By Bernie Williams, Chief Investments Officer, USAA Investment Solutions
The third quarter for equity markets was similar to the two quarters that preceded it in 2016 – a long stretch of relative calm interrupted by brief bouts of volatility.
As a result, U.S. equities and international developed markets quickly moved past the tempest created by Britain’s vote in late June to leave the European Union. Despite concerns about valuations, the Standard & Poor’s 500 index hit a new all-time high in August, the first time that’s happened in more than a year. Even better results were posted by emerging markets, which are benefiting from improving economies and stable currencies.
In the bond market, the trend of falling yields from January through June gave way to a modest rise in the most recent three months, but credit still generated positive returns as spreads continued to tighten. High yield had a very strong quarter as fears about the energy sector waned.
THE DOMINANT FED: For both asset classes, the Federal Reserve was at the center of the price action. When it appeared that the Fed might increase interest rates in September, both stocks and bonds sold off. When the Fed chose to push back any rate hike, markets quickly recovered most of the ground they lost. This has long been the behavior pattern.
The Fed’s November meeting comes days before the 2016 general election, so it’s hard to see anything happening then. It is more likely to raise short-term rates in December, a full year after its initial 0.25% increase during this very slow tightening cycle. We expect that move, whether it’s in December or later, to cause some volatility.
What’s more important than when the Fed chooses to act is how quickly short-term rates rise and how longer-term rates respond. A flattening yield curve — the long end falls as the short end rises — would indicate market worries about an economic slowdown. For our part, we think the odds are low that a recession will occur during the next 12 months.
During the quarter, we saw more of a rotation in U.S. equities, with investors selling more defensive, bond-like stocks — utilities, telecom and consumer staples, whose valuations have become quite rich — and buying more cyclical companies in the industrial and financial sectors in response to good economic data. The Fed’s policy action could impact whether this rotation continues.
POLITICS AND MARKETS: Another potential source of volatility in the fourth quarter is the November presidential election between major party candidates who generate a lot of passion, both among their supporters and their detractors. The markets are clearly trying to discern which of them might be better for asset values; stocks in particular were shaken in September by reports of a tightening race.
Both major-party candidates are touting infrastructure, both to upgrade our roads, bridges and other public assets and as a fiscal stimulus for the economy. Infrastructure makes good political sense — it’s easy to visualize and the spending would create good jobs across the country. We think this could give the economy a short-term lift assuming it comes as a concentrated push, as opposed to a trickle over many years.
AN EARNINGS COMEBACK? Third-quarter earnings for the S&P 500 are expected to shrink more than 2% compared to the third quarter of 2015, according to the financial data firm FactSet. If the forecast is correct, it would mark a sixth straight quarter of negative earnings growth.
FactSet’s early outlook is much better for 4Q — earnings growth of nearly 6% and revenue growth above 5% — and the expectations grow even higher for 2017. This is promising news for a stock index trading well above its five- and 10-year averages.
There’s a tendency for early earnings forecasts to be overly optimistic. We’d feel more comfortable if there was a clear catalyst to drive revenue and earnings. One thing that could fill that void is an economy that surpasses the modest growth expectations for the second half of 2016 — this could be a sign of improving conditions that could carry into next year.
The UMP portfolios in general made a strong showing versus their benchmarks in the third quarter.
A key contributor to the performance was an increase in our tactical allocation to emerging markets in May. On both the equity and the debt side, EMs have benefited from the Fed’s hesitancy to move on rates because this is keeping a lid on the U.S. dollar. Many EMs, most notably Russia and Brazil, rely on commodity exports that are priced in dollars, so a weaker dollar tends to support demand.
Also helping was our strategic overweight to high yield, one of the best-performing asset groups in 2016 (+6.2% in 3Q, +16.2% YTD). High yield has been driven in large part by high demand among income-minded investors, and by an easing in the default concerns facing energy-related issuers as the price of oil has risen.
In September, we trimmed our exposure to intermediate-term, investment-grade corporate debt in order to add to our U.S. large cap allocation. This rotation detracted slightly from performance through quarter-end.
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This material is provided for informational purposes only.
The Benchmarks & Major Markets Performance Scorecard is presented to you for informational purposes only and provides return information for the asset classes underlying your UMP model, as well as the S&P 500 Total Return Index, a broad major market indicator. The S&P 500 is not a part of the UMP Benchmarks. While the Benchmarks do not reflect performance of your UMP portfolio, they do reflect the individual benchmarks against which performance in your UMP model is compared.
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Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.
Benchmarks: Each Benchmark is unmanaged and cannot be invested in directly. Since your portfolio is designed across several asset classifications, you should not directly compare your performance against any one of these Benchmarks. For detailed information on the benchmarks, please see the final pages of this statement.
MSCI USA IMI (gross) is designed to measure the performance of the large-, mid- and small-cap segments of the U.S. equity market. With 2,481 constituents, the index covers approximately 99% of the free float-adjusted market capitalization in the U.S.
MSCI ACWI ex U.S. IMI (net) is designed to measure the performance of the large-, mid- and small-cap equity segments across 22 of 23 Developed Markets (DM) countries (excluding the United States) and 23 Emerging Markets (EM) countries. With 6,070 constituents, the index covers approximately 99% of the global equity opportunity set outside the U.S.
Barclays U.S. Universal Index represents the union of the U.S. Aggregate Index, the U.S. High-Yield Corporate Index, the 144A Index, the Eurodollar Index, the Emerging Markets Index, and the non-ERISA portion of the CMBS Index. Tax-exempt municipal debt, private placements, and non-dollar-denominated issues are excluded from the Barclays U.S. Universal Index. The only constituent of the index that includes floating-rate debt is the Emerging Markets Index.
Citigroup U.S. T-Bill 3 Month Index — an index, with income reinvested, generally representative of the average yield of three-month Treasury Bills. This index represents 100% of the cash portion of the Strategic Blended Benchmark for each taxable account.
Standard & Poor’s 500 Total Return Index: The S&P 500 Total Return Index is a well-known stock market index that includes common stocks of 500 companies representing a significant portion of the market value of all stocks publicly traded in the United States. Most of these stocks are listed on the New York Stock Exchange. S&P 500 is a trademark of the S&P Dow Jones Indices LLC, a part of McGraw Hill Financial 2015.
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