06 Oct Whistling in the Wind
Continued profit growth and a weak dollar propelled risky assets to another strong quarter, led by emerging markets and non-U.S. real estate securities.
Securities sensitive to interest rates, such as U.S. REITs and utilities, continued to lag.
All eyes are on Washington in the upcoming quarter, as we learn how hurricane damages and a proposed corporate tax cut will affect the economy.
Four of the five top asset class performers were the same as the previous quarter. Non-U.S. equities—in particular, emerging markets and real estate—led the field. Equities that are sensitive to interest rates, such as U.S. real estate investment trusts (REITs), lagged, despite a flat Treasury yield of 2.33%.
It took two tragic natural disasters within a week of each other, but Washington finally acted. As part of relief efforts from Hurricanes Harvey and Irma, Congress eliminated the debt ceiling for three months. Also, the Federal Open Market Committee (FOMC) crystalized plans for the reduction of its $4.5 trillion balance sheet.
The hurricanes will make economic forecasting virtually impossible in the near term. Following Harvey, weekly initial jobless claims spiked by 62,000, hitting 298,000. In 2012, Hurricane Sandy caused a similar effect when jobless claims jumped by 81,000 to reach 446,000. Prior to September of this year, the Atlanta Fed’s GDPNow, which attempts to estimate the current quarter’s growth with real-time economic data, had estimated third-quarter GDP of nearly 3.5%. After Irma, the estimate was lowered to around 2.2%, but has since bounced slightly to 2.5%. Although the impacts to Houston and parts of Florida are unlikely to cause that much of a decline in nationwide GDP, they will make it challenging to analyze economic data in the coming months.
Q3, 2017: Key Market Total Returns
Corporate earnings were strong once again, sustaining robust equity returns. According to Standard and Poor’s, second-quarter operating earnings for the S&P 500 were up 19% from a year earlier. Just two sectors, Materials and Real Estate, posted negative earnings growth. Operating profit margins jumped to over 10% and the highest since data started being collected in 1994.
Equity analysts remain upbeat and expect third-quarter earnings growth of 15% on a year-over-year basis. Should this be the case, the trailing twelve-month price-to-earnings ratio would be approximately 20.8x. Expectations for 2017 S&P 500 operating earnings are relatively unchanged at $127 per share, implying a 20% increase over 2016.
Looking ahead to the fourth quarter, some technical issues will be important for markets, particularly in fixed income. For one, the temporary raising of the debt ceiling means the U.S. Treasury can issue bonds at a more rapid clip. The Treasury Borrowing Authority Committee (TBAC) has recommended issuing $501 billion in net new debt by the end of the year. This is a staggering increase, compared to the net $96 billion that was issued in the third quarter. At the same time, the Federal Reserve will begin to allow securities from its balance sheet to roll off. Although the amounts are expected to be minimal, starting with $10 billion per month in both Treasuries and mortgage-backed securities, the combined impact may create some indigestion for the market. During the late September press conference, Janet Yellen had this to say about the balance sheet.
“Our balance sheet is not intended to be an active tool of adjusting the stance of monetary policy. We therefore do not plan on making adjustments to our balance sheet normalization program. But, of course, as we stated in June, the Committee would be prepared to resume reinvestment if a material deterioration in the economic outlook were to warrant a sizeable reduction in the federal funds rate.”
In September the FOMC signaled it would raise interest rates one more time in 2017, which comes even with headline inflation below the Fed’s 2% long-run target. The Personal Consumption Expenditures (PCE) inflation index has been below 2% in 61 of the last 63 months, and the most recent data available (August) was substantially below, at just 1.4%. Non-farm payroll gains remain solid: The three-month average, ending in August, stood at 185,000 per month.
In settling the debate between strong labor market data and still below-target inflation, the FOMC appears to be focusing on financial conditions, which—according to the Chicago Fed National Financial Conditions Index—have been easing throughout the year, even though the FOMC is tightening. This metric measures risk, liquidity, and leverage in money market, debt, and equity markets. It hit new lows (representing an incremental easing of financial conditions) in September.
