Despite the pickup in volatility and marked weakness during the end of September, Q3 showed some continuation of the capital markets embracing the “re-opening” economy. A dovish Fed (despite some hawkish rumblings) mixed with more fiscal stimulus in the pipeline is a recipe for healthy equity markets. The uptick in rates started to put pressure on stock valuations, but with bonds still offering almost no yield and almost no upside, stocks continued to be the only place in town to deploy new capital.
The rotation we observed early in the year from core equity to diversifying positions notably reversed during Q3 with large cap blend equities (IVV) regaining the crown as top equity asset class up a bit at +0.59% during Q3 (see table below). Diversifying equities that lagged were small cap (SCHA, -3.64%), mid cap (SCHM, -1.70%), REITs (SCHH, +0.23%), developed international (SCHF, -1.90%), and especially emerging market equities (SCHE, -7.30%). Mathematically, bonds delivered on their promise for low yields and low returns with relatively low risk during Q3 with core bonds (SCHZ) offering only -0.10% return. Bonds with some credit spread like investment grade corporates (LQD, -0.45%) and high yield bonds (HYG, +0.34%) offered comparable return during Q3.
It is not “market timing,” but simply arithmetic that bonds will be a drag on portfolio total returns with yields still near historic lows. For client accounts that can tolerate a bit more risk, we are targeting at least a 5% underweight to bonds. As I said in my January 3, 2021 blog post, “2020 Q4: Reversion to Mean?”, core bonds do not look like a good place to be in 2021:
“…core bonds delivering as much return as it could in the first part of the year [2020]; mathematically, with rates so low there is almost no potential return left in the U.S. Treasury market. …we should not expect much return in 2021 from these holdings.”