Investors are likely wiping their brow and wishing the third quarter good riddance. After years of flattening volatility and bull-markets fuelled by easy credit and emerging-markets growth, the third quarter provided enough fireworks to jangle the nerves of even the hardiest market participants. It was marked by a slow slide in western developed-market equities, punctuated by the credit-crunch induced sell-off that rocked global markets in August.
The quarter as a whole displays some clear patterns, including some notable shifts away from previous trends. Overall 44 of the 166 Morningstar Categories lost money for the period, but the difference between markets was extreme: Returns ranged from a high of nearly 34%, to a low of -7.8%.
Emerging Markets Surge
One thing that didn’t change: Emerging Markets came out on top. The top performing Morningstar Categories were China Equity (+32.94%), Greater China Equity (+22.45%), Hong Kong Equity (+21.59%), and India Equity (+15.31). Other strong emerging-markets Morningstar Categories included Emerging Markets Equity (+11.48%), Taiwan Small/Mid Cap Equity (+9.89%), Latin America Equity (+8.18%), Taiwan Large-Cap Equity (+8.02%), Emerging Europe Equity (+7.16%), and Russia Equity (+6.73%). The ride was not smooth, however. China funds, for example, plunged sharply during the August credit-crunch, only to come roaring back later in the period.
Asia Rolls, Japan Funds Slump
For the quarter, Asia-Pacific ex-Japan in general was very strong, with China clearly the strongest segment of the group. The returns followed news of continued strong economic growth: The National Bureau of Statistics in Beijing announced in mid-July that China's second-quarter GDP clocked in at an annualized growth rate of 11.9%.
However, Japan fared poorly as concerns about the US market spooked investors after a solid second quarter. Both the Morningstar Japan Large-Cap Equity and Japan Small/Mid Cap Equity categories posted losses for the quarter. This dragged down The Asia-Pacific with Japan Equity category, which returned just 5.49% in the quarter, nearly eight percentage points less than the Asia-ex Japan Equity category (+13.14%).
Resources, Precious Metals Continue to Run, Real Estate and Financials Weak
The past five years have seen resources stocks buoyed strongly by surging demand from Emerging Markets, most notably China. The trend was sustained in the third quarter as the Morningstar Sector Equity Industrial Materials and Sector Equity Energy categories rose 6.24% and 5.17% respectively, easily ranking in the top third of all Morningstar Categories for the period. The Sector Equity Precious Metals category was even stronger, jumping 14.26% for the quarter. The category suffered a big drop during the August downturn, but rose sharply in September in the wake of the Fed’s interest rate cut in the United States. On the flip side, the Sector Equity Financial Services category dropped 3% as the credit crunch took its toll, whilst the Real-Estate Indirect – Europe category, which contains funds focused on real-estate securities, plummeted 6%.
UK, European Issues Lag
The financials-heavy UK market was hit hard during the turbulent quarter, and all five UK Equity peer groups performed in the bottom-decile of our 166 Morningstar Categories. The best performing, UK Large-Cap Blend Equity, lost 2.21%. The worst, UK Small Cap Equity, lost 5.65%. UK Large-Cap Growth fell 2.78%, UK Large Value lost 3.49%, and UK Mid-Cap Equity lost 3.68%. Much of developed Europe followed suit. The only European categories in positive territory were: Denmark Equity, Norway Equity, Finland Equity, Germany Equity Large-Cap, Spain Equity, Europe Large-Cap Growth Equity, and Eurozone Large-Cap Equity.
Large Caps Finally Have Their Day
Speaking broadly, large-caps have badly lagged small-and mid-caps over the past five years. In the UK, the Morningstar UK Large-Cap Blend Equity Category has returned 12.78% annualised, whilst the UK Mid-Cap Equity category returned 17.68 annualised and the UK Small-Cap Equity category returned 21.08%. The same pattern played out in major markets around the globe, with the notable exception of Japan, where small and mid-caps slightly underperformed large-caps for the period.
The trend has gone on so long that small- and mid-caps trade at premiums to large-caps in most markets on a forward P/E basis. This inverts the historical relationship: In the past, large-caps have commanded premiums over smaller fare due to their superior liquidity and perceived lower risk. Investors seemed to find the latter trait attractive in the quarter, however. Almost universally, the Morningstar Large-Cap equity categories outperformed the small-and mid-cap counterparts for the quarter. This was true in the UK, as noted above, and also in the broader European market, where the Morningstar Europe Large-Cap Growth Equity category rose 1.22%, compared to a loss of 5.15% for the Europe Small-Cap Equity category.
