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Second Quarter 2018

US stocks rose to the top of asset class performance charts with solid returns in the second quarter. Larger-cap US stocks gained 3.4 percent, but were outdone by smaller-cap stocks, which jumped 7.9 percent. The smaller-cap outperformance was driven by the market narrative du jour that smaller companies are more domestically focused and therefore not as exposed to a strengthening US dollar or potential trade wars, both of which are assumed to be detrimental to larger-cap (multinational) company profits.

Developed international stocks fell 1.8 percent and European stocks declined 1.6 percent for the period, as the US dollar rebounded. Dollar appreciation can be a meaningful headwind to returns for dollar-based investors in foreign securities.

Emerging-market (EM) stocks fared the worst, dropping 9.6 percent in dollar terms. In addition to the currency effects, EM stocks were buffeted by trade tensions between the United States and nearly all its major trading partners. As we discuss this quarter, we remain confident in our modest overweight to EM stocks in our tactical portfolios.

Moving on to the bond markets, in May, the benchmark 10-year Treasury yield pierced the 3 percent level, hitting a seven-year high before falling back, ending the quarter higher by 11 basis points at 2.85 percent. The core bond index had a slightly negative return (bond yields move inversely to bond prices). Once again, floating-rate loan funds outperformed core bonds and generated positive returns, as they have every month this year. For the year, the core bond index is down nearly 2 percent and floating-rate loans are up roughly 2 percent.

With the US economy growing above trend and the labor market tight, the Fed continued its gradual path of tightening monetary policy. It raised interest rates again in June, but also forecasted a slightly accelerated path of hikes over the next two years. Whether the economy can withstand that degree of tightening remains to be seen.

Beyond the strength of the US economy, the global economy remains in pretty good shape, with real GDP growth expected to be above trend again this year. However, last year’s highly synchronized growth has decelerated and may have peaked for this cycle.

Recent US dollar strength may continue for a while as currency momentum can take on a life of its own. But there are fundamental reasons to expect the dollar may weaken looking a bit further out: the prospect of a ballooning US federal budget deficit in the coming years, a large US trade deficit, the eventual convergence of central bank monetary policies, and the fact that the Trump administration seems to prefer a weaker dollar.

Regardless, from a portfolio management perspective, we remain tactically agnostic on the dollar—we don’t have a high-conviction view relative to the currency markets that we would want to reflect in our portfolios. Instead, we maintain our strategic (long-term) diversified approach of having both dollar and non-dollar exposure—with the latter coming primarily from our foreign stock funds.