Hello everyone and welcome to the third quarter Quarterly Market Perspectives.
My name is Broderick Mullins and I am the Portfolio Manager at Covenant Wealth Advisors. I’ll be your host for this presentation.
As was the case last quarter, this presentation has been revised to provide a better discussion of quarterly equity and fixed income performance along the framework of absolute returns, relative returns, and future expectations for market performance.
We begin our discussion with a high-level look at a collection of major asset classes. As we can see from the illustration, U.S., international and emerging markets stocks were all lower during the third quarter, with Emerging Markets experiencing the largest decline of 7.4 percent for the quarter. Returns for U.S. and global bonds on the other hand were positive.
Next, I’ll draw your attention to the upper right hand portion of the graphic. The US Dollar was up 4.8% for the quarter and up 0.4% over the last 12 months. Interesting to note, the movement of the US dollar matters because a strengthening US dollar can hurt your international stock performance and a weakening US dollar can improve your international stock performance.
Now, Let’s look a little deeper at what was driving the returns of stocks and bonds.
We’ll start by taking a look at how global markets performed for the quarter, and we’ll isolate the performance between U.S. stocks and developed international stocks.
The two charts show the performance of different investment styles between the U.S. and international stocks. The bright blue bars represent the performance of different investment styles, and the dark blue bars represent the total market performance for the region. U.S. returns are measured with the Russell indexes, and international market returns are measured with the MSCI World xUS index series, which represents global developed market performance, excluding the United States. As we can see from the dark blue line on the chart located on the left, the U.S. market was down 0.1 percent in the third quarter, compared to down 0.4 percent for developed international markets depicted on right side of the page.
Continuing the trend from the second quarter in the U.S., large growth was the dominant style. However, we saw small cap stocks of all styles outperform their large cap counterparts internationally. It’s important to remember that the performance of one quarter is filled with statistical noise that is difficult to make sense of in such a short time frame.
Now we take a longer view to see how different investment styles have performed for standard periods ending September 30, 2021. Looking at annualized returns in the U.S., we can see extraordinary returns for the one year as the recent performance still shows the effects from coming out of the COVID market downturn. Small value performance far exceeded the general market over the last year, returning more than 63 percent compared to nearly 32 percent in the U.S.
However, we see that small value has underperformed most other styles at the 3, 5, and 10 year investment horizons. Consequently, we expect that portfolios that have a small value tilt, such as those that we typically design for clients, will have underperformed portfolios that are market-cap weighted or tilted to large growth stocks at these longer investment horizons.
It is important to recognize, however, that despite the under performance, small value has still returned a formidable 13.2 percent per year in the U.S. for the last ten years.
Turning to international markets, we see small cap value has led the pack over the one year period albeit at a lower total return compared to the U.S.. At the longer time horizons, we see small caps, particularly neutral and growth stocks, offering the highest returns over the 10 year period at 10 percent and 11.1 percent respectively. Relating the prior slides, we see that international markets have under performed the U.S. market at every horizon, with the 3 year performance trailing by nearly 8 percent per year and the 5 and 10 year performance trailing by 7.8 and 8.4 percent per year respectively.
Given the higher U.S. return, we expect portfolios concentrated in U.S. stocks to outperform a globally diversified portfolio. However, as we’ll see in the next slide, these relative performance numbers aren’t reason enough to abandon international stocks.
Thus far, we’ve discussed quarterly performance on a relative and absolute basis. Now, let’s take a look at current stock market valuations and how they relate to future expectations of market performance.
The charts on this slide show how expensive stocks are by measure of the price-to-earnings ratio, a very common metric used to value equities. The higher the ratio is, the more expensive the asset class is overall. Thought of another way, these values depict how expensive one dollar of earnings are. For example, as we can see in the chart on the top left, the average dollar of earnings for the total U.S. stock market costs roughly $24. Internationally, as we can see in the chart on the top right, earnings are cheaper at roughly $17 per dollar of earnings on average. The values represented here used historical fund and ETFs to establish the price ratios, and the average P/E is reflected by the dotted line on the chart. These averages start in the first quarter of 2004 for U.S. measures, and in the 4th quarter of 2006 for international stocks. So the average is roughly 18 years in the US and 15 years internationally.
