The US economy maintained its resilience during October, with strong economic data across the board. The third quarter GDP report showed the domestic economy running at a 3.0% annualized growth rate.
The number came in slightly higher than expectations (estimates were for a 2.6% rise) and marked the first time since 2014 that we’ve had back to back readings at or above 3.0%. It’s uncertain what impact hurricanes Harvey and Irma had on the Q3 number, yet when combined with the massive fires in California’s wine country, the broader US economy will likely experience the same slight boost via rebuilding efforts that it has historically.
The Unemployment Rate in September dipped to 4.2% from 4.4%, despite a -33k drop in nonfarm payrolls.
Economists were quick to point out the likely “noise” in the data resulting from Harvey and Irma, and it may be a few months before we see a cleaner picture of the US employment landscape.
Average hourly earnings did tick up more than expected, surging +0.5% in September, and are now up +2.9% YoY. Initial jobless claims held steady in October, averaging 240,000 per week.
The housing market remained strong in the third quarter, fueled once again by low interest rates and affordable mortgages. The S&P CoreLogic CS US Home Price Index rose 6.07% in August from the same period a year ago.
New Home Sales surged 18.9% MoM in September while both Pending Home Sales and Existing Home Sales were essentially flat. Affordability remains a challenge as homebuilders turn to so-called “starter-homes” to meet growing demand.
With inflation remaining muted, the Federal Reserve is feeling little pressure to hike interest rates. The Consumer Price Index rose 2.2% YoY in September while PPI was up 2.6%. The PCE Deflator, one of the Fed’s preferred measures of inflation, rose just 1.6% in September while the Core PCE edged up only 1.3% YoY. Should the US economy maintain this streak of 3.0%+ growth, we’re likely to see growing signs of inflation, primarily via rising wages. If Congress were to pass tax reform in early 2018, giving the economy a boost, it’s likely the Fed would need to increase the pace of its tightening agenda.
Domestic Equity
Domestic Equities posted strong gains in October, with the S&P 500 closing near an all-time high.
The benchmark Large-Cap index gained +2.33% during the month, and is up a stellar +16.91% for the year. Mid- and Small-Caps, as measured by the S&P 400 and S&P 600 indices, returned +2.26% and +0.95% during the period. That comes after Small- and Mid-Caps outperformed Large-Caps by a wide margin in September on the heels of positive tax-reform related news.
Growth stocks, as measured by the S&P 500 Citi Growth Index, returned +3.28% during the month, and has returned +23.24% for the year. Growth stocks continue to shine, led by technology behemoths such as Apple, Google, and Microsoft, to name a few. This stands sharply in comparison to Value stocks, as measured by the S&P 500 Citi Value Index, which returned +1.15% during the period and has returned +9.74% for the year. Value stocks continue to be held back by Financials, Energy, and rate sensitive sectors, with the delta between the performance of Growth and Value stocks standing at +13.5% for the year, a significant margin.
From a sector standpoint, the aforementioned Technology sector was the month’s best performing group, gaining +7.76% after strong quarterly earnings reports from the likes of Google, Microsoft, Intel, and Visa. The positive momentum in the sector carried over to the world’s largest company (Apple), which is set to report quarterly earnings this week. Apple, Google, and Microsoft represent more than one third of the sector’s weight. The month’s worst performing sectors included Consumer Staples, Healthcare, and Energy; however, the most notable standout was the Telecom sector, which shed -7.62% after dismal earnings reports.
Lastly, through the first 10 months of the year Technology has been a clear winner up +37.24% for the year, standing in stark contrast to the Telecom and Energy sectors, which are both negative on the year, down -11.95% and -7.25%, respectively.
International Equity
International equities were strong performers across the board in October, with the MSCI ACWI ex. USA Index, a broad measure of international stocks outside the U.S. returning +1.89%.
Emerging Markets led the way, with the MSCI EM Index returning +3.51% during the month to extend the year’s gains to +32.60%. Emerging Markets continue to benefit from a pick up global growth, and their own version of the S&P 500’s “FAANMG” stocks. More specifically, Samsung, Alibaba, Tencent, and Taiwan Semiconductor continue to power the EM Index. These four companies have returned +65.45%, +107.67%, +79.19%, and +48.00%, respectively year to date (No, these are not typos), and combine for nearly 15% of the MSCI EM Index as the top four holdings.
Developed Market equities, as measured by the MSCI EAFE Index, also posted positive returns, up +1.53% for the period. Developed Market equities continue to benefit from strong earnings momentum in Europe and Japan. Specifically, the Eurozone, as measured by the MSCI EMU Index , returned +2.46% in EUR terms, or +1.12% for a USD based investor, as the Euro weakened against the Dollar, detracting from performance. Furthermore, the Nikkei 225 Index, a key Japanese equity benchmark, gained +8.13% in JPY terms and +7.12% in USD terms.
