Almost every sector of the stock market continued to make gains in the third quarter. Small cap stocks, as measure by the S&P 600 SmallCap index led the increases with a 6% gain, followed by large cap stocks (S&P 500) which gained 4%. The S&P 400 MidCap Index was up 3%. As with the last quarter, these gains were overshadowed by international equities. The MSCI EAFE, which measures the performance of large and midcap stocks in 21 developed economies, gained 12%.
These gains have been bolstered by strong corporate earnings. S&P 500 companies delivered double-digit earnings growth for the second quarter in a row and forward guidance continues to be favorable with earnings growth in the high single digits expected over the next one to two quarters. Consistent with the increase in corporate earnings, gross domestic product (GDP) has increased at a strong pace. GDP grew at an annualized rate of grew at an annual rate of 3.1% in Q3 compared to 1.2% for the first quarter of 2017 and 1.6% for all of 2017.
The labor market has added more than 1.7 million jobs in 2017 through the end of August and the unemployment rate remained steady at 4.4% at the end of the quarter, compared to 4.7% at the end of 2016 and 5.0% at the end of 2015. These conditions normally lead to increases in inflation and increases in wages. Inflation has increased modestly but is showing signs of a systemic disconnect from the other relevant economic metrics. Wages have increased but not at the level expected given the growth in GDP and the unemployment rate at a level many experts consider to be full employment. This situation has prompted some economist to speculate that a fundamental shift in the relationship between these metrics is taking place. Under these conditions, the Federal Reserve has, understandably, been cautious in its approach to carrying out planned increases in interest rates. The Fed last raised rates in March and will not discuss the issue again until November 1, 2017.
At the end of the second quarter, market expectations for a near-term rate increase appear to have been somewhat higher than at the end of Q3. As a result, the S&P 500 Muni Bond index reflected a gain of 4% in Q3, a modest rally. For the year, fixed income returns continue to be disappointing, but remain an important hedge against stock market declines and provide stability through cash distributions.
In conclusion: Conditions appear favorable for a solid finish to 2017. Offsetting factors include potential interest rate increases as well as disruptions caused by political uncertainty, including mishandled health care reform and tax-reform efforts. Factor in the saber-rattling with foreign adversaries and we have an environment that could be full of surprises. A well-diversified portfolio is key to mitigating these risks.
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