The overall “risk-on” sentiment of the second quarter transitioned to a more cautious tone in the third quarter as volatility in the capital markets began to increase in response to several major factors including: (1) elevated geopolitical risks, (2) a focus on inflection points in U.S. monetary policy and (3) a noticeable divergence in monetary policies and reforms between the U.S. and other major economies. Such an environment led to a stronger U.S. Dollar, a flattening U.S. Treasury yield curve and noticeably low or negative returns across all asset classes during the third quarter.
Albeit taking place outside of the U.S., geopolitical risks were at the forefronts of investors’ minds during the quarter which had direct impacts across the performance of most global markets. The number of events with possible material negative ramifications were many. Notable events included Russia’s escalated offenses on Ukraine, uprisings between Israel and Hamas, unsettled reforms between Hong Kong and China, the Scottish referendum vote with the United Kingdom and ISIS bringing the U.S. back into battle in the Middle East. For investors, geopolitical risk is difficult to predict. Elevated uncertainty related to economic impact, in turn, led to higher implied volatility in the markets and contributed to lower asset prices globally.
Secondly, and as discussed in last quarter’s fixed income commentary, the U.S. is roughly six years removed from the great recession of 2008. Since that time, the Federal Reserve has persistently utilized aggressive monetary policy, including quantitative easing, to spur the domestic economy out of the depths of the financial crisis. As we enter the final quarter of this year, the Federal Reserve’s quantitative easing program (consisting of purchasing U.S. Treasuries and mortgages) is coming to an end. Although there is evidence through economic reports of an improving U.S. economy, there is some question as to how the domestic economy will perform going forward without quantitative easing during a period of rising interest rates. Many asset classes are considered at fair value or expensive and are dependent upon future earnings growth for appreciation.
Lastly, global economic growth has become increasingly dependent upon the improving U.S. economy as other central banks around the globe have been taking action to stimulate growth. In the U.S., the Federal Reserve is ending quantitative easing and the markets are beginning to price in future rate increases. As a result, rates on the shorter end of the U.S. Treasury yield curve increased during the quarterly period. In contrast, Europe and Japan are steps behind as they continued to take monetary policy actions and reforms to stimulate ailing economies. Simultaneously, emerging markets’ economies have also suffered as a direct result of slower developed market growth and lower demand for commodities. The environment of stronger U.S. economic growth and higher U.S. rates (relative to other major countries), has caused a strong appreciation in the U.S. Dollar, which has generally had a negative impact on returns for U.S.-based investors investing internationally.
The Barclays U.S. Aggregate Bond Index (“Barclays Aggregate”), the proxy for the broad U.S. fixed income market, was up a modest 0.17%, with all the positive performance being generated during the month of August. Comparatively, the S&P 500® Index, the proxy for the broad domestic equity market, was up 1.13% for the period.
The Federal Reserve, coming out of their September Federal Open Market Committee (“FOMC”) meeting, provided some clarity to the markets. The FOMC believed there may be further slack in the labor markets than what has been indicated by the unemployment statistics (unemployment hit 5.9% in September). With no signs of inflation, the Federal Reserve commented that it will keep the current range for the federal funds rate for a “considerable time” after it completes the asset repurchase program during the fourth quarter. The comparison of U.S. Treasury yields during the quarter was noteworthy as long U.S. Treasury yields declined while intermediate yields modestly increased. The flattening yield-curve indicated that investors expect higher short-term rates in the future with limited to no inflation. The third quarter ended with the 10-year and 30-year U.S. Treasury yields at 2.49% and 3.20%, respectively. The U.S. Treasury sector, the top performing sector within the Barclays Aggregate, posted a quarterly return of 0.34%. Not surprisingly, longer dated U.S. Treasuries outpaced their mid-to-lower dated counterparts given the decline in long-term interest rates.
All other sectors within the Barclays Aggregate generated modestly positive or negative returns during the third quarter. The U.S. investment grade (defined as credit quality of BBB- or higher) credit sectors posted a quarterly return of -0.08% as the increase in corporate spreads due to poor market sentiment more than offset the yield which resulted in a slight negative return. Within the credit sector, the utility bond segment was the standout performer, posting a quarterly return of 0.45% while both the financials and industrial segments generated negative returns. From a credit perspective within investment grade, higher quality credits (AAA and AA) outpaced lower quality (BBB) during the period. Despite the Federal Reserve’s reduction in mortgage purchases, the sector posted a modest positive gain of 0.18% during the quarter.
The third quarter proved to be difficult for the extended sectors of high-yield bonds and emerging market debt. High-yield bonds (defined as below investment-grade corporate bonds) suffered a setback generating a quarterly return of -1.87% due to poor market sentiment, concerns over valuations and sizable outflows. While there was not much evidence of credit deterioration, the sector experienced a record amount of outflows over the period causing widening spreads and lower liquidity. Within high yield, the upper-tier credits (BB) generally outpaced lower-tier credits.
Emerging markets suffered as volatility increased in the markets, especially related to concerns over geopolitical risks (Russia), a slowing China, a strong U.S. Dollar and weaker demand for commodities. For the quarter, emerging markets posted a return of -2.11% as measured by the J.P. Morgan Emerging Markets Bond Index Plus (EMBI+), a dollar denominated index. In general, emerging markets debt indices in local currency terms performed much worse given the strengthening of the U.S. Dollar.
In summary, the quarter ended with a great deal for investors to contemplate; therefore, a continuation of market volatility should be anticipated. The Federal Reserve is in the unenviable position of balancing opposing forces – removing the tailwind of accommodative monetary policy without stifling domestic economic growth. Over the near-term, expectations are for U.S. Treasury yields to be somewhat range-bound with upper pressure coming from projected future rate increases while opposing pressure may come from the lack of inflationary pressure and the overall low-yield environment across the globe.
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