Despite headline news surrounding the US Federal Reserve and government shutdown, the US economy appeared to trend mostly positive for much of Q3.  While the Citigroup Economic Surprise Index (CESI) has trended in negative territory for most of the year, it recently trended into territory not seen since December 2012.  With that said, other indexes are beginning to trend downward indicating that the CESI could roll over and revert back to its mean in the coming months.

In spite of the positive developments as illustrated by the CESI, ISM indices paint a more mixed picture.  The ISM Manufacturing Index increased steadily from 50.9 at the end of Q2 to 56.2 at the end of September.  The ISM Non-Manufacturing Index increased from 52.8 to 54.4 over the same time period.  However, the index fell sharply from 58.6 in August to 54.4 in September.  The 4.2 drop in the Non-Manufacturing index came as a surprise as forecasters expected just a 1.6 decline.

Employment numbers continued their steady downtrend, as seen through the weekly initial jobless claim reports.  Following a short-lived spike to 358,000 in early July, initial jobless claims have fallen to 308,000 at the end of the September.  With the government shutdown in place, there is no news to report on unemployment numbers for September.  Unemployment figures will not come out until the government resumes operations.

Housing prices, as measured by the S&P/Case-Shiller index, continue to rise, albeit at a somewhat slower pace than observed earlier in the year.  The 20-city index rose 0.6% in July over the month, which was below analysts’ expectations of a 0.8% increase.  Since reaching a 1.9% monthly gain in March, the series has gradually slowed on a month-to-month basis.  Over the past 12 months, however, the report indicates housing prices have increased 12.4%, the highest level of the recovery.

Consumer confidence numbers came in more sobering over the course of the quarter.  The Consumer Confidence Index fell from 82.1 at the end of June to 79.7 at the end of September.  The Consumer Sentiment Index followed suit dropping from 84.1 to 77.5.  Consumer expectations beginning to roll over from post-crisis highs could signal trouble ahead as consumer confidence and sentiment indices suggest consumers may become more frugal this holiday season.

Central Banks

Central bank news was once again at the forefront of headlines throughout Q3 with the quarter concluding on a government shutdown.  Markets around the world expected Bernanke to confirm the Fed’s plan to taper its bond purchasing program following the release of FOMC minutes in mid-September.  Bernanke stressed that the tapering of the Fed’s $85 billion a month bond purchasing program is “not a preset course,” reaffirming that tapering is contingent on data that support strong economic growth.  On a similar note, it was reported that Larry Summers withdrew his name from consideration for Federal Reserve chairman.  This leaves Janet Yellen as the frontrunner for the position.  Yellen’s dovish nature would be viewed as positive by markets as financial markets around the world continue to hang onto the Fed’s easy monetary policy.

While the US central bank continues to grapple with how and when to slow its bond purchasing program, the European Central Bank (ECB) confirmed that they will “remain accommodative for as long as necessary.”  Mario Draghi stated that he would keep money market rates from rising through the extension of additional long-term loans to banks.  The ECB continues to hold its refinancing rate at 0.5%.  Extended monetary stimulus has proven beneficial to the region as the Eurozone exited a six-quarter recession in Q2 with a positive GDP reading of 0.3%.  The Bank of Japan confirmed that they will keep their easy monetary policy status quo as Governor Haruhiko Kuroda stated they were on course to escape deflation.

Central banks around the world seem to be hitting a floor in terms of their key refinancing rates.  Banks across developed, emerging, and frontier markets continue to hold the course following the US Federal Reserve’s decision not to taper in September.

Source:, BEA, BLS, ISM, Econoday, Reuters


Although the path was more volatile, global equity markets remained strong in Q3, with the MSCI ACW Index rising 8.0% as improving economic growth increased investor demand for equities. Europe was the regional leader with positive economic surprises, stronger earnings, and improving political clarity. The Asia-Pacific region troughed in August and rallied strongly in September as improving economic indicators and continued monetary support from global central banks helped brighten the earnings outlook in these cyclically sensitive economies. However, this strength did not carry over to the broader emerging market category, as currency volatility in India and lingering weakness in Mexico and Brazil dampened returns. Meanwhile, the US and Japan kept pace and remained YTD leaders, as supportive monetary policy and stabilizing economic conditions continue to support equities in both regions. Although there were several sharp moves in the quarter, volatility was flat with the VIX rising just 0.7% to 16.9. Despite stronger leading economic data, the market outlook for Q4 remains uncertain as the fiscal debate in Washington and corporate earnings season come to the forefront. Furthermore, the Fed has become an increasing source of uncertainty, with potential QE tapering and the nomination of the next Fed chair both lingering over the markets for the foreseeable future.

