The third quarter proved to be a good environment for investors in most asset classes. While domestic taxable bonds returned 0.5%, and investment grade municipal bonds returned 0.7%, the global taxable bond market returned an exceptional 2.8%. The stock market provided the best returns though. The S&P 500 returned 5.2% for the third quarter, emerging market stocks returned 5.9%, frontier market stocks returned 6.3%, and developed international stocks returned 11.7%. Smaller company stocks were the star performers as domestic small-cap stocks returned 10.2% and their counterparts in developed international markets returned a hefty 15.6%. The losers for the quarter were the more defensive and higher yielding hybrid equity securities like REITs (down 3%), preferred stocks (down 2.2%) and energy infrastructure MLPs (down 0.7%). High yield municipal bonds (down 3%) were the hardest hit bond sector due to the uncertainties surrounding the Detroit bankruptcy.
While the end result was positive the road to it was a little bumpy. Most stock and bond markets struggled during August as investors grappled with the potential for another military action in the Middle East (Syria), the Federal Reserve’s pending tapering of bond purchases (quantitative easing), speculation regarding Federal Reserve Chairman Ben Bernanke’s successor and the coming showdown in Washington over the nation’s debt ceiling. Fortunately, the Syrian situation was resolved peaceably, the Fed decided to postpone tapering, and Larry Summers removed his name from consideration as the next Fed chief, leaving Janet Yellen, the current Vice Chair of the Federal Reserve, as the likely heir apparent. That removed sufficient uncertainty to allow the global market rally to resume. The debt ceiling debate still hasn’t been resolved. The government shutdown, while devastating to those whose jobs have been furloughed, will not have a huge impact on overall GDP growth. Failure to make good on our debt obligations, which we would still place a very low probability of happening, would be a disaster that would likely impair GDP growth and the markets for some time to come.
Most of our client’s portfolios experienced strong absolute returns for the quarter but we did lag benchmarks somewhat on a relative performance basis. Much of this is by design as we seek to keep up in strong markets but give it back more slowly in weak markets. It was predominantly our non-traditional investments that caused the biggest drag on relative returns. As noted above, real estate investment trusts (REITs), energy infrastructure master limited partnerships (MLPs) and preferred stocks were the losers for the quarter. While we much prefer to have all winners, we are comforted in knowing that these more defensive positions should outperform in any market pullback.
Most of the market’s headwinds of uncertainty have been removed; but, the one really big headwind remains—a resolution to the debt ceiling debate. The global stock market is poised for one more leg up—we have breadth (the developed international markets began to outperform last quarter), we have depth (small- and mid-cap stocks are outperforming their larger brethren in all developed markets, and in the domestic market we are starting to experience price-to-earnings multiple expansion. A timely (within the next couple weeks) resolution to the debt ceiling debate will allow the rally to continue. If it drags on too long it will eventually have a detrimental effect on the economy, markets and investors’ psyches.
We remain committed to our mandate to build the least risky portfolios necessary for our clients to achieve their financial goals.