Strong Economy, Expectations Boost Stocks but Pressure Bonds

U.S. equities generated further post-election gains last week on expectations that more fiscal

spending by the next administration will boost economic growth. Meanwhile, the U.S.

economy under the current administration continues to improve: Nearly every piece of

economic data reported recently has been better than expected—including initial jobless

claims, retail sales, housing starts and consumer confidence.

Positive earnings reports last week from retailers Target and Best Buy further reinforce that

consumer sentiment is strengthening, which bodes well for consumer-focused businesses

heading into the holiday season.

Internationally, Japan’s GDP growth in the third quarter (0.2%) handily beat expectations

thanks to strong exports driven by a weak currency. Other Asian nations, including the

Philippines and Hong Kong, also reported GDP growth that exceeded estimates. In Europe,

GDP growth met expectations while industrial production was better than expected due to

strength in nondurable consumer goods. Additional positive results recently include strong

retail sales in the UK and positive investor sentiment in Germany.

GAIN: Active Asset Allocation

Value stocks lead the way in the U.S. equity markets last week, driven by many investors’ view

that a December interest rate hike by the Federal Reserve is a near certainty. The energy and

financial services sectors, which are key segments of the value stock universe, both gained

ground.

Although developed international equity markets lagged the U.S. indices, emerging markets

stabilized and kept pace with the U.S. market. The relatively low valuations in emerging

markets have helped fuel increased flows of investment capital to these stocks.

In the fixed-income market, interest rates continued to rise along with higher inflation

expectations in the wake of the election results. We are avoiding longer duration bonds but

are maintaining a relatively large exposure to corporate securities–both investment grade

and high-yield–which we believe will benefit from a strong stock market.

PROTECT: Risk Assist

As global equity markets have continued to rally modestly, measures of expected future equity

market volatility have plummeted.

• The CBOE Volatility Index (VIX), which measures anticipated levels of volatility, has fallen to 13 from 22 in early November.
• Implied correlation (a measure of how expensive options on an entire index are relative to the price of options on the individual stocks in that index) dropped to around 0.30—an extremely low level, historically.

Bond yields have risen sharply, mostly as a function of modestly higher inflation

expectations. That development has caused interest rate-sensitive sectors which have

historically been considered “low volatility” sectors—such as utilities—to sell off. However,

we had forecasted that utility stocks would be meaningfully more volatile than they had

been historically, and shifted assets away from the sector as a result—a strategy that has

benefited performance.

SPEND: Real Spend

Real Spend’s overweight to equities (relative to other retirement income strategies) has been

a positive as inflation expectations rise and the aggregate bond market sells off. As the new

administration begins to reveal its plans for economic growth and less accommodative monetary

policy, we expect these trends to continue.

Our equity focus is designed to mitigate both inflation risk and interest rate risk by seeking to

generate investment returns that outpace inflation and that are less sensitive to the direction of

rates. It may be valuable in the current environment to remember that we have done the research

to greatly simplify the quest for generating adequate retirement income. A retirement income

solution must be optimal across four dimensions:

1. Duration of retirement
2. Desired income during retirement
3. Risk tolerance
4. Portfolio allocation (e.g., equity/debt mix)

Real Spend has been designed with these dimensions in mind, with the goal of providing successful

portfolio allocations for long retirement durations.