2nd Quarter Update
Reacting to the Fed’s “Tapering” Decision
Market Overview
The beginning of the quarter continued the upward trend of the markets that we saw in the 1st quarter of 2013. With considerable cash on the sidelines, any dips in the equity markets during April and early May saw investors buying into the markets for fear of being left behind. The economic data for the quarter reinforced the view that the U.S. growth was not going to be stellar but it was going to be slow and consistent. The impact of the sequester spending cuts to the Federal budget were limited in part because many of them were delayed until the summer and overall consumer and business confidence was not impacted by the cuts.
For the markets, the major headline news of the quarter were the statements made by Federal Reserve Chairman Ben Bernanke in May and his follow-up press conference on June 19th. In these statements he indicated that if the economy continued to improve and when the unemployment rate declines to 7.0%, the U.S. Federal Reserve (the Fed) would begin scaling back on their $85 billion in monthly bond purchases, also known as Quantitative Easing (QE)3. The markets reacted dramatically to the possibility of less global liquidity and higher rates as both the bond and stock market experienced sizable sell offs. As Exhibit 1 below shows, the markets posted a decent final week to end up for the quarter, but it was investments that have an income component such as bonds and utility stocks that ended down for the quarter.
(Exhibit 1)
For the 2nd quarter and the first half of the year, US equities were the primary area of strength versus most other asset classes. The S&P 500 index was up 12.63% for the first six months of 2013 which was the strongest start to the first half of any year since 1998. The Dow Jones Industrial Average is down 3.2% from its record high set on May 28th but it is still up 13.8% year-to-date. The NASDAQ composite was up 9.43% year-to-date and the S&P Small Cap index showed the strongest performance, up 3.73% for the quarter and 15.63% for the past 6 months.
With the exception of Japan, weakness was seen across most international equity markets for the quarter and year-to-date. The MSCI EAFE index was down 2.85% for the quarter and up less than 1% over the past two quarters. The MSCI emerging markets index was down 6.54% for the quarter and 13.19% year-to date.
As shown in Exhibit 1, the yield on the 10-year Treasury bond increased from below 1.75% in May to 2.49% at the end the June, putting downward pressure on bond prices and driving the Barclays bond index down 3.18% for the quarter.
The broad commodity price index was down almost 8% for the quarter and 9.54% for the first 6 months. Gold prices fell 22.89% in the second quarter, the biggest quarterly decline since trading of U.S. gold futures began in 1974.
Domestic Insight
Strength continues to be a relative word for domestic economic data. The revised GDP growth estimates for the first quarter were lowered from the original annualized estimate of 2.4% to 1.8%. This slow but steady growth is also reflected in the labor market which recently has been adding an average of 155,000 jobs each month, bringing the unemployment rate to 7.6%. Although this rate has continued to decline over the past several years, it is important to remember that the labor markets have considerable slack as can be seen in Exhibit 2 where the share of adults with full time employment has been stagnant at 58.5%, down from 63% in 2007.
(Exhibit 2)
Source: Department of Labor
The primary area of strength this year has been the housing market with new housing starts rising 6.8% in May, while existing home sales rose 4.2% to reach their highest level since 2009. As shown in Exhibit 3, the median price for those sales was up 15.4% year over year, helping bolster net worth and consumer confidence.
(Exhibit 3)
Source: FactSet. Nat’l Assoc. of Realtors. As of June 24, 2013
The manufacturing sector has shown some mixed results with the widely track Institute for Supply Manufacturing (ISM) index showing contraction in its May number but the durable goods manufacturing report for April and May showing continued strength.
The fact that the Federal Reserve finds sufficient strength in the U.S. economic data to begin removing any economic stimulus is a positive situation. The goal behind their “tapering” plan is to clearly communicate their future actions and the parameters by which the plan will be implemented. They have also stressed that if the economic indicators weaken, they will continue with their quantitative easing and not scale back their bond purchases. The Fed reiterated their position that they do not expect to increase the federal funds target rate from its current level of almost 0% until the unemployment rate reaches 6.5%. It helps to understand historically how the stock market performed after the Federal Reserve began removing stimulus from the economy. In mid-2004 when the Fed began raising the target rate, the equity markets continued higher until the 4th quarter of 2007, more than 3 years after the Fed’s initial action to remove stimulus from the market.
International
The performance of the international equity markets for the quarter was very weak and there were very few areas of strength. In Europe, it has been a rare quarter where there has been no negative political or economic news coming from the Continent. With inflation staying at a reasonable level, the European Central Bank (ECB) felt comfortable to lower its benchmark rate in May and several countries, including Germany, are considering fiscal stimulus measures. With international equities, it is important to remember how far below we still are from the 2007 peak in the market. As shown in Exhibit 4, it would require a 10.9% annualized return in the international markets over a five year period to get back to the peak levels.
(Exhibit 4)
Source: JP Morgan
The emerging markets have been dramatically impacted this quarter by a number of factors including concern over liquidity risks now that the dollar is strengthening and U.S. interest rates are increasing, political and social unrest in places such as Turkey and Brazil, weakness in commodity markets and tightening of credit in China. The emerging markets portion of a portfolio is one of the riskier asset classes but historically it has also been one of the strongest performing asset classes. The long-term economic growth story is well intact in these countries but the duration of time they may underperform their historical average return is uncertain. Based on current valuations, there is considerable bad news priced into the asset class as it continues to trade well below its historical P/E ratio.
Fixed Income
Following the Fed’s statements on “tapering” this quarter we are potentially embarking on a period of slowly rising interest rates. The bond market’s performance this quarter reflected more of a panic in reaction to the news rather than a true assessment of the situation. For the quarter, every major bond category was negatively impacted by the higher rates and those areas with longer maturities experienced the greatest declines. With inflation in the U.S running well below the Fed’s target rate of 2% and the unemployment rate struggling to move lower, it is likely that interest rates could plateau at this level for an extended period of time before moving higher.
During a period of volatility it is important to remember the reason for holding the asset class in a portfolio. In the case of bonds, the purpose is to provide income and to protect the portfolio in a crisis situation as a diversification to equities. Even with the volatility in bonds, these two reasons for holding the asset class are still intact and it’s beneficial not to overreact to the current environment. From a long-term perspective, higher rates can actually be viewed as a positive occurrence for bonds because as new bonds are issued, they will provide a higher income yield, something that has been missing from bonds for some time.
2nd Half 2013 Outlook
Our outlook for the 2nd half of the year continues to be positive for both the economy and the markets. For the U.S., the economy has shown itself to be incredibly resilient in its slow recovery and we feel comfortable that the Fed will only reduce its stimulus if the economic data remains strong. From a political perspective, there is the potential concern of a federal debt ceiling discussion scheduled for this quarter and there is still the potential impact of the federal sequester spending cuts. Internationally, although equity valuations are very attractive, the short-term picture is more uncertain. The primary concerns we will be evaluating are whether the European economy and markets can gain any traction and whether China is capable of tightening its credit markets without causing its growth to drop. China also needs to continue to transition its economy to one that is based more on a domestic consumer spending versus its current focus of capital infrastructure and exports.