Domestic equity markets rallied during the third quarter of 2018, as positive economic data and strong corporate earnings once again helped to offset the impact of rising interest rates and continued trade tensions. The S&P 500 index increased 7.7% during the quarter, its best quarterly gain in nearly 5 years.
Large-cap stocks outperformed their small-cap counterparts during the quarter, with the Russell 1000 index and Russell 2000 index returning 7.4% and 3.6%, respectively. Growth stocks in the Health Care, Technology, Consumer Discretionary, and newly formed Communication Services sectors led the rally, while value stocks in the Materials and Energy sectors were the biggest laggards. Growth-oriented stocks considerably outperformed their value-oriented counterparts across all market-caps.
International equity markets significantly underperformed the U.S. during the third quarter. After a strong second quarter, the U.K. was one of the worst performing markets, as the Bank of England raised base rates and Brexit negotiations appeared to reach an impasse. Despite gains in Latin America, boosted by Brazilian and Mexican markets, the MSCI EM index fell over 1% during the quarter. Markets in China remained volatile as concerns over the escalating trade war with the U.S. and an industrial slowdown continued, leading Emerging Markets lower. Japanese stocks posted solid gains during the quarter, with the MSCI Japan index rising 3.7% as exporters benefited from weakness in the yen. As of September 30, 2018, the S&P 500 index outperformed the rest of the world, as measured by the MSCI ACWI Ex USA index, on an annualized one-, 3-, 5- and 10-year basis.
The Federal Open Market Committee (“FOMC”) lifted its federal funds target rate by 0.25%, to a range of 2.00% to 2.25%, during its September meeting. Current expectations are for one additional increase during 2018, three increases in 2019 and one
in 2020. The U.S. yield curve continued to flatten throughout the quarter, with the yield on the 2-year Treasury rising 0.29% and the yield on the 10-year Treasury rising 0.20%, finishing the quarter at 2.81% and 3.05%, respectively. A risk-on mentality returned to the fixed income market, with the High Yield and Emerging Markets Debt sectors performing the best, while Treasury Inflation Protected Securities (TIPS) and Treasuries provided negative returns.
The initial estimate of third quarter gross domestic product (GDP) came in above market expectations, at 3.5% growth. Consumer data remained very positive during the quarter, with U.S. consumer confidence reaching an 18-year high in September. An increase in consumer spending was the largest contributor to GDP growth, supported by a rebound in inventories. Conversely, a sharp decrease in business investment and a fall in exports were a drag on growth. The global economic expansion continued at a slow but steady pace.
The unemployment rate fell from 4.0% to 3.7% during the third quarter of 2018, reaching its lowest level since December 1969. The labor force participation rate fell slightly, from 62.9% to 62.7%. The U.S. economy added an average of 190,000 jobs per month during the quarter, and wages grew at an annualized rate of 2.8% in September.
The year-over-year headline inflation rate fell from 2.9% to 2.3% during the quarter, with a sharp slowdown in gas prices having the largest impact in September. During the same period, core inflation, which excludes food and energy, fell marginally from 2.3% to 2.2%. The indices for both new and used cars and trucks fell sharply but were partly offset by increased shelter costs.
