3Q 2017 Market & Economic Commentary
While news about Hurricanes Harvey and Irma dominated the headlines during the latter part of the 3rd quarter, markets continued their steady march toward new highs. Despite the significant disruption to the Gulf Coast economy brought about by two substantial storms, U.S. economic growth remained robust. It is significant to note that despite their destructive nature natural disasters have little measurable effect on the U.S. GDP (Gross Domestic Product) calculation.
For example, when Hurricane Katrina hit New Orleans in August of 2005, the BEA (Bureau of Economic Analysis) estimated the damage at $110.4 billion. However, 3rd quarter GDP in 2005 was positive to the tune of 3.4%. Harvey and Irma were certainly destructive, but probably the most significant impact felt in the broader economy related to gas prices and employment. The timing of the hurricanes significantly impacted the September employment figures, but this effect was likely transitory as the unemployment rate actually fell during the period.
Nonfarm payrolls actually fell 33,000 in September 2017 bringing to an end an 83 month string of job growth.
In spite of the weak month, the unemployment rate fell to 4.2% and the participation rate continued to climb. Broader measures of unemployment also improved, and the current picture painted by recent labor statistics portrays a robust labor market with strong job growth and rising wages.
Along with employment, the broader U.S. macroeconomic picture improved as well. The ISM manufacturing index rose above 60 reaching its high for this expansion and was closely followed by the U.S. Non-manufacturing index which ended the month at 59.8. Inflation remained subdued, but the overall improvement in economic conditions seemed to impact the Federal Reserve. At its September meeting, FED governors cemented their plan to begin “normalizing” the FED’s balance sheet by allowing both mortgage backed and treasury securities to roll off without replacement. Interest rate projections supplied by the FED reaffirmed that an additional rate hike is likely prior to the end of the year. Following the meeting, the futures market suggests that the probability of a rate hike in December has risen significantly and is now above 90%.
Macroeconomic improvement could be seen overseas as well with PMI indices improving throughout the developed world, giving legs to the concept that, for the first time in many years, the world is experiencing a synchronized global expansion. Political risks in the Eurozone fell with the re-election of Angela Merkel in Germany. In short, despite the distortions caused by the hurricanes and continued conflict in the Middle East the third quarter was characterized by improving macroeconomic conditions and declining political risk. Buoyed by improving economic conditions, falling political risk, and solid earnings, global equity markets continued to advance. The third quarter of 2017 proved to be remarkably strong from an equity perspective! Virtually every sector of the market improved between July and September, and growth strategies continued to dominate throughout the quarter as well. The S&P 500 and Dow Jones Industrial Average both hit new highs during the quarter. Both indices achieved those milestones in late September with Dow up 15.45% YTD and the S&P right behind with a total return of 14.24% for the same period. Smaller cap stocks gained ground with the Russell 2000 up more than 6% during the month of September and just under 11% on a year to date basis.
Boosted by strong currency appreciation the returns of international and emerging markets equities continue to dominate the equity spectrum. The MSCI EAFE index ended the quarter up nearly 20% YTD, and the MSCI Emerging Markets index was up 27.28% for the same period. Bond markets also moved higher during the period. The Barclays Aggregate Bond Index was up nearly 1% for the quarter and is now up more than 3% on a year to date basis. Cornerstone portfolios performed well during the period. Our small cap positions boosted portfolio returns, and fixed income strategies continue to bolster our performance in 2017. Structurally, our portfolios continue to be challenged by our relatively low weighting to international equities relative to the broader global investable equity universe.
For much of the last five years, this structural underweight has benefited our portfolios; however, the change in the trend of the U.S. dollar coupled with strong local currency returns on foreign equities has proved challenging. We continue to believe that moving to a “market weighting” relative to a global basket of equity securities. like the MSCI ACWI (All Country World Index), is not an optimal long-term solution for our clients. We thought a brief outline of our philosophy regarding this position might prove helpful to our readers. Three basic rationale underpin our position:
1. Developed market international equities have a higher absolute risk than domestic equities.
2. Diversification benefits gained due to correlation diversity are relatively limited due to high and rising correlations.
3. Investors exhibit a strong home country bias, and given the relative advantages enjoyed by U.S. investors (i.e. a significant share of global investment opportunities reside in this country (over 50%) and the U.S. dollar remains the defacto world currency), moving to a “market weight” may prove unsustainable from a U.S. investor perspective.
While our philosophical position could certainly be outlined in a more detailed and nuanced fashion, these three rationale distill our position into a manageable summary. Given these rationale, we believe that a strategic underweight to international equities is warranted. However, our Investment Committee regularly reviews the macroeconomic and investment environment, and given recent changes in that environment, we believe a change to our strategic asset allocation targets is in order. For a number of years, equity valuations overseas have looked attractive relative to domestic equity valuations. However, valuation alone was, in our opinion, not enough reason to adjust our portfolios.
Recent changes in the direction of the dollar, declining political risk in large Eurozone countries, and a synchronized economic expansion coupled with the aforementioned lower valuations are enough, in our estimation, to justify a change. Our team has analyzed and re-optimized our portfolios and determined that adding additional exposure to developed market international equities would add little benefit other than, perhaps, a minor tactical advantage. However, increasing exposure to emerging market equities and including dedicated exposure to international small cap stocks provides a much more significant portfolio advantage - one that we believe can be capitalized on over a longer period of time. Consequently, we have begun adjusting portfolio allocations to reflect this view. We expect to be fully re-positioned prior to the end of the year. As we move into the fourth quarter of 2017, we believe that economic fundamentals underpinning the U.S. market have improved, and it is likely that the U.S. economic expansion will persist a while longer. Consequently, despite relatively lofty valuations, the bull market in equities is likely to continue through the end of 2017 and into 2018. We are entering the most positive quarter of the year and initial earnings estimates are positive as well. Despite this more sanguine view, we would remind our readers that recent lows in market volatility suggest a high level of complacency, and it is quite possible that a short market correction could occur prior to the end of the year.