Four of the five top asset class performers were the same as the previous quarter.  Non-U.S. equities—in particular, emerging markets and real estate—led the field.  Equities that are sensitive to interest rates, such as U.S. real estate investment trusts (REITs), lagged, despite a flat Treasury yield of 2.33%.

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Corporate earnings were strong once again, sustaining robust equity returns.  According to Standard and Poor’s, the S&P 500 second-quarter operating earnings were up 19% year-over-year.  Only two sectors, Materials and Real Estate, posted negative earnings growth.  Operating profit margins jumped to more than 10% - the highest since data started being collected in 1994.

 

Equity analysts remain upbeat and expect third-quarter earnings growth of 15% on a year-over-year basis.  Should this be the case, the trailing twelve-month price-to-earnings ratio would be approximately 20.8x.  Expectations for 2017 S&P 500 operating earnings are relatively unchanged at $127 per share, implying a 20% increase over 2016. 

 

Looking ahead to the fourth quarter, some technical issues will be important for markets, particularly in fixed income. First, temporarily raising of the debt ceiling means the U.S. Treasury can issue bonds at a more rapid clip.  The Treasury Borrowing Authority Committee (TBAC) has recommended issuing $501 billion in net new debt by the end of the year.  This is a staggering increase compared to the net $96 billion that was issued in the third quarter.  At the same time, the Federal Reserve will begin to allow securities from its balance sheet to roll off.  Although the amounts are expected to be minimal, starting with $10 billion per month in both Treasuries and mortgage-backed securities, the combined impact may create some indigestion for the market.  During the late September press conference, Janet Yellen had this to say about the balance sheet.

 

“Our balance sheet is not intended to be an active tool of adjusting the stance of monetary policy.  We therefore do not plan on making adjustments to our balance sheet normalization program.  But, of course, as we stated in June, the Committee would be prepared to resume reinvestment if a material deterioration in the economic outlook were to warrant a sizeable reduction in the federal funds rate.”

 

In September the FOMC signaled it would raise interest rates one more time in 2017, which comes even with headline inflation below the Fed’s 2% long-run target.  The Personal Consumption Expenditures (PCE) inflation index has been below 2% in 61 of the last 63 months, and the most recent data available (August) was substantially below, at just 1.4%.  Non-farm payroll gains remain solid: The three-month average, ending in August, stood at 185,000 per month. 

 

In settling the debate between strong labor market data and below-target inflation, the FOMC appears to be focusing on financial conditions, which—according to the Chicago Fed National Financial Conditions Index—have been easing throughout the year, even though the FOMC is tightening.  This metric measures risk, liquidity, and leverage in money market, debt, and equity markets.  It hit new lows (representing an incremental easing of financial conditions) in September. 

 

Congress continued to move at its typical glacial pace. At the end of September, Republicans announced a tax-cut plan, which included lowering the corporate tax rate to 20%.  For individuals, the plan is to simplify the tax brackets to 12%, 25%, and 35% while eliminating the estate tax, among other things.  Details were lacking, making significant conclusions about short- or long-term impacts premature.   

 

U.S. MARKETS

In an extension of the trend throughout the year, growth stocks outperformed value.  Small caps beat large cap, but still trail for the year. In the S&P 500 Index, Energy stocks finally posted positive quarterly returns (7%), aided by a 9.0% return in the benchmark WTI crude contract, which ended the quarter over $51. Energy stocks are still returning -7% for the 2017 calendar year.  Crude ended the quarter with the 12-month futures price slightly ahead of spot (referred to as ‘backwardation’), which has historically signaled balance between supply and demand. Technology stocks moved higher by 9%, leaving them up 24% in 2017.  Utilities lagged and were up just 3% for the quarter.

Fixed income securities produced decent absolute returns.  The Bloomberg BarCap U.S. Aggregate Bond Index was higher by 0.8%.  Tax-exempt fixed income fared slightly better, up 1.2%, as measured by the S&P National Municipal Bond Index. High-yield bonds performed marginally better: The Bloomberg BarCap High Yield Corporate Index increased by 2.0%.  The 10-year U.S. Treasury note yield was virtually unchanged from the start of quarter, ending at 2.33%, but it declined to 2.04% in September before rebounding.  The yield curve, as depicted by the spread between two- and 10-year Treasuries, flattened seven basis points and ended the quarter at 0.86%.

 

FOREIGN MARKETS

The MSCI EAFE Index increased 5.4% and the MSCI Emerging Markets Index was up 8% in U.S. dollar terms.  Brazil was by far the best performer, up 23%.  China increased 15% in the quarter, pushing it to 43% for the year.  Gains were broad-based outside of the U.S.  Of 40 developed and emerging countries that we track, only three posted negative returns—Israel (-13%), Greece

(-12%) and Indonesia (-1%).

 

Japanese Prime Minister Shinzo Abe unveiled a nearly $18 billion stimulus plan earmarked for child care and education.  This fiscal package comes at a time when Japan’s debt-to-GDP stands at nearly 250% and is yet another attempt in a non-stop effort to revive an economy that hasn’t produced 2% GDP growth in several years. 

 

In Germany, Angela Merkel was re-elected chancellor for a fourth term.  However, her center-right CDU party declined in parliament.  The relatively new far-right party, AfD, which has been very critical of Merkel’s refugee policy, gained ascendancy.

 

Overall, markets were unaffected by the escalating discourse between North Korea and the U.S.  Rockets were launched, militaristic rhetoric increased, and tweets flew while risk assets whistled their way to new highs.  The MSCI South Korea Index gained 3% in the quarter and is up 32% for the year. 

 

LOOK AHEAD

As we look toward the final quarter of 2017, we are especially interested in evolving economic policies, including an increase in U.S. Treasury supply alongside a potential rate hike and the start of quantitative tightening.  We are also intrigued by Amazon’s decision to open a second headquarters and the resulting economic impact on the chosen city and region.

 

In closing, we want to express our concern and support for the people of Las Vegas, Puerto Rico, Houston, Florida, and everywhere else struck by trauma in the past several weeks.

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