Outlook & Perspective
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- Milton Bryan
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1 Outlook & Perspective All data and information as of June 30, 2016 Approved for current clients. May be presented to prospective clients in a one-on-one setting only. Morningstar Investment Services LLC A summary of our market outlook Outlook at a Glance Positioning Summary 3 U.S. Stocks gained ground during the second quarter. Rising oil prices cleared the way for energy stocks to become the best performing sector. Sectors such as real estate and utilities benefited from falling bond yields. 3 International stocks underperformed U.S. stocks, as the U.K. vote to leave the European Union upended financial markets in late June. The British pound and the euro lost ground on expectations of reduced investment spending and perhaps recession caused by a protracted negotiation to separate the U.K. from its largest trading partner. The Japanese yen rose in value, but that hurt its exporters who have benefited from previous weakness in the yen. Central banks are challenged to find the right levers to pull, with renewed concerns about the potential for competitive devaluations. 3 Turmoil overseas is likely to remain a key factor in keeping the Federal Reserve from raising rates in the near term. The U.S. jobs market is close to the Fed s measure of full employment and inflationary pressures are gaining steam, yet the Fed will likely be wary of letting the U.S. dollar get too strong. So far, domestic issues have taken a back seat to international concerns, as the 10-year Treasury yield fell below 1.5% by the second quarter s end. Equity U.S. Stocks Large-Cap Mid-Cap Small-Cap International Equity Developed Markets Emerging Markets Bonds U.S. Bonds Duration TIPs Inv. Grade Credit High-Yield International Bonds Alternatives Commodities Absolute Return REITs Short Term Reserves Current Weighting Previous Quarter Weighting Underweight Neutral Overweight
2 Page 2 of 5 Asset Class Summary 3 U.S. Stocks Underweight We remain unenthused with the prospects for U.S. stocks. The long rally off of the 2009 bottom has left U.S. stocks looking fully valued, according to our analysis. Corporate earnings have been shrinking with exporters trying to cope with the strong dollar and energy producers struggling to adjust to a massive decline in oil and natural gas prices. The U.S. may indeed remain one of the faster growing developed economies, but relatively high price multiples are a concern, as are above-normal profit margins. Large-Cap: Underweight Earlier this year we removed our bias in favor of large-cap companies over smaller-cap companies. Small caps had been looking expensive to us, but large caps have outperformed by a wide margin over the past five years and brought valuations between the two closer together. Large caps are better positioned to take advantage of low bond yields, but they also tend to be more exposed to global forces. Mid-Cap: Underweight Mid caps have modestly outperformed both small caps and large caps in the first half of Valuations and fundamentals for mid caps are in line with the broader U.S. market. Small-Cap: Underweight Small-cap stocks outperformed large caps in 2016 s second quarter, but much of that was driven by real estate stocks, which benefited from lower yields and a view that U.S. real estate may be insulated from global turmoil. Our view is that publicly traded real estate is overvalued, however, and that small caps are not priced favorably compared to large caps. 3 International Equity Overweight Foreign stocks have lagged behind U.S. stocks in five of the past six years. A stronger U.S. recovery in corporate earnings and depreciating foreign currencies both contributed to the performance gap. Looking forward, however, we think there s more opportunity in foreign stocks. Most foreign economies have more room to recover from the cyclical lows, and the strong U.S. dollar makes foreign goods cheaper. Central banks in Europe and Japan are also providing greater stimulus than the Federal Reserve is in the U.S. Developed Equities: Overweight The U.K. vote to leave the European Union is the latest macroeconomic challenge to foreign developed-market stocks. After a couple days of frenzied trading, however, foreign markets calmed and the MSCI EAFE Index finished with a modest 1.5% quarterly loss. With U.S. stocks gaining ground in the quarter, we believe that the valuation gap that favors non-u.s. stocks has grown a bit. Some may argue that the British vote is the first step in a wholesale breakdown of the European Union, but our focus remains on the long-term earnings power of companies and the prices that investors are asked to pay to hold the shares of those companies. With that vantage point, we often find that periods of pessimism can provide the best opportunities for future gains; that s especially true when political woes top investors list of concerns.
