Equity Market Review
The third quarter marked a change in the underlying leadership of the market advance. After furtive attempts at rotation towards value in the large and small cap space in the market overall, over the summer, we experienced a reassertion of large cap growth leadership. The difference being that, rather than companies in technology and consumer discretion, this most recent leg of the advance was led by shares of healthcare and consumer staples. These changes reflect what we are experiencing in the domestic economy, as it not only continued to expand, but accelerate, during the third quarter. This acceleration is accompanied by a slight uptick in the overall rate of inflation. Though not a major resurgence by any measure, it is enough to benefit healthcare and consumer staples whose pricing power relies heavily upon inflation. As illustrated in Exhibit 1, this has hardly been a homogenous rally for stocks, and these performance differentials have reached inflection points sparked not only by the extreme nature, but by an evolving economy. Because of this rotation, large cap stocks were once more the performance leaders in the third quarter, due in large measure to their inherent liquidity, which facilitates realignment. While, on a year-to-date basis, small cap stocks retain the top return slot, shares in the large cap segment closed the gap.
The results for global equities during the quarter reflect many of the same dynamics with the large developed markets posting roughly the same gain as that of the domestic market. The smaller emerging markets, though positive, trailed considerably for the quarter, and there was a distinct geographic bias. Asian emerging markets posted declines, while those in Europe were positive. Some of this is attributable to the impact of the strength in the value of the dollar, but a considerably larger influence on the Asian emerging markets was the impact of China’s efforts to offset the impact of trade tariffs on exports by weakening its currency.
Exhibit 1 (Source: Crandall, Pierce & Company)
Fixed Income Market Review
The interest rate climate during the third quarter was favorable for bond holders, as the term structure continued to flatten from the short end with the Federal Reserve still on track to lift short-term interest rates, and longer-dated obligations continued to enjoy strong demand. The lingering influence of the Italian market scare from the second quarter held U.S. rates in check, at below 3%, for much of the third quarter, as foreign investors hesitate to leave the perceived safety of U.S. Treasury obligations. Even with this flow of funds, you can see in Exhibit 2 that rates finished the quarter at the upper end of their twelve-month band. Bond investors also have the strength of the equity market to thank for the continued demand for longer-dated obligations. Many institutional investors have been forced to rebalance their portfolios (because of the continued rise in equities) and add to their bond holdings, thus adding to the demand. This last part has largely masked what has been a noticeable trend of falling demand for U.S. Treasury debt among foreign central banks. The volume of buying from the central banks of several developed countries has been falling recently, most notably China and Russia, but Europe and Japan have throttled back as well. The most recent Treasury auction had the lowest bid-to-cover ratio since 2008. How much longer the current rate dynamic will hold in the face of rising deficits remains to be seen, but it appears clear the interest rates will continue to gradually rise. In Exhibit 2, you can see the compressed nature of the term structure of interest rates with the yield on thirty-year Treasury bonds offering only 1% more than available on three-month Treasury Bills. This compression represents a duration risk to holders of long-dated debt obligations, one we recommend addressing by moving to shorter maturity obligations. Paramount among our concerns currently is the corporate bond market and its declining credit quality. This type of debt, particularly high yield corporates, has enjoyed strong demand as investors search for yield. Now that rates overall are rising, the growing concern is the demand that supports this market will evaporate at a time when these obligations will need to be rolled over or restructured.
Exhibit 2 (Source: Crandall, Pierce & Company)
Other Asset Classes
The impact of China’s currency operations was also evident in the pricing activity for commodities during the quarter, as most experienced modest price declines in U.S. dollar terms but rose when priced in other currencies due to the impact of the Chinese currency intervention. Securitized real estate (REITs) posted gains during the quarter, as property values continue to rise, while yields offered elsewhere have yet to reach a level that would offer an attractive alternative to income-producing real estate. Precious metal prices fell during the quarter, thanks to benign inflation measures and a dearth of compelling crises – the two general catalysts for investor migration to these traditional safe-haven assets. The derivative markets, options and futures primarily, have gotten a boost from rising short-term interest rates, but continue to suffer from a dearth of volatility. There was a brief period in February where it did spike, and unlike last year, it has remained at a slightly elevated level, but as you can see in Exhibit 3, it is still at a level indicative of complacency.
Exhibit 3 (Source: Bloomberg)
The strength of the economy and the improving trend in corporate profit margins serve as powerful backstops to the equity market. Our bias continues to be shaped by a gradually-rising interest rate environment and a late-cycle economy where business spending on productivity enhancement rather than financial engineering takes center stage. We hold that the changes in the tax code, coupled with continued uncertainties regarding global trade, favor smaller, principally domestically-focused companies over larger multinationals. Our forecast calls for slightly slower growth in 2019, and that, along with rising rates, leads us to favor stocks with stronger value traits over those whose growth expectations will come under pressure in the immediate future. Our fixed income outlook continues to be one of reducing risk wherever possible, from shortening average maturities to reducing exposure to credit risk. Conditions in the global debt market show signs of unsustainable compression, and like any spring that has been wound too tightly, abrupt catastrophic failure is a very real threat.
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Source: Unless otherwise noted, all statistics herein obtained from Bloomberg.
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