Second Quarter Market Recap
The second quarter began much as the first quarter ended as investors chased yield in markets across the globe. This seemingly insatiable desire for income led to several historic events:
10-year U.S. Treasury Soared: The yield on 10-year Treasury bonds reached an all-time low of 1.67% in April.
Huge Corporate Debt Issuances: Apple sold the majority of a $16 billion debt offering at or below the rate of inflation – effectively borrowing money for free for years.
Valuations Soared: Low growth stocks in sectors including consumer staples and utilities were pushed to all-time highs as investors that could not find suitable income in bonds, were forced up the risk curve into equities.
In mid-June Fed Chairman Ben Bernanke spooked the markets with commentary that led investors to believe that he could begin winding down Quantitative Easing (QE) much sooner than expected. The subsequent selloff affected nearly every market in the world and left us with:
The S&P 500 down 4.7%, particularly high yielding stocks in overvalued sectors like Utilities and REITs, in one week from June 18 - 24.
The total return of the 10-year Treasury bond, a seemingly risk free asset, declined approximately 12% in May and June.
Gold prices fell 23% which was the biggest quarterly decline since trading of U.S. gold futures began in 1974.
Even our conservative portfolios took an unusually hard hit during these times due to the types of equities held – high yielding stocks that look like bonds. Although we had expected some correction, even we were surprised at the magnitude of the pullback.
However, what we found most interesting about this correction was that nothing had really changed. First and foremost, the economic data was still pointing to a recovering economy, albeit slowly, and the risk of falling into another recession remained very low.
Secondly, even if the Fed began tapering immediately, we are still far away from the Fed reaching its target unemployment of 6.5% and inflation is seemingly under control so the risk of a change to their zero interest rate policy was equally low.
Ultimately, these two observations led us to believe that this correction presented a buying opportunity for our portfolios.
Stocks have since recovered (and now sit at all-time highs) and bonds are nowhere near their all-time highs. We interpret this phenomenon as confirmation that, in the face of rising interest rates and an improving economy, investors will favor stocks over bonds.
Second Half of 2013 Market Forecast
Is the Fed really going to change course and allow interest rates to start rising unchecked? If so, when? We focus on making predictions that are supported by rigorous data and fundamental analysis. However, the good news for long term investors is that the answer to this question is inconsequential.
We think that eventually interest rates will rise and we can plan accordingly. In this spirit, we are in the process of making changes to the portfolios to anticipate some of the longer term trends that we are seeing take root in the global markets.
Global Consumer Spending is Bifurcated: Consumers drive 70% of our economy and while most are more confident now that personal debt is lower, housing has recovered, and investment portfolios look stronger, a portion of consumers will feel the pain of unemployment and higher payroll taxes.
• U.S. Economy Reigns Supreme: Some may argue that the U.S. markets look expensive, but compared to the rest of the world, we have the strongest economy and have recovered the fastest from the global financial crisis.
• Europe will Recover: Europe appears to be bottoming out, and although serious issues remain, investors seem less concerned given recent attention to their banking system and a verbal guarantee by the European Central Bank (ECB) to prevent the Eurozone from collapse.
• China is a Mixed Bag: On one hand, there is questionable accounting and economic data, but on the other, there is new leadership addressing imbalances between exports and consumption. The media will continue to make the argument that China continues to “build bridges to nowhere”, but the fact remains that they are still building and have enough financial reserves to do so for another decade or more.
Green Shoots in Equities: Equity rallies are led by cyclical sectors (industrials, technology, consumer discretionary, etc.) because cyclicals are the first to benefit from a rising economy. These stocks are beginning to show signs of life.
Defense Continue to Outperform: Sequestration appears to be a distant memory. Many stocks offer attractive dividend yields and valuations.
Consumers are Confident: Companies that sell high-end products to consumers should continue to benefit from a stronger and more confident buyer. Also, those who have postponed purchases now face replacement cycles that can no longer be extended such as automobiles and home appliances.
Shrink to Grow: Companies that continue to shed unprofitable and non-core businesses should continue to outperform as they refocus efforts on revitalizing their core business.
Mergers and Acquisitions (M&A): Cheap debt and low top line growth prospects will continue to be a powerful force driving acquisitions. Selected energy stocks are highly attractive candidates in the second half of 2013. We expect companies with good reserves and growth to be prime targets.
“The Great Rotation”: The media has reported extensively on this rotation from bonds to stocks. Investors now have a taste of what rising rates can do to a long-dated bond portfolio.
Treasuries Don’t Feel Risk Free: Holding the 10-year Treasury still carries too much risk and not enough return. However, we also see no compelling evidence to believe that the rapid selloff in the 10-year Treasury, a proxy for the bond market, will continue either. Rather we feel that Treasuries will remain range bound for the remainder of 2013.
Bonds Won’t See Record Highs Again: Bonds have yet to recover from the June correction, and given the potential for rising rates and an eventual unwinding of QE, we see no compelling evidence for bonds to make their way back to the highs of April.
Not All is Doomed: Fixed income always has a place in a portfolio and we see opportunity in those issues that exhibit low sensitivity to interest rate changes. Specifically we prefer short-term, high quality bonds.
We believe that we are at the beginning of a secular bull market in equities, and a potentially long and difficult bear market in bonds. To prepare for this, we continue to reduce our fixed income exposure across all portfolios.
Investors are anticipatory and we expect to see inflows into equities from bonds before interest rates begin their rise; however that is not to say that all bonds will be sold.
Investors hold equities and bonds for different reasons (capital preservation vs. growth) so we see opportunity in subsectors of fixed income with low interest rate risk including short maturity, high yield, and leveraged loans (these bonds vary their yield with interest rates which is beneficial in a rising rate environment).
The bottom line is: what fueled equities for the first half of the year was not a true equity rally, but rather a grab for yield. We feel that the second half of 2013 will bring the beginning of a real equity rally led by cyclical stocks.