The fourth quarter began with a US government shutdown but news thereafter was mostly positive for politics, economics, and markets across the globe. Political clarity and optimism around GDP growth drove most markets higher during the quarter.
On October 1st, the US government furloughed 800,000 employees and shut down for a period of 11 days. However, on the eve of the debt ceiling deadline, Congress agreed to reopen until January 15th and extend the debt ceiling deadline until February 7th, giving both sides of the aisle additional time to negotiate after the holiday recess. Surprisingly, this forced both parties to come together an ultimately reach an agreement on a budget. On December 10th, The Bipartisan Budget Act of 2013 passed the Senate after passing the House of Representatives with bipartisan support. Republican U.S. Representative Paul Ryan of Wisconsin and Democratic Senator Patty Murray of Washington negotiated the deal for their respective parties. The agreement reduces the amount of across the board cuts associated with the sequester by $63 billion. It also sets overall discretionary spending for the current fiscal year at $1.012 trillion and fiscal year 2014 at $1.0123 trillion leading to deficit reductions of $20 and $23 billion respectively. Since the budget deal was reached, optimism around a debt ceiling deal has increased significantly and talks have heated up in advance of the February deadline.
Employment data came in strong during the quarter. The November data showed a drop in the unemployment rate from 7.3% to 7% and total nonfarm payroll rose by 203,000. While government employment declined, most private sectors saw increases for the month. Core retail sales were also up 3.5% during the quarter which was stronger than the prior quarter’s reading of 1.4%. Third quarter GDP growth was revised up to 4.1% and fourth quarter GDP was tracking close to 2%. Some economists were even forecasting +3% GDP growth for calendar year 2014.
On December 17th in the final FOMC meeting for Federal Reserve Chairman Ben Bernanke, the FOMC announced that it would taper (or reduce) Quantitative Easing (QE) by $10 billion in aggregate per month starting in January of 2014. The $10 billion reduction would be split equally between the long term treasury market and the mortgage backed securities market. The minutes cited improvements in the labor market, household spending, and capital spending as reasons for reducing QE. In addition to the tapering, the Fed made it very clear that tapering is not tightening by reiterating its intent to keep short term interest rates low for an extended period of time. The following is an excerpt from the FOMC minutes:
“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”
As many had predicted throughout the year, Janet Yellen was nominated to succeed Bernanke and become the first Chairwoman of the Federal Reserve. Yellen had served as the Vice Chair of the Federal Reserve Board and it’s largely believed that she will remain dovish when she takes over from her predecessor. The nomination brings clarity to the future of the most important central bank position across the globe. It’s good for both boardrooms across corporate America and foreign exchange markets globally.
It’s hard to believe that the start of the European banking crisis is now 2.5 years behind us. Draghi’s commitment to do “whatever it takes” clearly eased fears of further declines in the Eurozone as peripheral sovereign bond spreads have been steadily declining. Greek debt and equities were one of the best performing regions in 2013. While the ECB’s actions may not appear as extreme as those of the Fed in 2008, the mere commitment of the ECB President created immediate confidence to support capital markets across the region. In fact, Eurozone banks have shed over $1 trillion of assets in the last two years lifting Tier 1 Capital Ratios from 10% to 11.7% creating a much stronger banking system for the EU economy. This, combined with improved investor sentiment, has created a much more stable Eurozone economy.
While the growth expectations in China have come down more recently and the economy focuses on consumption rather than exports, the capital base is actually much larger so the effects on global growth will still be pronounced.
As Abenomics continues to unfold, the Japanese Yen weakened to its lowest level since June of 1995 as inflation exceeded 1%. While this is only halfway to Prime Minister Abe’s goal, the Japanese economy has made progress in its attempt to boost GDP growth.
Many had predicted that the fourth quarter would be more volatile than the previous three but equity markets continued their upward move as the S&P 500 Total Return Index appreciated 10.52%, the MSCI World appreciated 7.61% and the MSCI EM Index appreciated 1.54%. The Dow Jones Industrial Average and the S&P 500 Total Return indices reached all-time highs during the quarter AGAIN. The end to the government shutdown, data on stronger GDP and jobs growth, and clarity around a budget lead markets higher.
The following chart summarizes various equity market indices in the Fourth quarter:
The table below outlines the performance of major equity markets for the full calendar year:
S&P 500 Total Return Index
Russell 2500 Index
The S&P 500 had its best year since 1996. While domestic equities certainly experienced a strong 2013, their results pale in comparison to Japanese equities. On the back of much-hyped money printing, the Nikkei was among the best performing equity markets generating returns of 56.72% for the calendar year.
