Equity markets rallied during the third quarter of 2016 after a mixed performance during the previous quarter. After the initial pullback following the surprising vote in the United Kingdom to leave the European Union, global markets rebounded after a less negative assessment of the impact of the withdrawal and the realization that several years will be required before so-called Brexit is completed. Global equity markets were favorably impacted by continuing highly accommodative monetary policy by central banks in Europe and Japan. In the U.S., the expected increase in short term interest rates by the Federal Open Market Committee was delayed at least until December, 2016.
For the first nine months of 2016 the total return of the U.S. stock market as measured by the Standard and Poors 500 Index showed a total return of 7.8%. Developed markets outside the U.S. as measured by the MSCI EAFE Index increased by 2.2% while emerging markets as measured by the MSCI Emerging Markets Index increased by 16.0%. The total return for global equities as measured by the MSCI All Country World Index was 6.6%. The nine months results reflected the stronger performance of markets outside the U.S. during the third quarter, reversing the pattern of the first six months. The S&P returned 3.8% during the third quarter, while the third quarter respective returns for the MSCI EAFE and MSCI Emerging Market indices were 6.5% and 9.0%. The third quarter return for the MSCI All Country World Index was 5.3%.
The pattern of slow global growth of the past few years has continued in recent months. In the U.S. this trend is reflected in 1.5%-2.0% growth in inflation adjusted Gross Domestic Product. The consumer sector remains relatively strong with consumer confidence at multi-year highs. The combination of low interest rates on mortgages and auto loans, low gasoline prices, and steady growth in employment are the major catalysts for the favorable trend in consumer spending. On the other hand, capital spending remains sluggish. The trend in corporate earnings should become more favorable in coming quarters as the negative impact of lower energy prices is replaced with favorable year on year comparisons in earnings for energy companies.
The upcoming Presidential election on November 8 is contributing to uncertainty and is having a negative impact on corporate spending plans. As Election Day approaches increased stock market volatility is likely. Regardless of the outcome, it appears that both candidates are amenable to increased Federal spending with an emphasis on infrastructure while growth in defense spending also is likely. The resultant increasing stimulus in fiscal policy should offset any negative impact from an increase in interest rates by the Federal Open Market Committee. The apparent hostility of both candidates to free trade also creates uncertainty.
The trend away from austerity in favor of fiscal stimulus is evident elsewhere, most notably, in the U.K., Japan, and Germany. With monetary policy reaching the limit of its ability to stimulate growth, more accommodative fiscal policy has the potential to take up the slack and contribute to faster growth in the developed world outside the U.S. Among emerging economies, China is showing more signs of accelerating economic growth. Stronger retail sales, vehicle sales, and housing prices are evidence of a more favorable Chinese growth trend. Accelerating growth in China would have a positive impact on other emerging economies which depend on rising commodity prices.
The potential for a gradual acceleration of global economic growth creates an overall favorable environment for equities. For the commitment of cash reserves, we are focusing on several areas which appear to offer exceptional value. These include companies which would benefit from an increase in infrastructure spending which appears likely not only in the U.S., but elsewhere in the developed economies. Defense spending beneficiaries are also of interest given the likelihood of increased spending in the U.S. The other area which appears attractive are select technology companies which offer attractive reward/risk characteristics.
U.S. interest rates increased slightly during the third quarter, most likely reflecting the likelihood of one increase in short term rates by the FOMC before the end of 2016. The yield on two year Treasuries increased from 0.6% to 0.8% during the third quarter. Five year Treasury yields increased from 1.0% to 1.1% and the yield on ten year Treasuries from 1.5% to 1.6% during the third quarter. German and Japanese ten year government securities remained at slightly negative levels, both ending the third quarter at minus 0.1%.
As indicated previously, we expect the FOMC to enact one rate increase before the end of the year, most likely in December. Thereafter, the Federal Reserve’s desire to normalize rates will likely lead to a gradual further rise in 2017 and beyond, although the end point of the rate increases will be well below prior peaks. This pattern enhances the potential for increases in intermediate and longer term rates in the U.S. With this outlook in mind, we maintain a shorter than average maturity for our taxable and tax exempt fixed income portfolios. We continue to pursue a highly selective approach to new positions, focusing on superior risk/return characteristics.