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Roof Advisory Group: Market View
3rd Quarter 2017

Unfazed and Grinding Higher
Market Update

Global equity markets continued to grind higher despite the backdrop of simmering tensions with North Korea, multiple devastating natural disasters and horrific terrorist attacks, as well as puzzlingly low bond yields. Equity markets quickly shook off these concerns and remained firmly focused on improving global growth, impressive corporate earnings results and the potential for meaningful tax reform.

The Barclays U.S. Aggregate Bond Index posted a modest gain of 0.8% for the third quarter. Bond yields were unable to move higher during the quarter given several disappointing inflation readings. In addition, the bond market remained well supported by strong inflows into fixed income funds.

Below is a summary of the third quarter performance results for the major indices we generally review in each quarterly MarketView.

Asset Class Index Q2 Return
U.S. Stocks S&P 500 Index 4.0%
International Stocks MSCI EAFE Index 4.8%
Global Stocks MSCI ACWI Index 5.3%
Bonds Barclays U.S. Aggregate Bond Index 0.8%

Economic Update

Data points continue to reflect healthy economic conditions. Second quarter GDP growth has been revised up to an above-trend 3.1% rate. Estimates for third quarter growth rates are hovering slightly north of the 2% level. However, the back-to-back destructive hurricanes have certainly contributed to more lukewarm expectations for third quarter growth results and a positive rebound is expected for the final quarter of 2017 as the rebuilding and recovery cycle gets started. Growth levels have also improved outside of the U.S. with no major foreign economies currently facing a recession.

Job growth continued to expand at an in-line pace compared to the recent positive trends. Corporate earnings growth remains a bright spot with S&P 500 companies recording the second straight quarter of double-digit profit growth. In addition, confidence levels remain close to 15-year highs among consumers, small businesses and corporate executives. Looking forward, leading economic indicators point to a continuation of growth trends in the near-term.

Portfolio Positioning

Sometimes the old saying "if it ain't broke, don't fix it" is very applicable to investing and was reflective of our views in the third quarter. Outside of a few strategic tweaks we made no dramatic changes to portfolios. We maintained a mid-point equity allocation and we remain comfortable with our fixed income stance focused on limited interest rate sensitivity and measured exposure to higher yielding and more economically sensitive fixed income strategies.

As we have discussed in the past, our reluctance in taking a more aggressive equity allocation is primarily driven by elevated stock market valuations. However, we are also cognizant that the pickup in global growth, the healthy rebound in corporate earnings and the potential for meaningfully lower corporate tax rates may translate into some relief from these higher than average valuations; potentially prompting us to reexamine our current equity weighting.

Performance Attribution

We are again very pleased with this quarter's performance results. Although we maintained moderate risk levels via our mid-point equity allocation, our level of upside participation in the stock market's advance was indicative of a more aggressive stance. The same outcome is reflected in year-to-date and twelve months returns as well.

Security selection decisions were a key contributor to the solid third quarter performance results. Strong equity performance was driven by significant weightings to technology and financial stocks. While we maintain a limited amount of energy exposure within equity allocations, that exposure was beneficial in the third quarter as the energy sector turned in the best performance among all S&P 500 sectors.

The outperformance momentum we have achieved within our fixed income allocations continued in the third quarter. While quarterly returns for passive bond market benchmarks weren’t dramatically exciting, our fixed income strategies turned in an impressive performance. Our meaningful weightings to Preferred Stocks and to the Pimco Income fund (a multi-sector bond mutual fund) were the main drivers of the outperformance on the fixed income side of portfolios.

Similar to the previous quarter, the list of detractors is short. While our international equity managers posted returns firmly in positive territory, their quarterly results did not keep pace with developed international equity or domestic stock indices. We are a bit disappointed with this short-term outcome but remain focused on their impressive longer-term track records and how well those international strategies protected capital during more volatile market environments.

Closing Thoughts

Last quarter we ended the MarketView with a series of charts that detailed several interesting topics. The charts were well received so we'll follow suit again this quarter. The first two charts represent visuals of important near-term issues that we will be monitoring closely; one we view as a potential positive (corporate tax reform), the other much more of an unknown (Federal Reserve balance sheet normalization).

