The first half of 2016 brought volatility to the markets in the form of an early year correction and turmoil surrounding the Brexit vote. For investors looking for a break from the action as they said goodbye to summer, the third quarter provided exactly that. While volatility has been trending in a downward direction as we enter the fourth quarter, history suggests that the impending presidential election is likely to change that market trend.
The third quarter was a solid if unspectacular one with all major US indices posting gains for the quarter. Both the S&P 500 and Dow Jones Industrial Average had low single digit returns for the quarter as the market benefited from the Federal Reserve opting to leave the fed funds rate unchanged again in the third quarter. Both indices are up roughly 5% year-to-date. The NASDAQ index led the major indices in the third quarter finishing up over 9% thanks to strong performance in the information technology sector. The S&P small cap index ended the quarter up more than 6% as interest rates bounced off of their post-Brexit lows, thus providing a tail wind for small cap stocks. Mid cap stocks finished the quarter up almost 3%.
International equities had a strong third quarter on the heels of continued accommodative policy by central banks across the globe. Large cap international stocks posted a 5% return for the quarter, outperforming US large caps in the process. Global markets were a benefactor of the continued effort of central banks to keep interest rates near or below zero in hopes of jump starting their respective economies. Europe had a bounce back quarter finishing up near 5% while Japan was up more than 7% in the third quarter. After a very weak start to the year, emerging markets were up 8% for the quarter and are now up approximately 13% year-to-date.
In the third quarter, we saw interest rates come off their second quarter lows on the heels of the Brexit vote as yields on treasury bonds rose more than 20 basis points, or 0.2%, across the yield curve. The Barclay’s U.S. Aggregate Bond Index, which is comprised of higher quality investment grade bonds, still managed to finish up 0.46% for the quarter despite the rise in interest rates. It is a very timely opportunity to remind investors that high quality bonds can still produce a positive return in a rising interest rate environment due to the income they produce as well as credit spread tightening that often occurs with high quality bonds that are bench-marked to US treasury bonds.
The backdrop of a rise in interest rates explains much of the sector performance for the third quarter. Information technology was the top performing sector for the quarter up more than 12%. Financials, industrials, and materials were the best of the rest in the third quarter. Each of these sectors has historically performed well when interest rates rise. Conversely, telecom and utilities both lost more than 6% as the worst performing sectors of the third quarter. Both sectors pay attractive dividends and have done well in the recent low interest rate environment but tend to struggle when interest rates rise as other income generating investments become more attractive.
As the fourth quarter begins, investors will shift their attention towards the upcoming presidential election. An unequivocal truth of investing is that markets dislike uncertainty. Look no further than the Brexit vote for evidence. An election by its very definition breeds uncertainty. It is this uncertainty that results in higher market volatility before and immediately following presidential elections and why higher market volatility in the fourth quarter should come as no surprise. Political preferences aside, the market views Donald Trump’s policy agenda with greater uncertainty than that of Hillary Clinton. As a result, the market is likely to display more volatility if Mr. Trump’s campaign proves to be a worthy challenger to Mrs. Clinton’s campaign leading up to the election. The same would hold true if Mr. Trump were to indeed win the presidential nomination.
Some investors are concerned about the impact to the market of each candidates’ proposed policies. It is important to note that if the Republican party wins the majority in the House of Representatives as is expected, it would make it unlikely that either candidate would be able to enact their bolder campaign promises. While Mrs. Clinton would struggle due to bipartisanship, Mr. Trump would likely meet opposition in the form of the Republican establishment in the House where Speaker of the House Paul Ryan would likely attempt to dilute Mr. Trump’s more aggressive proposals. For investors, the most important consideration for the upcoming presidential election is to consider their own investing time horizon. While presidential elections have proven to increase short-term market volatility, the long-term effect on market returns based on which party wins the election and control of Congress has been negligible. Over the long-term, market fundamentals such as earnings growth, valuations, and interest rates are what drive market returns. As a result, we suggest clients focus on what they can control, which is to make sure their portfolios are properly diversified and aligned with their objectives and risk tolerance as we lead up to what figures to be a more volatile final quarter of 2016.