After a few quiet months, U.S. large-cap stocks jumped 2% over the past two weeks, setting a series of record highs along the way. International stocks resumed their performance leadership, with developed-market large-cap stocks gaining 3% and emerging-market stocks rising by more than 5% over the same period. Amid the short-term global market rally, investors have largely ignored the political headlines regarding Russia as well as the ongoing debates on health care and tax reform, and instead have taken stocks higher as prospects for accelerating global growth proved to be the dominant market driver.
Given the mix of headwinds and tailwinds, the current environment appears reasonably balanced, in our view, adding to the importance of proper diversification and timely portfolio adjustments. This starts with a review of a portfolio's equity/fixed-income mix, followed by appropriate allocations to a broad set of asset classes. To that end, we offer our current outlook for each asset class in our Investment Pyramid.
Equity Versus Fixed Income – We recommend rebalancing to an appropriate mix of stocks and bonds, reflecting our view that the bull market in stocks still has legs, but likely with more frequent bouts of volatility. A laddered bond portfolio and enough in cash can provide you with current income to meet short-term obligations and downside protection as volatility picks up.
AGGRESSIVE (Portfolio Investment Category)
Commodities – The commodity price environment is likely to be a bit more stable looking ahead, but portfolio benefits from direct commodity positions are limited. In particular, oil prices could remain range-bound amid high global inventories and rising production in the U.S. The bulk of the declines have likely passed, but we don’t expect a sharp rebound in prices nor a return to the "commodity super-cycle" environment of the past few decades. We recommend only small allocations to direct commodity investments.
Emerging Markets – Emerging-market equities have rebounded following underperformance in recent years, but a modest allocation is still warranted as cheaper valuations are somewhat offset by ongoing commodity and currency volatility that have an outsized effect on the asset class.
Small- and Mid-cap Stocks – Potential policy changes, including easing the regulatory environment and changing the corporate tax code, would be a strong tailwind for small and midsized companies that are more closely tied to the domestic environment. Progress towards these objectives has been slower than originally expected and has dampened the performance of U.S. small- and mid-cap stocks in the first half of the year. International small- and mid-cap stocks trade at a discount to their domestic counterparts and are an investment opportunity, in our view. We recommend maintaining a moderate allocation towards small- and mid-cap stocks, with international stocks being more attractive than domestic stocks.
GROWTH & INCOME
Developed International Large-cap Stocks – Economic trends (specifically in Europe) are showing green shoots of improvement, which, coupled with our expectation for additional central-bank stimulus, could provide an attractive boost for more attractively valued and higher-yielding international large-cap stocks. We recommend an overweight position, aligning with our expectation for faster earnings growth as the global economy accelerates.
U.S. Large-cap Stocks – With U.S. large-cap stocks at all-time highs, stocks aren’t inexpensive, but price-to-earnings ratios, one way of valuing stocks, have been above average for several years and can be supported by continued improvement in the economy. However, turmoil surrounding President Trump, which prompted concerns that the administration could be distracted from executing its pro-growth agenda, is a growing headwind for U.S. stocks. While reactions to political events can lead to investor nervousness and even market corrections, they are usually short-lived. Conversely, above-average valuations have not predicted short-term market moves in the past but have usually been followed by below-average returns over the next decade. With fundamentals still exhibiting positive trends, investors should buy U.S. large-cap stocks when their prices drop.
Real Estate – U.S. commercial real estate property prices are at peak levels due to the low-interest rate environment over the past several years and from steady economic expansion since the financial crisis in 2008/2009. However, earnings growth is moderating across many property types because we are later in the commercial real estate and economic cycle and new supply (competition) is increasing in some markets. We believe investors should be selective given our cautious stance and look to diversify across property types, such as health care, industrial and office.
High-yield Bonds – The spread (difference) between the rates on high-yield bonds and investment-grade bonds has narrowed, and in our view, don't currently offer investors adequate compensation for their additional risks, especially as default rates have started moving higher. We recommend adding U.S. investment-grade income or cash to keep overall fixed-income allocations at the middle of the equity/fixed-income range.
International Bonds – With better global growth, central banks around the world are also starting to remove their stimulus policies, making slowly rising rates likely worldwide. Domestic bonds appear more attractive than global bonds, where longer-term returns will likely suffer from incredibly low or even negative yields. As a result, we recommend reducing international fixed-income investments, since we think their risks are high compared with their expected returns.
U.S. Investment-grade Bonds – Following four rate hikes since 2015, the Fed will likely continue to raise the overnight rate gradually. We also expect it to start winding down its balance sheet (reducing the amount of bonds it has purchased over the years). Historically aggressive stimulus policies helped reduce stock market volatility in the current expansion, but as the Fed pulls back, we think stock market reactions to shocks or disappointing data may be more volatile than we've experienced in recent years. Despite low yields, investment-grade bonds still offer stability for portfolios.
Cash – An above-average allocation to cash is, in our view, a reasonable position because it offers investors some “dry powder” to opportunistically buy quality investments during market pullbacks.
|Dow Jones Industrial Average||21,580||-0.3%||9.2%|
|S&P 500 Index||2,473||0.5%||10.4%|
|10-yr Treasury Yield||2.24%||-0.09%||-0.21%|
The bulk of the S&P 500's constituents are set to report earnings over the next few weeks with nearly 200 companies releasing their financial statements for the second quarter. On the economic front, the Conference Board's Consumer Confidence report will be released on Tuesday, the Fed is expected to keep short-term interest rates steady on Wednesday, and GDP for the second quarter will come Friday morning.
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