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Third Quarter 2016 Financial Market Review

As the third quarter began, investors were concerned about the expected fallout from the Brexit vote, the potential for a near-term Fed rate hike, the volatility likely to occur as the presidential election grew closer and the continued slowdown in the U.S. and global economies. However, these fears did not hurt risk appetites, as the S&P 500® climbed another 3.9% while small cap stocks and foreign equities produced even better returns. In fact, during August, the Dow Jones Industrial Average, the NASDAQ composite and the S&P 500 reached all-time highs on the same day — a feat that hasn’t occurred since 1999. However, in September, a brief spike in long-term interest rates caused a 3% stock sell-off and reminded us all that many risks remain, while the fundamental underpinnings of the financial markets leave much to be desired. As a result, the next few months will probably tell us a lot more about how markets are likely to fare in 2017.

Following the late June Brexit vote, the expectations for additional central bank stimulus kicked into overdrive, pushing the 10-year U.S. Treasury bond to an all-time low yield of 1.36% during July. This significant decline in rates, which occurred across the globe, created demand for stocks and eventually thrust the markets to all-time highs. Despite the fact that corporate earnings growth is slowing and economic growth remains weak, investors believed that the higher stock prices were justified by the ultra-low interest rates. However, the interest rate tailwind began to decline in September as fears about the possible slowing of central bank stimulus, including a Fed rate hike, pushed rates higher, with the 10-year Treasury yield reaching 1.60% by quarter-end.

U.S. economic data was somewhat mixed during the quarter, but the economy ended the period on a fairly weak note. Job growth was strong in July but fell well short of expectations in August and September. Also, the key manufacturing and service sector indexes both fell to low levels in August, while Industrial Production and Retail Sales also missed expectations during the month. Consumer confidence, though, remained at a high level while auto sales rebounded, with both measures being impacted by low gasoline prices and the still-solid job market. However, consumer savings rates continued to rise, thereby dampening the positive impact the consumer had on the economy.

Commodities were a mixed bag during the quarter. Oil prices fell early in the period on bearish supply data, but rallied at the end of the quarter on the speculation, then confirmation, of a production cut agreement among OPEC producers. However, the agreement won’t be finalized until November, so its viability remains in question. Gold prices were volatile, as the perception of economic health and the potential for higher interest rates varied, but finished the period unchanged. Fixed income assets generated positive returns as credit spreads continued to narrow, with longer-duration securities outperforming shorter-duration securities as the 10-year Treasury yield declined. High yield bonds were strong performers as spread contraction, coupled with higher risk appetites, drove returns north of 5.0%.

Foreign equity markets generally outperformed the U.S., as expectations for aggressive central bank policy and the belief that there would be no near-term fallout from Brexit, drove these markets. Specifically, the MSCI EAFE Index rose 6.4%, while the MSCI EM Index climbed 9.0%. Relatively stable commodity prices and bullish sentiment were additional positives for EM markets.

Central bank policy continued to have a large impact on asset price performance during the third quarter. Early in the period, expectations for additional easing were high. But by September, when four global central banks had meetings scheduled, investors began to fear that a reduction in stimulus was on the horizon, and this fear pushed interest rates higher. However, the results of all four meetings, which included the U.S. Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan, were perceived as neutral for risky assets, so markets generally rallied. However, the Fed was very clear in its intentions to raise the Fed Funds rate before year-end, even stating that “the case for an increase in the Federal Funds rate has strengthened.” As a result, investors should be prepared for a quarter-point rate hike no later than December.

We believe that the key to market gains going forward is corporate earnings growth. Earnings for S&P 500 companies have fallen five quarters in a row, while the expectation is that they will decline again when the third-quarter numbers are released. Such a string of declines is generally associated with an economic recession and hasn’t occurred since 2008. Importantly, the consensus expectations for 2017 earnings growth is 13%, a figure that is very unlikely to occur given that broad economic growth is so weak (the U.S. economy is currently growing at less than 2% annualized), while rising wages have created margin compression for U.S. companies. A material increase in revenues would be necessary for earnings to grow by more than 10% next year, and that just doesn’t seem likely today. If expected earnings do not materialize, stocks will likely have to adjust lower to reflect the slower pace of growth.

Over the next six to 12 months, we expect a continuation of very slow, but positive, U.S. and global economic growth combined with volatile asset returns. Please note, however, that we are growing increasingly concerned with the equity market’s reliance on ultra-low interest rates. With the Fed largely committed to raising rates, and signs that foreign central banks may be running low on stimulus, we expect the rate environment to be much less favorable for risky assets going forward. This belief, combined with unrealistic expectations for 2017 earnings' growth, leads us to believe that a normal and healthy stock market correction (in the 10% range) is very possible over the near term. Other events which may cause angst for investors in the near term include the U.S. presidential election, progression toward Britain’s exit from the EU (expected to occur in March 2017) or an unexpected hiccup in China’s economy.

The best strategy to manage this environment is to practice prudent diversification while maintaining a long-term investment focus and avoiding the temptation to time the market. We would not recommend a material change in your long-term asset allocation, but do believe that an increase in your retirement savings rate, to offset the expected weak investment returns, would be sensible today — especially if you are nearing retirement.

Thank you for your confidence in GuideStone. Please contact us if you have any comments or questions.


You should carefully consider the investment objectives, risks, charges and expenses of GuideStone Funds before investing. For a copy of the prospectus with this and other information about the funds, please call 1-888-98-GUIDE (1-888-984-8433) or download a prospectus. You should read the prospectus carefully before investing.

S&P 500® is a trademark of The McGraw-Hill Companies and has been licensed for use by GuideStone Funds. The Equity Index Fund is not sponsored, endorsed, sold or promoted by Standard & Poor’s and Standard & Poor’s makes no representation regarding the advisability of purchasing the Equity Index Fund.

All indices are unmanaged and not available for direct investment. Index performance assumes no taxes, transaction costs, fees or expenses. This update is prepared for general information only and it is not to be reproduced.

GuideStone Capital Management, a controlled-affiliate of GuideStone Financial Resources, serves as the investment adviser to GuideStone Funds.