A VERY INTERESTING QUARTER - BE CAREFUL WHAT YOU WISH FOR!!
We wrote after the strong first quarter to expect volatility to increase with stocks remaining the preferred asset class and that is largely what happened in the second quarter. Almost all risk assets wobbled after the Federal Reserve (Fed) hinted at a possible tapering of quantitative easing later this year. Regardless, most domestic stocks did well in the quarter. The S&P 500 rose by 2.91% with small- and mid-capitalization stocks performing about the same. However, international markets struggled, especially emerging markets. The MSCI World ex USA index declined by -2.69%, while the MSCI Emerging Markets index sank by -9.14%.
One of the big stories in the quarter was the dramatic rise in interest rates causing virtually all bonds to lose value. (see chart below) Long dated U.S. Treasury Bonds had been a haven for investors during times of market stress since the financial crisis. But not this time around as evidenced by a popular ETF specializing in this asset class losing -5.59% of its value.
The Fed has taken considerable criticism for their inaction leading up to both the technology and housing bubbles. We suspect the Fed is sensitive to this criticism which motivated them to try to cool, not crush, financial markets after a year of spectacular returns by discussing tapering. However, the market's reaction was more than they bargained for and was not welcomed. Not surprisingly, multiple Fed members quickly backtracked in hopes of jawboning interest rates lower. The bottom line is the Fed is trying to micromanage market expectations which will likely keep volatility high.
About a year ago we became fully-invested in our portfolios largely because the world's central banks were announcing quantitative easing programs, and our clients benefited from the strong rally. But where do we go from here? Current market signals are mixed. Yields have been rising for a year, and Richard Fisher, president of the Dallas Federal Reserve, said: "We've had a 30-year bond market rally. These things do not go on forever." Rising rates sometimes signal an improving economy and could be good for stocks. On the other hand, prices are declining throughout the economy (stock and bond markets, consumer prices, commodities and wages) sending a message of deflation which normally is good for bonds. The U.S. economy is the world's bright spot with stronger-than-expected (but not robust) job creation, housing, retail sales, and consumer confidence figures, but the recession in the euro zone persists and many emerging market economies are stumbling.
Given this potpourri of market signals our strategy is to remain diversified and flexible. This is not the time to take big bets. On balance we believe rising stock prices and interest rates are signaling a stronger, healthier economy than most pundits expect. Importantly, deleveraging is progressing quickly with debt service burdens for U.S. consumers extremely low, while loan delinquencies have collapsed. Household net worth soared by $6 trillion over the past year, rising by a stunning $3 trillion in the first quarter of 2013 alone. Therefore, we remain committed to stocks and hold short duration, high-quality bonds. BUT, we reserve the right to change our mind if future data proves these assumptions wrong. Our focus will be on corporate profits. With stocks no longer outright cheap, a global economy with plenty to prove, and profit margins at record highs, earnings growth may stall instead of accelerate in the second half of the year.
Jim Tillar, CFA Steve Wenstrup
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