The third quarter marked yet another period of strong performance for the U.S. equity market, which remained resilient despite weakness in overseas markets. While U.S. equity indices hit new record highs, attracting a lot of attention and headlines, the rest of the world’s equity and fixed-income markets did not perform very well, which has confused many people. As you watched the Dow set a new record,1 you would have expected a big return on your portfolio — but, if you look closer, you can see that diversified portfolios did not have that kind of a quarter.
We are making a special point of this occurrence (and will continue our analysis of it below) because confusion can lead to mistakes. If you mistakenly expect a bigger return and think there is “something wrong with your portfolio” when you don’t see it, you might be tempted to make an ill-advised change, probably at exactly the wrong time. Please don’t be fooled — if you average in the returns of the other asset classes, you will have a better understanding of what a reasonable portfolio return should have been last quarter, which should reassure you that you are not off course.
The Economy and Asset Class Returns
The U.S. economy is on sturdy footing: As revised second-quarter GDP estimates came in at 4.2%, the unemployment rate dropped to 3.7% at the end of September and wage growth (2.8% as of September)2 was up slightly from the previous quarter. While inflation also ticked up, the Federal Reserve did not consider inflationary pressures compelling enough to alter its original plan, and therefore raised rates a quarter of a percent in September (as anticipated) and signaled a steady rate-hiking path. On the trade front, the U.S. made progress striking a new trade deal called the United States–Mexico–Canada Agreement (USMCA), which is expected to benefit the U.S. auto and dairy industries. Trade talks with China continued to be a challenge as both countries ramped up tariffs during the quarter. Despite some overhanging clouds, investors in globally diversified portfolios reaped positive returns in both the U.S. and international-developed segments of their portfolios.
Returns shown in the chart above are for third quarter 2018.
Source: Morningstar®, data as of September 30, 2018. See disclosure page for more information.
The U.S. equity market was the best-performing segment in the third quarter, supported by the robust U.S. economy and business fundamentals. U.S. large-cap stocks, represented by the S&P 500 Index, gained 7.7% this quarter. This strong performance partially can be explained by the administration’s tax cut initiatives as well as resolution on the trade-front negotiations with Mexico and Canada, which tends to have a greater impact on large-cap companies. Within large caps, growth stocks outperformed value stocks, with the Russell 1000 Growth Index up +9.2% versus the Russell 1000 Value Index return of +5.7%. The story is similar in the small-cap asset class; the Russell 2000 Index ended the quarter with a 3.6% gain, and growth stocks (+5.5%, Russell 2000 Growth Index) also outpaced value stocks (+1.6%, Russell 2000 Value Index).
We saw muted gains in international stocks this quarter as the effects of dollar appreciation, relative to developed and emerging-markets currencies, hurt performance for U.S. investors in overseas markets. International-developed stocks, represented by the MSCI EAFE NR Index, gained 2.4% in local currency terms and 1.4% in U.S. dollar terms. On the other hand, the MSCI Emerging Market Index was nearly flat (-0.04%) in local currency terms and declined 1.1% in U.S. dollar terms. While international markets have underperformed U.S. markets so far this year, it is important to remember the diversification benefits of adding overseas exposure to a portfolio. It is extremely difficult to predict the timing of international-market outperformance. For example, in 2017, emerging-markets stocks were the best-performing asset class, but this year U.S. equity has taken the torch and emerging-markets stocks are at the back of the pack.3,4
On the fixed-income side, the Federal Reserve raised rates again in September, signaling their continued confidence in the economy. The Fed also indicated there likely will be another rate hike later this year and three more in 2019. Since the end of the second quarter, the 2-year Treasury yield rose from 2.52% to 2.81%, and the 10-year Treasury yield rose from 2.85% to 3.05%, which resulted in a slight flattening of the curve. The Bloomberg Barclays Aggregate Index, representing investment-grade U.S. bonds, was essentially flat (+0.02%). Municipal bonds, represented by the BBgBarc Municipal 1–10Y Index, slightly declined by less than 0.1%.
Although they are still struggling, emerging-markets bonds calmed down a bit after significant headwinds last quarter, due in large part to emerging-markets currency softness. The JPM GBI-EM Global Diversified Index (UH), representing local currency bonds issued by emerging-market governments, declined 1.8%. Meanwhile, high-yield bonds, represented by the ICE BofAML BB-B US CP HY Index, had a solid quarter and posted a 2.4% gain.5
The U.S. equity market was the strongest performer this quarter, while international and emerging markets struggled. With recent U.S. dollar strength and international trade concerns causing gyrations in international equity markets, it can be tempting to question the role of international stocks within a portfolio. However, making changes to a long-term portfolio based on a few quarters of lackluster performance can have a lasting negative impact, as today’s underperformers may well be tomorrow’s stars. In times like these, it is more critical than ever to remain disciplined and adhere to a well-diversified investment strategy — after all, as Harry Markowitz once famously said, ‘diversification is the only free lunch in investing.’”6
U.S. Stock Market: Russell 3000 Index
International-Developed Stocks: MSCI EAFE NR Index
Emerging-Markets Stocks: MSCI EM NR Index
U.S. Bond Market: Bloomberg Barclays Aggregate Index
Emerging-Markets Bonds: JPM GBI EM Global Divers TR Unhedged
Return data represent past performance and are not indicative of future results. Historical returns of indices do not reflect applicable transaction, management or other applicable fees, the incurrence of which would decrease historical performance results. Index information has been compiled by Wipfli Financial from sources Wipfli Financial deems reliable, but has not been independently verified. Historical performance results for investment indices and/or categories have been provided for general comparison purposes only. Indices are unmanaged. It is not possible to invest directly into an index. Any charts and graphs represented herein are for informational purposes only and cannot in and of themselves be used to determine which securities to purchase or sell, or when to purchase or sell securities.
Source: ©  Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.