Market Commentary - Third Quarter 2016
The major domestic indices posted positive returns in the third quarter and small caps in particular delivered a very strong third quarter performance. Overall international equities outpaced domestic equities, with emerging markets leading the way. Most bond indices also posted positive returns for the quarter. The markets have shrugged off the volatility experienced in January and February and have generated nice returns year-to-date.
Domestically, the economic environment, although still below optimal levels, is beginning to show signs of acceleration. In the US so far, "Brexit"–the UK's decision via referendum to exit the European Union–has had little economic effect. Economic conditions are currently favorable, with, among other things, continued low interest rates; an improving employment situation; surging vehicle sales; and a steadily recovering housing market. The upcoming US presidential election potentially could create unforeseen disturbances to the growth outlook, but so far none are apparent. The Bureau of Economic Analysis reported its third estimate of second quarter 2016 gross domestic product (GDP) of +1.4%, higher than both the prior estimate of +1.1% and the +0.8% reading of the first quarter. The employment situation showed marked improvement, with an average of about 232,000 jobs added each month. The unemployment rate was moderately higher at 4.9%.
Globally, the situation is a bit less rosy. The Brexit result has created a significant amount of uncertainty over what the ultimate impact will be from an economic standpoint. In addition, political effects stemming from Brexit in other European Union countries, such as Germany and Spain, are beginning to percolate. GDP growth in the Eurozone shrank to +0.3% in the second quarter from +0.5% in the first quarter. In China, the economy is slowing due to structural adjustments that will take time to play out. Asian economies generally have slowed as global demand for the region's exports has waned. Other emerging economies, including those in Latin America, are beginning to stabilize, but may remain under some pressure as a result of slackening demand for commodities. Although recent trends have not been favorable, economists believe that global economies will begin to pick up steam later this year and into 2017, partly on the tailwind of acceleration in the US economy.
At its most recent meeting in September, the Federal Open Market Committee (FOMC) again stood pat, deciding not to increase the target fed funds rate from the current range of 0.25% to 0.50%. The FOMC stated that risks to the economy are balanced, indicating to many analysts that the committee will decide to raise interest rates by the end of the year.
GROSS DOMESTIC PRODUCT (GDP)
The housing segment showed signs of moderating after having risen for three years. Existing home sales for August (the latest monthly data available) advanced at an annualized rate of 5.33 million units, down about -1% from the 5.38 million unit rate reached in July, but up +0.8% from August 2015. The inventory of existing homes was about 4.6 months of supply, down slightly from year-ago levels. Existing home prices in August were up moderately from May, and about +5.3% higher from August 2015. In the new home segment, the NAHB Housing Market Index, a measure of homebuilding activity, ended the quarter at a level of 65, the highest reading in 11 months. Homebuilders and analysts remain optimistic about the outlook for housing, as low interest rates and solid employment growth are expected to be supportive into next year.
The employment situation cooled somewhat in the most-recent monthly report. Employers added 151,000 jobs during August, short of consensus expectations of 180,000 new jobs, and much lower than the gains of the prior two months. The three-month moving average is still a very respectable 232,000, a rate that analysts believe will be able to absorb the growth in the working-age population. The unemployment rate in August was 4.9%, above the 4.7% level in May, but the same level of the prior two months. Average hourly earnings increased +0.1% in August and +2.4% in the past 12 months. Economists have recently lowered job growth forecasts slightly as a result of moderating economic data, but anticipate monthly gains of approximately 180,000 for the next several quarters. Such gains are expected to lower the unemployment rate to about 4.7% over that timeframe. Although the August results were short of the robust gains of the prior two months, the positive trend remains in place. The FOMC will likely consider the magnitude of these recent additions when determining whether to raise interest rates at its December meeting.
The FOMC ended its recent September meeting standing pat on interest rate policy, maintaining a target range of 0.25% to 0.50% for the fed funds rate; however, resilience in recent economic data, coupled with the committee's perceived desire to continue to normalize rates, leads many analysts to conclude that the FOMC will move to raise rates by the end of the year. The statement accompanying the recent decision noted that the FOMC considers the near-term risks to the economy as "balanced," a signal to economists that the central bank is readying a rate increase. At this meeting there were more dissents from the hawkish segment of the FOMC, who are eager to raise rates. The committee also noted that it would like to see further progress on meeting its dual objectives of full employment and price stability. Although the employment situation continues to improve, the FOMC would likely be interested in seeing some upward pressure on prices so that inflation nears its target of 2%. The futures market is currently assigning a roughly 50% probability to there being at least one increase by the end of this year.
In the third quarter, speculation about whether the FOMC would raise rates in September, coupled with more favorable economic data and the stock market's recovery to near record highs, drove the prices of fixed income securities. As with the lead-up to the FOMC's June meeting, much debate ensued as to whether economic conditions were strong enough to warrant a rate increase at the September meeting. The committee's continued preference is to begin normalizing interest rate policy as soon as practicable, but the FOMC voted not to initiate a second rate increase at the September meeting. Within the context of these various influences, yields generally trended higher into late September, at which time fixed income prices firmed and yields fell.
