The third quarter has a reputation as the worst seasonal period for stocks. This year, global stock markets rallied. Emerging-market stocks lead, climbing 8%, followed by European stocks, which gained 6.2%. More broadly, developed international stocks rose 5.5%. For the third consecutive quarter the U.S. dollar depreciated against foreign currencies, providing a boost for dollar-based investors.
In addition to great growth around the world, the U.S. market delivered strong returns in the third quarter, extending its winning streak to eight consecutive quarters. The S&P 500 Index closed at an all-time high after gaining 4.5%. Within the U.S. market, larger-cap growth stocks—technology stocks in particular—continued their year-to-date dominance over smaller-cap and value stocks.
Fixed-income markets and core investment-grade bonds inched up 0.7% for the quarter. The 10-year Treasury yield (which moves inversely to bond prices) ended the quarter flat, but this masked intra-quarter shifts. It bottomed in early September as fears over North Korea, hurricanes, and political events peaked. But the yield shot up at month-end, closing the quarter right about where it stood three months earlier.
Here are the broad index returns through the Third Quarter of 2017*:
| U.S. Large Cap Stocks | 14.2% | Emerging Market Stocks | 27.8% |
| U.S. Small Cap Stocks | 10.9% | Commodities | -2.9% |
| U.S. Real Estate | 3.6% | U.S. Aggregate Bonds | 3.1% |
| Overseas Stocks | 20.0% | International Bonds | 8.2% |
Economic Outlook
The synchronized global economic recovery continues, providing a solid foundation for corporate earnings and financial assets in general. The multinational Organisation for Economic Co-operation and Development (OECD) Composite Leading Indicator recently hit its highest level since October 2014, indicating growth is broadly distributed across OECD countries. In August, the U.S. Global Manufacturing Purchasing Managers Index (PMI) hit its highest level in over six years and Eurozone and Emerging Market PMIs also rose to multiyear highs. Easing inflationary pressures in emerging markets have allowed numerous emerging-market central banks to lower interest rates this year, which is typically positive for local stock markets. In the United States, GDP growth remains subpar by historical standards but continues to grind along at around a 2% annual rate. Financial conditions have eased over the past year and could suggest capacity for economic growth over the next few quarters at least. It seems that the economic recovery may still have legs.
Despite the U.S. economy’s rather healthy economic indicators, we are overdue for the typical correction. It is worth a reminder that historically, the marked drops at least 5% roughly three times a year and declines 10% or more about once a year. We are at 330 days and counting since the last 5% drop, marking the longest such streak in 26 years. Given that historical reference, investors must be prepared—psychologically and financially—for market dips and drops along the way. They are inevitable and may be unsettling, but remember, they are also temporary.
In contrast, a true bear market in U.S. stocks (a sustained 20%-plus decline) is almost always associated with an economic recession. Recessions, in turn, are typically caused by excessive Fed tightening, usually in response to inflationary pressures, an overheating economy, or financial market excesses. At this moment, none of these scenarios seems imminent in the U.S. or global economy.
However, the debate continues. There is disagreement among economists and strategists as to whether inflationary or deflationary risks should be paramount for the economy at this point in the cycle. Should the Fed policy be dovish or hawkish? As always, there are significant uncertainties when it comes to economic forecasting. Humility and intellectual honesty—knowing what you don’t know—are crucial. There are a range of potential scenarios in our investment decisions that avoid betting heavily on any single macro forecast. As the saying goes, “It’s difficult to make predictions, especially about the future.”
How to Measure the Cost of an Investment Strategy
There are many factors that affect portfolio performance but few have a more predictable impact than the cost of management. Unfortunately, when evaluating various strategies, the average investor is not familiar with the many contributors to total cost. The recent report published by Inside Information called “2017 Planning Profession Fee Survey” summarized factors that everyone should consider and shed light on some of the hidden costs. First, everyone is familiar with the costs associated with the investment management fee. A typical starting management fee is 1% but nearly one-half of advisors charge more than 1% on portfolios with as much as $1MM under management. Another cost consideration is the cost of the underlying investments. Low-cost investments tend to outperform higher-cost investments over time and managing those costs can contribute significantly to performance. Finally, minimizing trading costs (transaction fees) adds to performance. Ultimately, the report showed how similar firms’ total costs can be 3% or more per year. Because Brown Financial Advisory is committed to your performance success, your total cost with us is less than 70% of the firms in the study.
*U.S. Large Cap=Russell 1000, U.S. Small Cap=Russell 2000, Real Estate=MSCI US REIT Index, Overseas Stocks=MSCI EAFE, Emerging Market Stocks=MSCI Emerging Markets, Commodities=DJ UBS Commodity Index, U.S. Bonds=Barclays Aggregate Bond Index: Data Source: Blackrock Benchmark Returns Comparison September 2017. International Bonds=Barclays Global Ex-US Bond USD Index: Data Source: JP Morgan Guide to the Markets 4Q 2017.