Somewhat counterintuitively, the third quarter was characterized by the lowest volatility we’ve seen in a while. Following the “Brexit” vote at the end of the second quarter, markets stabilized and continued to march higher. Second quarter earnings (reported during the third quarter) were mainly favorable which reinforced the narrative that the economy continues its slow growth trajectory. The Federal Reserve met last month and decided to keep interest rates unchanged, citing that “the economy has a little more room to run than might have been previously thought.” The net result is a stock market setting all-time highs and a continued guessing game in regards to the path of interest rates.
Approximately 70% of U.S. GDP is tied to consumption. Accordingly, real consumption and real income (“real” denotes an adjustment for inflation) are two important statistics we track. The most recent August figures were below expectations on both fronts; consumption shrank marginally and incomes showed zero month-over-month growth. The recent period has exemplified slowing income growth coupled with an increase in the savings rate, the impact of which lead to negative 3rd quarter GDP expectations. Current GDP estimates reside in the 2.5% to 3.0% range.
While short term economic growth is hampered by the lack of spending, it does mean that the average American’s balance sheet is healthier. One fallout of the Great Recession is that Americans have reduced household debt. At the end of the first quarter, household debt as a percent of GDP stood at 80%. That same ratio in the first quarter of 2008 was 99%. While GDP growth has rebounded since 2008, the U.S. economy hasn’t hit “max speed” as consumers have tempered spending and increased savings. Should that disposition change, the U.S. economy just might hit a higher gear that everyone (particularly the Fed) has been hoping for. In the meantime, we will take a slower growth economy if it means consumers continue to strengthen their balance sheet which bodes well for the longer term health of the economy. The optimal situation is economic expansion through increased income.
On the employment front, the job market has recently been a disappointment with slower job growth and shrinking hours worked. Employment growth has been relatively stable during the recovery, averaging about 2.1% since 2011. More recently it has slowed with year-over-year employment dropping from 2.3% last August to 1.9% this August. While these are small changes, rising employment and incomes drive consumption and therefore GDP. Employment weakness appears to be one factor holding the Fed back from raising rates.
For the third quarter of 2016, the S&P 500 posted a positive 3.9% return. Year-to-date, the S&P 500 is now up 7.8%. Domestic equities have outperformed International Developed markets, which are up only 2.2% for the year, even after a strong 6.5% rally during the third quarter.
Seven of the ten S&P 500 sectors posted positive results during the third quarter. As mentioned last quarter, Real Estate has been split out from the Financials sector, making it the eleventh sector but performance tracking will not begin until the fourth quarter. In a bit of a “reversal of fortunes” from what we saw during the first two quarters of 2016, the higher dividend yielding areas of the market were the worst performers during Q3. Utilities (down 5.9%), Telecommunications (down 5.6%), and Consumer Staples (down 2.6%), were the three worst performing sectors and the only ones in negative territory. Technology (up 12.9%) was the best performing sector during Q3 after being the worst performing sector in Q2. Year-to-Date, Utilities (up 16.1%) and Telecommunications (up 17.9%) are still two of the best performing sectors of the market, along with Energy (up 18.7%).
The chart below shows the main reason why dividend-heavy sectors underperformed during the quarter. The yield on the 10-year Treasury rose from around 1.4% to 1.6% to close the quarter. These aforementioned sectors are often considered “bond proxies” for their steady and reliable dividends, but typically underperform in a rising interest rate environment. With this relationship in mind, the Dividend strategy we employ was designed to behave more like the S&P 500 as opposed to the bond market.
The Energy sector continues to recover from the rout experienced in 2015. As global supply and demand work towards rebalancing, prices have moved higher. In addition, OPEC members have recently begun tangible discussions regarding freezing and potentially cutting oil production to rebalance markets. OPEC is responsible for over one third of the world’s oil production and member nations have been increasing production even while oil prices have been falling. In the U.S. however, production has fallen from a peak of 9.7M barrels per day in April-2015 to 8.5M barrels per day currently. Oil inventories around the world are still at surplus levels, so for prices to move higher in the near term a production cut or increased demand would need to occur.
