Whether it’s a national election or a Fed vote on interest rates, markets hate uncertainty. Check out what’s been happening over the last quarter and our thoughts on where we go from here.
Key themes from the third quarter
Low Quality Dominates
Brushing aside evidence of a global economic slowdown and political uncertainty, investors appear to be chasing risky assets in search of higher returns. During the past quarter, low quality stocks (ranking lowest for return of equity, leverage, and operational stability) nearly doubled the performance of higher quality stocks. The same was true for fixed income, as bonds with lower credit quality, higher volatility, and equity-like characteristics significantly outperformed all other bond categories.
Despite a negative first six months, technology stocks sprung back to life, gaining the most of all market sectors during the 3rd quarter (+12.86%.) Further, typical “risk-seeking” categories such as small company stocks (+9.05%) and emerging markets (+9.03%) outpaced the S&P 500 (+3.85%) during the quarter as well. For the year, the S&P 500 is up +7.84%.
After last quarter’s “Brexit” selloff, U.S. equity markets rebounded to start the 3rd quarter before apparently taking the rest of the summer off. Despite bouncing to marginal new highs for the year, the stock market appears to be “treading water” as it keeps one eye on the U.S. elections and the other on the Fed.
The Federal Reserve voted not to change its benchmark interest rate this quarter. Of note is the 7-3 margin (seven against, three for) by which the decision was passed in September, representing the closest vote in nearly two years. With Fed meetings in November and December, there are two more chances to raise rates in 2016. The uncertainty left the Barclays Capital Aggregate Bond Index up just 0.46% for the quarter.
Where do we go from here?
While U.S. equity indices dominate headlines as they sit near their all-time highs, many fail to note that bond values are close to their all-time peaks as well. This conflicts with traditional investment theory, as stocks perform best when the economy is growing and bonds do better when an economy is slowing, thus they usually move conversely to each other. However, a dovish Federal Reserve has used its monetary tools to reduce interest rates (good for bonds), driving down the costs of borrowing to nearly zero, encouraging speculation, and pushing investors into riskier assets (good for stocks).Where do we go from here?
The Fed has maintained this low interest rate policy due to anemic and weakening U.S. economic growth. Since the current recovery began in 2009, economic measurements such as productivity, GDP growth, business investment, and wage growth have all been well below trend. Despite indicating a desire towards gradually increasing interest rates, the Fed faces a very challenging environment, especially when you add the last six consecutive quarters of declining corporate profits to the mix.
The fundamental picture of the economy is far from ideal and a looming election adds uncertainty. While we remain cautiously optimistic, we are prepared to respond should investors become more concerned about slowing global growth, Brexit repercussions, or struggling European banks.