- Economic activity in the U.S. continued to show moderate improvement. A look under the hood, however, reveals certain weaknesses. A rebound in global trade continued to bolster the global economy.
- Equity market returns for the third quarter and YTD have exceeded everyone’s expectations and they have done so based on improving global economic metrics and short-term corporate earnings improvement. Hope for tax legislation also helped drive equity prices higher in the US.
- Fixed income markets seemed to assess the economic landscape meaningfully different than the equity markets as rising yields during the third quarter signaled concern that the Fed’s policy shift from quantitative easing to tightening may be more problematic for the economy and the markets.
- The U.S. dollar weakened against a basket of currencies. However, after reaching a 35-month low on September 8, the USD rallied 2% in the last three weeks of the quarter.
- Oil prices rebounded sharply. The concern showed by fixed income investors was shared by Gold investors who pushed the yellow metal up 4.6% on the quarter.
The headline Q3 economic readings continue to reflect positivity. Unemployment is low, non-farm payrolls continue to print good numbers, unemployment claims continue to decline, and consumer sentiment is high. A look under the hood, however, reveals certain weaknesses, such as the quality of jobs created, the lack of wage growth, a declining savings rate, a meager rate of growth in retail sales, and lagging industrial production. Relative to the Big Four Indicators depicted in the chart below, one can see the overall picture has been a mixed bag over the past 12 months or so.
A rebound in global trade continued to bolster the global economy. The global expansion has been underpinned by a turnaround in export-oriented sectors and manufacturing activity. China’s rising import demand over the past year has helped push the percentage of major countries with expanding new export orders to more than 90%. Elsewhere, the Eurozone is on a cyclical upswing, enjoying a reasonably synchronized expansion across both its core and its periphery. The U.K., however, is confronting pressures, as consumers’ expectations deteriorate alongside rising inflation and faltering real income growth.
During the third quarter stock markets appeared to ignore extreme hurricanes, escalating tensions in North Korea, political turmoil in the US, and seemed to shrug off any concerns regarding the Federal Reserve Board’s policy shift from monetary easing to tightening. All in all equity markets finished the quarter at or near record or multi-year highs. Specifically, the broad equity market averages were up on the quarter in the range of 4.5% for the S&P500 to as much as 7.9% for the MSCI Emerging Markets. Growth stocks generally outperformed value stocks and international shares outperformed domestic stocks. Large-cap and small-cap stocks performed equally, both outperforming mid-cap stocks. Equity market valuations remain a concern. The chart below illustrates the average of four different valuation metrics, which shows that current market valuations have only been exceeded by the dot.com bubble.
During the quarter bond investors acted with considerably more caution than stock investors. The bond market experienced rising yields during the quarter, which indicates bond investor concern that the Fed’s policy shift may become an economic headwind. The 10-year Treasury note started the quarter at 2.30% and ended the quarter at 2.33%, but not without a rally to 2.06% early in September. Moreover, after the September Fed meeting short-term yields rose and long-term yields fell, which represents a flattening of the yield curve. A flattening of the yield curve has historically portended economic weakness, while an inverted yield curve is a recession red flag. On the quarter the Barclays US Aggregate Bond Index finished up 0.85%, with the Barclays Muni and the Barclays High Yield Indexes finished up 1.06% and 1.5%, respectively. High Yield bonds as measured by the BAML US High Yield Index were up 2.85% in Q3.
As measured by the six-currency DXY index the USD was down 2.7% in Q3 and is down 9.1% YTD. However, after reaching a 35-month low of 91.32 on September 8, the USD rallied 2% in the last three weeks of the quarter. Against the Euro the USD was down 3.5% during Q3 and was down 12% YTD 9/30/17. Against the Japanese Yen the USD was flat in Q3, but was up 3.5% YTD at the end of Q3. Relative to the British Pound the USD was up 3% in Q3 and was up 8% YTD through 9/30/17. Further and sustained economic improvement abroad as well as the course of the extended US recovery and ultimate Fed rate hikes should determine directional moves in currencies for the balance of the year. However, the USD continues to attract buying when there is a flight to safety, so any market or geopolitical dislocations should push the USD higher.
OIL & COMMODITIES
Oil prices rebounded sharply in Q3 after selling off in Q2. Brent Crude finished the quarter at $57 per barrel, up 19.7% for the quarter and now up 3.7% YTD. WTI finished Q3 at $51.67 per barrel, up 7% for the quarter, but still down 1% YTD through 9/30/17. Global inventories remain near historic highs and the price of oil will continue to be highly dependent on the ultimate pace of global economic growth, the level of shale production in the U.S. and crude production from OPEC. The GSCI Commodity Index was up 7.2% in Q3 and now up 2.2% YTD through the end of Q3. The increase in the index was largely due to the rise in the price of crude. We do not expect non-crude commodities to rally unless or until global growth absorbs current excess capacity.
Given the markets gains we have expectations for below average returns in the traditional investment markets in the near-term. Accordingly, we continue to allocate capital to alternative investments that have low or no correlation with equity and fixed income returns. We also reiterate our view that in the current environment cash ultimately provides the best hedge against market volatility and potential market dislocations. While we are confident in the diversified nature of our portfolios, we remain focused on the changing financial market landscape to determine if, and when, appropriate changes are needed or necessary.
As always, we appreciate your continued partnership with us and welcome your questions, comments, and insights at any time.
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