By Rodric E. Cummins, CFA , Senior Vice President and Chief Investment Officer
Capital markets suffered their worst results since 2008 in the third quarter, and market volatility returned to levels not seen in almost three years. While we don’t believe we are reliving the troubles of 2008, the lack of improvement in economic growth and a concern about governments’ ability to meet today’s financial challenges have driven markets significantly lower in the past three months. As the latest round of monetary stimulus faded during the summer, investor confidence was hit by growing concerns over mixed economic data that may be signaling a threat to an already slow economic growth picture.
Risky assets, such as stocks, were hit hard during the quarter, eliminating the gains achieved by investors early in the year. The S&P 500® Index returned -13.87% for the quarter, resulting in a year-to-date return of -8.68% as of September 30th. International stock markets fared even worse under the pressure of the European debt crisis and the impact that a further global economic slowdown could have on export-driven emerging market countries. The MSCI-ACWI Ex-U.S. posted a return of -19.85% for the quarter and -16.80% year-to-date.
In times of market turbulence, bond investments often provide a dampening effect to the volatility of risky assets. Investments considered to be safe havens for investors, such as U.S. Treasury bonds, did exceptionally well during the quarter, leading all major market segments with a return of 23.92% as represented by the Barclays Capital U.S. Aggregate Government Long Index. The broad bond market, as represented by the Barclays Capital Aggregate Bond Index, returned 3.82%, resulting in a year-to-date return of 6.65%.
Sovereign countries around the world are being forced to take a page from basic financial principles that govern the lives of individuals every day regarding the use of debt and the consequences of excessive debt. One of the biggest concerns facing the markets today is the growing visibility of sovereign debt problems both in the United States and in Europe. The world watched intently as U.S. debt ceiling negotiations brought to light a political impasse in Washington. With monetary policy already reaching its limits of effectiveness, the latest political gridlock symbolized to many the lack of clarity from world financial leaders on an effective plan to resolve the current global financial challenges. It also represented to many the lack of decisiveness needed to move the global economy forward into a more sustainable pattern of growth.
Whether its individuals, companies, or entire countries, those with excessive debt burdens in relation to their income are eventually forced to unwind that debt. Just as spending and consumption often ride high on the back of debt accumulation, the deleveraging process works in reverse, leading to long periods of reduced spending (or slow growth) as financial resources are allocated to reducing debt levels. As we have stated before, we believe we are in such a period, one marked by slow, below-capacity economic growth. On this point, there appears to be a consensus. The Federal Reserve has stated that interest rates will be held low for an extended period to promote economic growth. Low interest rates and the equity market pressures we’ve seen in 2011 are signs that most investors also believe that economic growth will continue to be weak for some time.
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