What were the top-performing separately-managed accounts for the third quarter? View the top ten in four categories here:
domestic equities,
international equity,
U.S. fixed income, and
U.S. municipals.
Nathan Behan, a senior investment analyst at
Prima Capital Holdings, outlines some key recent and long-term trends in the markets in an economic report and analysis on the third quarter.
DOMESTIC EQUITY
The domestic markets went from bad to worse over the course of the third quarter, with brief, sharp rallies mitigating some of the damage, but overall a dismal quarter indeed. The Russell 1000 Index was down 14.7% and turned in its worst performance since the final quarter of 2008 and fifth-worst since 1979. Within the large-cap index, only the utilities sector had a positive return for the quarter, a modest 27 basis points, while the energy, industrials, financials and materials sectors all were down more than 20%.
There were two clearly related trends during the quarter: an overall lack of confidence in the economy by both consumers and investors, and the search for income as rates in the investment-grade fixed-income market continued to fall.
The equity markets were dominated in the quarter by macroeconomic news rather than individual company fundamentals, and the news was generally negative. From weaker-than-expected gross domestic product growth in July to recurring issues with European sovereign debt (and the ancillary concern about the exposure to that debt in U.S. and foreign banks), the negative news continued to reduce the appetite for risk assets. Investors voted with their feet, and U.S. stock mutual funds saw an estimated $38.2 billion in net outflows through the end of August.
The managers we speak to on a regular basis were noting “reasonable” to “slightly cheap” valuations at the end of the second quarter, so it is safe to say they now believe that the equity markets have become distinctly cheap. According to Standard & Poor's, there have been 10 consecutive quarters of earnings increases and the last seven have been at double-digit year-over-year rates. Even with all of the negative news in the macro environment, there was only a slight decline in the estimates for the third quarter. The crux of the question for the fourth quarter and beyond is whether the earnings estimates still are too high, a sign that the overall market is not quite as cheap as it seems or, conversely, that earnings estimates are in the reasonable range with potential upside surprises if the macroeconomic shadow is lifted. For the most part, the managers we spoke to are in the latter camp and remained positive going into the final quarter of 2011.
Click here to view domestic equities rankings.
INTERNATIONAL MARKETS
As bad as the domestic-equity markets were in the third quarter, the international markets were even worse. The uncertainty around sovereign-debt default and the potential exposure of European banks had a more direct effect on those local markets. For U.S. investors, the dollar appreciated sharply against most currencies, with the exception of the Japanese yen. The Russell Developed ex-North America Index was down 19.7% in the quarter with slightly better performance in the Asian indexes and slightly worse in the European markets.
Outside of Greece, the worst performers were those trying the hardest to keep that country from default. Core European countries France and Germany were both down roughly 30% in dollar terms, with most of the eurozone down 20% to 25%. Results were slightly better on the other side of the globe, as the Asian-sphere countries were down 15% to 20% in dollar terms. In fact, there were only two countries with less than 10% losses in the quarter: The Russell Japan Index was down 5.2% in dollar terms, thanks to a positive 4% currency impact, and the Russell New Zealand Index, which actually had a slightly positive return for the quarter in local terms but was down 7.8% in U.S. dollar terms.
Most of the managers we have talked to this year have been underweight the eurozone, either favoring the non-European Union Nordic countries, or companies within core Europe that have significant emerging-markets revenue. We would expect this positioning to continue as long as the uncertainty remains around the weaker members of the European Union (Greece, Italy and Spain), and, more specifically, until there is more transparency around the actual holdings of the sovereign debt of these countries and the potential impact of a default on the stability of the European banking system.
While the emerging markets were a source of strength, and the only significant source of economic growth in the first half of the year, the third quarter's avoidance-of-risk theme played out there, as well. The Russell Emerging Markets Index was down 23% in U.S. dollar terms, as investors became increasingly concerned about slowing growth in China and Brazil, and falling commodities prices affected many of the resource-rich economies that benefited the most from rising prices over the past year.
The global slowdown will continue to affect those countries where exports remain a large factor in the economy. However, several managers we spoke to noted that this could be a prime opportunity for the leaders in those countries to make the transition to an economy more focused on the domestic consumer.
Click here to view international equity rankings.
FIXED INCOME
Multiple influences in the domestic fixed-income markets created several driving factors for returns in the quarter. Weaker-than-expected second-quarter GDP numbers pushed rates lower in late July. Then, despite the political wrangling in Washington over the debt ceiling, global investors continued to favor Treasuries and the dollar in the face of continued uncertainty about the stability of the euro through most of August.
Finally, although it appeared to be well-telegraphed in advance, the market reacted strongly to the Fed's announcement of Operation Twist, in which the government will sell shorter-dated maturities and begin buying much-longer-dated maturities (10 or more years) to push rates down and encourage business borrowing and expansion.
All of these actions led to a strong rally in Treasuries, but the overall market anxiety and shift away from riskier securities pushed spreads wider in the rest of the market.
The current Treasury yield curve shifted dramatically lower during the quarter, mostly in the last month, not only from June 30 levels but from year-earlier levels, as well. This sharp drop, particularly in the long end of the curve, dominated market returns as the Barclays U.S. Treasury Index led the market with a 6.5% return, and the 20+ Year Treasury Index was up 29.2% in the quarter.
Click here to view fixed income rankings.
MUNICIPAL BONDS
The municipal market continued to move forward despite concerns over budget shortfalls in individual states. The Barclays Municipal Bond Index was up 3.8% in the third quarter as maturities lengthened, gradually increasing return.
The muni market has continued to struggle to match the underlying fundamentals and technical factors that have been driving the market for most of the year.
Muni funds continued to see significant net outflows in the third quarter (just under $900 million in the first two months of the quarter), which would have resulted in significant pricing pressure in most market environments.
However, new issuance has been anemic all year and, according to the managers we spoke to, remained at about half the normal volume in the third quarter. This has limited supply in excess of the funds leaving the asset class, pushing prices upward.
Further complicating the market technicals was the significant shift in the Treasury curve during the latter half of the quarter. This pushed yields on municipals lower (and prices higher), though the muni yield curve still trades through the Treasury curve on a pretax basis in the longer end of the curve.
Click here to view municipal bond rankings.
