The pace of negative economic data slowed in the third quarter, indicating that data levels for major economic reports remain on the weaker side but are beginning to post more in line with consensus expectations.
- Labor markets and the housing sector are two areas that continue to receive increasingly positive news. Housing in particular showed momentum as the fifth straight monthly increase in the National Home Builders Housing Market Index pushed the survey to its highest level in five years.
- Other consumer driven measures were less impressive, as meager personal income and retail sales figures remind us that the economy remains less than optimal. This notion was furthered by a surprise downward revision to the final estimate of second quarter GDP, reduced to just +1.3% after an initial estimate of +1.7%. Lower inventories were a contributing factor as was reduced domestic demand.
The big news of the quarter was not unexpected but nonetheless impressive in its scale. For months investors and economists anticipated another round of coordinated global central bank easing and in September they were not disappointed.
- The European Central Bank (ECB) illustrated its commitment to the euro by announcing a new openended asset-purchasing program.
- While providing a serious backstop in the minds of investors to a meaningful deterioration in Spain or another major sovereign some details of the program are less than accommodative.
- The Federal Reserve announced its third explicit round of quantitative easing whereby it will purchase $40 billion per month in the agency mortgage market in addition to the bond purchases it had committed to under the extension of Operation Twist.The program is open ended in nature.
- The Fed’s expectation for zero interest rates was also extended through mid-2015, as the Fed signaled it will keep rates low even through a sustained economic recovery.
- The FOMC clearly appears to be favoring the full employment portion of its mandate at the expense of price stability. Persistently high unemployment may see it become more dovish and creative in its efforts to jumpstart the economy.
- Not to be left out, Japan surprised market participants by announcing an additional ¥10 trillion ($128 billion).
- This brought the total size of the Bank of Japan’s asset purchasing program to ¥80 trillion (over $1 trillion). The central bank also extended the program through the end of 2013, citing weak domestic growth and the “deceleration” of Western economies.
Buoyed by central bankers, equity markets rose sharply in the third quarter, defying the conventional warning signs of meager economic growth, mediocre earnings, and a bevy of potentially negative catalysts on the horizon.
- The MSCI ACWI Index, which includes both developed and emerging market equities, advanced +7.0% for the quarter. Markets advanced in every month in the quarter, as speculation that central banks would initiate additional monetary policy actions lifted asset prices.
- Risk appetites returned, as Asia ex-Japan led global performance, followed by Europe and emerging markets. Euro countries, in particular, rallied sharply as a series of announcements in the region restored confidence in the monetary union (at least temporarily).
- The U.S. modestly lagged the other major regions but posted a respectable showing despite the flight to higher risk investments.
- Japan was the outlier in the period, declining in the face of an upsurge in global equities.
Equity markets will try to hold onto the year’s positive gains heading into the final quarter of 2012. While some negative catalysts appear to have diminished, others remain, including the fiscal cliff, debt ceiling negotiations, and the ongoing crisis in Europe. Other uncertainties abound, including the US presidential election and the transition of Chinese leadership. Earnings will also take center stage as market participants evaluate the state of the corporate sector amid slowing economic growth. While corporations have consistently posted growth amidst a weak macro climate there are signs this phenomenon may be coming to an end.
Core taxable bonds (represented by the BC Aggregate Index), returned +1.6% during the quarter to propel year to date returns to +4.0%. Returns were primarily driven by spread compression in agency MBS and investment grade corporate bonds.
- Central banks were firmly in the spotlight during the quarter. Their interventions helped drive a global equity rally but safe haven bond yields were generally unmoved.
- The disconnect between the bond and equity markets is reminiscent of 1Q12 when a strong global equity rally was belied by stagnant safe haven yields. Yields for treasuries stayed within earshot of historic lows throughout Q3 despite bullish equity markets.
- Investment grade corporate bonds gained +3.8% in the third quarter to arrive at a very strong YTD return of +8.7%. Price appreciation accounted for more than two thirds of total return for the quarter. Demand for corporate credit has led to yields in the space breaching historic lows for three consecutive quarters.
- Agency MBS returned +1.1% in Q3 and YTD returns now stands at +2.8%. The coupon accounted for the majority of return during the quarter. Price appreciation was cancelled out by faster prepayments that pushed premium priced agency MBS to par.
- Non-agency MBS were strong outperformers as the housing market began to show more concrete signs of recovery. The fundamentals of the space are gradually improving with delinquencies and severities improving or at least stable. Investors desperate for yield also saw the space as an attractive conduit for higher carry.
- Intermediate municipals gained +1.4% for the quarter for an YTD return of +3.3%. Long duration munis continued to outperform as the yield curve flattened with long term yields coming down the most.
- Muni performance was strong relative to Treasuries. The BC AAA Muni Index returned +1.9% during the quarter while the BC Treasuries Index gained +0.6%.
- Retail investors have continued to pour money into the muni markets despite record setting low yields. Muni funds are on a 43 week streak of consecutive inflows with $39.6B allocated YTD.
Risk assets continued to benefit from a number of tailwinds in the third quarter, but particularly in the month of September. Directional hedge fund strategies experienced the highest returns riding the rising risk tide. Managed futures continued to struggle, but growing evidence supports a stabilization of trends in that arena.
- Inhospitable weather patterns provided fundamental backing for several sub-sectors within commodities, including agricultural and energy commodities. Broadly however, as was the case in all markets, global central bank actions played the primary role.
- The DJ UBS Commodity Index rebounded by nearly +10%, pushing YTD returns into the black. Pro-growth fiscal policies, inflationary monetary policies, a falling dollar, Middle East unrest, and less-than-stellar crop yields globally combined for a commodity maelstrom.
Heading into the fourth quarter, a number of issues could potentially derail the risk rally, but we could just as easily see a continuation of the strong risk appetite which would propel risk assets to further gains.
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.
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