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Quarterly Market Review Q1 2017 Michael J. Vogelzang, CFA President & Chief Investment Officer Eric Eaton, CFA Portfolio Manager & Allocation Analyst Boston Advisors, LLC – One Liberty Square, 10th floor- Boston, MA 02109 | p. 617.348.3100 | www.bostonadvisors.com Boston Advisors Quarterly Market Review | 2017 First Quarter First Quarter 2017 Review The U.S. stock market started the year like gangbusters. After a strong rally through January and February, prices eased off somewhat and finished lower for the month of March. Once the dust settled, the S&P 500 gained an impressive 5.5% for the quarter. International equity indices rallied even more as emerging markets powered up 11.5%, followed closely by developed international bourses rising 7.3% on the quarter. Source: Bloomberg Performance Contributors Overweight U.S. Large Cap Growth – Large Cap Growth stocks led the U.S. market higher, moving up 8.8%. After lagging the broader market in 2016, this was a welcome development. With as much as 45-50% of your portfolios invested in this slice of the U.S. market, this was the single largest contributor to a strong quarter. Allocation to Emerging Market Stocks – Emerging market stocks were the best performing asset class this quarter, as economic growth prospects increased with the global outlook, China’s outlook stabilized and investors continue to hunt for value. Developed International Equity – Our recent addition of International Developed equity to the portfolios is off to a good start. As interest rates remain low in Europe and Japan, economic and profit growth has accelerated. We continue to believe this combination, along with lower valuations than the U.S. market, will provide some durability to this rally. Page | 1 Boston Advisors Quarterly Market Review | 2017 First Quarter Performance Detractors Cash – Even a modest amount of cash reserves in a rising market weighs on performance. We strive to keep a small allocation to cash in a rising market and a larger allocation in a falling market. Cash provides a great level of “optionality” to the portfolio – that is, having cash not only reduces risk for unexpected downward volatility in markets, but provides dry powder to take advantage of lower prices should they come along. Fixed Income – While fixed income securities didn’t detract from performance, they didn’t help much either. Fixed income still maintains an important position in a globally diversified asset allocation portfolio for the income produced and diversification. During the quarter, several broad themes impacted markets, including U.S. politics, rising interest rates in the U.S., politics in Europe, the strength/weakness of the U.S. dollar, an expanding global economy and strong international equity markets. We see these themes continuing to play out as 2017 progresses. U.S. Politics: Healthcare, Tax Reform, Infrastructure With the vote to repeal and replace the Affordable Care Act seemingly permanently postponed, many are left wondering about the degree to which Trump can work with his own party. While not meant as an espousal of a political position, the current administration has clearly gotten off to a rocky start in terms of leadership. The Freedom Caucus, made up of the most conservative Republicans, has dug in its heels on issues like healthcare and continues to cause a split in the party. Polarization between Republicans and Democrats at almost every level compounds the political tension, creating dysfunction and lack of progress on many key issues faced by the country—and as it relates to the markets—the economy. The graph to the right shows recent polling data taken by NBC on Trump’s job approval ratings. The results indicate that the President’s approval has decreased, which could further impact his credibility and ability to get things done. However, he has a reputation as a good dealmaker and many believe that with a bit more political experience under his belt, deals will start to happen in D.C. As mentioned, we saw some softness in the U.S. equity market in March. Investor consensus remains that Trump can still make significant progress towards his goals of infrastructure spending, tax reform, and increased jobs Page | 2 Boston Advisors Quarterly Market Review | 2017 First Quarter for Americans – just that it will take a bit longer due to the political turmoil. Depending on this timing, a modest pullback in the market makes sense as these economic stimuli would arrive later. Regardless, the U.S. economy remains strong with solid and improving earnings growth, high and growing employment, and a positive outlook for the remainder of the year. U.S. Interest Rates: A Rising Rate Environment At the beginning of the year, the Federal Reserve (the Fed) expected to increase its benchmark interest rate three times during 2017. The first increase is now behind us (in mid-March), leaving two more potential rate increases on the table for the next nine months. The Federal Funds Futures market