3rd Quarter 2019
While market returns were muted in the third quarter, unexpected developments and jolting headlines were more than plentiful. A condensed list of these developments includes – a further escalation in China trade tensions with additional tariff increases, the Federal Reserve cutting interest rates for the first time in over a decade, additional “inversions” across the yield curve, and a formal impeachment inquiry launched against President Trump.
Despite several bouts of volatility, the S&P 500 Index advanced by 1.2% and closed out the third quarter less than 2% from all-time highs. Domestic stocks continued the procession of outperformance versus other global indices. International stocks (MSCI EAFE Index) posted a decline of 1.7%, and global stocks (MSCI All-Country World Index) slipped by 0.2%.
Bond performance was strong and consistent with the first half of 2019. The Barclays U.S. Aggregate Bond Index registered a 2.3% return in the third quarter, bringing the year-to-date gain to 8.5%. Fixed income performance is being fueled by plummeting interest rates and the voracious demand from foreign investors flocking to higher (and positive) yields in the U.S. bond markets. While U.S. bond yields are hovering near all-time lows, they still look appealing to foreign investors that are faced with a growing universe of bonds offering negative yields in their local markets.
Below is a summary of the quarterly performance results for the major indices we review in each quarterly MarketView.
The decelerating economic growth trend continued in the third quarter. Second quarter GDP growth dropped to 2%, and early estimates for the third and fourth quarters reflect expectations for a further moderation of economic activity. The slump in global trade and manufacturing activity is increasingly affecting other economic sectors via sagging corporate profits, reduced hiring, and pullbacks in business confidence and investment.
While areas of economic weakness have expanded and are more pronounced, several important positives remain. Consumer spending remains relatively solid, we are still adding enough jobs on a monthly basis to offset new entrants to the work force, and the housing market is showing some signs of a rebound after a significant drop in mortgage rates.
Going forward, investors will be monitoring the economic environment and data points for the impact of recent monetary easing efforts from the Federal Reserve and a host of foreign central banks. And as usual, global trade developments will be of key importance as well.
There were no dramatic changes to portfolio positioning during the third quarter. A mid-point equity allocation was maintained for the entirety of the quarter. Within fixed income segments of portfolios, we slightly increased our allocation to the Pimco Income fund. We maintain a favorable view on Pimco’s multi-sector and opportunistic approach to finding value in an ultra-low interest rate environment.
Third quarter portfolio returns were solid with results better than expectations given our risk exposures. Equity positioning was the main driver of outperformance. Equity allocations are heavily skewed towards domestic, large cap stocks with a value-oriented style tilt. Third quarter results heavily favored that stance with domestic stocks outpacing international, large cap outperforming smaller company stocks and we finally saw a quarter where value stocks produced better returns than growth stocks. Equity fund performance was also a significant contributor to results and a handful of individual stocks posted impressive double-digit advances.
Evaluated through the first three quarters of 2019, our decision to eliminate dedicated foreign equity exposure last year has been beneficial given the measurable underperformance of global and international equity markets.
Fixed income results were also firmly positive and outpaced broad bond market benchmarks with similar duration or interest rate risk profiles.
The U.S. stock market has traded within a tight and well-defined range over the past six months. Declines have been moderate and met with buying interest from investors looking to take advantage of lower prices and more compelling valuations. However, on the other side of the coin, investors seem to lack the conviction to propel stocks above the top of the recent trading range. This lack of conviction is related to the host of uncertainties ranging from the political environment to economic concerns and the potential for multiple outcomes to ongoing global trade disputes. In our view, a convincing breakout to new all-time highs seems difficult without some clarity on these issues.
Fixed Income Performance in Different Environments
The dramatic decline in interest rates since November of 2018 has been a massive tailwind for fixed income performance. And as we have written about numerous times, this declining interest rate environment has been more beneficial for long maturity bonds than short maturity bonds.
The chart below illustrates the decline in the 10-year U.S. Treasury bond yield (in blue) over the past year. In this environment, fixed income strategies with higher durations or more interest rate risk will generally produce higher returns than shorter maturity strategies. This is evident by the significant outperformance of the higher duration strategy (yellow line) versus the two shorter duration strategies (gray and orange lines) shown below.
We don’t have to look back too far to find a time where holders of long maturity bonds were penalized for their elevated exposure to interest rate risk. From June of 2016 through December of 2016, 10-year U.S. Treasury bond yield (in blue) increased by roughly 65%, moving from 1.49% to 2.45%. The chart below illustrates the measurable underperformance during this period of the higher duration strategy (yellow line) versus the two shorter duration strategies (gray and orange lines).
Long maturity bonds have performed extremely well over the last twelve months with results handily exceeding our expectations. However, going forward, investors should question if these recent performance results are repeatable and how long duration strategies would perform if interest rates were to normalize to higher levels.
We maintain a relatively short duration profile in fixed income allocations and remain of the view that investors are not being compensated adequately for the inflation or interest rate risks associated with long maturity bonds.
Dividends vs. Bond yields
Using the S&P 500 Index as a proxy for stocks and the 10-year U.S. Treasury note as a proxy for bonds, we are in an environment where stocks offer higher yields than bonds. As shown by the chart below, this is a rare occurrence over the past 25 years. We view this relationship as supportive of equity markets.
Roof Advisory Group (“Roof”) is a division of Fort Pitt Capital Group, an investment advisor registered with the United States Securities and Exchange Commission (“SEC”). For a detailed discussion of Roof and its services and fees, see the Form ADV Part 1 and 2A on file with the SEC at www.adviserinfo.sec.gov. Registration with the SEC does not imply any level of skill or training. You may also visit our website at www.roofadvisory.com.
Any opinions expressed are opinions held at the time of publishing and are subject to change. It does not constitute an offer, solicitation or recommendation to purchase any security. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Past performance does not guarantee future results. The performance shown is for illustrative purposes only and the intent is to show the performance of certain segments of the fixed income markets. This information is not reflective of the performance of any Roof client, or the impact of security selection on actual client portfolios.
The S&P 500 is a broad-based index of 500 stocks, which is widely recognized as representative of the equity market in general. MSCI EAFE™ Index is designed to measure the equity performance of developed markets outside of the U.S. and Canada. The MSCI ACWI™ Index is a market-capitalization-weighted index designed to provide a broad measure of stock performance throughout the world, with the exception of U.S.-based companies. The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based index of intermediate term investment grade bonds traded in the U.S. The Bloomberg Barclays™ Municipal 1-5 Year Bond Index is a capitalization-weighted index representing the aggregate performance of the investment-grade municipal U.S. bond market. These indices are unmanaged and may represent a more diversified list of securities than those recommended by Roof. In addition, Roof may invest in securities outside of those represented in the indices. The performance of an index assumes no taxes, transaction costs, management fees or other expenses. Additional information on any index is available upon request.