October 15, 2017
As the final days of summer ticked away and children started back to school, investors were faced with newfound market turmoil. Rising tensions with North Korea, tax reform, looming hurricanes, debt ceiling questions, and concern about the Fed’s future direction combined to renew investor anxiety. Put it all together and it should come as no surprise that markets saw their greatest volatility since the spring. What a difference a few weeks make. Fast forward to quarter-end and all three major U.S. indices hit record highs as the market resumed its focus on the solid economic fundamentals that have been the primary driver of the market rally. The third quarter should serve as an important reminder that while investor emotions and market sentiment can change quickly, your portfolio should not. Rather than swaying with the motion of the market, investors should construct their portfolios on the foundation of their financial goals, risk tolerance, and time horizon.
The U.S. economy continued to flex its muscles during the third quarter as S&P 500 companies reported second quarter earnings growth of 10.8%.1 The double-digit earnings growth in consecutive quarters marks the first time S&P 500 companies have posted such stout growth since 2011. The unemployment rate in September fell to a new 16-year low at 4.2% while wages grew 2.9% versus the year-ago period, exceeding expectations and giving consumers hope that higher wages may finally be a part of this economic expansion. Given consumer spending makes up roughly 2/3 of U.S. GDP, unemployment and wage growth trends offer confidence that the increasing financial health of consumers can continue to drive this market higher.
Despite the aforementioned market volatility, the third quarter ended in much the same fashion as the first two quarters of the year. All major asset classes posted gains for the quarter as the global growth recovery story continued and interest rates remained in a tight trading range. Emerging markets was the best performing asset class in the third quarter, up more than 7%. Improving commodity prices, continued global growth, and attractive valuations have bolstered emerging markets in 2017 with year-to-date performance surging nearly 30%. Domestically, small-cap stocks outpaced their larger peers for the quarter with hope that tax cuts would have a greater effect on their more U.S.-centric businesses.
After being the worst performing sector in the first half of the year, energy rebounded nicely during the third quarter with gains of more than 6%. Supply disruptions caused by Hurricanes Harvey and Irma along with continued supply cuts by OPEC boosted energy prices. The information technology sector continued its strong year on the back of robust sales and earnings growth, particularly from the largest companies in the sector. Financials posted solid gains on the expectation of higher interest rates and reduced regulation. Consumer staples was the only equity sector to finish down on the quarter as Amazon’s acquisition of Whole Foods sent shock waves through the sector.
While equity performance was strong again in the third quarter, investors continued to pay close attention to the Fed for additional clues about the future path of the fed funds rate as well as final details about when the Fed would begin reducing the $4+ trillion worth of bonds on their balance sheet. During the Fed’s September meeting, Fed Chair Janet Yellen indicated she expected one more fed funds rate increase before year-end given the continued strength of the U.S. economy. The Fed also announced it would begin the process of allowing bonds on the Fed’s balance sheet to mature without reinvesting the proceeds. These bonds were purchased after the last recession as part of the Fed’s quantitative easing policy, which was designed to keep interest rates low and thereby stimulate the economy. The decision by the Fed to begin reducing its balance sheet speaks to the strength of the U.S. economy in that it no longer needs the crutch that quantitative easing provided for the market.
How the reduction in the Fed’s balance sheet affects interest rates is yet to be determined. Despite the news that the Fed would begin to reduce its balance sheet, government interest rates finished the quarter relatively unchanged from where they began the quarter. While some investors will say higher interest rates are a virtual certainty as a result of the Fed’s plans, we would caution against such general assumptions lest we forget both the unexpected outcome and market reaction of our presidential election last year. Global demand for U.S. bonds continues to be significant and the aging demographics of our population and their desire for portfolios with a higher allocation to bonds will both likely serve to limit the upward trajectory of interest rates. The strength of the U.S. economy should help interest rates climb over time but we expect it to be a slow, methodical move. Investors should continue to own bonds given they often rise in value when stocks fall and thus offer ballast to portfolios in times of market uncertainty.
Given corporate profitability remains strong and consumers are trending up, we continue to believe that the economic fundamentals are in place for the bull market to continue. That said, while many of the market risks that rattled investors during the third quarter have faded to the background, it is important to remember they have not altogether disappeared. There are still heightened geopolitical tensions, uncertainties around tax reform, questions about the federal budget deficit and debt ceiling, as well as concerns about how the market will respond to the Fed’s recent actions. Thus, while there is reason for overall market optimism, the risks for a near-term market correction remain. We would advise investors to avoid making short-term portfolio adjustments driven by market sentiment that could harm their long-term financial goals. Rather, investors should make sure they are well-diversified with an appropriate balance of stocks and bonds for their risk tolerance and time horizon.
John Fischer, CFA®, CFP®
Chief Investment Officer