3 Page 3 of 5 Emerging Equities: Overweight This year s rally in commodity prices has buoyed emergingmarket equities and served as a reminder that the rear-view mirror is a poor way to manage an investment portfolio. Despite the recent bounce, emerging-market equites have significantly underperformed developed-market stocks (and especially U.S. stocks) in the past five years. China s slowing economy and the ensuing fall in commodity prices have been the primary causes of the drop in earnings and the resulting pessimism. Our view is that emerging markets have more than accounted for the known challenges and that current valuations do not reflect the potential for earnings to stabilize or rebound. 3 Bonds Neutral Duration: Owning long-term government bonds has been a successful strategy this year, as global interest rates have moved lower partly due to somewhat disappointing global growth early in the year, which led to slight downward revisions in the IMF s forecasts for global growth in both 2016 and Global interests again moved lower in response to expectations that central banks would provide additional easing to prevent any disruptions tied to the U.K. s decision to leave the European Union. Yields on 10-year U.S. Treasuries fell from 2.27% to start 2016 to 1.49% by June 30. Despite the rally in long-term bonds, we re not eager to take on much interest-rate risk today. With yields in record low territory, the reward for investing in long-term bonds is also low. While we would agree that the Fed is likely to be cautious about raising rates going forward, we think there is limited room for foreign bonds with negative yields to move further into negative territory and that U.S. economic conditions don t call for such extraordinarily low yields. While yields could always move lower, we don t think the reward is worth the risk for long-term investors. U.S. Investment Grade Bonds: Overweight While not as safe as Treasuries from a credit perspective, we think the extra yield offered by high-quality U.S. bonds is worth a modest overweight allocation. The recovery in the U.S. has been underwhelming but we do not see imminent danger of its demise. U.S. TIPS: Overweight TIPS offer a somewhat mixed risk and return potential for the portfolios. We believe that investors are underestimating the potential for a surprise move toward higher inflation, which may prove beneficial for TIPS investors. That said, TIPS tend to carry lots of duration risk, which can lead to losses if the long-term yields move higher to counter rising inflationary pressures. Overall, we believe the positives outweigh the negatives. Our overweight position in TIPS is couched in an overall portfolio stance that is underweight duration. Thus, we expect the portfolio to have some protection against the potential for rising rates while also being in position to benefit from a rise in inflation expectations. We also view the high-credit quality of TIPS as a welcome offset to other exposures. U.S. High Yield Bonds: Overweight This year s rally in high-yield bonds, which rebounded when oil prices recovered from lows set in February, has taken some of the shine off of the asset class. That said, we think that high-yield bonds are a reasonable place to invest given ultra-low yields on government bonds and stretched valuations on U.S. stocks. We are sensitive to the potential for a liquidity event in high-yield bonds and are aware that the credit cycle is aging, but spreads
4 Page 4 of 5 on high-yield bonds are still much wider than they were two years ago and think the tradeoff of risk for reward is justified. International Bonds: Neutral It is somewhat misleading to say that we are neutral on international bonds. We are highly bearish on foreign developed-market bonds, many of which have pushed deeper into negative yields during U.S. investors who are maintaining exposure to foreign bonds are either counting on yields to move further into negative territory, U.S. dollar depreciation (which would raise the value of assets priced in foreign currencies), or a diversification benefit if U.S. rates rise while foreign rates remain low. We don t see much value in those scenarios. In contrast to foreign developed-market bonds, we are bullish on emerging-markets debt. The downturn in the commodity cycle has pressured emerging-market debt just as it has emergingmarket stocks. Relative to other bonds, we think the yield is reasonable, however, and believe that emerging-market currencies are toward the low end of a fair trading range. Short-Term Reserves: Overweight In some ways, cash is the default option when neither stocks nor bonds look attractive. Our defensive positioning with regard to the risk of rising interest rates opens the door for an allocation to cash. That said, we re cognizant that there is essentially no return currently associated with holding cash and that short-term bonds may be better than cash for the defensive portion of the portfolio. 