Nuclear threats from North Korea, natural disasters Harvey and Irma, and tragedies in Charlottesville and Las Vegas all served as proof that stocks want to go up, despite the odds. Indeed, the 3rd quarter was chock full of potential pitfalls for the market. What the market was focused on however, was stronger fundamentals, pushing stocks to new highs and volatility down to levels not seen in decades.
The S&P 500 notched its 8th quarterly advance (+4%) in what is historically its weakest quarter. Stocks also achieved their lowest volatility streak since 1968. Interestingly, stock prices and bond yields bottomed during the quarter simultaneous with Trump’s deal with the Democrats on a debt ceiling extension. The market took this as an optimistic sign that tax reform could pass beyond party line votes. The deal also lifted the threat of a government shutdown which Republicans have historically wielded, but that the markets despise. Sectors with leverage to lower corporate tax rates, particularly small caps, rallied strongly.
During the quarter, longer term interest rates ended unchanged. The yield on the 10-year US Treasury Note, now 2.33%, is dramatically higher than its low last summer of 1.36%, but still lower than it should be relative to historic inflation premiums. We continue to believe longer term interest rates will rise given stronger economic growth as well as Fed inventory unwinding of bonds purchased through quantitative easing (QE). Although incremental, selling bonds will put downward pressure on prices, pushing yields up.
Globally, economies continue to be in sync and accelerating. Stronger growth in the US is underpinned by job growth that supports consumer spending, driving 2/3rds of our economy. Top-line revenue growth, which had been anemic throughout this cycle, has accelerated strongly this year and is running at a +6% rate. This portends strong bottom-line earnings growth and is the primary reason stocks have remained so resilient.
One of the biggest surprises this year has been the weakness of the US Dollar which has helped International equity investments outperform significantly in Dollar terms. Strong returns from non-US stocks have not just been a result of currency translation though. Quarterly earnings growth in Europe, Japan and emerging markets such as China accelerated to +30%, and continue to look strong over the next few quarters. Risk remains however, particularly in Europe, where populist winds are still blowing, as evidenced by the Catalonian independence vote and German elections that reduced Merkel’s position to the weakest point in her 17-year tenure.
Worries about market risk continues to be pushed out, bolstered by net global monetary stimulus to the tune of over $2 trillion this year alone. European and Japanese central banks have yet to lay out a timeline for tapering – much less reducing – their asset purchases, measures that could eventually bring instability to the market. In the meantime, their stimulus, better growth, and US confidence stemming from pro-growth initiatives, has given the Fed cover to move forward with incremental rate increases and a gradual reduction of the balance sheet.
3rd Quarter 2017 Performance
- Stocks globally were up (↑5.1%). Outperforming were International Emerging (↑8.3%) and US Small Cap (↑6.2%). US Large Cap (↑4.4%) and International Developed (↑5.0%) lagged slightly.
- Looking ahead, company earnings reports are expected to be strong, which should support stocks through year-end.
- Interest rates and credit spreads were flat for the 3rd quarter allowing investment grade and high yield bonds to earn their coupons with very little price adjustment up or down. Emerging markets sovereign bonds performed best again in the 3rd quarter (↑3.5%), as credit spreads continued to tighten relative to US Treasuries.
- Looking forward, bond returns are likely to face continued headwinds in the form of higher interest rates, which will keep total return at or below coupon return.
- Alternatives performed well this quarter (↑2.2%), led by managed futures (↑4.0%) which snapped a multi-quarter losing streak. Through September, alternatives are up about (↑4.3%), in line with the pace needed to achieve our long term annual return goal of (↑5-7%).
- At the end of 3Q, we made several changes to the alternatives portfolio including the elimination of MLPs and the Lazard long/short strategy. Those were replaced with emerging markets long/short and merger arbitrage strategies. The net result to the alternatives portfolio is a reduction of downside risk, while maintaining our long term return target.
Royce W. Medlin, CFA, CAIA
Chief Investment Officer