Third Quarter Market Review
Domestic equity markets struggled in the third quarter with the worst quarterly performance since the third quarter of 2011. The S&P 500 Index declined -6.4% for the quarter. Most of the volatility was caused by events outside the country. Given weak growth in most of the rest of the world, U.S. Economic momentum appears even more attractive on a relative basis. Sit Investment Associates favors developed markets over emerging markets, which are experiencing weak economic conditions. We have positioned fund portfolios with a diverse mix of high-quality growth companies that are predominantly exposed to U.S. Or European markets where economic growth is strongest. By shifting toward domestic-centric stocks and away from cyclical stocks with large emerging markets exposure, we have adopted a more defensive stance. Our emphasis continues to be on high quality, cash generative companies that benefit from the weaker euro, possess secular or niche growth drivers, and/or address domestic markets where there is pent-up demand.
Stock valuations can be characterized as reasonable. Small capitalization stocks underperformed their large cap peers in September and also year to date. Large cap growth stocks continued to outperform their value counterparts across all time periods, while small and medium capitalization growth stocks underperformed in recent months, but have outperformed over longer periods of time.
Treasury yields decreased during the third quarter as the yield curve flattened. All sectors of the bond market produced positive returns for the quarter, with Treasuries and government agency mortgage-backed securities sectors outperforming. Corporate bonds, driven largely by poor returns in industrial bonds due to low oil prices, and other asset-backed securities, due to their duration, underperformed in the quarter.
Given our expectations for modest improvement in the economy and continued strengthening in the job market, we anticipate the yield curve will continue flattening, as short yields rise in anticipation of the Fed raising its target for the federal funds rate. We expect long maturity rates to move relatively less than short rates given the market's belief that the Fed's actions will prevent inflation from becoming a problem. Our portfolios are positioned along the yield curve to take advantage of the expected flattening, while maintaining portfolio yields significantly above their benchmarks.
Tax-exempt municipal bond yields declined across the entire curve, with intermediate and longer maturities tending to decline at a greater pace than shorter maturities. During the quarter, returns were positive across all duration and credit quality strata. Given the flattening yield curve, bonds with intermediate and longer durations outperformed for the quarter. In terms of credit quality, the high yield segment of the municipal bond market performed best. As a group, BBB-rated bonds experienced the weakest performance of the quarter. Bothe general obligation bonds and revenue bonds exhibited strikingly similar positive returns during the quarter. Within the revenue bond sectors, housing bonds had the weakest performance, but we continue to believe that this sector represents some of the best value over the intermediate and long term.
We expect the tax-exempt yield curve to flatten slightly through the fourth quarter, with short rates remaining steady or moving slightly upwards. We expect long rates to remain mostly flat for the rest of the year. We continue to place a heavy emphasis on income and expect to maintain durations at or near their current levels, while generally investing in bonds with higher credit quality ratings.