currently prices in a very low probability of a rate hike in May but expects a 56% chance of an increase in June. That probability jumps to 73% by September. This graph of the Fed’s famous “dot plot” gives an idea of what the Fed members expect as of their recent March meeting. Each dot represents the opinion of one voting member of the committee. It shows that in 2017, nine members believe the Fed’s benchmark rate will end up between 1.25% and 1.50%, and one member believes it will end up between 1.0% and 1.25%, etc. (today it remains between 0.75% and 1.0%). Also, the Fed just released the notes from its March meeting, indicating that it will mostly likely start shrinking its balance sheet later this year – another way to reduce liquidity in the economy. The big takeaway is the expectation that rates will rise over the next few years. An expectation held not only by the market, but by the officials setting those rates. Rising interest rates endure as a negative catalyst for the prices of bonds already held by investors. As interest rates rise, investors would rather hold newly issued bonds with higher interest rates. Therefore, they sell their older bonds with lower rates to buy the newer ones with higher rates. Our purchases in late 2016 of the SPDR Bloomberg Barclays Investment Grade Floating Rate ETF (FLRN) and the PowerShares Senior Loan Portfolio ETF (BKLN) have done what we intended them to do. They provide an income stream while keeping prices stable while interest rates rise, rather than decreasing in price like traditional bonds. Page | 3 Boston Advisors Quarterly Market Review | 2017 First Quarter International and Emerging Equities: Returning Growth Continues Non-U.S. stock markets rallied this past quarter, continuing to show signs of reversing multi-year weak price performance. The big draw for investors? Cheap(er) companies and increasing growth prospects. Valuations of companies in International Developed markets (particularly Europe) and Emerging Markets remain significantly lower than companies in the U.S. – a relative bargain. However, these other markets do come with risks that we continue to watch closely. While emerging market equities took the crown for the best performing asset class in the first quarter, the risk here remains a strong U.S. economy/dollar. If the U.S. economy heats up, it motivates investors to move money from emerging market investments to U.S. investments. Ironically, a strong U.S. economy with good prospects for investment (both fixed income and equity) siphons money away from international investing, driving down the emerging currencies. The irony is that stronger U.S. economic vibrancy also provides the “engine” for stronger emerging economies, setting up excellent opportunity. Your portfolios currently have modest emerging market equity exposure. For now the risks seem to balance the rewards, but our bias remains to increase exposure at some point, perhaps later this year. The biggest risk in Europe continues to be political, as populism could gain ground, creating pressure on the common currency Euro region. While real – we have certainly seen examples of surprising election outcomes over the last year – we think this risk has gotten a bit overblown, particularly as the European economies begin to strengthen. Populism is catalyzed by weak economic conditions. With growth, there is less disenfranchisement and hence lessened appeal to populism. For example, we saw the populist candidate fail in the Netherlands several weeks ago. Although Marine Le Pen, the leader of France’s Populist Party, made it through round one of France’s presidential election, opinion polls expect her to lose badly to Emmanuel Macron in round two. However, Italy is the largest concern for investors. Political or populism risk has the largest toehold in Italy. The chart to the right shows the so-called “Euroskeptic” parties polling strongly there. Furthermore, the number of Italians that stand opposed to Page | 4 Boston Advisors Quarterly Market Review | 2017 First Quarter the Euro currency has grown while many Italians remain confident in the prosperity of an Italian state outside of the EU. This risk remains muted for now, as the earliest Italian elections would happen is this fall, but more likely in May of 2018. Conclusion As always, investment implications for a global portfolio are as varied as the globe. The outlined themes are ones that we see continuing to drive market action for now. With that said, we will continue to monitor Europe with the thinking that the political situation will quiet, and continue to assess the political situation versus growth prospects and the strength of our own economy. As we have written often, our main job is as risk managers with an eye to carefully complement risk management with opportunity. Risks are aplenty in today’s world – we continue to watch, remain vigilant and be on the lookout for true opportunity. As always, we welcome any questions or comments you may have. Boston Advisors, LLC ELF 2017-095 Page | 5