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Q3 Market Update

Oct 10, 2018

Who’s concerned about a trade war anyway? That seems to be the U.S. equity market’s take following a robust third quarter despite another $200 billion of Chinese imports targeted for tariffs. Large-cap U.S. equities led the way as investors bored with trade tensions. International and particularly emerging market (EM) equity struggled, likely due to U.S. dollar strength driving contagion concerns in EM.

The sharp rise in the 10-year Treasury yield in the final month of the quarter detracted from long duration U.S. Treasuries and subdued the fixed income market overall despite a better credit performance.

Below, we break down the market’s performances in Q3 and the first nine months of the year.

Equity indexes: U.S. large-cap accelerates

The trade rhetoric persisted, but the ongoing spat between the U.S. and China moving to the background helped large caps propel the three major U.S. market indexes to new all-time highs. The Dow Jones Industrial Average Index outpaced the S&P 500 Index and the NASDAQ Composite Index.

The S&P 500 Index had a total return of 7.71%, bringing its return for the first nine months of the year to 10.56%. Abroad, the MSCI World ex USA NR USD Index returned 1.31% in Q3 to take its nine-month haul to -1.50%. The MSCI Emerging Market (EM) NR USD Index stabilized somewhat, declining only 1.09% to take its nine-month return to -7.68%.

Leadership between small and large caps shifted early in the quarter, with the Russell 1000 Index’s 7.42% total return more than doubling the Russell 2000 Index’s 3.58%. Small caps beat large caps in the first half due to their domestic focus, and thus less direct exposure to trade uncertainties.

During Q3, the gulf between Growth and Value was wide among large and small-cap stocks. Reverting back to late 2017 trends, the top performing segments from a size and style perspective were the Russell 1000 Growth Index (+9.17%), followed by the Russell 1000 Value Index (+5.70%), the Russell 2000 Growth Index (+5.52%) and the Russell 2000 Value Index (+1.60%).

For the first three quarters, Growth took the lead with the Russell 1000 Growth Index (+17.09%) and the Russell 2000 Growth Index (+15.76%) being the top performing segments. The Russell 2000 Value Index (+7.14%) and the Russell 1000 Value Index (+3.92%) followed.

U.S. sectors: GICS changes affected Q3 performance

Positive sector performance across the board highlighted Q3. But the Global Industry Classification Standard (GICS) sector changes that went into effect on Friday, September 21, and the portfolio rebalancing in the run-up to it, took the spotlight.

Within the S&P 500 Index, Health Care (+14.53%), Industrials (+10.00%), and Communication Services (+9.94%) topped sector performances in Q3, followed by Information Technology (+8.80%) and Consumer Discretionary (+8.18%).

Health Care had its best quarter in five years despite being in the political crosshairs, namely the approaching mid-term elections. Pharmaceuticals, the sector’s largest industry group, shook off a weak first half and boosted performance.

The timing of the GICS sector change benefitted the new Communication Services sector, as well as solid performances from the core telecommunication companies. Simple investor intrigue in the revamped sector may have played a role too. During the first half, ETFs within the Communication Services sector had inflows that increased assets by 14%. In Q3, these inflows increased exponentially with assets up 10-11% per month during July and August while rising 58% in September.

Industrials’ robust performance was broad-based with 73.2% of the sector returning in excess of 10%, when viewed by industry group; that is up from zero in the first half. The sector benefitted from the easing of trade conflict concerns and tariffs starting to target other sectors.

A shift in tariff tactics seemed to weigh on the Information Technology (IT) and Consumer Discretionary sectors in Q3. Until now, they have been relatively insulated from the $50 billion worth of tariffs implemented thus far, while Industrials have borne the brunt. However, the proposed tariffs on an additional $200 billion worth of Chinese imports are likely to affect consumer goods, including furniture, handbags and computer parts.

The GICS changes affected these segments too. Some of the “growthier” segments of IT moved to the Communication Services sector while the Consumer Discretionary sector became a more concentrated play on online retail. This quarter, one internet-based company accounted for more than half the return in Consumer Discretionary. Weakness in the Internet and semiconductor industries detracted the most from IT. Auto manufacturing was the weakest segment of Consumer Discretionary.

Materials (+0.36%), Energy (+0.61%), Real Estate (+0.86%) and Utilities (+2.39%) had the weakest quarters.