While the Yen’s impact on returns was only 1.01%, the Nikkei is negatively correlated to the Yen’s performance, meaning as the Yen weakens Japanese equities tend to perform strongly, emphasizing the importance of the currency component to Japanese equities. Moving forward, Japanese equities continue to be propelled by earnings growth, improving measures of
confidence, and the re-election of PM Abe, which also serves as re-affirmation of unprecedented measures of monetary stimulus from the Bank of Japan.
From a sector standpoint, it should come as no surprise that Technology was the best performing international sector during the period, much like it’s U.S. counterpart. The MSCI ACWI ex. USA
Technology sector returned +5.95% during the period, propelling the sector’s gains to +51.05% YTD.
Nearly all other sectors finished the month in positive territory, with the lone exception being Healthcare, which gave back -1.59% on the month.
Fixed Income
Over the past month, the Treasury yield curve has continued on its bear flattener trend. Rates rose across all maturities, but the rate of increase was larger in short-term maturities. The greatest increase in yield was at the 1 year point of the curve (~13 bps), followed by the 2 year (11 bps), 3 year (10 bps), 5 year (8 bps), 10 year (4 bps), while the 30 year yield hardly moved, rising 2 basis points.
This yield curve movement, along with continued spread tightening, produced another month of outperformance for lower quality credits and longer duration holdings. Investment grade (+0.40%), high yield (+0.39%), and emerging market bonds (+0.56%), all notched strong performance in October. Credit spreads appear quite optimistic, underpricing risk, and sit at or near longer term troughs.
Corporate issuers appear to be taking advantage of the market’s demand and willingness to pay up for bond deals.
U.S. investment grade issuance has surpassed $1 trillion in 2017, and is on pace to be the 7th consecutive year of record corporate bond issuance.
High yield municipal bond performance did not follow this risk-on trend in October, and are actually trailing the YTD return of the broader municipal market (+4.64% vs. +4.83%). Investors’ recent negative experiences with lower quality municipal holdings such as Illinois and Puerto Rico are likely dampening demand for these bonds.
Market expectations for the Fed to approve a rate increase in December rose from 70% at the beginning of the month, to where they currently sit, slightly above 85%. This is the market’s way of saying it believes that the increase is a sure thing. Conviction on future rate increases is not as strong. While the Fed forecasts three additional rate increases in 2018, the market in not ready to acknowledge that possibility. This may change when the next Federal Reserve Chairman is named.
Alternative Investments
Alternative Investments were largely positive performers in October, led by sharp gains in West Texas Intermediate (WTI) crude oil, which gained +5.2% on the month to close above $54/bbl. October’s closing price represents the highest monthly close since June 2015. Crude oil’s performance has risen sharply since the end of August, rising +15.1% over the past two months helped by hurricane related production issues, a falling drilling rig count, and pledges for OPEC to continue to limit production and actually comply with it. The strength in WTI helped buoy the broad Bloomberg Commodities Index by +2.0% during the period; however, the asset class remains in negative territory for the year, down -1.5%.
Real Estate, as measured by the FTSE NAREIT All REIT Index, shed -0.3% during the period, hurt by rising interest rates and continued expectations for the Federal Reserve to hike rates again in December. REITs have had a tough go thus far in 2017, gaining a mere +3.1%, compared to a +16.91% gain for the S&P 500 and a +16.24% gain for the S&P 500 Utilities sector. The sub-par performance from REITs likely also reflects structural issues within the sector.
Additionally, the U.S. Dollar, as measured by the DXY Index, rose +1.6% on the month as speculation around the next Chair of the Federal Reserve and the outlook for interest rates caused a back up in rates. Rising interest rates took their toll on Gold, with the precious metal losing -0.7% to close at $1,271/oz. While Gold may face near term headwinds from rising interest rates, it’s safe haven properties should not be forgotten in the event of a market selloff, increase in volatility, or geopolitical crisis, meaning Gold likely still has a place in most client portfolios as a hedging instrument.
From a currency standpoint, the Euro weakened from $1.18 USD/EUR to $1.16 USD/EUR on the back of increased political risk surrounding the breakaway (remains to be seen) of the Catalonia region from Spain, plus news from the European Central Bank (ECB) that quantitative easing (QE) will begin to wind down in January 2018.
Rising interest rates in the U.S., coupled with a lack of clarity on the future path of interest rates in Europe could continue to give pause to the rise in the Euro; however, the pause is likely to be short lived. This stands in contrast with the Japanese Yen, which displays a high degree of sensitivity to a rising U.S. 10-Year Treasury, meaning if U.S. interest rates are likely moving higher, the Yen is likely to weaken further in the future.
This article was written by Nottingham Advisors, a participant in the ETF Strategist Channel.