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Larger-cap US stocks hit new highs in late September and gained 7.7% for the quarter, while smaller-cap US stocks gained 3.6%. S&P 500 operating earnings per share grew 27% year over year in the quarter—compared to their 6% long-term annualized growth rate. A record high 80% of S&P 500 companies reported earnings that beat the consensus expectations. Record levels of share buybacks (estimated by Goldman Sachs to reach $1 trillion for 2018) were another pillar of support for the US market.

Developed international stocks gained just 1.2% in the quarter, while emerging-market stocks (EM) fell 1.7%. Foreign stock markets were impacted by poor sentiment, and a rising US dollar was a further drag on returns for dollar-based investors.

In fixed-income markets, the 10-year Treasury yield rose to 3.05% at the end of September, flirting with a seven-year high. Consequently, the core investment-grade bond index had a negative return in September and was flat for the quarter.

Alternative bonds performed well, with floating-rate loans gaining 1.7% for the quarter. This was good news for the bond allocation in our portfolios, as our tactical allocation to floating-rate loans and non-traditional fixed income has outperformed core bonds (from which they are largely funded).

Our active bond managers have also outperformed the core bond index for the year. We expect these positions to outperform over the next several years as well, particularly as interest rates continue to rise. The Federal Reserve has raised rates three times so far this year with a fourth teed up for December. Policymaker forecasts call for three more increases in 2019.

In 2018, US stocks have strongly outperformed EM stocks, but this level of divergence is not unusual. Given the negative headlines surrounding emerging markets, we highlight several points this quarter that indicate EM stocks remain attractive and their long-term growth outlook is intact.  US stocks look expensive, and there are reasons to think the near- and medium-term outlook will result in underperformance. The high relative valuation of the US stock market represents a risk to our portfolios, which is why we maintain a slight underweight to US stocks.