Equity Markets: Records Set in Strong Quarter

The U.S. equity market posted broad gains in the third quarter, fueled by strong economic growth, soaring corporate profits, and record levels of stock buybacks. Several major indices hit record levels during the quarter, and the S&P 500 Index’s 7.7% gain was its biggest since the fourth quarter of 2013. Volatility was muted in spite of persistent headlines around tariff threats and the ever-changing trade negotiations.

Large growth stocks were the top performers (Russell 1000 Growth: +9.2%) and small value (Russell 2000 Value: +1.6%) occupied the bottom slot. All sectors posted positive returns within the S&P 500, but the differences were stark. Health Care (+14.5%), Industrials (+10.0%), Technology (+8.8%), and the new Communication Services (+9.9%) sectors were the top performers, bookended by Materials, Energy, and Real Estate, all of which returned less than 1% for the quarter. The new Communication Services sector replaced Telecommunications and adopted names from Technology and Consumer Discretionary—including Facebook, Alphabet, Netflix, Twitter, and Disney—and now includes over 20 holdings (initially, the new sector represented 10% of the S&P 500). FAANG stocks plus Microsoft contributed nearly a quarter of the S&P 500’s return in the third quarter, which was a lower impact than prior quarters. Apple (+22.4%) was the largest FAANG stock contributor while Facebook (-15.4%) was a detractor.

Non-U.S. developed markets underperformed the U.S. in the third quarter as the MSCI ACWI ex-USA Index rose a meager 0.7% (in USD terms). Japan was a top performer (+3.7%) as Prime Minister Shinzo Abe won his inter-party leadership battle and retained his role as president of the Liberal Democratic Party. The U.K. dropped 1.7% on uncertainty around Brexit, while Europe ex-UK finished up 1.8% despite being weighed down by political turmoil and financial woes in Italy (-4.5%).

Emerging market equities declined (MSCI Emerging Markets Index: -1.1%), but returns were highly divergent. Turkey (-21%) and Greece (-18%) fell the most due to macro-economic concerns. As a region, Latin America gained 5% with Mexico (+7%) and Brazil (+6%) up the most. Elsewhere, Russia (+6%) rebounded, largely due to the surge in its Energy sector (+16%). Conversely, China (-8%) dropped given a large sell-off in Chinese technology companies (-14%), and India (-2%) posted a modest loss due to a significant decline in its Financial sector (-12%).

Fixed Income Markets: Modest Returns as Fed Hikes Rates

Yields rose during the quarter; the 2-year U.S. Treasury Note climbed nearly 30 basis points to close at a multi-year high of 2.81% while the 10- and 30-year Treasuries rose roughly 20 bps. The yield curve continued to flatten with the spread between the 2-year Treasury yield and the 10-year Treasury yield falling to 24 bps as of quarter-end.

As expected, the Fed hiked rates by 25 bps in September, and one more hike in December 2018 appears likely. Markets expect two more hikes in 2019 while the median Fed projection is for three. The 10-year breakeven inflation rate rose modestly to 2.14% (9/30) from 2.11% (6/30) and the Bloomberg Barclays TIPS Index fell 0.8% as rates rose.

The return on the Bloomberg Barclays US Aggregate Bond Index was flat (+0.0%) for the quarter with the U.S. Treasury sector (-0.6%) underperforming the Corporate bond sector (+1.0%). High yield (Bloomberg Barclays High Yield Index: +2.4%) outperformed and leveraged loans rose 1.8% (S&P LSTA Leveraged Loan).

Meanwhile, returns for the Bloomberg Barclays Global Aggregate ex-US Bond Index fell 1.7% on an unhedged basis while the hedged version was flat (+0.0%). The U.S. dollar strengthened versus the Japanese yen and U.K. pound but was roughly flat versus the euro. As a result, Japan (-3.7%) and the U.K. (-3.1%) were among the worst performers in U.S. dollar terms. Canada was the only source of a positive result (+0.7%) due solely to currency appreciation versus the U.S. dollar. In local terms, Canada also delivered a negative return (-1.1%).

The quarterly return for the JPM EMBI Global Diversified Index (USD denominated) was +2.3% with all sub-regions delivering positive results. Local currency emerging markets, however, fared more poorly. The JPM GBI-EM Global Diversified Index fell 1.8% for the quarter, but also endured significant intra-quarter volatility including a 6.1% drop in August. Further, return dispersion among countries was significant. Argentina (-35%) has seen its peso fall more than 50% this year to a record low as investors were spooked by previous currency debacles and worries over the economic picture. In addition to securing support from the International Monetary Fund, the country’s central bank hiked short-term interest rates 15 percentage points to a global high of 60%. Turkey (-27%) endured a similar currency rout, though for different reasons. U.S.-imposed sanctions and concerns over central bank policy were the twin drivers of the lira’s weakness. Turkey hiked short rates by 6.25 percentage points to 24% to stem its currency slide. Elsewhere, returns were far more modest (positive or negative) with only Russia (-6%) and Mexico (+6%) being noteworthy.

The municipal bond market delivered modest negative returns in the third quarter as yields rose. The Bloomberg Barclays 1-10 Year Blend fell 0.1% and the broader Municipal Bond Index dropped 0.2%. Issuance remained muted and is down 15% from last year’s pace (through 9/30). In an ongoing trend, lower-quality bonds continued to outperform higher quality. The highest-quality sector, AAA-rated bonds, declined 0.3% for the quarter while the BBB sector was up 0.2%.

Real Assets: Tough Quarter for Most Commodities

Across real assets, MLPs were once again a top-performing category during the third quarter, as shown in the Alerian MLP Index gain of 6.6%. Interestingly, two other rate-sensitive real asset categories—REITs and Listed Infrastructure—were relatively flat during the quarter, with the FTSE NAREIT Equity Index returning a meager 0.8% while the DJ Brookfield Global infrastructure Index shed 0.8%. It’s a relationship worth monitoring and one that may continue as Real Estate and Infrastructure are somewhat more dependent upon leverage as part of their capital structures.

Meanwhile, Natural Resource equities were the only other broad area of relatively positive performance within real assets, with the S&P 1200 Energy and S&P 1200 Materials Indices up 1.3% and 0.1%, respectively. With the gain in the U.S. dollar in the third quarter, most commodities sold off with the exception of Energy (Bloomberg Commodity Sub Energy: +4.4%) and Livestock (Bloomberg Commodity Sub Livestock: +2.9%).  Given the much higher weighting to Energy in the GSCI Commodity Index as compared to Bloomberg, the former produced a modestly positive return (+1.3%) during the quarter.