Oh, What a Difference a Decade Makes
Happy 10-year anniversary to the Global Financial Crisis! Just a decade ago, some of the world’s largest and most revered financial institutions, along with the modern financial system itself, were left staring into the abyss. Several events, beginning with the fire sale of Bear Stearns and failure of Lehman Brothers, quickly transitioned into a bailout of AIG, conservatorship of Fannie Mae and Freddie Mac, multiple emergency relief programs, and forced marriages of several global investment and commercial banks. The series of events would eventually translate into one of the most painful economic recessions on record. And yet, as grave as things appeared in September 2008 and during the months that followed, the global economy just 10 years later finds itself in the midst of one of the longest economic expansions in the modern era. But as much as there is a great deal of positive news to go around as the current economic expansion grinds on, nearly all global economies face headwinds of some kind in the near term.
At the head of the pack, the U.S. economy has continued to feel the shot of adrenaline provided by early 2018 tax cuts and fiscal stimulus, recording 4.2% growth in the second quarter and an estimated 3.6% increase in the third quarter, which would be the highest two-quarter clip in nearly four years. Unemployment, which was hovering near the 10% mark during the depth of the financial crisis, is at 3.7% and wage growth, which has been anemic throughout the recovery period, has shown some signs of life recently with gains of approximately 4.7% over last year’s wages. U.S. Inflation remains subdued with a 2.7% increase during the quarter; prices were held in check with a slowdown in fuel and housing costs. Core inflation, which excludes food and energy, grew at a 2.2% rate during August. Tempering the enthusiasm, however, most market observers acknowledge that the stoked growth in the U.S. is unlikely sustainable, due to demographic trends (aging population, fewer new job entrants), uncertainty around the full impact of tariffs with China and other trading partners, and an unsettled political environment.
Looking abroad, global growth has continued to show resiliency, though moving at a slower pace than earlier this year. The Global Purchasing Managers’ Index (PMI), which provides a survey-based reflection of the economic health of the manufacturing and service sectors, continued to offer encouraging readings across much of the developed and emerging world throughout the third quarter. However, the steady rise in U.S. interest rates and U.S. dollar appreciation have begun to create some headaches for many parts of the world, particularly in the form of higher interest costs for EM countries with significant USD-based debt burdens. Within the euro zone, investors are trying to balance the health of the PMI, lower unemployment figures, and stable inflation with headwinds such as ascendant populism (e.g., Italy), declining net export and trade activity, and stalling progress on Brexit negotiations (with a rapidly approaching deadline).
In Japan, corporate earnings, export activity, and business sentiment remain relatively strong. Meanwhile, a tight labor market (a 2.4% jobless rate as of August) has yet to translate into higher wages and private consumption has remained weak, though the latter could see a bump in advance of a planned sales tax hike (to 10%) in October 2019 along with other fiscal reforms. And in China, President Xi Jinping’s national team of economists continue to focus efforts on deleveraging (non-financial corporate debt is estimated at 164% of GDP, according to the Bank of International Settlements) and structural reforms while balancing the need for policy stimulus, likely in the form of more infrastructure investment, to counteract the impact of U.S. tariffs that have yet to take full effect.
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 the tariff threats and the ever-changing negotiations. Large growth stocks were the top performers (R1000G: +9.2%) and small value (R2000V: +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-U.S. 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
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% 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%.
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.
With noted exceptions, we remain cautiously optimistic regarding the resilient global growth that has been exhibited by both the U.S. and foreign economies over the most recent quarter and year-to-date. And despite markets in both financial and real assets continuing to feel extended, such cycles are born without an assigned expiration date. Nevertheless, we are also realists and acknowledge that all good things must end, which is why we continue to encourage investors to maintain a long-term perspective and prudent asset allocation with appropriate levels of diversification.
Source: The Advisory Group & Callan