- It was a generally positive quarter for markets and volatility across equities and fixed income was markedly lower compared to recent quarters.
- US equities advanced and expectations rose that the Federal Reserve (Fed) would increase rates again before the end of 2016.
- Eurozone equities made gains with economically sensitive sectors such as information technology and consumer discretionary outperforming.
- UK equities moved higher against a more stable domestic political backdrop following the EU referendum vote. The Bank of England launched a series of monetary easing measures.
- Japanese stocks were supported as the government released details of a fiscal spending package designed to run alongside the Bank of Japan’s continuing aggressive monetary policy.
- Emerging market equities delivered strong returns as investors focused on high yielding assets. Among the equity markets to benefit most from the yield-seeking trend were Brazil, Russia and South Africa.
- In bond markets, the 10-year Treasury yield climbed over the period while gilt yields fell. Global corporate bonds performed strongly.
US stocks had their best quarter of the year in Q3 as the banking sector rallied with hopes that the Fed would raise rates and improve the earnings picture for banks. The S&P 500, DJIA, the Russell 1000 were up 3.3%, 2.1%, and 3.1%, respectively. The Nasdaq Composite ended the quarter up 9.7%, its best quarter since 2013. The ACWI and the ACWX were up 5.1% and 6.5%, respectively. European stocks were up 4.4%, Japan was up 5.5%, and the Shanghai and Shen Zen markets were up 3.3% and 1.1%, respectively. Several of the US markets closed the quarter at all-time highs as economic conditions remained stable, but the Fed continued to delay a hike in interest rates. Outside of the US, equity markets rose on the backs of central bank promises to maintain the current zero-bound monetary policy at all costs.
As noted above the banking sector was a big contributor to Q3 returns, as evidenced by the 9.2% return of the KBW NASDAQ Bank Index, which had its best quarterly performance in nearly three years. Bank of America was up 18% in Q3. However, historically low interest rates have weighed down banking sector returns so far in 2016, as reflected in the 3.1% decline in the Bank Index and Bank of America down 7%. In general, the mood of investors in Q3 was to take on more risk, moving into financial and technology shares and away from utilities and telecommunications companies. To wit, the S&P 500 utilities sector fell 6.7% in Q3, paring its YTD gain to 13%.
It is important to realize that with markets at or near all-time highs, valuations are extremely rich from a historical perspective. The chart below shows the P/E 10 ratio with the Standard Deviation highlighted from the geometric mean. As you can see the current valuation is 75% above the mean and approaching two standard deviations from the mean. Only three times before has the market been this overvalued: 1) in 2007 before the Great Recession, 2) in 2000 before the Tech-bubble crash, and 3) in 1929 before the market crash leading to the Great Depression.
Further to the issue of historical valuations, the chart below shows the P/E 10 ratio by percentile (excluding the Tech Bubble), which shows the current valuation in the 94.7 percentile vs. 95th and 97th percentile for the 2007 peak and the1929 peak, respectively. From a historical standpoint, equity markets have earned an average 4-5% for the forward 10-year period from these valuations. These two charts demonstrate that market valuations far exceed historical averages and are arguably in very dangerous territory.
GDP growth in Q3 was tracking at above 3% mid-way through the quarter, but the highly-watch Federal Reserve Bank of Atlanta’s GDPNow estimate is now down to 2.2%, which is still nearly double the rate of growth in the first half of 2016. However, even if this increased rate of growth is sustained through Q4, 2016 GDP growth would be only 1.7%, well below the current expansion’s 2.1% average annual growth rate, which is the weakest recovery since 1949. Business investment turned positive in Q2 and appears to have continued in Q3, led by investments in intellectual property, such as software and research and development.
WTI and Brent Crude prices finished Q3 2016 at $48.24 and $50.19, respectively, which left WTI down marginally and Brent up about 1% on the quarter. For 2016 YTD WTI and Brent are up 30.2% and 32.2%, respectively. In the last month of the quarter oil prices moved up on rumors that OPEC nations would freeze production only to have prices drop on news from the EIA that global petroleum inventories would continue to build well into 2017. Within days of the price decline OPEC announced that an agreement among most members to freeze production and crude prices climbed 10% in the last week of the quarter.
The US dollar finished the quarter 1.12 to the Euro, just a shade lower than the 1.11 exchange at the end of Q2. The EUR/USD exchange has been flattish over the past year with a slight strengthening of the Euro. Over the same time period the Japanese Yen has strengthened by about 16% vs the USD and the Euro. Relative to a broad basket of currencies the DXY finished the third quarter of 2016 at 95.67, a 0.49% decline from the end of Q2.
At the end of 2015 the Fed had raised rates by 25 basis points and telegraphed four additional rate hikes in 2016. So far, not one rate cut has taken place in 2016 and the current messaging from the Fed is different from day to day, depending on the latest economic news as well as the Fed messenger. Current Fed thinking is thought to be that a 25 basis point rate increase will come in December after the Presidential election and the famous (or infamous) Fed dot plots are now indicating the likelihood that 2017 will only have one 25 basis point rate hike. The 10-year Treasury note began the year at 2.24%, ended Q1 at 1.78%, and finished Q2 at 1.49%. During Q3 the 10-year yield traded as low at 1.38% and as high as 1.68%, but finished the quarter at 1.56%. On the long end of the curve the 30-year Treasury bond started the quarter at 2.17% and finished at 2.28%, after trading as high as 2.48%.
Sovereign interest rates abroad remain meaningfully below rates in the US, which means that the bond market is continuing its misguided pricing of risk and reward. French and UK 10-year sovereigns now trade 140 bps and 100 bps below US 10-year Treasuries, respectively. Spain’s 10-year trades 70 bps below the US and even Italy sovereign 10-years trade 40 bps below the US.