During Q3 we experienced a change in equity market leadership. With the upcoming election cycle and earnings season, we would expect to see more volatility in Q4. Notable, however, U.S. equity valuations as a group are not what we would consider egregious. According to FactSet Research, the 12-month forward P/E ratio for the S&P 500 is 16.6x, which is just above long-term averages. As in all market environments, we continue to focus on long-term business fundamentals and investing in quality companies selling below fair value, across all market sectors.
As stocks set new highs, bond volatility increased as fixed income investors continue to grapple with the mixed signals coming from the Federal Reserve and Central Banks overseas. After setting a low yield of 1.36% on July 8th, the U.S. Ten Year note sold off to a 1.7% in early September, rallied back to 1.55% after the Fed did not raise rates on September 21st, only to sell off again to 1.7% in early October in anticipation of a future Fed hike. While these moves in yield are not large in nominal terms, it does have several percentage points of impact on the price of bonds. Clearly the bond market is searching for direction.
It does not appear the Fed has any economic justification for holding rates at current crisis levels, which is one of the reasons why bonds reprice after the Fed delays the tightening process. The Chart to the right shows that the Federal Funds rate, in real terms, is negative and has been for some time. The Consumer Price index is represented at a 1% annual run rate below, however after you strip Food and Energy the index was actually up 2.3% year-over-year; above the stated Fed target. Employment continues to grow, and the Unemployment rate is running sub 5% nationally. While we have mentioned that we continue along the slow growth path, and we realize wage gains are not as robust as we would hope, we do not believe monetary policy should remain so accommodative.
Even considering this volatility, the taxable fixed income market overall barely moved, returning 0.4% for the quarter as represented by the Barclay’s U.S. Aggregate index. However this gain has been erased in the first week of October as volatility continues into the next Employment report, normally the first Friday of the month, and the next Federal Reserve meeting. We hate to sound like a broken record but our domestic bond market is being driven by the actions of the Federal Reserve, inflation expectations as a result, and the presence of negative interest rates overseas. We do not see a sustained move in yields, in either direction, until these uncertainties abate. With this as a back drop we are investing in Agency Step-up callable bonds and Taxable municipal bullet structures.
The tax free municipal market was slightly negative for the quarter, down 0.3% as represented by the Barclays Municipal Bond Index. Yield spreads relative to U.S. Treasury bonds are favorable, and have been widening, as can be seen below. Tax free bonds can be purchased over 100% of the Treasury equivalent, showing value for any investor that has an income tax bracket or is concerned about higher tax rates. New issuance is oversubscribed in the primary markets; in some cases over 10 times (meaning a municipal issuer had 10 times the amount of bonds being issued). We view this as an indication of robust demand for tax free securities. The secondary market is relatively expensive at current levels. Credit quality remains our top focus, followed by yield curve positioning. We continue to invest in above market coupons with longer term final maturities with intermediate call dates, and typically AA rated or higher issuers.
Last year at this time we were discussing the possibilities of a recession. As we entered the year the market feared the worst, sending stock prices lower the first 6 weeks of the year. No recession appeared and we recovered strongly into June only to be hit by the “Brexit” vote that stunned markets and drove them lower – but only for a short time. This is how markets operate – short term reactions eventually tempered by more long term fundamentals. Once again we head into more uncharted territory with the presidential election. Once more we think the effects of the election will be short lived and then fundamentals will drive the markets. It is the fundamentals we struggle to ascertain but as we look ahead from here, we continue to see a lot of what we’ve seen over the last 7 years – slow growth, concerns over the impotence of central banks to increase economic growth and large amounts of sovereign debt. We do not see a lot of these factors changing quickly, but in spite of these headwinds, investors have benefited. We are cautiously optimistic this can continue no matter who wins the presidency.
 Source: Robert Johnson, Economist for Morningstar