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Eye Of The Storm

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by: Michael Loewengart
Michael Loewengart
Long-term horizon, portfolio strategy
Summary

The prevailing trend in 2017 had been large caps over small, but investors rotated into smaller players, especially toward the end of the month.

Developed markets stepped out ahead of their emerging market peers in September.

The yield on 2-year Treasuries ended September at 1.45%, its highest level since 2008, while the 10-year broke above its 200-day moving average before ending at 2.33%.

The winds are light and all is relatively calm. That's how the National Weather Service describes conditions within the eye of a storm.

And remarkably that's how you could describe the market this past month. It continued to brush off tumult all around, from escalating geopolitical tensions, to yet more health care reform machinations, to the natural disasters that wreaked havoc across the U.S. Gulf Coast, Mexico, and the Caribbean. Despite all this commotion, the major domestic indexes marched steadily higher, with the S&P 500 notching its ninth straight monthly increase, and likely on its way to an eighth straight quarterly increase.

Inflation still wouldn't budge much higher, but the Federal Open Market Committee (FOMC) seemed undeterred. As expected, officials held the fed funds rate at 1.00-1.25%, but said a third hike is still in the offing for 2017, and that three more 0.25% increases are on the docket for 2018. That's the same number officials forecast in June, based on the median in the "dot plot" of interest-rate forecasts. According to Federal Reserve Chair Janet Yellen, "Given that monetary policy affects economic activity and inflation with a substantial lag, it would be imprudent to keep monetary policy on hold until inflation is back to 2 percent."

In another move toward normalizing monetary policy, the Fed said that in October it will begin to unload the $4.5 trillion of debt that it bought to prop up the economy during and after the financial crisis.

Source: The Federal Reserve

Domestic equities

The prevailing trend in 2017 had been large caps over small, but investors rotated into smaller players, especially toward the end of the month. Market observers pointed to President Trump and Republican leadership announcing details of a proposed tax reform as a driver for the small-cap stock surge to record highs. The likely rationale for the move is that the smaller players have more to gain from a potential tax cut, given that more of their sales come from the US.

Traditional value plays like energy did not disappoint during the month. Energy led all sectors with a robust 9.94% gain amid higher crude oil prices. Conversely, growth-oriented sectors, including technology and consumer discretionary, pulled back earlier in the month before pushing toward modest gains of 0.64% and 0.84%, respectively. Those moves could be attributed to profit-taking, or mixed news flow, depending on who you ask.

Source: FactSet

International equities

Developed markets stepped out ahead of their emerging market peers in September. In particular, European stocks seemed to cheer comments from the Fed's Yellen about continued gradual rate hikes. The rather hawkish Fed-speak helped the dollar gain on the British pound and the euro. That likely boosted European exporters, whose goods become more competitive in the US when the dollar strengthens. Market observers pointed to basic resources and financial services stocks as drivers toward the end of the month.

Also likely providing euro-area stocks some solid footing were comments from European Central Bank President Mario Draghi. He said the ECB would keep as much stimulus as the euro-area economy needs when policy makers adjust their 2.3 trillion-euro ($2.7 trillion) bond-buying program.

Market participants also continued to turn toward Japanese equities, with many citing better corporate governance, higher dividends, and a weaker currency as helping Japanese companies deliver solid earnings.

Source: Morningstar

Fixed income

Bonds slid as September came to a close, with market observers attributing the weakness to optimism about the U.S. economy and the plan to overhaul the tax code steering investors away from havens. Along with increased expectations for the year's third rate increase, likely in December, U.S Treasury prices declined and yields hit their highest level in almost three months.

The yield on 2-year Treasuries ended September at 1.45%, its highest level since 2008, while the 10-year broke above its 200-day moving average before ending at 2.33%. As a result, the 2-10 Treasury yield spread, a common measure of the yield curve, widened during the month. The yield curve plots interest rates for Treasuries against the length of time they have to reach maturity. A flattening curve could indicate muted expectations for future economic growth, while a steepening yield curve historically means there is confidence in the economy.

By segment, high yield corporates increased 0.90% and were the top performing part of the market, despite bankruptcy headlines, including Toys "R" Us. Long Treasuries were the weakest segment, down 2.16%. Municipal bonds were modestly lower but appeared to show little effects from Hurricanes Irma, Harvey, and Maria.

Source: U.S. Department of the Treasury

The bottom line

The market remained calm amid several storms both real and figurative in September. The resiliency shown is nothing new in 2017, as the market has seemingly shrugged off uncertainty after uncertainty, and continued on its path higher.

Some say resiliency can lull investors into a false sense of security, or even complacency. Diversifying across assets is one way to stave off additional uncertainty sure to come at home and abroad. Based on September's performance and where the markets could head from here, investors may want to research the following areas:

  • International exposure, given the momentum in developed and emerging markets amid a positive global growth story. (For a deeper look into foreign equities, check out our latest weekly, International calling.)
  • Small caps, especially if a new tax code favors smaller, domestically oriented players.
  • Value stocks, as some investors could find themselves overexposed to growth stocks given their rise, and so are looking for new longer-term opportunities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.