Bottom Line: After another strong quarter for equities, we continue to be positive on the long term outlook both domestically and internationally. We have begun to increase allocations to developed international and emerging markets through active equity managers and believe this trend will continue as we rebalance within equity portfolios.
Fixed Income Markets
The fourth quarter was a difficult quarter for longer-dated fixed income instruments and was especially difficult for MBS securities and treasuries after the taper announcement late in the quarter. The 10 Year Treasury yield reached 3% on December 23rd, the first time it reached that mark since September 5th. Prior to this September date, the 10 Year last yielded 3% in July of 2011. Fixed income instruments that tend to perform better during periods of higher economic growth, such as high yield and emerging market debt, rebounded during the quarter.
The following chart summarizes performance for various fixed income indices in the Fourth quarter:
Bottom Line: We continue to believe that allocations to traditional fixed income should remain at the short end of the curve with credit quality high. Active managers will outperform more passive allocations going forward. Potential outflows from bond mutual funds and ETFs may continue to place pressure on bond prices going forward. In some instances, that will provide buying opportunities for active managers.
Alternative strategies also had a good quarter with those that are most equity oriented generating the strongest returns. The following chart summarizes broader performance for various hedge fund indices in the Fourth quarter:
Long equity positions generally drove performance for long/short equity managers and those with the highest net exposures benefited most. That being said, we saw a number of long/short managers actually take profits on short positions as some of the more company specific catalysts unfolded. This is positive for the strategy as a whole since it means that correlations are coming down and bad companies are separating from good companies. Below is a chart outlining the correlation across S&P 500 companies over the last 5 years:
Gold declined 28.3% on the year, its first annual decline since 2000 and the metal’s worst year since 1981. The decline can be partly attributed to investor fears that a reduction (or outright end) of QE would curb inflation. Optimism around an improved economy leading to higher interest rates forced money out of gold as a currency hedge. Additionally, funds flowed in to equities during a strong equity market and out of gold ETFs further contributing to the metal’s decline.
Silver and platinum also declined for the year as each of the three metals is viewed as a currency alternative and safe haven during periods of high inflation. The global easing programs created a rich environment for precious metals prior to this year but recent tapering talk reversed the course. Precious metals are a good hedge against global inflation but, at least for now, inflation has been managed. The chart below outlines the performance of the three metals since 2008.
Bottom Line: Liquid and illiquid alternative strategies belong in multi-manager multi asset class portfolios for very different reasons. The illiquid strategies are long term oriented with the goal of delivering growth above and beyond more traditional asset classes. We continue to find interesting opportunities in the illiquid markets as traditional players exit or reduce their involvement. Liquid alternatives, specifically hedge funds, are the most risk managed component of multi-asset class portfolios but they have and will underperform in bull markets as hedges and alpha shorts detract from performance. Hedge funds remain a core component of client portfolios to dampen volatility and provide consistent returns over time.
Conclusion and Outlook
Many of the “risks” heading in to 2013 have either dissipated altogether or have been dramatically reduced. We have clarity at the Fed and have witnessed progress in Congress. If the EU and Japan can continue to move forward with their easing programs, their economies may not be far behind the U.S. We continue to focus on asset allocation when implementing client portfolios as returns tend to come from some of the least expected places.
1Source: Investment Company Institute
This letter is being furnished on a confidential basis to the recipient for discussion purposes only and is not intended as investment advice. This letter is not to be transmitted in whole or in part without the prior consent of Massey, Quick & Co. LLC (Massey Quick). Massey Quick makes no express or implied representation or warranty with respect to the accuracy or completeness of this letter. Massey Quick has no obligation to inform the recipient when the information herein is no longer current. This letter does not constitute an offer to buy or sell, or a solicitation of an offer to buy or sell any securities or interests of any entities, or to provide investment advisory services.
Index data is supplied from various sources and is believed to be accurate but Massey Quick has not independently verified the accuracy of this information. This letter is based upon information Massey Quick believes to be reliable. However, the information set forth herein does not purport to be complete and is subject to change.
Certain information contained herein may constitute “forward‐looking statements,” which can be identified by the use of forward‐looking terminology such as “may, “ “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue” or “believe” or the negatives thereof or other variations thereon or other comparable terminology. No representation or warranty is made as to such forward‐looking statements.
The use of this letter in certain jurisdictions may be restricted by law. Prospective recipients of this letter should inform themselves as to the legal requirements and consequences of such use within the countries of their citizenship, residence, domicile and place of business.