United States:
US equity markets endured much more volatility in Q3 compared to the first half of 2013. July and the first half of September were characterized by strong market rallies, while August and the last week of September were plagued by corrections. As has been the case all year, uncertainty surrounding monetary policy remained the primary concern for investors. Unfortunately, clarity on Fed policy did not improve. After hinting that a tapering of QE was likely in September, the Fed’s decision to maintain its current pace of purchases ultimately added confusion for investors as to what level of labor market improvement would be sufficient to scale back monetary stimulus.  Conversely, improving economic growth drove a noticeable reversal in sector leadership. Relative strength in long underperforming cyclical sectors like industrials, materials, and energy started to climb as rising commodity prices, improving economic data, and depressed valuations created a compelling relative value opportunity. Financials, which had been the best performing sector since September 2012, lagged considerably since August, which may portend a deeper correction in the broader markets in Q4.

Earnings season came to an end in the first half of August, and results were largely better than feared. The bulk of positive surprises came from the financials, with 71% of companies beating expectations with an average YOY growth of 29.4%. However, forward guidance continued to be disappointing, with an overwhelming majority of corporate CFOs reducing earnings outlooks below consensus. With many analysts still expecting strong earnings acceleration in the second half of the year and valuations beginning to get stretched, near-term upside may be limited as analysts revise their estimates to reflect a more uncertain outlook.

Market cap dispersion increased significantly in Q3, as the traditionally more growth-sensitive small- and micro-cap stocks outperformed their large-cap equivalents. This divergence in favor of growth was also evident across style categories, with growth stocks vastly outperforming value across all market caps.

International/Emerging Markets:
Q3 saw fluctuations across international markets, with gains in July (particularly in Europe) followed by broad but measured pull-backs in August, and then strong positive results in September. Europe was strongest during the quarter thanks to an improved economic outlook, strong earnings, and the exiting of recession. Angela Merkel’s reelection as German Chancellor should provide continued stability and allow policy makers to pursue efforts to support economic growth. Japan’s performance reversed positively in September, as the Japanese government shifts toward the structural reform portion of “Abenomics”. This includes a fiscal stimulus package aimed at encouraging businesses to invest in higher wages and new projects.

During September, emerging markets produced their strongest monthly performance in a year. The index enjoyed an initial bounce due to the Fed’s non-taper, but trailed off slightly toward month end. China and South Korea were consistently positive throughout Q3, with positive economic data supporting the case for another soft landing. PMIs across developing Asia were positive in September, with South Korea and India the only sub-50 prints among the majors. India has been a very interesting case study in macro management over the past three months. Having already faced stubbornly high inflation and slowing growth, the country also experienced a sharp rupee selloff between the end of April and August 28th, when it reached its all-time lowest point at 68.8 INR/USD. The Reserve Bank of India initiated short-term measures to help prop up the currency, but it was not until Raghuram Rajan began his term as Governor on September 4th and announced plans for reform that we began to see a positive turn for the rupee and Sensex, India’s local equity market. His primary action was to open a swap window to help attract dollar funds from non-resident Indians, and the central bank followed by initiating a 25bps rate increase as expected. It will be interesting to follow future moves as the country still faces difficulty.

Sources: MSCI, Bloomberg, WSJ, The Economist, Morgan Stanley, Bespoke, FactSet, Russell, Reuters, J.P. Morgan, Barclays Capital, Financial Times, Goldman Sachs

Fixed Income

The no taper decision shocked the fixed income markets. Members of the FOMC spent the previous several months telegraphing the taper and it was already priced into the markets. In the aftermath, rates fell instantaneously and areas of the fixed income markets hit hardest by taper talk rallied sharply. The Fed emphasized data dependency for its no taper decision, specifically citing a need for more clarity on the labor markets and inflation, along with the upcoming debates regarding the federal budget and the debt ceiling.

The tone of communications was decidedly dovish with Bernanke steering away from the headline unemployment rate as a barometer of Fed policy. He backed away from the presupposed 7% unemployment threshold for ending QE and instead cited broader measures of labor market health such as the participation rate. With the withdrawal of Larry Summer’s candidacy for chairman, Janet Yellen is back as the frontrunner to succeed Bernanke. These developments are boons for accommodative monetary policy going forward. However, we note that the Fed did shift the goalposts and may have hurt its credibility with its about-face on taper. Going forward, there is more uncertainty about the exact path that the FOMC will take towards normalized monetary policy.

