Q3 Review Article

Despite Trade Jitters, U.S. Stocks Keep Advancing: Q3 Review

Q3 Review Article

With technology bellwethers Apple and Amazon becoming America's first companies with market capitalizations surpassing $1 trillion, blue chip domestic stocks turned in banner performances in 2018's third quarter.

Robust economic growth and corporate profits overshadowed jitters over trade tensions between the U.S. and China. After targeting smaller tariffs on Chinese products over the summer, in September a 10% tariff was set by the developed markets leader on another $200 billion worth of the emerging markets giant's goods.

But such a development, which didn't come until well into the third quarter, wasn't enough to derail business and consumer optimism for the three-month period that ended in September.

The rally in U.S. stocks that started in March 2009 reached new heights in late August, becoming the longest bull market yet. GDP growth hit 3.5% and consumer spending increased by 4%, its biggest three-month spurt since 2014.

Corporate earnings by S&P 500 constituents increased on average by nearly 25% from a year earlier, FactSet research recently reported. If it holds up, such an estimate would mark the benchmark's second-biggest Q3 profits jump in eight years.

The S&P 500 closed at an all-time high in late October and wound up posting its best quarterly return (7.71%) since late 2013. Also in the quarter, consumer confidence readings reached an eight-year high. Strong economic growth led to multi-year lows reported for initial jobless claims and wage growth was its best since 2009.

With such a backdrop, growth stocks kept outperforming value-styled indexes in the quarter. The all-cap Russell 3000 Growth Index increased by 8.88% while its cousin value benchmark gained 5.39%. In terms of market capitalization size, investors turned to shares of larger companies, a reversal from the previous quarter. By Q3's end, the Russell Midcap Index had returned 4.99%. Meanwhile, the small-cap Russell 2000 Index gained nearly 3.57%.

International stocks were Q3 laggards. The MSCI EAFE Index, a widely followed benchmark tracking major foreign developed markets, returned 1.35% as denominated in the U.S. dollar. Weighing on eurozone investors were concerns about exposure to Turkey's economic crisis and Italy's budget woes.

In fact, U.K. stocks as tracked by the FTSE slid by almost 3% amid uncertainty over Brexit negotiations and early jitters about U.S. and European trade talks. But an agreement to keep working towards "zero" tariffs and postponement of threatened tariffs on cars helped to ease tensions. The European Central Bank reiterated it would hold steady with interest rates through at least next summer, and sequential Q2 economic growth was revised up slightly across the eurozone.

Amid U.S.-China trade discourse, the MSCI Emerging Markets Index lost 1.09% in the third quarter. As bilateral trade negotiations failed to resolve differences between these two world powers, China ended up reporting year-over-year Q3 economic growth of 6.5%, its weakest pace since early 2009. The MSCI China Index lost 7.51% in dollar terms in the quarter.

A sharp sell-off in the lira, Turkey's currency, and slower-than-expected growth in South Africa contributed to a negative quarter for broader emerging markets equity benchmarks. Bright spots included: Thailand, which profited from strength in energy stocks; Mexico, where markets posted gains after elections and agreement with the U.S. over a new trade pact that includes Canada; and Russia, buoyed by rebounding oil prices.

 

Domestic Equities

Returns for the different size and style of domestic equities differed quite a bit in Q3 of 2018. The returns ranged from 7.80% for large-cap growth equities to 1.51% for small-cap value equities. Meanwhile, stocks as captured in IFA's blended domestic large-cap benchmark jumped by more than 7.71% as IFA's U.S. large-cap value index ended up with a positive gain of 5.71%.

Returns of IFA Domestic Equity Indexes Q3

For the domestic equity indexes used in IFA portfolios, the quarterly return was 4.00% for Q3. This was less than the U.S. market as broadly measured by the Russell 3000 Index, which returned 7.12% in the same time period.

 

International (Developed) Equities

IFA index returns from developed countries that are outside the United States posted a mixed third quarter. In Q3, results ranged from a gain of 1.29% for large-cap international value equities to -1.15% for international small company stocks. When looking at the year-to-date results through Q3, the initial nine months of 2018 saw returns ranging from -6.58% (international small- cap value) to -3.35% (international large-cap value).