3 Alternatives Neutral Commodities: Underweight Having even a small allocation to commodities for diversification purposes has been painful in recent years. The Bloomberg Commodity Index lost ground in five consecutive years through 2015 and is down 10.8% annualized in the five-year period ending June 30, As much as we regularly call for patience with regard to the benefits of diversification, we have reassessed our outlook for commodities and have shifted to an underweight. China s economy continues to slow, as does its formerly insatiable appetite for commodities. That has left excess production capacity in many markets with few signs of new facilities being shuttered. Commodity investing through the future is also challenged as returns on collateral remain near zero and many futures curves no longer present the opportunity for positive roll yield. Absolute Return: Neutral Alternatives continue to make a compelling pitch in a world of low bond yields and fully valued stocks. But high fees and modest returns to date have thus far kept most absolute-return strategies from fulfilling their promise. As a result, we have less conviction in mixing these strategies into an asset allocation portfolio. 3 Global REITs Underweight After a multiyear stretch of yield-hungry investors pushing prices up, we continue to believe REIT valuations are stretched and do not offer much potential for capital appreciation. Moreover, given their rate sensitivity, REITs could face significant headwinds in the face of rising interest rates, which, as we ve discussed, is not improbable at this stage of the game. Given these concerns, we remain underweight the asset class.
5 Page 5 of 5 Important Information The opinions expressed herein are those of Morningstar Investment Services, are as of the date written and are subject to change without notice, do not constitute investment advice and are provided solely for informational purposes. Morningstar Investment Services shall not be responsible for any trading decisions, damages, or other loses resulting from, or related to, the information data, The Morningstar Managed Portfolios SM Program is offered by Morningstar Investment Services LLC, a registered investment adviser and subsidiary of Morningstar Investment Management LLC. In addition to the Program, Morningstar Investment Services also offers model portfolios to third party advisory programs ( Advisory Program ) on a non-discretionary basis as a strategist and a discretionary basis as an investment manager. About Indices The indices noted are unmanaged and can not be directly invested in. Individual index performance is provided as a reference only. Since indices and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although index performance data is gathered from reliable sources, Morningstar Investment Services LLC cannot guarantee its accuracy, completeness or reliability. Investment Risks Investments in securities (e.g., mutual funds, exchange-traded funds, common stocks) are subject to investment risk, including possible loss of principal. Please note that bonds are also subject to interest-rate risk. Portfolios that hold bonds are subject to fluctuations in value due to changes in interest rates. Before making any investment decision, customers should read and consider all the relevant investment products offering documents and information. Diversification is an investment method used to help manage risk; it does not ensure a profit or protect against a loss. This document contains certain forward-looking statements such as expects, anticipates, believes, estimates, forecasts, and similar expressions. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason. Past performance does not guarantee future results. Asset Class Definitions High-Yield Bond Funds Investing in lower-rated debt securities (commonly referred to as junk bonds) involves additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default. International/Emerging Market Funds The investor should note that funds that invest in international securities involve special additional risks. These risks include, but are not limited to, currency risk, political risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks. Convertible Arbitrage Includes the purchase of convertible securities and the sale of the underlying common stock. These securities tend to be convertible bonds or convertible preferred stocks that may be converted into the stock of the same company. This strategy strives to gain profits from potential pricing errors made in the conversion and is typically included in the equity component of a portfolio. Long-Short Equity A strategy which combines a long position (number of contracts bought exceeds number sold) in one security with a short position (number of contracts sold exceeds number bought) in another. While the funds using this strategy are attempting to protect their portfolios against market declines, they are susceptible to stock investing risks. Share prices will be affected by market activity and declines are possible. Merger Arbitrage Seeks to profit from the successful completion of corporate organizations. The process commonly used to execute this approach involves purchasing shares of an announced acquisition target company at a discount to their expected value upon completion of the acquisition. Hedging strategies are utilized to reduce market exposure and volatility. Credit Arbitrage Seeks to exploit the mispricing of different classes of securities of the same company, and may invest in investment grade and/or non investment grade corporate debt, credit derivatives, loans, equities, structured products, credit index securities and private debt.
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