INVESTMENT DIRECTIONS

Summertime and the living is easy?

Sep 7, 2018
By Christopher Dhanraj

Shifting tides

In the United States, the economic backdrop continues to shine, and earnings remain strong. But uncertainty surrounding trade tensions has sparked investor interest in more defensive factor exposures, like quality, while fervor has cooled for more cyclical factors such as value. At the same time, growth-oriented stocks have continued their momentum—although exhibiting bouts of volatility of late. Earnings have been the drivers of both performance and pullbacks.

Feeling the heat

Meanwhile, developed countries and regions outside the United States have not just suffered from historic heatwaves, but continue to face political and economic headwinds. As such, we have downgraded Europe to underweight and Japan to neutral. Political and economic uncertainty is casting a shadow over the former and lack of a catalyst in sight affects the latter.

Why we’re sticking with emerging markets

Emerging market equities have performed miserably this year, a victim of tighter financial conditions (namely, the strong dollar) and trade tensions. However, we continue to favor the asset class and believe this year’s poor performance has created an attractive entry point. Yet rising dispersion among emerging markets (EM) assets underscores the need for selectivity at the country level.

Focus on mortgage-backed securities

The fixed income market remains challenging, but market technicals have improved as demand from banks and others has absorbed the increased supply as the Federal Reserve (Fed) normalizes its balance sheet. The key is being selective: We think mortgage-backed security valuations remain attractive and prefer agency MBS over credit, TIPS over Treasuries and investment grade over high yield within credit.

The new yield environment

This year marks the most meaningful change in interest rates since the financial crisis. As the Federal Reserve increases interest rates and ends largescale asset purchases in the United States, risk-free yields have increased. The current U.S. 2-year Treasury yield is greater than 95% of the curve just two years ago. The ability to earn attractive risk-free returns within short-maturity assets means that investors have a real alternative to earn yield without taking duration or equity risk. While long-duration bonds can offer diversification benefits, we continue to favor short-duration bonds.

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