Returns of IFA International Equity Indexes Q3

For the blend of international indices used in the IFA Index Portfolios, the return was -0.278% in Q3. This was worse than the MSCI World ex-US All Cap Index, a benchmark of developed international stocks, which delivered a return of 0.94%.

Returns by developed country in Q3 ranged from 8.32% (Israel) to -5.75% (Ireland). Top performing countries included Sweden (6.43%), France (2.37%), Japan (2.26%) and Singapore (0.18%). The worst performing countries included Belgium (-4.29%), Italy (-4.00%) and Spain (-2.57%).

 

Emerging Markets Equities

Emerging Markets had a mixed quarter. For Q3, EM returns ranged from a gain of 2.20% for emerging markets large-cap value equities to -4.54% for emerging markets small-cap equities. By comparison, so far in 2018 returns ranged from -12.58% (emerging markets small-cap value) to -5.13% (emerging markets large-cap value).

Returns of IFA Emerging Markets Equity Indexes Q3

For the blend of emerging markets indices used in IFA Index Portfolios, the return for Q3 was -0.55%. Our mix outperformed the MSCI Emerging Markets Index, which returned -1.09%.  

Returns by country in Q3 ranged from 14.13% (Thailand) to -21.03% (Turkey). Top performing countries included Qatar (11.64%%), Mexico (7.02%), Brazil (4.07%) and Russia (3.20%). Worst performing countries included Greece (-13.38%), Egypt (-10.88%) and India (-4.75%).

 

Real Estate Equities

Global real estate was a picture of the broad benefits of diversification. In the third quarter, international real estate stocks returned -1.17%. Domestic REITs gained 1.18%, providing the IFA Global Real Estate Index with a 0.36% blended return in Q3.

Returns of IFA Real Estate Index Q3

 

Fixed-Income

Interest rates in U.S. income markets increased during Q3, resulting in a change in return for our fixed income positions. In the third quarter, the 30-year U.S. Treasury rate and the five-year U.S. Treasury rate each increased by 21 basis points.

For Q3, the four bond funds used by IFA delivered returns ranging from 0.50% for One-Year Fixed-Income to 0.02% for Short-Term Government Fixed-Income.

Returns of IFA Fixed Income Indexes Q3

For the blend of fixed income used in the IFA Index Portfolios, the return was a positive 0.31% for Q3. If interest rates rise, so do yields. But the market value of bonds will diminish because investors can get a higher rate of return on newly issued bonds with the same maturity that are currently being offered in the market. That’s an advantage of mutual funds, where bond principals can be reinvested on an ongoing basis. 

 

IFA Index Portfolios  

The returns of the IFA index portfolios are shown below net of the maximum annual 0.90% advisory fee through Sept. 30, 2018.

Returns of IFA Index Portfolios Q3 2018

What investors need to remember is that there will always be periods in which their IFA Index Portfolios will underperform in the short-term. This is the very nature of taking risk. Given the recent underperformance in U.S. value stocks as compared to domestic growth stocks in both large- and small-cap market sizes, many investors may be wary about their asset allocation.

The chart below shows rolling period return of the IFA U.S. Small Cap Value Index versus the IFA U.S. Large Cap Growth Index. Over any given month, the odds of U.S. Large Cap Growth stocks outperforming are slightly less than a coin flip. But once we expand our view to longer time horizons, you can see that a disciplined approach yields favorable results for the globally diversified investor. (Note: this interactive chart allows you to compare different periods and indexes.) 

Each Quarter, IFA monitors the funds they recommend for clients and as part of that process, we’ve developed a rating system. Below is a link to our Performance Monitoring Report for client portfolios: IFA 3rd Quarter 2018 IFA Client Performance Monitoring Report.

 

Investment Kit

We recently created the IFA Investing Kit that includes a copy of Index Funds: A 12-Step Recovery for Active Investors book, the documentary, as well as The Galton Board, which simulates market outcomes based on fair prices right before your very eyes. You can find the kit on Amazon.