Taxable Market:
In review of specific fixed income sectors and markets:

  • High-quality fixed income, as represented by the BarCap Agg, was on course for a losing quarter before the taper reprieve. The index rallied 1.2% post taper to record a gain of 0.6% for the quarter. Falling Treasury yields and narrowing MBS spreads were the main contributors to return.
  •  TIPS rallied strongly after the taper announcement to post a quarterly gain of 0.7%. The late bounce  was fueled by falling real rates and increasing inflation assumptions. Fed policy is distorting the traditional relationship between real yields and inflation expectations which usually move in tandem.
  • Agency MBS gained 1.0% in Q3. Spreads in the space narrowed throughout the quarter. Given its decision to delay taper, the Fed is sponsoring a steadily larger portion of the market. Plummeting refi rates and lower new home purchases has led to gross agency MBS issuance falling approximately 50%.
  • Non-agency MBS rose modestly during the quarter. We may be on a cusp of a new market segment with both Fannie Mae and Freddie Mac looking to privatize credit risk for their guaranteed mortgages.
  • Corporate bonds gained 0.8% as yields fell with Treasuries, while spreads remained unchanged.
  • High yield bonds rose 2.1%. The sector was ignored compared to loans for much of the year with YTD fund outflows. However, the sector outperformed loans during the quarter and sentiment may be turning. Flows into high yield bonds handily beat loan flows following the taper announcement.
  • Leveraged loans returned 1.2%. It was one of the few fixed income sectors to post negative returns, post the taper announcement, as rate fears dissipate.
  • Convertible bonds gained 7.4% in Q3 on the back of strong equity market performance. YTD issuance is on pace to match that of 2008 with the cost of debt and equity financing converging.

Municipal Market:
Taper talk hit the muni market exceptionally hard. Investor angst was soon exacerbated by headlines over Detroit and Puerto Rico. The retail dominated asset class swiftly shed assets and performance wilted. Over the last seven months, munis experienced 17 weeks of outflows with $45 billion exiting during the span. Performance during the timeframe reached multi-decade lows. The pain was not distributed evenly, however, and the indiscriminate selling has created distortions in the muni markets that present opportunities.

International Markets:
One of the more unpleasant consequences of the May/June taper selloff is the sharp underperformance of local currency EM debt. The asset class proved very susceptible to market expectations of US and Japanese monetary policy and developed world liquidity. Investors were buffeted by two forces: rising yields and depreciating currencies.

Growth is broadly slowing in EM and inflation is above target in many countries. Some key EM countries such as India and Brazil will have trouble trying to reignite growth in an environment of tighter liquidity spilling over from Fed policy. The challenges faced by EM policymakers now are reminiscent of previous episodes of EM capital flight and remind investors of the left-tail risk that is inherent in this market. The taper reprieve was a big boost to EM, but expect volatility ahead as future Fed policy is priced into the markets.

Sources: Barclay’s Capital, Bloomberg LP, Financial Times, J.P. Morgan, Municipal Market Advisors, US Treasury 


Hedge Funds:
The familiar refrain of 2013 continued to play out in the third quarter, as beta-oriented solutions performed best.  With equity markets rising sharply in July and September, risk assets broadly crept higher.

  •  Event-driven managers led performance in Q3, led higher by less-hedged activist and special situations managers.  Distressed securities have contributed to a lesser extent, while merger arbitrage remains mostly disappointing for the year.
  • Equity hedge managers ended the quarter with similar net exposure to the beginning.  With a 2.0% return, these Funds generated performance essentially in line with their net exposure, suggestive of little alpha.  The environment has been difficult for such managers due to the strong performance of many low quality stocks.
  • For market neutral and other relative value strategies, 2013 continues to be a story about beta and some unique idiosyncratic situations, but the opportunity for broad alpha extraction remains tepid.
  • For systematic trendfollowers the woes continued in the third quarter, with the HFRX proxy shedding 1.5% in the period.  Most systematic models flipped to short positioning in fixed income following steep losses in those markets in May and June and the first part of Q3; that positioning was detrimental in September, however, as yields came back in quickly.

Liquid Alternatives:
Alternative Investment (AI) mutual funds posted performance mostly similar to hedge fund peers, with some strategies easily outperforming, but others were lagging.  Long/short equity mutual funds are currently performing ahead of their peers, while nontraditional bond funds and multialternative managers lag.

