The U.S. economy continues to grow at a steady, albeit a very slow, pace. First quarter real GDP grew at 0.8%, followed by second quarter growth of 1.4%. This continues a string of very slow overall growth in the economy that stretches back to the beginning of the most recent economic recovery that started in the third quarter of 2009. In the quarter just ended, real GDP appears likely to have accelerated slightly and is expected to come in around 2.5%.
The labor market continues to show signs of improvement and now appears to be reaching levels that most economists would consider to represent full-employment. As of the end of August the headline unemployment rate stood at 4.9%. Despite non-farm payrolls that were slightly disappointing in the month of August, average growth has remained right at 200,000 through the first eight months of 2016.
The health of the consumer side of the economy shows that it remains in relatively good shape. According to the Census Bureau, median household income increased by 5.2% in real terms in 2015 to $56,516. This was the first annual increase since 2007, which was just prior to the last recession. Other measures of wage growth have also shown a pick-up over the past couple of years. Combined with the low level of interest rates and low energy prices, housing and autos continue to be strong. The S&P/Case-Shiller Housing Index showed an increase of 5.1% in July compared to last year. Light vehicle sales remain near all-time highs and are expected to come in at an annualized rate of 17.6 million units in the month of September.
The manufacturing side of the economy showed a contraction in the month of August. The Institute for Supply Management’s Purchasing Managers Index (PMI) came in at 49.4%, down 3.2% from the prior month. This follows five consecutive months of expansion.
A flight-to-quality that began at the end of the second quarter following Great Britain’s Brexit vote pushed yields on U.S. treasury securities back down to the lowest levels seen over the past several years. In early-July the yield on the 10-yr treasury fell to close below 1.40% for the first time on record. The last time yields were that low was in the late-spring and early-summer of 2012.
Globally, interest rates have also reached lows that are difficult to fathom. According to BofA/Merrill Lynch, more than 25% of government and corporate bonds in developed countries now have negative yields. According to some estimates, the total value of government bonds globally with yields below zero is around $16 trillion. As the third quarter comes to a close, yields on sovereign bonds in Germany, Japan and the Netherlands were all negative out to 10 years, while the yield on all Swiss government debt out to 30 years is less than zero.
Here in the U.S., yields bounced from their post-Brexit lows and traded in a range of 1.50% to 1.60% for most of the summer. Fears that the Federal Reserve would hike rates earlier than expected caused bonds to sell-off rather significantly in early-September. The 10-yr yield traded above 1.70%, but drifted downward as it became clear that the Fed would remain on hold.
The Federal Open Market Committee voted to leave rates unchanged at their September meeting, but indicated that there was a good possibility of a move prior to year-end. In their post-meeting statement, the Fed acknowledged that the labor market continues to strengthen and economic growth has picked-up from the pace seen in the first half of the year.
Three regional bank presidents dissented as they said they preferred to see an immediate increase in rates. As it stands now, odds appear to be 50-50 that the Fed will raise rates before the end of the year.
Over the past twelve months longer dated bonds have seen yields fall while shorter maturity bonds have increased in yield, leading to a flattening of the overall yield curve. This has allowed for reasonably good returns for most bond indices. The Barclays US Aggregate has returned over 5% over the past year, with corporate bonds doing slightly better. Higher risk issues have seen exceptionally good performance as measured by the Merrill Lynch US High Yield index, which has returned nearly 13% over the past year.
Treasury yields of selected maturities for recent time periods are displayed below.
|Treasury Bill||Treasury Notes & Bonds|
|3 mo.||2 yr.||5 yr.||10 yr.||30 yr.|
The total return numbers for various fixed income indices over the last twelve months are displayed below (data from Bloomberg).
|12 Month Returns (as of 9/30/16)|
|Barclay Capital US Aggregate||5.19%||Merrill Lunch US High-Yield||12.81%|
|Barclays Intermediate Government||2.44%||Merrill Lynch US Municipal Index||5.88%|
|Dow Jones Corporate||5.43%||JP Morgan Embi Global||16.82%|
The U.S. stock market was relatively calm for the majority of the quarter. Coming into the month of July, equity markets had recovered most of the immediate losses suffered in the wake of the Brexit vote. On July 12th, the Dow Jones Industrial Average notched a record closing high of 18,347.67, surpassing the previous high of 18,312.39 set on May 19, 2015. That was the longest the Dow had gone without setting a new record high since the period from October 2007 to March 2013. In August, all three major U.S. stock indexes (the Dow, S&P, and NASDAQ) hit new highs on the same day. That was the first time since December 31, 1999, at the end of the Dot Com bubble, that all three of the major market averages set simultaneous closing highs.
The calm in the markets continued into the first part of September. Between July 14th and September 8th, the S&P traded in a very narrow range and did not have a single day where the market moved either up or down by more than 1%. As investors turned their attention to the Fed they became concerned that future actions may no longer be as accommodative as they have been in the past. This caused markets to decline by 2.5% - 3.0% in mid-September. The Fed’s decision to remain on hold led to markets recovering most of their losses and finishing the quarter within 1%-2% of all-time highs.
Below is a table which displays various equity index returns for the past quarter.
|Equity Indices||3rd Qtr. 2016|
|Dow Jones Industrial||2.78%|
|S&P 500 Growth||4.76%|
|S&P 500 Value||2.94%|
|Russell 2000 (small-cap)||9.05%|
|MSCI/EAFE (developed international)||6.50%|
|MSCI/EM (emerging markets)||9.16%|
Looking at sector performance within the S&P 500, there was once again a wide dispersion of returns. Technology stocks were by far the best performing group in the quarter. Shares of some of the largest technology companies including Apple and Microsoft, which both saw double-digit gains, were responsible for a significant portion of the sector’s strong performance. Consumer Staples, Telecom, and Utilities, which have produced strong performance over the past several quarters due to their defensive characteristics and higher yields, were all a drag on the market this quarter. Another development this quarter was the separation of Real Estate stocks from Financials to create an 11th sector in the market.
The following table details S&P 500 sector returns for the quarter (price only).
|Return by Stock Sector||3rd Qtr. 2016|
|1. Information Technology||12.44%|
|5. Consumer Discretionary||2.51%|
|7. Health Care||0.52%|
|8. Real Estate||-2.87%|