The third quarter of 2017 was newsworthy on many fronts. We witnessed striking natural events including a total solar eclipse, three major hurricanes, and widespread wildfires in the western U.S. Geopolitical and domestic affairs were also unsettled during the quarter with increasing antagonism between the leaders of North Korea and the U.S., political divisiveness surrounding health care and tax reform, and racial violence in Charlottesville, all of which created elevated levels of anxiety.
The most stable area to report was the stock market, which exhibited remarkably low volatility and continued to rise despite the headlines. Bonds were also relatively stable for the quarter, resulting in positive returns for most investors with exposure to these asset classes.
Stocks positive for another Quarter
The major U.S. stock indices ended the quarter strong, with the S&P 500 large cap index rising 4.5% including dividends, its eighth consecutive quarterly gain, and the small cap Russell 2000 index gaining 5.7%. The S&P 500 closed the quarter at a record high and has now risen over 14% in 2017. Stocks have continued to hit new highs in part due to positive economic growth in the U.S. (GDP rose 3.1% in the second quarter), and solid earnings growth, with U.S. companies posting their highest profit growth in six years. Persistently low interest rates, inflation and unemployment have also benefited U.S. stocks.
International Stocks reflect global growth
For the first time since the great recession, we are seeing coordinated signs of economic growth patterns around the world. According to a report from Blackrock examining global manufacturing trends, roughly ¾ of countries around the world are experiencing economic expansion, all of the economies in the euro zone are improving, and Eurozone consumer sentiment has hit a 16-year high.
International stock returns have reflected this spirit of growth, as developed and emerging markets gained 5.4% and 7.9% respectively for the third quarter, as measured by the MSCI EAFE and emerging markets indices.
International stocks have also outperformed U.S. stocks so far in 2017, with developed and emerging markets indices gaining 20% and 28% respectively for the year, versus 14% for the S&P 500. Much of that performance has been driven by global growth trends noted earlier. Additionally, an over 8% decline in the dollar this year has boosted returns on foreign assets held by U.S. investors.
We are optimistic that the benefits of international diversification will continue. Valuations and dividend yields appear more compelling: Foreign stocks, as represented by the ACWI ex-US index, are trading at more attractive valuation measures than long term averages (14.2x P/E versus 20-year averages of 14.6x) and are also paying higher dividend yield (currently 3.1% vs. a long-term average of 3.0%). The S&P 500 Index is trading at more expensive valuations (currently at 17.7x earnings versus a 20-year average of 16.0x) with a lower yield of 2.1%.*
In terms of real assets, U.S. real estate investment trusts (REITs) were positive, up over 1% for the quarter, while global real estate gained almost 2%, reflecting strength in many overseas residential and commercial real estate markets. Commodities were also positive as energy and gold prices rose during the quarter.
Fixed Income Stable
The third quarter was relatively quiet in the fixed income arena. Short term bond yields ticked up slightly as the Federal Reserve confirmed they would start to unwind their balance sheet by trimming their bond purchases, also keeping open the possibility that they would raise interest rates one more time before the end of the year. Intermediate to long term bonds were relatively unchanged.
For the quarter, investment-grade bond funds rose slightly, while high-yield fared better, gaining almost 2%. Prices on corporate and high yield debt rose with corporate earnings and economic growth as well as increased demand for higher-yielding securities.
*Source: MSCI, Standard & Poor’s, JP Morgan. Forward P/E excluding dividends.