The U.S. economy continues to register moderate growth supported largely by the consumer-oriented sectors of the economy, with business investment and government spending making a modest positive contribution. The industrial sector and exports are struggling with tepid global demand and the impact of a stronger U.S. dollar. With the U.S. labor market approaching full employment, wage growth remains on an uptrend, but the pace remains below historical norms. Pricing power has been elusive and inflation remains benign. Focused on cost-cutting and efficiency, firms have been able to maintain operating margins while corporate earnings growth has largely tracked nominal GDP. The Federal Reserve (Fed) appears committed to raising rates, but can do so only at an extremely slow pace. Longer term rates should gradually drift higher, but strong global demand will likely keep yields low. We expect market volatility to normalize, with occasional spikes of sharply increased turbulence. Growth outside the U.S. is expected to be tepid, especially in Europe, and highly dependent on monetary and fiscal stimulus, while commodity prices should eventually stabilize largely due to reduced production.
U.S. Capital Markets
The third quarter saw a robust market for equities with the major domestic indices hitting all-time highs. However, the summer doldrums were clearly evident as the S&P 500 Index spent over half of the quarter without moving more than 1% in either direction on a single day.
Small cap equities outpaced gains in the large cap space by approximately two-to-one during the quarter. After the weak first-half, U.S. economic data improved over the summer, supporting the move higher in the markets. Those trends stabilized, rather than accelerated, as the quarter came to a close. The recent decision by the Fed to wait on raising rates effectively shifts the focus to their upcoming meeting in December. Increasingly, investors expect policy to push fiscal stimulus in 2017 in an effort to help boost the economy, regardless of the outcome of the election. Such plans have historically provided modest bumps in overall GDP growth in the short-term while having little, if any, impact on medium- or long-term economic growth. We continue to focus on finding high-quality companies with undervalued earnings and growth prospects where we see asymmetric return potential.
Global and Emerging Markets
Global equity markets rose almost 5% in the quarter, led by Emerging Markets with a YTD gain of almost 14%.
Emerging Markets specifically saw an advance of over 8% during the quarter. The strong performance was supported by an appreciation in currencies following the Fed’s decision to postpone further rate hikes until the end of the year. Exports from Emerging Markets continued to show recovery amid a stabilization in global growth, but prevailing issues related to Brexit, the U.S. presidential election and OPEC discussions raised near-term uncertainty in outlook.
2016 Third Quarter and One-Year Trailing Returns Across Asset Classes
Global and Emerging Markets, continued
The Asian region led returns as China rose sharply following an announcement from the China Insurance Regulatory Commission that allowed mainland insurers to invest directly in Hong Kong via the Shanghai-HK Stock Connect. Latin America was also positive, highlighted by Brazil posting a 10% gain despite the ongoing political transition with impeachment proceedings underway against the former president Rousseff. Mexico, however, fell due to political uncertainty tied to the U.S. election. Europe, Middle East and Africa (EMEA) also advanced as Egypt and Hungary outperformed, while South Africa and Russia were positive. A recovery in oil prices contributed to a strengthening of the Russian ruble as the central bank lent support by cutting rates, citing a slowdown in inflation.
Treasuries posted small losses while corporate bonds logged small gains. Investment Grade Bond returns were flat in the third quarter. Fallout from Brexit caused the 10-year Treasury yield to fall to its lowest level on record, 1.36%, at the beginning of the quarter. Treasury market strength was short-lived, however, as June and July payroll reports exceeded expectations, causing yields to rise across the maturity curve. This weakness was compounded with Regional Fed Presidents stepping up expectations of a rate hike by year-end.
The Barclays U.S. Aggregate Bond Index gained 0.46% for the quarter, leaving the benchmark up 5.80% year-to-date. The yield on the 10-year Treasury increased from 1.47% to 1.60%, handing owners a loss of 0.75%. Investment Grade credit spreads tightened by roughly 15 basis points (bps), causing duration-matched corporate bonds to outperform Treasuries. The U.S. Treasury Yield Curve continued to flatten as the yield differential between the 10-year and 2-year Treasury fell to its lowest level since 2007. Inflation expectations increased, causing Treasury Inflation-Protected Securities (TIPS) to outperform nominal Treasuries. Within corporates, industrial sector bonds were the strongest performer, while utility sector bonds posted smaller gains. Triple B rated bonds were the best performer while triple A rated bonds posted smaller gains. Municipal Bonds posted a loss of 0.30%, reducing their year-to-date gain to 4.01%.
The High-Yield market posted impressive gains during the quarter. The Bank of America Merrill Lynch High-Yield Master II Index gained 5.49% and is up 15.33% so far this year. High-Yield credit spreads tightened by roughly 110 bps. Metals and Mining along with Telecom were the top- performing sectors within High-Yield. Health Care and REIT sector bonds underperformed with smaller gains during the quarter. Weaker credit quality substantially outperformed stronger credit quality. High-Yield bond issuance was light in the third quarter, down 22% compared to the same period in 2015. Year-to-date, High-Yield bond issuance is down 33% compared to the same period in 2015.
Specialties: Convertibles, MLPs and REITs
While the third quarter is generally characterized as historically more volatile than others, 2016 was quite benign, with only a small pick up in downside volatility in September. Post-Brexit fallout has been well contained and equity markets continue to push higher. Credit markets also improved, with credit spread tightening overcoming a small backup in U.S. interest rates. Convertible bonds performed well on a global basis, with U.S. convertible bonds leading the way.
The MLP asset class continued its positive performance after a very strong second quarter. Although crude oil and natural gas prices gyrated during the quarter, they were both flattish point to point. High-yield credit spreads continued to grind tighter and treasury yields marched higher. All in all, the backdrop was positive for the asset class, but returns were muted after such a strong run in the second quarter. Investor flows into the asset class remained strong, but slowed modestly in September.
The NAREIT Equity Index posted modest declines for the third quarter of 2016 following stellar performance for the index during the first half of the year. The small declines posted by REITs are comparable with returns posted by investment grade bonds while REITs lagged the positive returns posted by the broader equity market.
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The information contained herein represents the views of Westwood Holdings Group, Inc. at a specific point in time and is based on information believed to be reliable. No representation or warranty is made concerning the accuracy or completeness of any data compiled herein. Any statements non-factual in nature constitute only current opinion, which is subject to change. Any statements concerning financial market trends are based on current market conditions, which will fluctuate. Past performance is not indicative of future results. All information provided herein is for informational purposes only and is not intended to be, and should not be interpreted as, an offer, solicitation, orrecommendation to buy or sell or otherwise invest in any of the securities/sectors/countries that may be mentioned.