The yield curve continued to flatten, as has been the prevailing trend for several quarters. Yields on short-term securities rose more than those in the intermediate- to long-term end of the spectrum. By the end of the quarter, the yield on the benchmark 10-year U.S. Treasury note rose to 1.60%, from 1.47% on June 30.
Yield changes along the maturity spectrum were affected by many of the same factors as in the prior quarter, including a FOMC bias toward raising short-term rates, modestly improving domestic economic data, and investor demand for intermediate- to long-term Treasury securities resulting from negative yields in other safe haven markets, such as Germany and Japan. Except at the very shortest end of the yield curve, yields rose, and those of shorter-term maturities rose more than longer-term maturities. This resulted in a further flattening in the yield curve relative to June 30. In terms of total returns, fixed income securities on balance generated positive returns across the spectrum, as they have for the prior two quarters. High yield securities performed well, advancing +5.6%, as investors' risk tolerance increased and appetite for yield drove prices higher. Municipals were a segment that lost ground, as the Barclays Municipal Bond Index eased by -0.3%. As within the prior quarter, emerging markets bonds delivered solid gains, with the JPM EMBI Global Index adding +3.7%.
Equity markets quickly shrugged off the Brexit referendum that occurred late in the second quarter. After plunging several percentage points following the announcement that the U.K. would be exiting the European Union, stock prices reversed course at the beginning of July, resuming their previous uptrend and carrying the S&P 500 to a record high. Investors also were heartened by improving news on the employment front, which they believe may presage acceleration in the recovery. The S&P 500 Index finished the quarter with a gain of +3.9%.
More than in recent prior quarters, the ten primary economic sectors exhibited substantial dispersion in performance, making sector allocation and security selection extremely important. The performance disparity between the best- and worst-performing sectors during the quarter was more than 16%. Information technology, financials, and industrials were the strongest performers, delivering gains of +12.9%, +4.6% and +4.1%, respectively. The telecommunications services, utilities, and consumer staples sectors were the poorest relative performers, posting losses of -5.6%, -5.9% and -2.6%, respectively.
The Russell 1000 Index of large capitalization stocks generated a +4.0% total return. Within the large cap segment, growth stocks significantly outperformed value stocks. Small cap stocks, as represented by the Russell 2000 Index, vastly outperformed large caps, ending with a total return of +9.1%. Small cap growth performed better than small cap value. The Nasdaq Composite, dominated by information technology stocks, finished with a strong gain of +10.0%. The Dow Jones Industrial Average of 30 large industrial companies gained +2.8%.Real Estate Investment Trusts (REITs) were little changed, as interest rates, although still relatively low, trended higher during the quarter. The DJ US Select REIT Index posted a loss of -1.2%. Commodities gave back some of the gains made in recent quarters, with the Bloomberg Commodity Index declining -3.9%. International stocks delivered better performance than US equities overall, led by a surge in Asian issues. Even though economic data in many regions remains listless, foreign central banks, including the European Central Bank, continue to implement aggressive monetary policies. At the same time, lawmakers around the world have been urged by the heads of the central banks to enact fiscal policy reforms to spur demand. Against this backdrop, international stock indices were almost uniformly higher. The MSCI ACWI ex-USA Index, which measures performance of world markets outside the US, gained +6.9%. The MSCI EAFE Index of developed markets stocks advanced by +6.4%. Regional performance was positive across the board, with Asia in particular enjoying solid gains. China and Japan were the strongest performers on a relative basis, with the MSCI China and MSCI Japan indices posting returns of +13.9% and +8.6%, respectively. Europe and Latin America were the poorest relative performers, with gains of +5.4% and +5.4%, respectively. Emerging markets performance was strongly positive, as the MSCI Emerging Markets Index gained +9.0%.
On balance, there are many reasons to be optimistic about the domestic economy, including improving job growth, a sustained recovery in housing, very strong vehicle sales, and high levels of consumer confidence. In addition, households have taken advantage of years of low interest rates to lock in low mortgage payments and still maintain an adequate level of savings. Many economists believe that employers will continue to add about 180,000-200,000 jobs per month into 2017, and that the unemployment rate will trend back down to 4.7%. And while the FOMC is likely to resume raising interest rates again by the end of the year, the prospect of the hike has been clearly signaled, and seems to have been digested by the markets. The impact of the US presidential election on the markets is a wild card, but markets are an excellent discounting mechanism, meaning any dislocation occurring as a result of the outcome may be short-lived, much like Brexit's impact. There are certainly other ongoing risks, such as the threat of terrorist activity and unforeseen setbacks in either the domestic or global recoveries, but the consensus among economists is that an end to the economic recovery is not yet on the horizon.
Given the way the year started for the market, we have been very pleased with market returns since mid-February. With the upcoming election and eyes on the Fed regarding interest rates, it will be interesting to see how the rest of the year plays out. That being said, we anticipate continued volatility.