do so into 2018.
THE FED SLOW-WALKING ON RATES
For most of 2017, investors had doubts that the Fed would follow through on its promise to raise interest rates three times this year. The thinking: Economic growth and inflation are both too low, so there’s no reason to rush things.
By now, however, it seems the markets are taking the central bank at its word – at quarter-end, futures positioning tracked by the CME Group set the likelihood at close to 80% that a third 2017 rate hike will occur in December. This fall will also see the beginning of the Fed’s effort to pare back the $4.5 trillion in bonds now residing on its balance sheet, the bulk of which was accumulated via quantitative easing after the 2007-08 financial crisis.
But at the same time, the Fed signaled that it has no plans to stomp on the accelerator. It is penciling in three more rate increases in 2018 and has made clear that it plans to move slowly on its balance sheet runoff. This gradual approach is consistent with the Fed’s reluctance to imperil the slow and often fitful recovery from the Great Recession.
TAX REFORM OFF BACK BURNER
The White House and Congress are taking a run at tax reform, one of the key components of the pro-growth Trump agenda that excited markets in the weeks following the November election but that has since lost most of its luster. Individual income tax rates, corporate tax rates and the rate at which overseas profits can be repatriated are all in play.
Of course, talking about tax cuts and actually implementing them are two very different subjects. The Republican administration and GOP majorities on Capitol Hill appear to be still working to align their interests, but with the 2018 election cycle soon to start, we think taxes could be an issue where they find common ground.
If tax reform is passed, we would expect real GDP growth to pick up, though it would come with a lag. There’s little chance it would make much difference to GDP during the next couple of quarters, so the Fed would likely not feel any immediate pressure to speed up its pace on interest rate hikes. This could support bond prices in the near term. The prospect of lower taxes could support stocks sooner by boosting corporate bottom lines.
The USAA asset allocation portfolios entered the final quarter of 2017 with essentially the same positioning as during the prior three months. Our focus on relative valuation leads us to favor international equity markets over the U.S. market, while on the bond side, we maintain a slight tilt toward credit.
We are overweight non-U.S. developed market equities, emerging market equities, high-yield bonds and long-dated Treasuries. Emerging market stocks have been among the best-performing asset classes in 2017, and we think they remain an appealing investment opportunity based on valuation and earnings growth potential. Profitability is also on the upswing in developed markets as GDP growth improves. High yield is benefiting from very low default rates, while expectations of a slow-moving Fed buoys long Treasuries.
We are underweight U.S. large cap and small cap stocks, primarily based on relative valuation metrics. While second-half 2017 forecasts call for solid revenue and earnings growth, which would stand to support U.S. stocks, we simply see better opportunities in overseas markets. We’re also a little cautious: Double-digit gains for the S&P 500 through September have come with almost no volatility. History tells us a modest pullback is certainly possible in the months ahead.
As always, we advise members investing for the long term to expect volatility and to not get swept up in short-term market moves. Our consistent advice to USAA fund shareholders is to remain focused on the long-term investment plan that 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 investment advisor.
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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.
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.
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.
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