Our overarching theme at the beginning of this year was the stellar performance of U.S. fixed income since 2009 would end and equities would outperform bonds handily over the next few years. With results for the first half now in, our call, if anything, appears understated: The S&P 500 Index generated a total return of 13.8% compared with a negative return of 2.4% for the Barclays’ Aggregate Index.
A sell-off in bonds is not surprising in light of what transpired in the second quarter. Ten year Treasury yields had dipped close to 1.6% at the end of April on fears the economy would experience a “spring swoon,” but subsequently rebounded as data showed the economy and jobs creation was consistent with moderate growth. Yields rose across the curve and accelerated in mid June as the Federal Reserve laid out its plan to scale back on bond purchases if the economy gains traction. This caused a sharp spike in yields to levels not seen since mid-2011.
Perhaps more surprising was the ability of the U.S. stock market to weather this spike. While volatility increased and high dividend paying stocks sold off markedly, the broad market closed the quarter only 3% below its all-time high. Even more telling the market has experienced only a very brief pullback of 5% over the past 12 months during which it has generated a total return in excess of 20%.
Looking ahead, investors are now assessing whether these market moves will persist. We believe bond yields are on a rising trajectory over the next couple of years, but do not foresee a further spike in the balance of this year. And we anticipate the stock market will remain choppy until there is a clearer indication of the economy gaining traction and the Fed’s response.
So far, two risks that we flagged at the beginning of the year – the impact of fiscal drag in the U.S. and weaker growth abroad – have not slowed the private sector of the economy or unsettled the stock market. However, investors increasingly are focusing on the implications of slower Chinese growth for commodities and emerging markets, which have suffered large setbacks.
The Market Shakeout: A Preview of Coming Attractions
Global markets have turned more volatile in the past two months, following a calm period in the first four months of 2013. Catalysts were statements by Chairman Bernanke in mid-May and mid-June on the prospect of the Fed reducing bond purchases later this year. While the Chairman indicated such action was contingent on steady progress on the jobs front, market participants viewed his statements as a sign of what lies in store when the economy gains traction.
The timing of these announcements surprised investors, because recent economic data have been mixed while inflation and inflation expectations have fallen to record lows. While a variety of considerations influenced the decision, the Fed believes downside risks to the U.S. economy have lessened since September, when QE3 was launched. Fed officials also are more confident the economy will gain traction in the second half of this year and into 2014 as the effects of fiscal drag lessen.
The other message Fed policymakers conveyed is that tapering, or the phase down in asset purchases, is not the same as tightening monetary policy in which securities would be sold outright. Indeed, a histogram of their views released after the June FOMC meeting indicates Fed officials do not expect short rates to be increased until 2015.
Our own perspective is that the market shakeout demonstrates how aggressive investors were in stretching for yield in a low interest rate environment. Normally, investment grade and high yield bonds lag Treasuries in sell-offs. This time, however, corporate spreads versus Treasuries have widened, as there is considerably less liquidity in the bond market now than before the Financial Crisis. Also, with bond yields near record lows, investors are more concerned about interest rate risk than credit risk. As discussed later, these developments have reverberated to other parts of the world, as well, especially for emerging economies that are commodity producers and those with close trading ties to China.
The U.S. Economy: Poised for Stronger Growth?
The ability of the U.S. stock market to weather the back-up in bond yields, in part, reflects a growing belief that the economy is on the mend and the Fed will not tighten policy until it is on solid footing. For the most part, we share this belief, as we see signs the private sector of the economy is gaining traction. Private sector demand – i.e., GDP minus government spending – has been growing at a 3% rate for the past couple of years, and residential housing is on the road to recovery. This sector, along with autos, typically leads economic expansions and has wide ranging effects on the economy. Also, financial institutions are more willing to lend to businesses and individuals, and corporate profits have surpassed the previous record set in 2007 by a considerable margin, as companies have found ways to make money in a low growth environment.