Corporate Tax Reform

The current administration is pushing for a far-reaching tax reform package designed to lower and simplify taxes for corporation and individuals. The plan is currently light on important details, mainly how it would be funded. Tax reform certainly won't be an easy proposition for Congress to agree on. However, we do think if the plan were to come to fruition, significantly lower corporate tax rates would have a measurably positive impact on both corporate earnings and to the competitiveness of U.S. corporations. Below is a comparison of current global tax rates. It's hard to argue the U.S. corporate tax rate is currently very competitive when compared to other developed countries.

Global Corporate Income Tax Rates

Global Corporate Income Tax Rates Source: Country representatives on the OECD Working Party 2: Tax Policy and Tax Statistics of the Committee on Fiscal Affairs.

Federal Reserve - Balance Sheet Normalization

In the depths of the financial crisis the Federal Reserve initiated a massive bond buying program, commonly referred to as Quantitative Easing (or "QE"). This program was designed to reduce borrowing costs and to stimulate an economy in the grips of a major recession. This QE program resulted in a huge increase in the size of the Fed's balance sheet from below $1 trillion in 2008 to roughly $4.5 trillion today. Many other global central banks initiated their own QE programs and orchestrated similar increases to their balance sheets.

The Fed recently announced their intentions to begin the process of reducing the size of their balance sheet starting as early as October. The pace of their reductions will start at an extremely slow pace and their intentions have been well telegraphed to investors for some time now. No one was caught off guard by their announcement. However, it is difficult to not recognize the correlation of the balance sheet expansion to the stock market's steep ascent. A rudimentary conclusion might be that this correlation would work in reverse as well. We don't think so. But we recognize the actions taken by global central banks were experimental and something that needs to be monitored closely as the process starts to be reversed.

Fed Balance Sheet and S&P Performance

Fed Balance Sheet and S&P Performance Source: Board of Governors of the Federal Reserve System, All Federal Reserve Banks: Total Assets [WALCL], retrieved from FRED, Federal Reserve Bank of St. Louis

Corporate Earnings Growth

Last quarter we highlighted the impressive improvement in corporate earnings results. Second quarter earnings growth came it at a solid 10.6%, much better than expectations at the beginning of the quarter. Near-term future estimates continue to look very positive as well.

S&P Earnings Growth

S&P Earnings Growth

Couple of Random Thoughts

The stock market has been on a tear over the past 20 months. That's great. But let's not let the current environment be a distraction from the benefits of a balanced and diversified approach. Below is a graph from JPMorgan that illustrates that point. It took an all-equity portfolio roughly 4.5 years to fully recover from the financial crisis drawdown in 2008/2009 while balanced portfolios recovered in roughly half of that time. Our investment view has always been that an actively managed, balanced and diversified approach is the ideal way to optimize portfolio value in both the near and long-term.

Portfolio Returns: Equities vs. equity and fixed income blend Source: JPMorgan Asset Management, “4Q 2017 Guide to the Markets”. 60/40 and 40/60 are portfolios invested in the S&P 500 (stocks) and the Barclays U.S. Aggregate Index (bonds). The portfolio is rebalanced annually. The example above is not representative of the adviser’s results Past performance is not indicative of future results.

Adding Value in Fixed Income

We wanted to highlight the very strong performance of one of the actively managed fixed income funds we are utilizing in client portfolios. We have held the Pimco Income fund in portfolios for a little over five years and could not be more pleased with the results we have achieved through the utilization of this strategy. Below is a five-year chart that shows the impressive excess returns Pimco has generated compared to a passive intermediate-maturity bond index.

With the debate about actively managed funds versus passively managed funds heating up among investors, we think it is important to outline our rationale for selecting our lineup of actively managed funds. We do not have a firm bias for either style and utilize both active and passive strategies in portfolios. However, we do think our carefully selected active managers are "worth their salt" and will continue to highlight additional examples in the future.

PIMIX - Pimco Income Fund vs AGG - iShares Core U.S. Aggregate Bond ETF

PIMIX - Pimco Income Fund vs AGG - iShares Core U.S. Aggregate Bond ETF

We welcome all Roof Advisory Group clients to attend our interactive online webcast discussion scheduled for 1:00 pm EDT on Thursday October 12th. The purpose of this webcast is to provide a more in-depth overview of the most recent quarter, financial market conditions, portfolio positioning, as well as our firm's outlook going forward. Invitations to register for the webcast are currently being emailed to our valued clients.



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