Kai W. Hong, CFA
Managing Partner & Chief Investment Strategist
After almost a year and a half of a relentless march upwards, markets finally took a bit of a pause as inflation concerns and a glimpse at the beginning of the end of recent central bank accommodation caused investors to reassess. Adding to concerns, as much as we would all like to be done with COVID, the Delta variant and summer surge showed that COVID was not quite done with us. Supply chain bottlenecks continued to complicate the path towards recovery, and the Chinese government continued to turn away from a previously laissez faire approach towards their domestic companies. Global growth expectations moderated and valuation periodically re-entered market consciousness. That said, the broader sense of there being no alternative to equity (public and private) has provided support whenever bearishness threatened to build.
The Russell 3000 Index finished the quarter with a return of -0.1% with growth and larger capitalization leading once again. The Russell 1000 Index returned +0.2% while the small cap Russell 2000 Index returned -4.4%. Returns in international markets were modestly worse as incremental US dollar strength weighed on performance. The developed market MSCI World ex USA Index returned -0.7%. An aggressive crackdown on some major companies in China caused the developing market MSCI Emerging Markets Index to return -8.1%. While US 10Y yields saw a meaningful decline early in the quarter, economic concerns caused them to rebound towards the end of the period, finishing roughly where they started. The Bloomberg Barclays US Aggregate Index returned +0.1% and the Corporate High Yield Aggregate returned +0.9%. Performance in non-US fixed income was broadly negative as the Global Aggregate ex-US Index returned -1.6% and the JPM EM Bond Index returned -0.7%.
At the Sector level in US equities, there was a fairly narrow spread in performance with only 8% separating the best and worst performers. In a fairly balanced quarter, five sectors were positive and six were negative. A mix of Financials (+2.8%), Utilities (+1.0%), and the ever-present Technology (+0.9%) sector led while Materials (-4.6%) and Industrials (-4.2%) lagged. Outside of the US, dispersion was greater with a 17% spread in sector performance. Energy (+6.8%) was the standout with Financials (+1.4%) and Industrials (+0.8%) the only other positive sectors. Consumer Discretionary (-10.2%) and Communication Services (-7.6%) were the main laggards as the Chinese government restrictions in the education and interactive media segments caused many Chinese companies in those sectors to fall dramatically.
Country market returns were once again highly varied, with a range of +17% to -20%. While in the last quarter there were countries posting greater than 10% returns, this quarter only Argentina (+17.1%), the Czech Republic (+15.8%), and India (+12.8%) were able to do so. In a dramatic reversal, Brazil (-19.9%) went from best to worst performer in the span of one quarter. More impactful to index returns, China (-18.0%) was the second worst performer as the previously mentioned government actions had a deleterious effect on investor sentiment. Among the other major markets, Japan (+4.5%) and the United Kingdom (-0.2%) both outperformed the broader index. The trade-weighted US dollar index increased by 1.9%.
Despite sizeable moves in interest rates intra-quarter, total returns for the quarter were generally muted in the core US fixed income markets. Treasuries (+0.1%) and MBS (+0.1%) were the main positive performers with all other core sectors – Corporate Investment Grade (+0.0%), ABS (+0.1%), and CMBS (-0.0%) – essentially flat. Outside of the core sectors, returns were slightly more robust. Given increasing concerns about inflation, Inflation-Linked Treasuries (+1.6%) performed well while US High Yield (+1.0%) and Leveraged Loans (+1.1%) continued to add to their YTD performance. Municipals (-0.3%) were once again negative. In a reversal of the reversal of the prior quarter, emerging market debt saw Corporates (+0.3%) outperform Governments (-3.1%).
Overall market volatility was largely contained until September’s sell-off saw the VIX move to higher than average levels. Trading volumes stayed elevated while market breadth declined. At the factor level, July and August saw investors continue to retreat from the short-lived rally in Value and Smaller Size as both factors continued to underperform before rebounding somewhat in the down-markets of September. Yield saw the same dynamics and was negative for the overall quarter. Despite a partial reversal at the end of the quarter, Stability was the top performing factor with Quality and Momentum also positive. Given this backdrop, equal-weighted portfolios underperformed market cap-weighted portfolios.