2017 Q2 Investment Report Commentary
Market Update: Steady as She Goes?
“Steady as she goes” is a common nautical phrase used when maintaining current course. The command says nothing about a ship’s current surroundings; it can be issued in the calmest of seas or in the most brutal of storms. While the command means to maintain the status quo, it does not mean to drop guard and settle into careless complacency. Vigilance is always paramount while at the helm, as identifying hazardous developments is of the utmost importance. Foresight is equally crucial, as a prompt, and more importantly, proper response to any perilous changes could mean the difference between foundering and continuing forward.
Daintree portfolios are currently in a “steady as she goes” state. Economic winds are blowing in the right direction to support capital markets, and no egregious imbalances exist that call for us to alter our present heading. Global markets continued to advance steadily in the 2nd quarter, with only Commodities declining. Sustained improvement in global GDP growth along with receding inflation expectations drove both stocks and bonds higher. Overall, returns were robust, with Non-U.S. Equities leading the way and volatility remaining exceptionally low. Similar to the 1st quarter, U.S. Equities rose significantly with the S&P 500 up 3%, but domestic markets once again trailed international markets.
For most of the recovery since the Great Recession, the U.S. has had better economic trends that justified higher equity valuations. Now, however, international markets have improving growth and cheaper equity valuations. As the chart below shows, Non-U.S. Developed (“DM ex US”) and Emerging Markets (“EM”) equity valuations, as measured by price-to-forward earnings, are lower than the U.S. even when controlling for differences in long-term growth rates. With the relative attractiveness of Non-U.S. Equities, investors have shifted focus overseas. Given that most Daintree client portfolios already had an overweight to Non-U.S. Equities, no major shift in positioning is necessary.
The first half of 2017 benefitted from a combination of solid fundamentals, high investor optimism, and little negative news. Despite another strong quarter devoid of major developments, potential risks do exist. As stated before, valuations in many markets are richer, and therefore less attractive, than their historical averages. Geopolitics and governmental policy could provide an inflection point in the near future. North Korea’s missile program, US tax reform, the UK’s Brexit negotiations, and terrorism all have the potential to move markets significantly. As always, Daintree continues to monitor these risks to attempt to keep your portfolio on a safe course.
What’s on Our Radar?
Even as clients enjoy strong absolute returns and low volatility, we continue to closely monitor developments that could impact client portfolios, including:
- The fate of Trump’s policy. The rise and fall of the “Trump trade” subsequent to the election shows the impact even potential policy changes can have on markets. For example, a meaningful corporate tax cut would benefit U.S. small cap stocks in particular and U.S. Equities in general. Markets seem to discount less than a 50% likelihood of any changes in tax rates.
- The direction of inflation. Inflation is a central risk to client portfolios due to its corrosive effect on purchasing power. Inflation has remained tame since the financial crisis, but a definitive upturn in inflation expectations would have implications for our Real Assets (positive) and Bond (negative) allocations.
At the year’s halfway point, returns have been very robust. Although the global economy continues to perk up, U.S. valuations may be slightly in front of the fundamentals. While no action seems necessary at this time, vigilance is necessary. As we chart the course forward, Daintree portfolios will continue to adhere to our philosophy of seeking returns that appropriately compensate our clients for the risks involved.