Congress continued to move at its typical glacial pace. At the end of September, Republicans announced a tax-cut plan, which included lowering the corporate tax rate to 20%. For individuals, the plan is to simplify the tax brackets to 12%, 25%, and 35% while eliminating the estate tax, among other things. Details were lacking, making significant conclusions about short- or long-term impacts premature.
In an extension of the trend throughout the year, growth stocks outperformed value. Small caps beat large cap, but still trail for the year. In the S&P 500 Index, Energy stocks finally posted positive quarterly returns (7%), aided by a 9.0% return in the benchmark WTI crude contract, which ended the quarter over $51. Energy stocks are still returning -7% for the 2017 calendar year. Crude ended the quarter with the 12-month futures price slightly ahead of spot (referred to as ‘backwardation’), which has historically signaled balance between supply and demand. Technology stocks moved higher by 9%, leaving them up 24% in 2017. Utilities lagged and were up just 3% for the quarter.
Fixed income securities produced decent absolute returns. The Bloomberg BarCap U.S. Aggregate Bond Index was higher by 0.8%. Tax-exempt fixed income fared slightly better, up 1.2%, as measured by the S&P National Municipal Bond Index. High-yield bonds performed marginally better: The Bloomberg BarCap High Yield Corporate Index increased by 2.0%. The 10-year U.S. Treasury note yield was virtually unchanged from the start of quarter, ending at 2.33%, but it declined to 2.04% in September before rebounding. The yield curve, as depicted by the spread between two- and 10-year Treasuries, flattened seven basis points and ended the quarter at 0.86%.
The MSCI EAFE Index increased 5.4% in U.S. dollar terms. In local currencies, the index gained 3.4%, indicating about 2% in U.S. dollar weakness against the basket of currencies. The MSCI Emerging Markets Index was up 8% in U.S. dollar and local currency terms. Brazil was by far the best performer, up 23%. China increased 15% in the quarter, pushing it to 43% for the year. Gains were broad-based outside of the U.S. Of 40 developed and emerging countries that we track, only three posted negative returns—Israel (-13%), Greece (-12%) and Indonesia (-1%).
Japanese Prime Minister Shinzo Abe unveiled yet another stimulus plan. The nearly $18 billion idea is earmarked for child care and education. This fiscal package scheme comes at a time when Japan’s debt-to-GDP stands at nearly 250% and is yet another attempt in a non-stop effort to revive an economy that hasn’t produced 2% GDP growth in several years.
In Germany, Angela Merkel was re-elected chancellor for a fourth term. However, her center-right CDU party declined in parliament. The relatively new far-right party, AfD, which has been very critical of Merkel’s refugee policy, gained ascendancy.
Overall, markets were unaffected by the escalating discourse between North Korea and the U.S. Rockets were launched, militaristic rhetoric increased, and tweets flew while risk assets whistled their way to new highs. The MSCI South Korea Index gained 3% in the quarter and is up 32% for the year.
As we look toward the final quarter of 2017, we are especially interested in evolving economic policies, including an increase in U.S. Treasury supply alongside a potential rate hike and the start of quantitative tightening. We are also intrigued by Amazon’s decision to open a second headquarters and by the possible effects for the chosen city and region.
In closing, we want to express our concern for the people of Las Vegas, Puerto Rico, Houston, Florida, and everywhere else rocked by trauma in the past several weeks.
The SpringTide Investment Team
Disclosures & Footnotes
The indexes referred in the performance table are as follows: U.S. large cap stocks: S&P 500 Index; U.S. small cap stocks: Russell 2000 Index; International developed stocks: MSCI EAFE; emerging market stocks: MSCI Emerging Markets Index; U.S. taxable bonds: Bloomberg Barclays U.S. Aggregate Bond Index; U.S. municipal bonds: S&P National Muni Bond Index; U.S. high yield bonds: Bloomberg Barclays High Yield Corporate Bond Index; international developed bonds: S&P/Citi International Bond Ex-U.S. Index; emerging market bonds: JP Morgan Emerging Market Bond Index Global; U.S. REITs: MSCI U.S. REIT Index; international real estate securities: S&P Global Ex-U.S. Property Index; commodities: Bloomberg Commodity Index; master limited partnerships: Alerian MLP Index.
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