STOCKS CONTINUE THEIR STEADY RISE

  • Economic data received over the last three months reflected steady economic growth. The Citigroup Economic Surprise Index, an aggregate measure of economic surprises, rebounded from spring weakness as data mostly surpassed expectations. The last month of the quarter was marred by hurricanes Harvey and Irma, but Bloomberg’s consensus estimates still reflect 2.6% annualized real gross domestic product (GDP) growth in the third quarter, down just 0.5% from the strong 3.1% final reading for the second quarter and still above the 2.1% expansion average. Measures of consumer confidence remain strong and steady—consumer spending gains continued up until the hurricanes hit. Job growth in July and August further tightened labor markets, pushing wage growth higher and supporting consumer spending. Survey data suggest manufacturing activity picked up over the past three months while businesses generally remained quite confident. Despite the modest negative impact of the hurricanes, as the quarter ended the Federal Reserve (Fed) remained on track to raise interest rates in December, supported by tightening labor markets and related accelerating wage gains.
  • U.S. stocks returned 4.5% during the third quarter, based on the S&P 500 Index (including dividends). Continued steady growth in the U.S. economy, solid earnings gains, and increasing optimism surrounding tax reform in Washington, D.C., provided a favorable macroeconomic environment for domestic stocks during the quarter, despite hurricane impacts, tightening monetary policy, and geopolitical risks. Growth beat value for the third straight quarter on technology strength; even though the biggest value sector, financials, also outperformed during the quarter. Small caps outpaced large caps for the first time since the fourth quarter of 2016, as smaller, domestic companies generally stand to benefit more from potentially lower corporate tax rates. Strong earnings and semiconductor gains drove technology, while energy was also a strong performer, benefiting from the 13% jump in WTI crude oil during the quarter. Foreign stocks outperformed domestic, as the MSCI EAFE and MSCI Emerging Markets (EM) Indexes returned 5.5% and 8.0%, respectively. Overseas markets benefited from improving global growth, rebounding earnings, and a weaker U.S. dollar.
  • Fixed income investors experienced three different market environments in the third quarter: a period of relative calm in July, several flight-to-safety events in August, and a resumption of risk taking in September as August risks faded. The net result during the quarter was little movement in longer-term interest rates and a flattening of the yield curve, leading to positive returns for all major segments of fixed income. Short-term rates were pressed higher by the Fed’s commitment to a continuation of gradual rate hikes and monetary policy normalization.The Bloomberg Barclays Aggregate Bond Index returned 0.9%, outperforming Treasuries which returned 0.4% (Bloomberg Barclays U.S. Treasury Index). Richening valuations helped investment-grade corporates outperform the broader market, returning 1.4% (Bloomberg Barclays Corporate Index). Economically sensitive, lower credit quality sectors continued to rally, with high yield returning 2.0% (Bloomberg Barclays High Yield Index), bank loans returning 0.9% (S&P/LSTA US Leveraged Loan Index), and emerging market debt returning 2.3% (Bloomberg Barclays EM USD Aggregate Index).
  • Alternative investment strategies were led by the HFRX Equity Hedge Index, which gained 3.2% during the quarter. The 7.0% year-to-date gain now represents the best start since 2008. The HFRX Event Driven Index gained 1.9%, with continued strength seen in the merger arbitrage and special situations subcategories. Distressed strategies were down 0.13% in the third quarter, as weakness in the consumer sectors offset moderate energy-related gains. The HFRX Systematic Diversified CTA Index gained 0.9%, with long equity exposure continuing to provide a majority of the positive returns.
  • Commodities rebounded from second quarter weakness to gain 2.5% during the third quarter. Oil rallied 13% in the quarter after falling 9% during the second quarter, thanks to firming global demand, Saudi-led production caps, and slower U.S. production early on. Oil’s strength, however, did not translate over to natural gas which fell 3%. Improved global manufacturing activity and tighter supplies supported gains in industrial metals, notably copper, while precious metals pared July and August gains in September, as the dollar rose and the odds of a Fed rate hike increased. Agriculture prices fell as better weather conditions led to strong crop yields, although supply pressures in Latin America and winter weather risks helped grain prices stabilize in September.

A LOOK FORWARD

During the fourth quarter we believe the stock market may be susceptible to event-driven risks from budget negotiations, a policy mistake by a major central bank, or geopolitical tensions. Still, with the potential for tax reform—or tax cuts—in early 2018 and a still favorable global economic and earnings environment, potential dips may present opportunities. Our favorable intermediate-term stock market view is driven by: 1) improving economic growth, 2) mid- to highsingle-digit earnings gains with the potential for a boost from fiscal policy in 2018, and 3) a stable price-to-earnings ratio of 19 – 20. We expect the 10-year Treasury yield to end 2017 in the range of 2.25 – 2.75%, with the potential for 3%. We believe the Fed may hike rates one more time in 2017 assuming economic growth or inflation doesn’t falter. Importantly, rising interest rates, along with a potential pickup in the pace of economic growth and inflation, may limit bond market return potential. Updates to our stock and bond market views will be released in LPL Research’s Outlook 2018, coming in November.

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This research material has been prepared by LPL Financial LLC.

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