October 4, 2016
THIRD QUARTER RETROSPECTIVE
In the aftermath of the surprising Brexit decision in June, the U.S. equity markets showed remarkable recovery. The S&P 500 sank over 5% in late June after the Brexit announcement, but recovered sharply through the end of June. As we entered the third quarter, U.S. equities continued to climb, and the S&P 500 closed the quarter with a third-quarter return of 3.9% and a year-to-date return of 7.8%. Additionally, most investors were expecting the European equity market to trade down sharply, but the Brexit-based theme of surprise continued through the third quarter. The Eurozone-based stocks rallied even more than U.S. stocks as measured by the MSCI European Monetary Union index. Europe was up 7.8% for the quarter, but flat year-to-date. Even though emerging markets were considered less impacted by the Brexit decision, one hardly expected that market to log in such a stunning return of 9% for the quarter and 16% year-to-date as measured by the MSCI Emerging Markets index (Exhibit A).
The third quarter was mixed from a domestic economy standpoint. On the negative side, the U.S. added 151,000 jobs in August relative to an expected 180,000. Also the Institute for Supply Management reported that its manufacturing survey dipped below 50 for the first time since December – a reading below 50 usually signals a slowdown in manufacturing. On the positive side, the service segment came in at 51.4, suggesting continued slow growth, although the reading fell 4.1 points from July. Another interesting measure–real median household income– showed the best one-year gain since the late 1960s, rising over 5% year-over-year.
In view of the contrasting data, the Federal Reserve decided to maintain the target range for the federal funds rate until its December meeting. Chair Yellen’s narrative shifted to a slightly more hawkish stance regarding a rate hike in December. However, given the continuing combination of good news/bad news on the economy, the prospect for a rate hike remains murky.
Within this backdrop, the U.S. fixed income market reflected the same theme of continued uncertainty. The 10-year Treasury yield rose from 1.47% at the beginning of the quarter to 1.60% by the quarter’s end, after hitting a high of 1.73% in mid-September. Although short-term rates have increased slightly over the past year fueled by the Fed Funds rate increase in December, medium and long-term yields have declined over the past three years, causing the yield curve to flatten (Exhibit B). This suggests that even if the Fed was to raise short-term rates further, the curve is signaling that it will pivot around the intermediate maturity points (two to three year maturities). Many investors may have overlooked this dynamic and as a result, avoided bonds with intermediate maturities.
ECONOMIC AND MARKET OUTLOOK
As we enter the last quarter of 2016, there are more uncertainties than usual. For example, we are always certain that an election year will end with a conclusive outcome. But this election year presents more uncertainty about gauging each candidate’s possibility of winning, and about how the U.S. and global markets will react to either candidate’s victory. Although this election may appear to be unique in some regards, a number of past elections have been difficult to assess for various reasons. Therefore, past results may provide some guidance. Looking at the impact on the Dow post- inauguration, a period of adjustment usually follows as the markets become calibrated to the new leadership. Note: Differences exist depending on the incumbent party winning or losing. As the year develops, there typically is a period of optimism most likely reflecting analysts’ refining their models and working with greater certainty of inputs. However, the circumstances of the current election are so unusual that there simply may not be a precedent.
Another “certain uncertainty” is how Brexit will impact the Eurozone and world markets. We certainly know that the U.K. is leaving the E.U., but the impact of that decision is uncertain. The U.K. will endure several years of fluctuating trading relations with the European Union. Additional immigration policy tensions may also make reaching a trade agreement more challenging among E.U. members. Two years may simply not be enough time to negotiate a workable trade agreement. There is no precedent for the exit and as a result, analysts’ models will have wide dispersions about future market returns predictions. It is reasonable to expect slower growth for both the U.K. and the Eurozone countries as all parties begin the long, tedious assignment of working out a mutually acceptable trade agreement.
Given this backdrop, in the near-term we expect increasing volatility through November if the U.S. presidential election does not converge around one candidate. [10/14/2016 update: Since the writing of this article, the presidential election has been converging toward Clinton, although there is increasing uncertainty around the balance of power in Congress]. The Fed meets two more times this year, but the November meeting is so close to the election that it is unlikely there will be material action. The same reasoning may apply to December as markets start to process the election results. Through year-end, there will be multiple economic reports to analyze for signs of inflation as well as earnings results for the third quarter. In spite of the weaker past earnings and expected forward volatility, analysts expect fourth quarter U.S. corporate earnings to show considerable strength against last year’s period. S&P 500 fourth quarter earnings growth is expected to be around 6% year-over-year (Exhibit C).
Looking toward 2017, we expect U.S. markets to digest the leadership change and to remain an attractive base for investors. U.S. equity valuations are somewhat above average with a forward price/earnings ratio of 16.8 for the S&P 500 as of September 30. This valuation assumes strong earnings growth. If this growth does not materialize as projected, the U.S. equity markets would possibly trade off, and analysts would need to reevaluate their forward models.
Developed international markets will work through the Brexit details as they unfold. We also expect emerging markets will remain somewhat isolated to both processes. In the long term, we believe that the facts demonstrate a continuing slow, steady but strong U.S. economy. Throughout the unfolding election results, Brexit solutions, and other uncertainties, we expect that a well-diversified portfolio will remain durable and is the best solution to grow and protect investment portfolios.
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.