  •  In the long/short equity universe, the Morningstar Long/Short Equity category returned 3.4% against a 5.2% gain in the S&P 500, capturing 65% of the market performance.  The dispersion between manager performance was wide, as top-quartile managers matched the S&P 500, but bottom-quartile managers were up 1.5%.  Sector selection was important during the third quarter, particularly for domestic focused strategies.  The materials, industrials and consumer discretionary sectors gained 10.3%, 8.9% and 7.8%, respectively.  The worst performing sectors were telecom, utilities and consumers staples with returns of -4.4%, 0.2% and 0.8%, respectively.
  • Nontraditional bond mutual funds continued to struggle in the face of rising interest rates and changing dynamics in the fixed income markets.  The category lost 0.2% in the quarter as the 10-year Treasury rose from 2.5% to a peak of 3%, before closing the quarter at 2.65%.  Managers were positive in July and September, but the rise in interest rates during August led to a 0.6% loss.
  • Multialternative funds finished with a gain of 0.9% in the third quarter and are up 1.5% on the year.  A combination of interest rate sensitivity and equity bias hurt these funds over the summer months, particularly in June and August.  Multialternative funds lost 1.1% in August due to the selloff in equities and fixed income.
  • Managed futures funds were down 2.1%, matching similar negative performance by systematic hedge funds.  For the year, managed futures mutual funds are performing nearly identical to the HFRX Macro: Systematic Diversified CTA Index.  Positioning of traditional trendfollowers was largely long USD, long equities and short fixed income, which created choppy performance and losses across all three months of the quarter.   

Sources: Bloomberg LP, Factset, Credit Suisse, Barclays, JP Morgan, Morningstar Direct, CBOE, Hedge Fund Research NewEdge

Liquid Real Assets:
Although Middle East unrest popped up in the headlines in the middle of the quarter, it was ultimately the Fed’s talk of tapering and the subsequent lack thereof that drove real assets within the US. Prior to the non-announcement, interest-rate-sensitive REITs and MLPs were down almost 6%. Thereafter they rebounded by 3%. Within commodities, Fed action was evident in a substantial bounce of precious metals, immediately after the announcement.

Precious metals led returns during the quarter, continuing to rebound after a record selloff. Investor exodus slowed, but the recovery lost momentum toward the end of September when India, the world’s largest gold importer, increased import taxes on gold jewelry from 10% to 15%.

  • Energy: Crude oil rose almost 15% in the first two months of Q3, in part due to concerns over US military intervention in Syria. As rhetoric calmed, so did the rise of crude, with a 5% decline in September. Natural gas remained range-bound on no real news.
  • Industrial Metals: Copper rose nearly 8% during the quarter, with improving China economic data. A pickup in iron shipments was another positive, evident in the rebound of the Baltic Dry index which at points earlier in the year fell to multi decade lows.
  • Agriculture: Grain performance continued to diverge. Corn fell 17.5% as the US crop came with record yields. Corn ended the quarter at less than $5 a bushel, a level that portends less planting outside of the US in the coming months. Soybeans, on the other hand, continued to trade higher on very pessimistic US yield expectations, and growing China demand. Cocoa (+21) was again the major standout within softs on growing West African weather concerns.

MLPs finished the quarter slightly lower on no real news. At the sub-sector level, midstream MLPs declined the least, followed by gathering and processing (G&P), and exploration and production (E&P) MLPs. Without headlines to direct prices, some of the absolute weakness was attributable to the continued backup in US interest rates. Given that a large component of MLP returns comes via yield, investors are sensitive to corresponding increases in less risky rates. Similarly, when rates retraced post the Fed non-taper, MLPs caught a substantial bid. The asset class finished the month yielding 6.0% vs. 2.8% for the 10-Year Treasury.

Domestic REITs fell for much of the quarter, on concerns over Fed tapering. Tapering bore the prospects of slowing growth and more expensive financing, both strong drivers of REIT performance over the past few years.

Outside of the US, Japanese REITs continued to lead the charge on the wings of BOJ liquidity commitments which have pushed real assets higher in the country. European REITs also showed strength, erasing the YTD loss on improving economic fundamentals. A pickup in M&A activity in both regions aided stronger pricing.

Sources: MLPHINDSight, S&P, FactSet, Alerian, USDA, USGS,, Barclays, Bloomberg


This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.

There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.