Materials slipped in Q3’s final weeks after analysts downgraded several large chemical companies following lower-than-expected commodity earnings. Additionally, agricultural tariffs dampened expected demand for crop chemical products and dented Materials’ chemicals groups.

Energy performed basically in line with the movement in crude oil prices. After rallying in the first half of the year, West Texas Intermediate (WTI) Crude had a softer first two months of the quarter but improved in September.

Rising yields detracted from bond proxy sectors such as Real Estate, Utilities and Consumer Staples.

During the first nine months of the year, Consumer Discretionary (+20.62%), Information Technology (+20.62%), Health Care (+16.63%), and Energy (+7.46%) led the way. Consumer Staples (-3.35%), Materials (-2.73%), Financials (+0.09%), Communication Services (+0.75%), Real Estate (+1.67%), Utilities (+2.72%), and Industrials (+4.84%) performed the worst.

Fixed income: Duration went unrewarded while credit showed strength

Fixed income remained subdued. The Bloomberg Barclays U.S. Aggregate Bond Index returned +0.02% in Q3 to take the 2018’s nine-month performance to -1.60%. The 10-year U.S. Treasury’s up and down ride continued; the yield on the 10-year Treasury started the year at 2.4%, ended Q1 at 2.74%, breached the psychological 3% level in mid-Q2 before ending that quarter at 2.85%, and then rallied back above 3% in September to end Q3 at 3.05%.

Year-to-date the spread between the 10-year and the 2-year U.S. Treasury yield has been on a downward trajectory after spiking in early February. It started the year at 0.51%, ended Q1 at 0.47%, retreated to 0.33% at the end of Q2, and ended Q3 at 0.24%. Notably, EM contagion concerns reduced the spread to a low of 0.18% in August before the slight rise at the end of the quarter. Despite this spread contraction, short duration U.S. Treasuries outperformed intermediate and long duration due to the rapid increase in the 10-year Treasury yield in the quarter’s final month.

U.S. Corporates, and the High Yield segment in particular, had a strong Q3. The ICE BofAML U.S. Cash Pay High Yield Index rose 2.42% and the ICE BofAML U.S. Corporates Index increased 0.95%, driven by the improved Corporate spread over Treasuries and lower credit default swap spreads.

The spread between the yield on Investment Grade Corporate bonds and the 10-year Treasury, as measured by the U.S. Corporate BBB/Baa 10-year Treasury Index, decreased from 1.64% at the end of Q2 to 1.47% at the end of Q3. More subdued U.S. equity market volatility contributed to the high yield credit default swap spread, as measured by the Markit CDX North America High Yield Index, contracting from 361.15 basis points (bps) at the end of Q2 to 331.01 bps at the end of Q3.

Variable Rate Preferreds had a strong quarter with the S&P U.S. Variable Rate Preferred Stock TR Index returning 0.93%. Fixed Rate Preferreds were more subdued with the ICE BofAML Fixed Rate Preferred Securities Index returning 0.18%.

Emerging market debt was both one of the weakest and one of the strongest fixed income categories during Q3. U.S. Dollar Denominated EM debt (ICE BofAML BBB & Lower Sovereign USD External Debt Index) returned 2.33% while Local Currency Denominated EM debt (ICE BofAML Local Debt Markets Plus Index) returned -1.11%. EM contagion concerns that adversely affected EM currency markets in August spoke for the substantial discrepancy in performance between the local currency and U.S. dollar denominated EM debt. These currencies stabilized and started to regain traction in the final weeks of Q3.

Year-to-date, High Yield Municipals (ICE BofAML US Municipal High Yield Securities Index, +6.91%), High Yield U.S. Corporates (+2.48%), and Variable Rate Preferreds (+1.59%) were the top performing fixed income segments. Local Currency Denominated EM Debt (-6.70%), Long-Duration U.S. Treasury (ICE U.S. Treasury 20+ Year Bond Index, -5.92%) and U.S. Dollar Denominated EM Debt (-3.81%) were the weakest during the first nine month of 2018.

All data sourced from Bloomberg

Definitions

S&P 500 Total Return Index: The index includes 500 leading U.S. companies and captures approximately 80% coverage of available market capitalization.

Dow Jones Industrial Average Index: Is a price-weighted measure of 30 U.S. blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928. The index covers all industries except transportation and utilities.

