The intent of this blog is to provide an update on the state of domestic and international stock and bond markets as well as provide insight into our Macro guidance.
The S&P 500 Index (US large cap stocks) gained 14.1% year-to-date with 4.5% of that gain in this last quarter. Smaller firms (S&P 600) 8.9% return year-to-date is almost entirely attributable to September’s 7.7% return. Volatility (VIX) has ended below 10 year-to-date.
Historically, when the U.S. market is declining, for a variety of reasons, international, and especially emerging markets, will typically outperform. However, in 2017, we are seeing a synchronized global rebound, highlighting a strength in the global market. For example, developed markets gained 20.8% year-to-date and emerging markets gained 27% year-to-date.
Barclay’s Capital Bond Index lost 0.5% in September but is up 3.1% year-to-date. The yield on the 10-year treasury rate began the third quarter at 2.31% and ended at 2.33%. More notable is the jump in the 2-year treasury yield to its 2008 levels; in the next paragraph you will note how this reflects a view towards the Fed’s next interest rate hike. Similar to the last quarter, the higher equity correlated bonds such as Preferreds and junk bonds, have performed best year-to-date.
Federal Reserve and Wage Inflation
At the beginning of the third quarter, over 75% of managers (source: Bloomberg) predicted that the fed would not raise rates another time this year. September’s 2.9% wage increase is now part of a mosaic of evidence pointing towards a near certainty of another Federal interest rate hike this year.
In October the fed begins reducing reinvestment of its 4.5 Trillion dollars of treasury and mortgage bonds. While there is much debate about how much this will increase interest rates, there is little doubt that this ending of Quantitative Easing will likely increases long-term rates. This month they will begin rolling off $10 billion of treasury and mortgage bonds, increasing for 6 quarters until stabilizing at $50 billion redeeming monthly. Overall, look to the Fed to take advantage of a strong stock market and any inklings of inflation to continue to normalize their holdings. What this means for you is a continued bias towards low-duration, low interest-rate sensitive bonds, and other bond-like instruments.
Within equity, while not as strong as the prior quarter, earnings growth estimates for the S&P 500 companies is a robust 4.2%. This is now the fourth quarter in a row that Large cap earnings have outperformed small caps and forward expectations are similarly skewed toward large firms. While it is tempting, and sometimes appropriate, to attribute short term market swings between small and large firms as favor/disfavor of the Trump agenda, it is noteworthy that over a 10-year period, small cap stocks have performed within a few basis points (bps) relative to large firms.
Within the U.S. Sectors, Health Care and Tech firms had a slow September but are the top performers, up 20.3% and 27.4% year-to-date. At the opposite end, energy firms finally had a great month (up 9.9%) but, along with telecom firms, have lost -6.6% and -4.6% year-to-date. Overall, interest sensitive sectors such as Real Estate and Utilities, were negative in September.
Our declining US dollar, while causing a negative impact on our personal spending power, makes it cheaper for foreigners to buy our services and products. Europe has now moved to a 2% growth rate as of the second quarter, an improvement. Despite political risks, once again making news in Europe and elsewhere, international opportunities remain; as the unemployment environment continues to improve, U.S. exporters should see better sales growth. Currently, over 40% of US large firm’s revenue comes from overseas. For example, Asian markets are the largest export destination, with tech firms taking the most advantage of international trade.
Noteworthy for the recent quarter is what the market is likely discounting. The three major storms caused devastation throughout the United States. Consequently, housing growth, homebuilder confidence, auto sales, and insurers were all affected to different degrees – for instance commercial insurers could see a lagging effect over the next few quarters and years. Existing housing stock is currently at 1982 levels, with concerns over building costs not being helped by the recent weather. Excluding weather effects, however, the U.S. economy is performing well. The institute for Supply management’s manufacturing (ISM) index both continue well above 50, and the non-manufacturing index reached a 13 year high.
As of August, monthly Job’s growth has averaged just under 200,000 in the last 3 months; for the reasons stated above, September’s negative 33,000 number is considered an anomaly. Solid wage growth at 2.9% in September did help smooth over the September job growth number - if this is a trend, it is another data point solidly pointing to an ever-improving economy. What this means is that the anti-robotic luddite argument is about as valid as it was back in early 1800’s; countries, industries, and individuals will eventually adapt to the new work realities. As the consumer represents the majority of this country’s spending, consumer confidence tops the ISM data above, as it represents the 2nd highest level in 16 years.
As we stated for the first and second quarter, growth continues internationally and domestically. But, as this review has been slightly positively skewed, it is important to note that with any equity investing, risk always remains; for example, while both energy and telecom firms superficially show earnings to cover their dividends, on a raw cash basis (free cash flow) neither sector currently covers payouts. As stated above, while emerging markets have had a tremendous year, for those unfortunate enough to have owned it for the last decade, you have effectively earned the equivalent of a bank checking account rate. For our clients, however, this means that there is plenty of opportunity to enter the market. US large cap firms have served investors well. This all leads to the same conclusion as Harry Markowitz, a professionally managed and appropriately diversified portfolio matching your goals to your risk tolerance remains the best way to invest for the intermediate and long-term.