In addition to identifying relatively cheap segments of equity markets, these ratios also help set the table of forming expectations about the future. Although we like to say our crystal ball is always cloudy, there tends to be an inverse relationship between current equity valuations and future performance. Generally, investors will bid up the price of certain stocks in expectation of higher future earnings. Therefore, as a particular group of stocks becomes more expensive, their expectations for future earnings growth are lessened because investors are less willing to pay an ever-growing premium for those expected earnings, especially when earnings can be bought elsewhere for less. I’ll emphasize that this is a long-term relationship, and as we’ve already seen on previous slides, there’s a wide range of possible short-term outcomes.
Here we have the same analysis but isolating US equities so we can see how valuations compare across different styles. Recalling the annualized performance slides, we know that large cap growth has had an exceptional 10 year period. We can see that the growth in prices has exceeded the growth in earnings as the P/E ratio has climbed to 35.3 to close the quarter. Small cap value, on the other hand, even with the rebound in the year, still has a P/E ratio under 13 and under the average of the last 18 years.
Although many investors may be interested in chasing the returns of large cap growth companies, we would point to these valuation charts as one reason to stay the course in a diversified portfolio tilted to smaller, distressed companies.
Next we’ll take a look at fixed income performance, the shape of the current yield curve, and how the market is currently pricing inflation.
The charts on the screen show the average performance of different bond maturities and the segments of the fixed income market that we commonly track.
We typically prefer investing in bonds that are shorter maturity and higher quality compared to the broader market. In the chart on the left side, we see short-to-intermediate term bonds posted generally flat performance. The 3-7 year maturities lost 0.1 percent for the quarter, but were outperformed by longer dated bonds as the longer end of the yield curve fell. It’s worth noting that the extreme price fluctuations that we tend to see in the 10-20 year bonds are why we like to keep maturities short to intermediate. Although it was a tail wind this quarter, we’ve seen plenty of quarters historically where the yield curve has moved against us.
The chart on the right shows the performance of different intermediate maturity credit quality bonds. We see that inflation protected bonds have continued to be bid up as more investors seek to hedge their exposure to inflation. Treasuries had flat performance for the quarter, while corporate and municipal bonds returned 0.1 and -0.2 percent respectively, indicating tightening credit spreads and investors showing a slight preference for corporate debt as opposed to municipal debt during the third quarter.
Next we’ll look at the treasury yield curve and what it means for returns going forward.
Here we plot the yield curve to show us the current yields for treasury bond investments at different maturities.
The bright blue line represents current rates, the dark blue line represents interest rates at the end of 2020, and the gold line represents rates one year ago. In short, the early part of the curve is steeper and is elevated overall compared to the end of 2020 and to one year ago.
Practically, this means that expected returns on fixed income are higher, but that treasury returns would have been negative year to date and over the one year period. It’s worth noting that most of the yield curve changes year to date happened in the first quarter, and that rates continued to rise slightly between the end of the second quarter and the end of the third quarter, which is why we saw generally flat performance from bonds in the third quarter despite seeing higher yields compared to the first part of the year.
Finally, we plot the markets’ forecast of inflation by taking the difference in yields between U.S. Treasury bonds and TIPS at different maturity levels. Like the last chart, the bright blue line represents current inflation expectations, the dark blue line represents inflation expectations at the end of last year, and the gold line at the end of the third quarter last year.
Consistent with what many are expecting and what we’re hearing in the media, inflation expectations are higher compared to this time last year or even compared to the end of 2020. It is important to remember that these levels of inflation are baked into prices today: the markets are pricing an average inflation rate of 2.5 percent per year for the next five years, and the market collectively expects inflation to exceed the Fed’s 2 percent target over the next 30 years. Not only are these expectations baked into bond prices, but they’re also baked into equity prices. Making a bet on ‘higher’ inflation would mean that we expect inflation to exceed the current forecast – the market already expects inflation to be higher than what was previously expected over the last year.
And with that, we’ve reached the conclusion of the presentation. As always, I hope you learned something new and if you are an existing client, thanks for your trust.
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