November 11, 2016
Monthly Market Summary – October 2016
One of the major news items in financial markets during October was that a sell-off in global bonds pushed yields up. Better economic data and expectations of less accommodative monetary policies sparked the sell-off. In the U.S., the 10-year Treasury bond traded as high as 1.85% which was back to levels in June before the vote in the United Kingdom (UK) to leave the European Union (Brexit). Yields in Germany, Japan, and the UK also moved higher. Significantly, the German 10-year bond yield moved back above 0% after the European Central Bank (ECB) did not announce an extension of its asset purchase program after its October meeting. The story in global equity markets was a return to “risk-off” sentiment. The result was generally lower equity prices. Earnings reports, higher yields, potential changes in global monetary policy, and the spotlight on healthcare pricing issues had the most significant impact on sector returns. Continued improvements in country fundamentals and capital in-flows resulted in emerging market equities outperforming developed market equities.
Market Indices – October 2016
Much of the economic news reported during October showed improving conditions and many reports came in better than expected. For example, in the U.S., third quarter gross domestic product (GDP) growth was 2.9%, which was much higher than the second quarter growth of 1.4%. Both the Institute for Supply Management (ISM) manufacturing and non-manufacturing indices were higher than the previous month and were above expectations. The non-manufacturing index posted the largest month over month increase on record. Retail sales were up 0.6% and industrial production grew 0.1% after both declined the previous month. The UK reported the first post-Brexit GDP number. Third quarter UK GDP grew 0.5% which was better than expected even though it was lower than second quarter GDP growth of 0.7%. The eurozone industrial production report showed a 1.6% gain, which was higher than forecasted. China’s year-over-year GDP growth was in line with expectations at 6.7%. China’s consumer and producer inflation measures were both ahead of expectations which moderated concerns about a hard landing in that economy.
The third quarter corporate earnings reporting season has been better than many analysts forecast. According to Standard and Poor’s, 73% of companies in the S&P 500 index that have reported had earnings that beat analysts’ estimates. Many earnings reports from European companies have also been higher than analysts’ estimates.
U.S. equity markets trended lower during October. Each of the equity indices we track had a negative return for the month. After being the performance leader for the previous three months, small company stocks had the largest declines. The Russell 2000® index of small capitalization (cap) stocks had a return of -4.8% compared to returns of -3.2% and -1.8% for the Russell MidCap® and S&P 500 indices respectively. Value stocks outperformed growth stocks in each market cap category due in large part to the sizeable negative returns for healthcare stocks. Looking at the S&P 500 index, only 2 of the 11 sectors had a positive return. The financials sector was up 2.3% and the utilities sector gained 0.9%. Financials gained on expectations for higher interest rates with the Federal Reserve (Fed) expected to raise its policy rate in December. Higher interest rates are a benefit to financial company margins. Utilities gained on safe haven trading as higher risk sectors sold off. Healthcare had the weakest return of -6.5%. This sector continues to be pressured by product pricing issues. News about the sizeable price increases for Affordable Care Act (Obamacare) polices also hurt the sector. Real estate was another sector that posted a large decline of -5.5%. Real estate stocks were hurt by the prospect of higher interest rates raising funding costs.
International equity market results were mixed. The MSCI Emerging Markets (EM) index had a small positive return, while the MSCI EAFE index of developed international market equities had a negative return. The EM index return was 0.2%. Within the EM index Latin America continued to post the strongest returns. Brazil had another double-digit gain of 14%. Chile was up 8% and Mexico gained 5%. Emerging Europe also had a positive return whereas emerging Asia had a small negative return. The EAFE index had a return of -2.1%. Europe had the weakest return hurt by declines of 5% or more by the UK, Ireland, and various Scandinavian country indices. The Pacific ex Japan index also had a negative return for October. Japan had a small gain boosted by the weaker yen.
For the third consecutive month, the Bloomberg Barclays U.S. Aggregate Bond index had a negative return. The index return was -0.8%. Bond prices traded lower during the month on expectations that the Fed would raise its Fed funds rate in December. The 10-year Treasury closed the month with a yield of 1.84% up from 1.60% at the end of September, but still lower than the 2015 year-end yield of 2.27%. Yields on corporate, mortgage-backed, and municipal bonds also rose as bond prices declined. Bonds with a longer time to maturity had larger price declines than shorter maturity bonds. High yield bonds were the top performing sector as the higher income offset price declines. However, the Bloomberg Barclays U.S. Corporate High Yield bond index posted only a small gain of 0.4%.
The Bloomberg Commodity index had a return for October of -0.5%. During the month the price of West Texas Intermediate oil hit a 15-month high of $51.60 per barrel but then traded lower to close October at $46.86. The October closing price was down from the September close of $48.24 on concerns about the ability of the Organization of Petroleum Exporting Countries (OPEC) to reach agreement on production limits. Gold was down 3% for the month and silver declined 8%. However, industrial metals prices moved higher. Agriculture prices were sharply higher.
Vogel Consulting, LLC (Vogel) Tactical Recommendations
One change was made to our tactical asset allocation recommendations. The developed international equity recommendation was changed to underweight from equal weight. The uncertainty surrounding Europe in particular, but also Japan, due to Brexit, several important elections, and concerns about whether central banks may be reaching the limits of stimulus raise the probability of heightened volatility in financial markets in those regions. In addition, the outlook for economic growth in developed international countries is muted despite various stimulus measures.
We continue to recommend an equal weight position in U.S. large-cap, mid-cap, and small-cap stocks as well as emerging market equities. We continue to recommend an equal weight to hedge fund strategies. We favor hedge fund strategies over fixed income for the lower expected volatility portion of portfolios since bond yields are near historically low levels and are likely to rise and bond prices fall as central bank polices are adjusted. Our fixed income recommendation is to underweight this sector and to maintain a focus on short to intermediate term bonds. Non-Treasury bonds are favored for the yield advantage they provide compared to Treasury bonds. Since our expectation is for a moderate rate of inflation to continue, we recommend an equal weight to real assets. Finally, since we expect that financial markets will experience periods of wide swings up and down in reaction to changes in expectations to Federal Reserve interest rate policy, oil prices, economic data reports, and political news, we continue to recommend using periods of market strength to raise any cash needed to support spending needs over the coming 12-24 months.
The statistical information contained in this commentary has been compiled from publicly available sources and is presented to you for your review and for discussion purposes only. The information contained in this commentary represents the opinion of the author(s) as of its date and is subject to change at any time due to market or economic conditions. These comments do not constitute a recommendation to purchase, sell or hold any security, and should not be construed as investment advice or to predict future performance. Past performance does not guarantee future results.
The statistical information contained in this commentary was derived from sources that Vogel Consulting, LLC believes are reliable, and such information has not been independently verified by Vogel. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of the Russell Investment Group. An index is not managed and is unavailable for direct investment.