Market Outlook: October 2017

Economic Summary:

Improving economic growth. Economic growth in the U.S. was revised upward to a rate of 3.1% in the second quarter of 2017, its fastest pace in almost two years. The continued strength of the economy depends on the recent hurricanes’ potential to slow this growth. The increased growth came from both consumption and nonresidential investment. Improving net exports and a rise in business inventories added to the growth as well. The second half of the year should see a slight softening of growth, offset by rebuilding from the hurricanes and the potential for fiscal stimulus in 2018.

Weak job growth. The U.S. economy added 156,000 jobs last month, lower than expected and accompanied by a downward revision to the previous month’s number. The unemployment rate increased to 4.4% and the participation rate stayed at 62.9%. Wage increases slowed, increasing to only 2.3% year-over-year. If the labor market continues to tighten (lower unemployment rate), we would expect wage pressures to increase. Although the employment data is somewhat skewed since many workers are “under-employed”, we are reaching full employment in our economy.

Inflation increased slightly. The headline consumer price index (CPI) increased 0.4% in August, advancing the year over year number to 1.9% from 1.7% in July. Increases in gasoline and rent were the major reasons for the increase. We still need to see more wage growth before rising inflation becomes a major concern. The Fed’s preferred measure of inflation, the Personal Consumption Expenditures (PCE) index, which covers a wide range of household spending items, came in slightly lower than expected for August at 1.4%.

Consumer sentiment down slightly. The University of Michigan’s consumer sentiment index fell to 95.1. Consumers were more optimistic about the future in the survey, but their view of current conditions fell. U.S. consumer confidence decreased in September due to hurricanes Harvey and Irma.

The Federal Reserve and interest rates. The Federal Open Market Committee (FOMC) did not change the federal funds rate from its 1% to 1.25% range at its September meeting. The Fed outlined its plans to reduce its balance sheet holdings of Treasuries and mortgage-backed securities, beginning in October, and accelerating monthly. They will begin by reducing their holdings by $10 billion in the first month and gradually increase this rate each quarter for the next five quarters. It will be interesting to see what effect this has on longer-term interest rates. The expectation is they should rise (and prices fall) as the Fed sells Treasuries, due to a larger supply of those securities being available, but time will tell as to the exact effect on rates.

 Equity Market Summary

• Broad based equity market acceleration, but Small Caps, Developed International, and Value-oriented stocks were exceptional winners in the month of September. The S&P 500 Index continued to climb in September with a 2.1% gain and the Dow Jones Industrial Average (DJIA) advanced 2.16%. The NASDAQ Composite gained only 1.1%, but Technology is still the top performing sector in the S&P 500. Small cap stocks outperformed large and mid-cap, with the Russell 2000 returning 6.24% during September, thanks in part to improving economic data and hints of tax reform. Despite ending higher, falling interest rates throughout the quarter helped REITs to close up 1.1%, and commodities saw a broad-based resurgence after a weak 2Q, up 2.5%. Emerging market (EM) assets have outperformed through much of 2017 but have slipped relative to Developed international stocks since the middle of September. Although Growth has still outperformed Value among all large, mid, and small cap stocks, this trend began to reverse during September for large (Growth +1.1%, Value +3.3%) and small caps (Growth +5.4%, Value +7.1%). Economic growth is slow but improving, which tends to favor Value, and we have seen two consecutive quarters of earnings growth, which also tends to correlate with better Value performance. Add to that the fact that over the past 10 years, including the entire financial crisis period of 2008 and 2009, growth has outpaced value by about 50%, and technical analysis suggests that the Growth rally may be overextended.
  LARGE CAPS OUTPERFORM SMALLER CAPS YTD:

  Dow Jones	15.45%
  S&P 500	14.24%
  Russell 2000	10.93%

  GROWTH OUTPERFORMING VALUE YTD :

  Large Cap	19.3% vs. 8.5%
  Mid Cap	17.3% vs. 7.4%
  Small Cap	16.8% vs. 5.7%

   

• Best sector performance: The strongest sector in September was Energy (+9.9%), as investors speculate that oil may soon be in short supply, followed by Financials (+5.1%), as more certainty has returned that we will see another rate hike before year end. However, year to date through the end of September, the Technology sector still has the best returns YTD at 27.4% followed by Healthcare at 20.3%. While both sectors have benefited from reasonable valuations and improved earnings, the growth expectations of Technology and Healthcare have increased from an improvement in consumer sentiment over the last several months.
• Worst sector performance: Utilities (-2.7%) and Consumer Staples (-0.9%) were the worst performing sectors during the month of September, as data supporting a stronger economy and likelihood of another rate hike before year end gathered during the month. Energy (-6.6%) and Telecom (-4.7%) remain the worst YTD performers with oil prices despite the recent bounce in Energy.
• Developed international markets outperformed Emerging markets for the first time this year during September; EM still best performing YTD. Driven by improving economic data, earnings expectations, and a weaker U.S. dollar, Developed International markets as measured by the MSCI EAFE index advanced by 2.5% for the month. Emerging markets stocks measured by the MSCI Emerging Markets index were -0.40% for the month (after being the best performing asset class in August, the third quarter (+8%) and year to date (+28%)).

Fixed Income Summary

The 10-year Treasury yield increased to 2.33% by the end of the quarter (9/29). This move reflects the Fed raising short-term rates and the expectations of another rate hike before year-end, as well as the possibility of multiple rate hikes in 2018 and an October start to the measured removal of Quantitative Easing (QE) by letting Treasury and mortgage-backed security holdings mature without replacing them. The Federal Reserve also commented on the strength of the U.S. economy, which also contributed to rising rates.

The proposed U.S. Presidential administration’s plans for tax cuts also contributed to the selloff of U.S. Treasury securities (and pushing the benchmark 10-year yield to 2.33% at the end of September) as analysts debated how any cuts would affect economic growth and the federal deficit’s need for more Treasury debt issuance.

Fixed income investment performance was negative for the month except for high yield. The Barclays Aggregate index dipped by 0.48% for the month of September and the Barclays High Yield returned 0.9% for the month. Municipal bonds declined by 0.51% for the month.

Year-to-Date Index Returns (as of 9/29):