After the excitement of the Brexit vote last quarter, markets calmed down in the third quarter, and for the most part, we saw significantly less volatility relative to previous quarters. This isn’t unusual for the late summer months, when even traders take some time off from the markets.
But it wasn’t all smooth sailing — especially in September, when the European Central Bank decided against extending its quantitative easing program, and there was uncertainty about whether the Fed would raise rates. That bout of volatility was quelled by the Fed’s decision not to raise rates in September. Overall, investors’ appetite for risk increased this quarter, and stocks (particularly small-cap stocks and international stocks) outperformed bonds.
In the U.S., small-cap stocks (represented by the Russell 2000 Index) were the star performers, returning 9.1%. This far exceeded the 3.9% return of the S&P 500 Index, which is composed of U.S. large-company stocks. In a reversal from last quarter, value stocks (Russell 1000 Value TR: +3.5%) modestly trailed growth stocks (Russell 1000 Growth TR: +4.6%); however, year-to-date value stocks are still outperforming growth stocks.
International-developed markets posted strong performance, as investor fears regarding the Brexit impact receded. The MSCI EAFE Index of international-developed market stocks gained 6.4% in US$ terms; most of these gains took place in July. Emerging-markets stocks (MSCI EM GR) returned an impressive +9.2% (in US$ terms). Brazil, Russia and China were among the strongest performers in the emerging markets. Currency fluctuation had a mildly positive impact on the returns for U.S. investors overseas, as the dollar depreciated relative to the euro and many emerging-market currencies.
On the fixed-income side, the Federal Reserve decided in a split vote against raising rates in September (note that the last time the Fed had three dissenting votes was in December 2014). U.S. Treasury yields inched up over the course of the third quarter with shorter-term Treasury yields rising slightly more than longer-term yields. Despite the meager bump up in Treasury yields, bond yields in both the U.S. and international-developed markets still remain very low.
The Barclays Aggregate Index of domestic investment-grade bonds (the U.S. bond market) eked out a 0.5% return this quarter. Municipal bonds were down slightly with the Barclays Capital 1-10 Year Municipal Bond Index declining 0.1% this quarter. Meanwhile, high-yield bonds (BofAML US HY C Pay BB-B Constd Index) gained 5.0%, and emerging-markets bonds (JPM GBI-EM Global Divers TR USD Unhedged) were up 2.7%. Both of these segments have logged double-digit returns year-to-date, as investors continue to search for yield in the low interest-rate environment.
Achieving long-term returns requires discipline and patience. Over the past few years, that meant sticking to international stocks, emerging-market stocks and small-cap stocks when the only segment that seemed to be adding to returns was U.S. large-cap growth stocks. This quarter and so far this year, the patience and discipline of sticking to a globally diversified portfolio has started to pay off.
*The U.S. stock market is represented by the Russell 3000 Index.