By Bob Landry, CFA, Chief Investment Officer, USAA Investment Management Company
Stronger corporate earnings amidst a macro backdrop of synchronized global economic growth proved a boon for international equities in the third quarter.
Emerging market stocks led equities with an 8.8% return for the three-month period, bringing its year-to-date gain to 28%. Non-U.S. developed markets, led by Europe, returned close to 6%, while U.S. large caps picked up 4.5%.
In terms of the tactical allocations for the USAA Managed Portfolios (UMP), we maintained both momentum and discretionary allocations to developed markets throughout the quarter. In August, we shifted tactical allocations from U.S. small cap (momentum) and high yield bonds (discretionary) to emerging markets to position ourselves to take advantage of improving conditions.
The third quarter of 2017 demonstrated just how entrenched this low-volatility stock market truly is.
In the span of just a few weeks in late August and early September, a string of powerful hurricanes clobbered Texas, Florida and Puerto Rico, causing tens of billions of dollars in economic damage. Threats and counter-threats were flying back and forth between North Korea and Washington over nuclear weapons. And the Federal Reserve sent a clear signal to skeptical investors that interest rates are going up one more time before year-end.
Bond markets sold off in response to the Fed, but despite the natural and manmade turmoil, stocks continued their slow upward grind. By mid-September, the Standard & Poor’s 500 had pushed through the 2500 mark for the first time. The S&P 500 inched up from there, finishing the quarter with a 4.5% total return, which lifted its year-to-date gain over 14%.
International stocks also rose, with U.S. investors in overseas markets benefiting from a depreciating dollar. The gains have done little to dim the appeal of non-U.S. equities, whose valuations still significantly trail those of both U.S. large caps and small caps (Figure 1).
IS THE ‘TRUMP TRADE’ BACK? Stocks took off after the 2016 presidential election on expectations that the Trump administration would quickly get a pro-business agenda through the Republican-led Congress to kick up economic growth. But by spring, investors had pretty much lost faith.
Now there’s a loose plan to revive a key pillar of the so-called “Trump trade”: tax reform for individuals and corporations. We have our doubts about Congress piecing together a workable bill before year-end — there are a lot of moving parts, including figuring out how to deal with popular deductions for state/local taxes, mortgage interest and charitable contributions. The 2018 midterm elections may motivate legislators to get something done before then.
If tax reform is passed, we would expect it to provide a lift to GDP growth, though with a lag that would not exert immediate pressure on the Fed to hasten its pace on interest rate hikes. This could support bond prices in the near term. We would expect to see a faster reaction in the stock market, where investor skepticism suggests that tax reform is not yet priced in. Effective tax rates vary widely across the different S&P sectors, so we could also expect some industries to benefit more than others.
PATIENCE STILL REIGNS AT FED: For months the market was heavily discounting the possibility of a December interest rate hike, and then that changed almost overnight — a sub-30% expectation of Fed action in early September became 80% before quarter-end. This fall will also see the beginning of the Fed’s effort to reduce its $4.5 trillion balance sheet, the bulk of which is government and asset-backed bonds accumulated after the 2007-08 financial crisis.
Many wonder why the big rush toward monetary tightening, given the plodding pace of economic growth and scant inflation, the latter of which Fed chair Janet Yellen calls a “mystery” given that we’re near full employment. One explanation could be that the U.S. economy is stronger than the GDP numbers suggest, and that inflation is being kept in check by technological advances that are lowering prices.
But in any case, the Fed has made it clear that it has no plans to become an aggressive tightener. It is penciling in three more rate increases in 2018 and has given every indication that it plans to move slowly on its balance sheet runoff. This gradualist approach is in keeping with the Fed’s long-standing reluctance to do anything that might trigger a recession.
The Managed Portfolios generated positive returns during the risk-on months of July and September, while relative performance lagged in August, when worries related to domestic and international politics briefly sent investors in search of safe havens. For the quarter as a whole, the portfolios performed essentially in line with their benchmarks. Liquid alternatives, held in some of the Managed Portfolios, delivered value during periods of rising volatility.
