Despite increasing political instability at home and rising tensions abroad, the underlying economic backdrop has largely been supportive of financial markets. U.S. Gross Domestic Product (GDP) grew by 3.1% in the second quarter of 2017, the fastest growth seen in over two years. The 3.1% growth figure was an acceleration from the 1.2% growth reported in the first quarter, while estimates currently are in the 2.5% growth range for the third quarter as the major hurricanes likely caused some temporary disruption. Overall, the combination of steady growth, low interest rates, and the absence of inflation concerns have provided fuel for the markets to produce strong returns.
The overall employment picture remains fairly robust. In the month of August, employers added 156,000 jobs. On average, payrolls have grown by 176,000 per month so far in 2017, which is somewhat lower than the pace in 2016. At 4.4%, the jobless rate remains little changed, as it has been either 4.3% or 4.4% each month since April of this year. Jobless claims have been inching higher, although some of this rise is due to impact from the hurricanes.
Individuals appear upbeat overall. Consumer confidence surveys remain near multi-year highs. This data helps paint a picture of a very resilient consumer, as the recent devastation caused by hurricanes in addition to a higher degree of political discourse have yet to significantly dent confidence. This data is generally supportive of decent consumer spending going forward. However, housing data has been relatively disappointing. Both existing home sales and new home sales have drifted lower in the past couple of months. While home prices are still trending higher nationally, signs of a stall in the housing market may be emerging.
The manufacturing side of the economy continues to show strength. The Institute for Supply Management’s Purchasing Managers Index (PMI) registered at 60.8 for September, its highest level since 2004. A reading above 50 indicates that the manufacturing economy is expanding; below 50 indicates contraction.
After a concerning decline during the second quarter, oil prices rebounded in the third quarter due to a combination of stronger than expected demand and a slight drop in supply from OPEC and hurricane-impacted areas of the US. WTI crude oil closed the third quarter at $51.67 per barrel, over 10% higher than the previous quarter close, but still slightly below where the commodity started 2017.
As we head into the final quarter of the year, investors will likely keep a keen eye on Washington DC. Any progress on tax reform will likely be taken as a positive from equity investors, and could help to maintain or even accelerate economic momentum. Absent any political progress, the consensus view generally is more of the same backdrop we have been experiencing.
Yields on government bonds drifted lower throughout much of the third quarter before a September sell-off resulted in yields finishing the quarter above where they started. The 10-year Treasury bond experienced its largest one-day loss since March in late September after Republicans released a plan to overhaul the tax code. 10-year and 2-year Treasury bonds ended September yielding approximately 2.3% and 1.5%, respectively. This roughly 80-basis-point spread between the two yields is 40 basis points less than at the start of the year, and may suggest that market participants see little inflationary concerns despite continued economic expansion and tightening labor conditions.
Corporate bond spreads continued to narrow throughout much of the third quarter resulting in corporate bonds generally besting their government counterparts. Spreads across the credit spectrum, from investment-grade to high-yield, are now at or near historically tight levels relative to government bonds. While economic prospects remain good, corporate bonds appear priced for perfection and may expose investors to outsized losses in the event of an economic downturn.
The Federal Reserve maintained its Federal Funds Target Rate at 1.25% during the quarter after 25 basis point increases in March and June. The Federal Open Market Committee’s September statement indicated that they anticipate future Fed Funds rate increases while the economy continues to expand at a moderate pace. Importantly, the Fed also stated that it plans to initiate its balance sheet normalization program in October. The plan calls for the Fed to slowly shrink its $4.5 trillion portfolio of Treasury and mortgage-backed securities purchased during the three rounds of quantitative easing following the 2008-2009 financial crisis.
Inflation continues to surprise to the downside to date in 2017. Core PCE inflation dropped to 1.3% year-over-year, marking its softest number since late 2015. Headline PCE inflation for August came in at 1.4%, also slightly below expectations.
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 09/30/17)|
|Barclays Capital US Aggregate||0.07%||Merrill Lunch US High-Yield||9.06%|
|Barclays Intermediate Government||-0.66%||Merrill Lynch US Municipal Index||0.97%|
|Dow Jones Corporate||1.82%||JP Morgan EMBI Global||4.15%|
Stock markets both in the U.S. and around the globe continued to march higher during the third quarter, tacking additional gains onto the first half of 2017’s already strong performance. The S&P 500 Index closed September at an all-time high, as the index rose 4.5% during the quarter. The third quarter marked the eighth consecutive quarterly gain for the S&P 500, while volatility remains at or near multi-decade lows. Joining the S&P 500 at record highs were the tech-laden Nasdaq Composite Index, which posted its 50th record close for the year at quarter-end, while the small-cap Russell 2000 also ended the quarter at an all-time high. Record high market levels and low volatility show that investors for now are shrugging off geopolitical tensions, devastating hurricanes, and domestic political conflict.
The gains seen in major stock market indices have largely been supported by stronger fundamentals. Companies within the S&P 500 have posted earnings reasonably strong earnings so far in 2017, and analysts expect this trend to continue into 2018. During the most recent earnings season, over two-thirds of the companies in the S&P 500 exceeded analyst’s projections for sales and earnings. While the S&P 500 is trading at above-average Price to Earnings (P/E) multiples, its valuation levels are still well below those seen at the March 2000 market top.
Global equity markets have seen outsized returns so far this year versus their domestic counterparts. A weaker dollar as well as earnings growth and easy global monetary policies have helped propel international markets higher to date in 2017. Emerging market stocks are on pace for their biggest gains in 8 years, after an 8.0% rise in the third quarter pushed the emerging markets index to an impressive 28% return through the first three-quarters of 2017. Developed foreign markets are up over 20% year-to-date, also outpacing the S&P 500 over that time period. International economic data has continued to show areas of strength, with global manufacturing, surging exports out of Asia, and job creation in the Eurozone among the recent highlights.
Below is a table which displays various equity index returns for the past quarter.
|Equity Indices||3rd Quarter 2017|
|Dow Jones Industrial||5.58%|
|S&P 500 Growth||5.29%|
|S&P 500 Value||3.48%|
|Russell 2000 (small-cap)||5.67%|
|MSCI/EAFE (developed international)||5.47%|
|MSCI/EM (emerging markets)||8.01%|
At the sector level, returns were relatively broad based with most individual sectors in positive territory for the quarter. Technology stocks continued in their leadership role and were top performer for the quarter and have led the market with a 26% gain year-to-date. Energy stocks rebounded during the third quarter, but remain in negative territory year-to-date. Basic Materials stocks also benefitted from a general rebound in commodity prices. Health Care stocks have largely brushed off the on-again off-again political rhetoric surrounding the Affordable Care Act, as they gained ground during the quarter and trail only the technology sector so far in 2017. The biggest laggard for the quarter was Consumer Staples, where a lack of growth and a potential shake-up in the retail landscape has pressured the outlooks of many consumer staples companies. Finally, interest-rate sensitive stocks diverged to some degree, with Utilities and Real Estate being weighed down by rising rates, while Financials outperformed the market as many financial companies may benefit from higher rates.
The following table details S&P 500 sector returns for the quarter (price only).
|Return by Stock Sector||3rd Quarter 2017|
|1. Information Technology||8.28%|
|7. Health Care||3.20%|
|9. Consumer Discretionary||0.48%|
|10. Real Estate||0.10%|
|11. Consumer Staples||-2.02%|