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Stocks continue to offer better risk-adjusted return than bonds

August 3, 2018
By IAN N. BREUSCH , Island Reporter, Captiva Current, Sanibel-Captiva Islander

U.S. stock markets continued to move modestly higher during the second quarter of 2018 despite pockets of volatility along the way. As is often the case, broader market measures of performance do not always capture the underlying details of what moves markets - particularly over short periods of time. For example, the U.S. stock market continues to be led by growth stocks, while dividend-paying companies have largely lagged this year. As interest rates rise (even modestly), the relative value of dividend-paying companies diminishes somewhat in favor of bonds now yielding modestly more.

However, we fully expect these pricing issues to be short-lived since the fundamentals of dividend payers remain fully intact. Moreover, there is ample evidence that dividend-paying companies outperform non dividend-paying companies over the long term. It remains appropriate for the majority of our clients to maintain a balance between growth and income within their portfolios - with the understanding that certain segments of their portfolio will out/under perform at different times. Of course, everything we do from an investment standpoint remains custom-tailored to your individual needs and goals.

We have been pleased with the earnings results of the companies we follow so far this year. Fourth- and first-quarter results have been quite strong. Considering we remain optimistic about broader U.S. economic growth, it stands to reason that companies should continue to post solid results through the end of the year, particularly when you add in the benefits of corporate tax reform.

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Ian N. Breusch

On June 13, the Federal Reserve Board announced their decision to raise the federal funds rate by another 0.25 percent. This move was largely anticipated by market participants. However, the Fed still anticipates two further rate hikes in 2018 (four hikes in total). If economic growth continues to expand, inflation continues to increase, and unemployment remains low, the Fed will have the fundamental justification for more rate hikes. However, there are other issues at play. The rate decisions by the European Central Bank also play a role in setting prevailing interest rates here. European bonds serve as an alternative to U.S. bonds; therefore, the pace and timing of European monetary tightening will affect U.S. bonds. To the extent interest rates continue to rise, bond prices will fall, with the most pain being felt by holders of longer-term bonds, particularly those who continue to hold them. Though interest rate risk is inherent with all bonds, as the yield curve flattens, we continue to emphasize shorter maturity bonds for clients who desire income generation and/or volatility reduction. We also continue to find more value in U.S. Treasury and corporate bonds instead of municipal bonds on a tax equivalent basis.

Our team of portfolio managers continues to monitor corporate earnings results and interest rate movements closely. As such, our bias for stocks over bonds remains for the time being. Quite simply, we believe stocks continue to offer a better risk-adjusted return than bonds - all else being equal. However, we are willing and prepared to make bonds a larger portion of client accounts as appropriate when, or if, interest rates rise to a level that makes them more attractive on a relative basis.

Ian N. Breusch is the chief investment officer for the Sanibel Captiva Trust Company.



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