As we enter the fourth quarter of 2017, key investment themes include:
DEVELOPED MARKETS: The economies of the eurozone and Japan are both picking up steam, with both regions reporting annualized GDP growth exceeding 2% in the second quarter. In the case of the eurozone, that growth is being shared across the region. Corporate earnings are growing as well — the pace of per-share earnings growth within the MSCI EAFE index (developed markets ex the U.S. and Canada) is exceeding the S&P 500 (Figure 2). The eurozone is still contending with some fundamental economic issues: unemployment is too high and the European Central Bank believes inflation is too low. In addition, the euro has been appreciating against the U.S. dollar this year. Any momentum to wind down the eurozone’s unconventional monetary policies could strengthen the euro, which could hurt Europe’s important export sector. We maintained a tactical overweight to developed markets throughout the third quarter.
EMERGING MARKETS: Emerging market stocks have been top-notch performers in 2017, with the MSCI EM Index up more than 28% through the first nine months of the year. Even after these gains, we think emerging market stocks continue to present an appealing long-term investment opportunity. On a fundamental basis, they are cheap relative to DM, and EM earnings growth is pegged to rise faster than that of DMs over the next two years. History suggests EM performance trends can play out over multi-year periods, and we believe we are still early in the game. A depreciating U.S. dollar has been an important contributor to EM performance in 2017 — the dollar recovered a bit at the end of the quarter, but we don’t see that trend being sustained. Constant caveat for EM: its shallower capital markets often make its stocks more volatile than developed markets.
FIXED INCOME: Our tilt toward credit in fixed income continues to be the biggest contributor to success within the asset class, while high yield and emerging market debt have consistently delivered strong absolute performance. With the Fed likely to continue moving slowly on interest rate increases through 2018, we don’t envision a major threat to bond prices. High yield and EM debt, which offer higher income returns than Treasuries and investment-grade corporates, are both on the pricey side, and in the case of high yield, narrowing credit spreads have increased risks. On the other hand, earnings growth is helping to keep high-yield default rates close to historic low levels. Even as rates rise, we believe in the role played by bonds in a well-diversified investment portfolio. The blue line in Figure 3 (above) shows a significant correlation between the S&P 500 and U.S. and non-U.S. developed market stocks — when one is up, the other tends to up as well. The green line shows a negative correlation between the S&P 500 and the 10-year Treasury — when stocks fall in value, bonds tend to rise.
As always, our guidance to members is to remain focused on the long-term investment plan that you have put so much thought into. For those Managed Portfolio shareholders who may be uneasy about market risk in general or have concerns about current asset-class allocations, we suggest consulting with a USAA advisor.
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.
USAA Managed Portfolios — UMP® (UMP) is an advisory service of USAA Investment Management Company (IMCO), a registered investment adviser, that is offered through its affiliate, USAA Financial Advisors, Inc. (FAI). Brokerage accounts are introduced and brokerage services provided by FAI and IMCO, both registered broker-dealers and Member SIPC. Clearing, custody and other services provided by National Financial Services LLC (NFS), Member NYSE and SIPC. A full description of the UMP program, including the investments, risks and applicable fees, is provided in the UMP Brochure. Information about UMP is also available by calling 1-800-531-1345.
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.
The unmanaged MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The unmanaged MSCI EAFE Index comprises 21 MSCI country indices, representing the developed markets outside of North America: Europe, Australasia and the Far East. It aims to include in its international indices 85% of the free float-adjusted market capitalization in each industry group, within each country.
The MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the U.S. equity market. The index covers approximately 85% of the free float-adjusted market capitalization in the U.S.
The MSCI Europe Index captures large- and mid-cap representation across 15 developed market countries in Europe. The index covers approximately 85% of the free float-adjusted market capitalization across the European developed markets equity universe.
The MSCI World Index is a global equity benchmark that represents large and mid-cap equity performance across 23 developed markets countries. It covers approximately 85% of the free float-adjusted market capitalization in each country.
The S&P SmallCap 600 Index measures the small-cap segment of the U.S. equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable.
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.
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