Nasdaq Composite Index: Is a broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market.

MSCI World ex USA Net Total Return Index: The index captures large and mid cap representation across 22 of 23 Developed Markets countries –excluding the United States. With 1,017 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

MSCI Emerging Markets Net Total Return Index: The index captures large and mid cap representation across 24 emerging market countries. With 845 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

Russell 1000 Total Return Index: Consists of the largest 1000 companies in the Russell 3000 Index. This index represents the universe of large capitalization stocks from which most active money managers typically select.

Russell 2000 Total Return Index: Consists of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization.

Russell 1000 Growth Index: The index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.

Russell 1000 Value Index: The index measures the performance of those Russell 1000 companies with lowest price-to-book ratios and lowest forecasted growth values.

Russell 2000 Value Total Return Index: The index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.

Russell 2000 Growth Total Return Index: The index measures the performance of those Russell 2000 companies with highest price-to-book ratios and highest forecasted growth values.

The Russell 3000 Index: A capitalization-weighted stock market index, maintained by FTSE Russell that seeks to be a benchmark of the entire U.S stock market. It measures the performance of the 3,000 largest publicly held companies incorporated in America as measured by total market capitalization.

Bloomberg West Texas Intermediate (WTI) Cushing Crude Oil Spot Price Index: Designed to track the spot price of WTI.

Duration: Is a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates. Duration is expressed in years.

Bloomberg Barclays U.S. Aggregate Bond Index: The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-through), ABS and CMBS (agency and non-agency).

U.S. Corporate BBB/Baa 10-year Treasury Index: This is a Bloomberg provided spread index of the difference in yield between the U.S. Corporate BBB/Baa Index and the yield on 10-year Treasuries.

U.S. Corporate BBB/Baa Index: This is a Bloomberg provided yield index that is constructed daily using USD denominated senior unsecured fixed rate bonds issued by U.S. companies that have a Bloomberg composite rating of BBB/Baa.

Credit default swap: These are financial contracts used to mitigate the possibility of loss arising from default by the issuer of the bonds. As the probability of default increases, the premium rises. Similarly, as investor sentiment improves, or equity market volatility subsides, these spreads improve. An increase /decrease in the swap rate will put downward/upward pressure on the underlying bond index.

Markit CDX North America High Yield Index: This index tracks the credit default spread on 100 non-investment grade entities that are domiciled in North America.

Basis point: A basis point is a hundredth of one percent. It is predominantly used to express differences in interest rates.

ICE BofAML U.S. Cash Pay High Yield Index: This index tracks the performance of U.S. dollar denominated below investment grade corporate debt, currently in a coupon paying period, that is publicly issued in the U.S. domestic market.

ICE BofAML U.S. Corporate Index: This index tracks the performance of U.S. dollar denominated investment grade corporate debt with an outstanding value greater than $250 million that is publicly issued in the U.S. domestic market.

S&P U.S. Variable Rate Preferred Stock TR Index: This index comprises of preferred stocks that pay dividends at a variable rate. Variable rate preferred stocks pay a fixed dividend for a period until a trigger date is reached, at which point the dividend rate floats at a spread to a specified benchmark rate.

ICE BofAML Fixed Rate Preferred Securities Index: This index tracks the performance of fixed rate, U.S. dollar denominated, investment-grade exchange-traded preferred securities ($25 par) with outstanding market values of at least $100 million issued in the U.S. domestic market.

ICE BofAML BBB & Lower Sovereign USD External Debt Index: This index tracks the performance of U.S. dollar denominated emerging market and cross-over sovereign debt publicly issued in the Eurobond or U.S. domestic market.

ICE BofAML Local Debt Markets Plus Index: This index tracks the performance of emerging markets sovereign debt publicly issued and denominated in the issuer’s own currency.

ICE BofAML US Municipal High Yield Securities Index: This index tracks the performance of U.S. dollar denominated below investment grade tax-exempt debt publicly issued by U.S. states and territories in the U.S. domestic market.

ICE U.S. Treasury 20+ Year Bond Index: This index is part of a series of indices intended to assess U.S. Treasury issued debt. Only U.S. dollar denominated, fixed rate securities with a term to maturity greater than twenty years are included.

Category: Commentary

Topics: Macroeconomic

Q3 Market Update

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