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Thought Leadership

Market Commentary October 2018

Posted by First Affirmative | Oct 23, 2018 10:23:53 AM

Also In this Issue: Quarterly Performance Benchmarks

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It's the Earnings...

By Theresa Gusman

  • U.S. equities surged 7.71% in the third quarter as earnings remained strong.
  • The MSCI KLD 400 Social Index underperformed this quarter, but continued to track the broader market this year.
  • U.S. interest rates and the dollar continued higher, along with the economy.
  • Non-U.S. equities showed signs of life, as both emerging and developed markets advanced.

The U.S. equity market posted its best quarter since the end of 2013 as the S&P 500 advanced 7.71%, boosting its year-to-date gain to 10.56%. News flow during the third quarter was highly volatile: The narrative on trade policy shifted day by day; the drumbeat of controversy out of Washington reached a crescendo in recent weeks; and social, regulatory, and privacy issues were top-of-mind. However, you would never know it looking at the US stock market, which rose broadly and resumed 2017’s trend of steady gains with limited volatility.

Blockbuster earnings growth continues to drive the market – but it won’t last forever. U.S. corporate profits as measured by the Commerce Department jumped 16% in the second quarter, and according to FactSet, S&P 500 earnings are expected to leap another 19% in the third quarter. Following a strong fourth quarter, corporate profit growth is expected to slow to 7.1% in the first quarter of 2019 as the impact of the tax cuts fades. Although 7.1% is strong by historical standards, it pales in comparison to recent gains. This looming deceleration in corporate profit growth – combined with rising inflation and interest rates – could challenge the bull market in 2019.

Growth continued to outperform value in the third quarter. U.S. Large and Small Growth Funds advanced 7.55% and 7.02%, respectively, driving the year-to-date gains to stunning increases of 15.66% and 18.91%, respectively. Large Value Funds rose 5.50% in the quarter, while Small Value increased a pedestrian 1.03%. Among the Morningstar sectors, Healthcare (+13.87%), Industrials (+9.85%), and Technology (+9.25%) were the top performers, and Basic Materials (-1.20%), Energy (+0.77%), and Real Estate (+0.88%) lagged.

Reinforcing the notion that incorporating environmental, social, and governance factors into the investment decision-making process, does not present a financial trade­—off, the MSCI KLD 400 Social Index continues to perform in line with the broader market. Although the Social Index advanced “only” 6.11% in the third quarter (compared with the S&P 500’s 7.71% gain), it is up 9.80% year-to-date and 16.20% on an annualized basis over the past three years, essentially in line with the S&P 500. As active SRI investors, our starting point is returns in line with the broader markets and higher impact—and that is what we expect of our mutual fund and model managers.

Non-U.S. equities showed signs of life in the third quarter as the dollar stabilized. Nonetheless, among developed markets countries, the U.S. was the top performer followed by Switzerland (+7.26%) and Sweden (+6.98%) while the MSCI EAFE index advanced by a relatively sluggish 1.35%. Despite the quarter’s modest gain, the EAFE Index remains down 1.43% year-to-date and up just 9.23% on an annualized basis over the past three years.

Emerging markets remain stymied by U.S. trade tensions, economic and profit growth below recent “norms,” and dollar-denominated debt, which continues to bite with the rise in U.S. interest rates. The MSCI Emerging Markets Index fell 1.09% in the third quarter, as Thailand (+13.64%) and Poland (+12.83%) advanced strongly, while Turkey (-20.54%) and Greece (-17.59%) plunged. The third quarter decline brought the year-to-date decrease in emerging markets to 7.68% and constrained the annualized three-year gain to 12.36%.

Thinking about the outlook for emerging markets, it is important to remember that emerging markets have often been categorized as faster growing with relatively low correlation to the U.S. equity market. With the economy, corporate profits, and the equity market surging higher in the U.S., this categorization remains true—albeit in reverse—as evidenced by the numbers cited above. Looking to the end of the 10-year U.S. bull market (which we are loathe to predict), we anticipate a period of non-U.S. excess performance.

For the time being, however, US economic and earnings growth remain strong, the equity market is well-supported from a valuation perspective, unemployment is at historic lows, and inflation is within the Fed’s parameters. However, the beneficial effects of this year’s tax cuts have been incorporated into corporate and individual expectations, international growth has slowed, particularly in emerging markets, interest rates are rising globally, the dollar remains strong, and oil prices have increased—none of which bode well for economic or corporate earnings growth. Furthermore, the detrimental consequences of the U.S. trade war with China are already being felt internationally and by US companies. In the end, nobody wins a trade war.

As we look toward 2019, positive and negative factors are well-balanced, suggesting increased volatility amid decelerating equity market increases. Given current valuations, with U.S. economic activity strong relative to the rest of the world, the dollar strong and well-supported by rising interest rates, and trade tensions continuing to escalate, we believe U.S. equities may continue to outperform international stocks over the next several months. In the long term, we remain convinced by that well-structured, highly diversified portfolios—across the geographic, market capitalization, and growth-value style spectrums—will continue to enable our clients to achieve their financial and impact objectives.

Quarterly Performance Benchmarks

Passive Benchmarks* Q3 2018    YTD  1 Year 3 Year** 5 Year**
 S&P 500 Index 7.71 10.56 17.91 17.31 13.95
 MSCI KLD 400 Social Index  6.11 9.80 16.42 16.20 12.61
 DJIA (reinvested dividends) 9.63 8.83 20.76 20.49 14.57
 S&P MidCap 400 3.86 7.49 14.21 15.68 11.91
 Russell 2000 (Small Cap) 3.58 11.51 15.24 17.12 11.07
 MSCI EAFE (Europe, Australasia, Far East) 1.35 -1.43 2.74 9.23 4.42
 MSCI Emerging Markets -1.09 -7.68 -0.81 12.36 3.61
 Bloomberg Barclays Aggregate Bond 0.02 -1.60 -1.22 1.31 2.16

Morningstar Mutual Fund Benchmarks  Q3 2018    YTD   1 Year  3 Year**  5 Year**
 U.S. Large Cap Growth 7.55 15.66 23.22 17.67 14.01
 U.S. Large Cap Value 5.50 4.51 10.84 13.47 10.19
 U.S. Mid Cap Growth 6.53 13.51 20.33 15.84 11.72
 U.S. Mid Cap Value 3.07 3.30 8.96 12.60 9.34
 U.S. Small Cap Blend 2.78 8.11 12.03 14.67 9.72
Foreign Large Blend 0.60 1.24 3.42 7.17 8.52
U.S. Real Estate 0.79 -2.33 1.51 8.74 4.10
Intermediate-term Bond 0.18 -1.38 -1.07 1.65 2.16

* Sources: Morningstar 
**3-Year and 5-Year returns are average annual returns for that benchmark

Performance data presented reflects past performance. Past performance is no guarantee of future results. Investing involves risk, including loss of principal. Passive benchmarks are unmanaged groups of stocks and are not directly available for investment. Information has been obtained from a source considered to be reliable; however, neither First Affirmative nor its agents can guarantee the accuracy of the numbers reported.

 

Topics: Market Commentary

Written by First Affirmative