“For the loser now will be later to win
For the times they are a-changin’”
– Bob Dylan
With a modest improvement in unemployment, a nascent housing recovery and continued accommodative Federal Reserve, the US markets continued to generate positive returns, albeit with considerable volatility in the second half of the quarter. In the prior quarter’s Market Commentary in the Guardian, Randall Buck suggested that a short term pullback in the US market would not be surprising. That forecast was prescient indeed, from late May to late June, the S&P 500® had a peak to trough correction of 7.5% then posted positive returns in the final days of the quarter.
Despite this market correction, the S&P 500® generated the best first half return in 15 years. The S&P 500® gained 2.9% in the second quarter, and 13.81% for the first six months. Smaller company stocks also posted strong returns, the Russell 2000® Index of small company stocks rose 3.3% in the March to June timeframe and 16.11% for the first half while the S&P 400® Index of mid-cap stocks gained 1.0% in the quarter the 14.64% January to June.
However, US stocks were one of the few bright spots on the investment horizon in the second quarter. Most bond benchmarks are negative for the year and emerging market stocks, bonds and commodities are down 7 to 10% year to date. In fact, the selloff in U.S. stocks from mid-May to late June was a time when bonds of all types had large negative returns and when foreign stocks, commodities, real estate investment trusts also had considerable losses.
Developed international markets, as measured by the EAFE® Index fell 2.11% in the second quarter which pulled down the year to date returns to 2.18%. The continued credit issues in Europe, while no longer a crisis, have been a distraction to economic growth. By far, the best performing developed country market was Japan with the Nikkei gaining 10.3% in the second quarter and up an impressive 31.59% in the first six months on the back of PM Shinzo Abe’s easy monetary policy and strong foreign buying.
Emerging markets as measured by the MSCI Emerging Markets® Index fell 8.08% in the second quarter, and were down 9.62% for the first six months. Both China and Brazil have had sharp corrections in 2013. China’s Shanghai A shares declined 11.5% in the March to June timeframe and 12.8% in the first half; Brazil’s Bovespa® Index fell 15.8% in the second quarter, and 22.1% year to date to June 30th.
Commodities, as measured by the Dow Jones UBS Commodity® Index tanked 9.45% in the second quarter and lost 10.47% in the first half. Real Estate Investment Trust NAREIT® Index fell 2.13% in the March to June timeframe, but generated a positive 5.79% return for the first six months.
Much of the US market buoyancy has stemmed from the very low interest rate environment created through the Federal Reserve’s quantitative easing. Quantitative easing has kept long term rates low because the Federal Reserve has been purchasing $80+ billion of US Treasuries and Agency Mortgage Backed Securities per month creating demand at the margin for these securities. Bond yields and interest rates move in opposite directions, so this additional demand for the Treasury and Agency bonds has driven up the price of the bonds, and, until recently, kept interest rates low.
Investors have been warily watching the Fed for any change in its current highly accommodative stance, and recent Federal Reserve communications have started to talk about under what conditions they may start to “taper” asset purchases. That discussion has spooked the markets, and interest rates have jumped. The 10 year Treasury Bond yield rose from 1.86% at the end of the first quarter to 2.48% at the end of June. The 30 year Treasury Bond jumped from 3.12% to 3.5%, and the 5 year Treasury Note hit 1.39% at the end of June compared to 0.78% at the end of March. This jump in interest rates caused most US bond market indices to turn negative in the second quarter. In addition to the investing implications, since financial instruments such as mortgage rates and bank loans price off the 10 Year Treasury Bond, these higher yields will be felt throughout the economy.
We expect rates to rise further in future years, which could make the potential risk/return tradeoff for longer maturity bonds unattractive. For this reason we have focused on shorter maturity bonds and have also invested in non-traditional fixed income securities. We also believe that the very accommodative monetary policies of the World’s central bankers could lead to inflation in future years and some exposure to tangibles and commodities represents a prudent hedge against this potential future inflation. However, with traditional commodity futures performing very poorly we have also sought to invest in non-traditional tangible assets that should hold up or increase in inflationary periods. Our positive outlook for the US economy and keen eye on the international markets will continue to be reflected in our diversified approach to client portfolios as we move through the second half of 2013.