The third quarter of 2015 was one full of activity and news. Please find below a summary of the quarter’s highlights.
The S&P 500® Index of large cap US stocks returned -6.4% for the quarter, faring better than global equities. The US economy was lifted by favorable consumer spending and housing data. Small cap stocks, as measured by the Russell 2000® Index, trailed large caps with a -11.9% return on heightened volatility. In particular, energy and materials stocks were weighed down by the decline in commodity prices. The healthcare sector was also impacted as biotechnology stocks reversed some gains made over the past year. The more defensive and higher income sectors such as utilities, consumer staples, and REITs saw better relative performance as Treasury yields declined.
The MSCI EAFE® Index of international developed stocks trailed US stocks with a -10.2% return for the quarter, with Asia and Europe both more sensitive to recent developments in China. Japan saw larger declines among the developed regions with recent economic weakness expected to continue into the third quarter, and potential for a recession. In Europe, low inflation readings suggested that the quantitative easing program may need to be extended past 2016. Emerging markets saw a sharper decline with countries impacted by the slowdown in China, lower commodity prices, and depreciating currencies.
In fixed income, the Barclays US Aggregate Bond Index returned 1.2% during the quarter. Longer-term bonds benefited as bond yields declined, amid global growth worries and with the Federal Reserve delaying a potential move to raise interest rates. Higher quality bonds outperformed the more credit-sensitive sectors with larger gains seen in government and municipal bonds. High yield bonds declined as credit spreads widened, with investors more cautious about the global economy. International developed market bonds rose on lower bond yields, while emerging market bonds were weighed down by slower economic growth and depreciation in currencies.
US economic activity expanded during the second quarter of 2015 with a GDP reading of 3.9%, up from 0.6% in the first quarter. The economy was lifted by consumer spending, higher state and local government expenditures, as well as a rebound in exports. The Federal Reserve of Atlanta forecasted that third quarter GDP will moderate to 0.9%, with recent declines in consumer sentiment and data pointing to slower growth in the service sector. In addition, inventory buildup and the impact of the stronger dollar, although temporary, could also weigh on economic growth.
The Federal Reserve chose to not raise short-term interest rates at the much anticipated September FOMC meeting. While highlighting an improved employment picture, the committee suggested that recent global economic developments could put downward pressure on inflation. The unemployment rate declined to 5.1% in August, near the level the committee estimates for “maximum employment”, but the lack of wage growth remains a concern. The Consumer Price Index (CPI) Inflation rate rose 0.2% for the 12-month period through August, while core inflation was up 1.8% — below the Fed’s preferred 2.0% level.
There was considerable attention paid to the September FOMC meeting, with many market observers surprised by the Federal Reserve’s decision to not raise interest rates. The probability for a rate hike this year continues to diminish, with recent futures prices now only indicating a 31% chance of a rate increase by year-end. Given there is no press conference scheduled for the October meeting, this leaves December as the most likely opportunity for the Federal Reserve to move during 2015. A key factor that could weigh into the Fed’s decision is the market’s view that low inflation levels could persist over an extended period.
Corporate earnings for S&P 500 companies are expected to decline by 5.1% in the third quarter, compared to a year ago. Much of this is due to an estimated 65% earnings decline in the energy sector. This would mark two consecutive quarters of earnings declines – the first time this has occurred since 2009. However, when excluding energy companies, earnings are expected to increase by 2.3%, led by 18% and 10% respective increases in the telecom and consumer discretionary sectors. Looking ahead, the headwinds of a strengthening US dollar and impact on exports could potentially diminish, while improving the prospects for globally-oriented companies.
Increased market uncertainty can often translate to additional investment opportunities. On the equity side, there is growing disparity in valuations across US and international markets, particularly emerging market countries. In fixed income, credit spreads on high yield bonds widened considerably, creating potential attractive yield opportunities for income-oriented strategies and selective managers. Finally, alternative strategies such as managed futures demonstrated their value as portfolio diversifiers with the recent spikes in volatility. This suggests maintaining a diversified portfolio with core equity and fixed income exposures, complemented with allocations to tactical and other diversifying strategies.
2- Source: MSCI Inc.
3- Source: Bureau of Economic Analysis