That said, we are also cognizant that expectations for the economy’s performance in the first half of the year were low due to the unwinding of the 2% payroll tax cut and the onset of sequestration. Going forward, expectations are higher, and it remains to be seen whether the Fed’s upbeat forecast for 2014 calling for growth of 3%-3.5% and the unemployment rate declining to 6.5%-6.8% is attainable.
Thus far, there is little sign that overall economic growth is accelerating from its post Financial Crisis trajectory of 2%, and previous Fed forecasts have proved to be overly optimistic. If this is again the case, we do not believe the stock market is vulnerable to a major pullback, as worries about changes in Fed policy would lessen. But the stock market’s upside would be limited, because valuations are less compelling and earnings growth would likely be lackluster.
Challenges Confronting Emerging Economies
While we are generally sanguine about the U.S. outlook, we are cognizant that growth abroad is the weakest since the onset of recovery in mid 2009, with Japan being the principal exception. Until recently, investor attention had focused on Europe and the prospect of a financial crisis there spreading to other parts of the world. However, these concerns have faded as the European Central Bank now has authority to act as a true lender of last resort for the euro-zone. Also, while the euro-zone is mired in recession and record unemployment, the latest indications point to a bottoming of the cycle, and the ECB has affirmed it will keep interest rates unusually low for an extended period.
The focus this year has shifted to the slowing trend in China and other emerging economies. EM equity markets trailed the U.S. and international markets considerably in the first half, with MSCI’s equity index posting a negative return of 9.6% in U.S. dollar terms. The sell-off has been most intense in the so-called BRIC markets, comprised of Brazil, Russia, India and China, where the ETF stock price has plummeted to its lowest level since the global recovery began in the second half of 2009.
While the EM sell-off has been exacerbated by worries about Fed tapering, these markets have underperformed the U.S. stock market considerably for several years now, and, their fate is closely tied to China’s prospects. The EM markets, for example, were the best performers during the recovery phase immediately following the Financial Crisis, when Chinese growth exceeded 10% and commodity prices rebounded off their lows. Over the past 2-3 years, however, commodity prices have been on a downward trajectory while China’s growth rate has slowed to 7%-8%. This has been accompanied by a substantial slowing in the other BRIC economies and former rapidly growing economies in Asia.
There has also been a dramatic shift in international capital flows recently. According to JPMorgan, a cumulative $300 billion flowed into EM fixed income funds since the 2008 Financial Crisis, which put considerable upward pressure on their currencies. More recently, EM markets have experienced withdrawals, which have pushed up local market rates while putting downward pressure on their currencies.
Considering the extent to which these markets have underperformed, some investors are wondering whether the EM markets represent a buying opportunity. However, a recent BCA research report entitled “Will An EM Breakdown Transpire?” contends many signs that are typically consistent with a durable market bottom are absent. Moreover, the report concludes the odds of a breakdown of EM risk assets are substantial and advises investors to stay short EM stocks and currencies.
Our own assessment is less definitive, as the fate of the asset class will continue to be dictated in large part by how well China’s economy fares. We are not in the camp that China’s economy is a bubble, and believe it is transitioning to a more sustainable growth path. But it is too early to know whether it will be the 7.5% rate that the Chinese Government is targeting or a lower trajectory. Meanwhile, the emerging economies are likely to stay under close scrutiny.
In light of these developments we have reviewed our portfolio positioning and made several changes in our fixed income strategies. Regarding duration, our long-term bias is to be underweight; however, we currently are neutral following the recent spike in yields. With respect to credit risk, we have increased our overweight position in high yield bonds with yields having risen by about 175 basis points. We have also shifted from an underweight position in agency mortgage-backed-securities while reducing our former overweight in commercial mortgaged-backed securities.
In the case of balanced portfolios, we continue to overweight stocks relative to bonds. This reflects our assessment that stocks are reasonably valued and earnings prospects are favorable if the economy gains traction. That said, we do not expect material outperformance in the balance of this year considering the strong showing in the first half, but believe stocks will outperform bonds over the next few years.