Larger-cap US stocks hit new highs in late September and gained 7.7% for the quarter, while smaller-cap US stocks gained 3.6%. S&P 500 operating earnings per share grew 27% year over year in the quarter—compared to their 6% long-term annualized growth rate. A record high 80% of S&P 500 companies reported earnings that beat the consensus expectations. Record levels of share buybacks (estimated by Goldman Sachs to reach $1 trillion for 2018) were another pillar of support for the US market.
Developed international stocks gained just 1.2% in the quarter, while emerging-market stocks (EM) fell 1.7%. Foreign stock markets were impacted by poor sentiment, and a rising US dollar was a further drag on returns for dollar-based investors.
In fixed-income markets, the 10-year Treasury yield rose to 3.05% at the end of September, flirting with a seven-year high. Consequently, the core investment-grade bond index had a negative return in September and was flat for the quarter.
Credit-sensitive segments, on the other hand, performed well, with floating-rate loans gaining 1.7% for the quarter. This was good news for our balanced (stock/bond) portfolios, as our tactical allocation to floating-rate loans has returned over 3% for the year compared to a nearly 2% loss for core bonds (from which they are largely funded).
Our active bond managers have also outperformed the core bond index for the year. We expect these positions to outperform over the next several years as well, particularly as interest rates continue to rise. The Federal Reserve has raised rates three times so far this year with a fourth teed up for December. Policymaker forecasts call for three more increases in 2019.
Our balanced portfolios also continue to hold liquid alternative strategies funds that we believe improve our portfolios’ long-term risk-adjusted return potential. Our lower-risk multistrategy alternatives fund produced a modest quarterly gain, outperforming core bonds and foreign stock markets but trailing US stocks. Our position in a diversified basket of trend-following managed futures funds had a small positive return for the quarter.
Finally, our private equity real estate funds continue to be strong performers. The managers of these funds are still able to find real estate investment opportunities within the less efficient niches in which they operate that offer promising returns on an absolute basis and relative to our expectations for traditional US equity and bond investments.
In 2018, US stocks have strongly outperformed EM stocks, but this level of divergence is not unusual. Still, given the negative headlines surrounding emerging markets, we highlight several points this quarter that indicate EM stocks remain attractive and their long-term growth outlook is intact. On the other hand, US stocks look expensive, and there are reasons to think the near- and medium-term outlook for them is not so rosy. The overvaluation of the US stock market represents one of the biggest risks to our portfolios, which is why we maintain a meaningful underweight to US stocks.
Investment Key Takeaways—First Quarter 2019
Our portfolios generated strong performance for the first quarter, benefiting from the rebound in financial markets as they reversed much of the market downturns from fourth quarter 2018. The first quarter was a strong period for equities around the world. Bond markets and certain alternative strategies also performed well.
Commentary from Our Chief Investment Officer—First Quarter 2019 Review & Outlook
The market rebound was due more to a shift in Fed monetary policy than any meaningful improvements in the economic fundamentals. Our portfolios have exposure to a wide range of investments that will particularly benefit if global growth continues.