Third-Quarter Market Update & Outlook

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  • Economic data was mixed during the quarter. Positive news regarding the condition of the U.S. consumer was offset by weakness in business activity.
  • Central banks around the world eased in response to the late June Brexit vote, fueling strong returns for both U.S. and international stocks during the quarter.
  • Core bond returns were flat, as interest rates rose slightly during the period. However, reduced risk aversion and demand for higher yields translated to strong results for emerging market and high-yield bonds.
  • While many extraneous factors influenced stock prices through the past year, corporate profit growth is likely to be the key factor in determining future returns.

Economic Environment

Second-quarter real U.S. gross domestic product growth was revised upward to 1.4 percent from the initial estimate of 1.1 percent. Growth in consumer spending was strong, rising at an annual rate of 4.3 percent. Exports grew faster than imports, and business investment increased for the first time since the third quarter of 2015, although only modestly.

Consumer spending remains well supported. Several encouraging statistics were released during the quarter regarding the condition of the U.S. consumer, including:

  • August nonfarm payrolls grew by 151,000, and the unemployment rate held steady at 4.9 percent.
  • A news release from the U.S. Census Bureau indicated that U.S. median household income rose by 5.2 percent in 2015, the largest year-over-year increase since it began keeping records in 1968.
  • The Conference Board Consumer Confidence Index hit a nine-year high of 104.1 in September.
  • The personal savings rate rose from 5.6 percent to 5.7 percent in August, indicating that increased consumer spending isn’t occurring at the expense of overall financial health.

Despite good news on the consumer front, economic concerns developed in other areas. The Institute for Supply Management (ISM) Purchasing Managers Index dipped below 50 in August, indicating manufacturing activity contracted during the month. This measure rebounded back to expansionary territory in September, but activity in this sector is still sluggish. The ISM Non-Manufacturing Index declined in August to its lowest level since 2010, but remained more than the growth threshold.

The current economic recovery and expansion has lasted seven years, which is lengthy by historical standards. However, the slower-than-normal pace of growth through this period has helped prevent excesses from developing, which reduces the chance of recession in the near term.

The Federal Reserve elected to hold interest rates steady at its September meeting, stating, “The Committee judges that the case for an increase in the federal funds rate has strengthened, but decided, for the time being, to wait for further evidence of continued progress toward its objectives.” With unemployment at less than 5 percent and inflation beginning to rise, the Fed signaled a rate hike is still probable in 2016. Most anticipate this occurring at the December meeting.

Stock Market

World stock markets swiftly rebounded from the Brexit turmoil at the end of June. In response to this event, central banks around the world took actions to ease monetary policy, boosting investor optimism. Market participants also recognize that Great Britain’s withdrawal from the European Union will take at least two years once initiated, pushing theuncertainty further down the road.

As a result, both U.S. and international stocks marched higher from the beginning of July through mid-August, before plateauing toward the end of the quarter. Here are the index returns for the quarter and for the year to date:

Third-Quarter Index

U.S. stocks hit an all-time high during the third quarter, breaking out of the trading range that had been in place since late 2014. The Dow Jones Industrial Average, S&P 500 and Nasdaq Composite indices closed at record highs in mid-August. Encouragingly, the advance occurred broadly across stocks and sectors. Breadth indicators showed the number of advancing stocks versus decliners climbed at the fastest rate since 2009.1 Broad market advances tend to be more sustainable than those focused on a small group of industries or stocks.

Market volatility noticeably receded during the quarter. The U.S. stock market traded 51 straight days through September 9 without a decline of 1 percent or more. In addition, the Chicago Board Options Exchange Volatility Index fell by half from late June levels.

While central bank actions prompted the strong results for stocks, investors should be cautious in depending on this catalyst for market returns going forward. Ultimately, corporate earnings growth is a better and more reliable driver of stock market performance. While corporate profits have declined for several quarters in a row, most analysts expect improvement in the second half of 2016. Given stock valuations at or slightly above the long-run average, the resumption of earnings growth will be crucial to further stock market gains.

Bond Market

U.S. interest rates rose modestly in the third quarter, with the benchmark 10-year Treasury note rising from 1.49 percent to 1.61 percent. For core (investment grade) bonds, this translated into flat returns, as a slight decline in bond prices was roughly offset by coupon income. The Barclays U.S. Aggregate Bond Index gained .46 percent for the quarter and is up 5.79 percent for the year. The Barclays 10-Year Municipal Bond Index declined .30 percent during the quarter and remains up 4.01 percent for the year.

Easy central bank policies combined with the scarcity of cash flow yield in the current environment fueled further gains in satellite bond categories. The J.P. Morgan Emerging Markets Bond Index returned more than 3 percent for the quarter and is up more than 15 percent in 2016. U.S. corporate high-yield debt performed even better, gaining 5.49 percent during the third quarter and 15.32 percent for the year to date.2

Better-than-expected returns in both core and satellite bond categories this year have been driven by price appreciation, rather than income production. In the long run, the majority of the return from bonds comes from the interest income they produce. With core bond yields currently in the low single digits, and satellite bond yields near the bottom of their historical range, returns from this asset class are likely to be lower going forward.

Investment Outlook

Investors have coped with two stock market corrections in the past year and weathered an additional round of volatility surrounding the Brexit event. Despite these challenges, investment performance has been relatively successful in 2016. Diversified portfolio returns generally are in the mid-single digit range, with all asset classes (U.S. and international stocks, bonds and alternative investments) making a positive contribution.

Much of the gain in stocks and bonds this year can be attributed to a significant easing from central banks around the world. With a quarter of all global government bonds now offering negative yields,3 investors have been forced to look to stocks for cash flow and total return. Meanwhile, the extremely low global interest rate environment causes U.S. core and satellite bonds to appear relatively attractive, resulting in increased foreign demand. But the Fed is on the brink of raising interest rates in December, which means the prevailing central bank tailwind of recent years isn’t as likely to power returns going forward.

In the short term, the U.S. presidential election will take center stage. Given the public’s apparent lack of confidence in both parties’ nominees, investor angst and associated market volatility may develop leading up to November 8. But the current trading pattern of the 2016 U.S. stock market has closely followed the election-year norm—a summer downtrend followed by an uptrend in the second half of the year. The market has historically tended to climb through year-end once election uncertainty has passed. There is a decent chance this year’s gains will be preserved, perhaps even enhanced, in the fourth quarter.

While many outside factors have affected stock prices this past year, business fundamentals are still key and likely to take on renewed importance going forward. Stock valuations today are full, leaving little room for price-to-earning multiple expansion to move the market higher. In our view, stocks will struggle to make further progress without broad-based profit growth. Therefore, third-quarter corporate earnings reports will be closely monitored, as actual results and forward forecasts likely will play a significant role in determining market direction and strength through the remainder of the year.

Portfolio diversification has been effective in protecting investors from the volatility of the past year, and investment returns have been reasonably good. Both economic growth and corporate profits are expected to improve in the latter half of 2016 and into 2017. So despite the near-term uncertainties mentioned above, opportunity still exists for investors in the current environment.

1Thomson Reuters, InvesTech Research
2BofA ML US High Yield Master II
3Fidelity Investments, Bloomberg Inc

Jeffrey A. Layman, CFA®
Chief Investment Officer

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BKD Wealth Advisors, LLC is an SEC registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks, and it should not be assumed that future performance of any investment or investment strategy or any noninvestment-related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.

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