The following is the third quarter commentary of Nathan Behan, senior investment analyst at Prima Capital. For more information, visit Prima Capital's site here.
Domestic equity: The third quarter was a roller coaster ride as investors quickly shifted between “risk on” and “risk off” trades.
After the fairly poor results in the second quarter, the third quarter started with a bang as the Russell indexes were up between 6.5% and 7.5% in July, pulling all but the Russell 1000 Growth Index into positive territory for the year. However, poor economic news in late July and early August pushed the indexes down sharply by the end of August, particularly the small-cap indexes.
September saw yet another reversal as the risk trade was once again in vogue, given the rally in the fixed-income markets in August that pushed the 10-year Treasury below 2.5%. Investors responded by pushing equities up across the board, led by small-cap-growth stocks at 14.2%.
The small-cap managers with whom we spoke noted that technology was one of the main drivers in the third quarter and that mergers-and-acquisitions activity was slowly picking up in that space.
Across all market capitalizations, there continues to be an expectation for an increased level of M&A activity, as the environment appears to be nearly perfect for it. Most domestic companies have substantially strengthened their balance sheets and improved cash flow through cost controls, and cash levels on corporate balance sheets are nearing all-time highs.
This is coupled with very low interest rates, and open and accommodative capital markets. Yet through the end of the third quarter, the number and size of the announced deals remained relatively small.
INTERNATIONAL MARKETS
The international indexes enjoyed a dramatic turnaround in the third quarter which was turbocharged by a rapidly weakening dollar.
In local-currency terms, the country indexes looked very similar to the U.S. indexes, with returns ranging mostly from 6% to 10%. These returns, when translated into the much weaker dollar, jumped dramatically in some cases to the 10% to 30% range.
This was particularly true for the eurozone countries, which enjoyed a 13% currency return. The two notable laggards for the quarter were Japan (Russell Japan Index was flat in local-currency terms and gained 5.8% in dollar terms) and Ireland (Russell Ireland Index was down 13.5% in local-currency terms, down just 3.5% in dollar terms).
Japan continued to struggle with a low-interest-rate and very low-growth environment, but U.S. investors did benefit from the strong currency appreciation that reached multidecade highs against the dollar. Ireland remained the weakest of the European countries, struggling with a significant banking crisis.
The emerging markets showed similar results to the developed markets in the third quarter, though the currency impact was significantly less pronounced, ranging from 3% to 6% on a regional basis. The Russell Emerging Markets Index was up 18.5% during the quarter in dollar terms.
FIXED INCOME
The domestic taxable-fixed-income markets had a broadly positive quarter as the Treasury yield curve continued to shift downward and flatten as the two- to 10-year spread fell another 25 basis points. Treasuries and government-related issues were up about 2.7% during the quarter and corporate issues rallied to a 4.7% return.
The big laggard for the quarter was the residential-mortgage-backed-securities market, as the U.S. MBS Index was up just 63 basis points. However, timing was crucial in the third quarter, as the fixed-income markets went through several phases.
In July, the markets went back to a “risk on” mode and corporate issues rallied nearly 2% in the month, compared with just a 68-basis-point gain for Treasuries. In August, the risk trade was placed on hold once again, though both the Treasury and corporate markets rallied 2% during the month on falling yields.
Corporates outperformed again in September as the risk trade came back in vogue, while Treasuries were flat overall due to slight backup in yields on longer-dated issues. Despite the broad rally in fixed income during the quarter, the residential MBS sector struggled, posting modest returns in the August rally and posting a small loss during September.
The primary cause was the overdue widening of spreads from unprecedented levels seen at the end of the second quarter. The option-adjusted spread, a measure of the excess return of a bond, compared with that of a similar-maturity Treasury, on the Barclays U.S. MBS Index was actually negative at the end of the second quarter, meaning that MBS issues were paying a lower yield than Treasuries.
By the end of the third quarter, the option-adjusted spread had moved out to a slightly higher-than-average 85 basis points. The high-yield market also rallied during the quarter, with the Barclays High Yield Index up 6.7%, more than doubling its return through the first half of the year.
The lowest-rated credits rallied strongly in September, making up for the losses posted in August.
MUNICIPAL BONDS
The Barclays Municipal Index was up 3.4% during the third quarter, more than doubling the index's return in the first half of the year.
Returns for the quarter followed the expected bull market pattern, with longer-term securities and lower-rated securities generating the largest returns. Like their taxable compatriots, the municipal bond managers with whom we spoke this quarter were in general agreement on a “slow growth” outlook for the domestic economy.
Some managers have internally increased the probability for a second recessionary period, but this is still a less likely scenario. Generally speaking, the muni managers have been implementing “barbelled” portfolio structures and offsetting some slightly longer purchases (in the seven- to-12-year range) with higher levels of cash.
This allows the portfolio to pick up some additional exposure to the steepest part of the yield curve, as well as giving the managers some “dry powder” should yields back up. Taxable muni issuance through the Build America Bonds program continues to be robust, reducing the new issuance of traditional muni bonds by an estimated 25%.
