The second quarter of 2013 was not nearly as sanguine as the first quarter; Boston experienced the devastation of the Marathon Bombing, the IRS was accused of targeting conservative groups for auditing, Bloomberg was found accessing private client data, China experienced a Shibor shock, and on June 19th the Fed ignited fears of tapering which put markets in a tailspin. Bond markets, equity markets, commodities, and precious metals sold off sharply during June with some markets touching lows that hadn’t been seen in in quite some time.
At the Federal level, expenses were down in the first quarter thanks to the sequester kicking in and revenues were up as the economy improved. Contributions to revenues included higher 2012 income tax collections, first quarter 2013 income tax collections, payroll taxes, and corporate taxes. Additionally, the $66 billion in dividends paid to the Federal government by Fannie and Freddie due to improvements in the housing market was substantially beneficial. The deficit is estimated to be reduced by $400 billion during 2013. The positive news at the Federal level indicating that our economy may be heading in the right direction led Bernanke to hint at “tapering” of QE in late 2013 and potentially eliminating it altogether in early 2014 if economic conditions warrant. While the Fed stated that expectations for improved growth and unemployment are improving, the short term shock of “tapering” sent global markets, both debt and equity, sharply downward. Fortunately, as Fed governors began to “clarify” Bernanke’s comments, some confidence returned and markets started to recoup some of the losses heading in to the third quarter. The nature of the Fed’s “backtracking” is clear upon consideration of the following quotes:
“If labor market conditions and the economy’s growth momentum were to be less favorable than the FOMC’s outlook – and this is what has happened in recent years – I would expect that the asset purchases would continue at a higher pace for longer.”
- William Dudley
“Market adjustments since May have been larger than would be justified by any reasonable assessment of the path of policy… I want to emphasize the importance of data over date.”
- Jerome Powell
The chart below outlines the performance of the S&P 500 index in the month of June following Bernanke’s comments and the comments of a handful of other Fed governors. Markets clearly responded very favorably to the follow up comments later in the month after the initial negative reaction to Bernanke.
The news in international markets was overshadowed by the Fed comments. However, Europe is not out of the woods yet. There were rumors of a German downgrade and French bank troubles. Additionally, Eurozone and German GDP came in worse than expected and 2013 GDP expectations were lowered. Portugal also reentered the negative spotlight as its economy is now expected to contract by 2.3% versus the previous expectation of 1.2%. This sharp correction has increased the chance of Portugal once again needing a bailout package. Nevertheless, the ECB temporarily assuaged broader Eurozone fears by cutting rates by 0.25% after stating that they had an “open mind on negative deposit rate” and that they were “ready to act if needed”.
The news out of China continued to be weak as a contraction in liquidity and deteriorating manufacturing data seemed to justify fears of a slowdown. Japan, meanwhile, reaffirmed their loose monetary policy causing the yen to weaken and the Nikkei to appreciate meaningfully.
Equity markets across the globe experienced sharp declines during the third week of June after reaching new highs in late May. From peak to trough, the S&P 500 Index was down 5.76%, the MSCI EAFE Index was down 10.28%, the MSCI World Index was down 7.87%, and the MSCI EM Index was down 16.75%. The VIX (volatility index), an index that many believe is a measure of fear, was up 69% from low to high during the quarter. Clearly, the fear of the Fed tapering their mortgage and Treasury buying programs sent many investors for the exits in a global “risk off” trade. As outlined above, the Fed governors’ comments later in the month reduced the fears of market participants sending equity markets up from their lows. Domestic markets finished the quarter in the black while most international markets were down.
The following chart summarizes various equity market indices in the second quarter:
As outlined above, Emerging Markets were hardest hit during the quarter and on a year to date basis. On the year, Brazil is down 19.5%, China is down 12%, India is down 8.8%, and Russia is down 14% with the vast majority of the decline coming in the second quarter. The concerns around further negative GDP growth in Europe, a slowdown in China, and the tapering of QE in the US have all contributed to the decreased demand for Emerging Markets. While the BRICs experienced a very difficult quarter, some of the less popular emerging economies and frontier markets that rely more on domestic consumption performed much better.
Bottom Line: Equities will continue to be the growth engine of client portfolios. If, in fact, domestic growth improves, the move away from larger cap value names earlier this year will begin to pay off as US focused and smaller capitalization names drive performance via secular oriented growth. With the recent decline in emerging markets, we’ve begun adding capital to more actively managed emerging market strategies. We remain constructive on equities and will selectively increase international and emerging market exposures as volatility surfaces.
Fixed Income Markets
The activity in fixed income markets can be summed up by the following sentence: for the first time ever, the yield on the U.S. 10-year Treasury rose over 40% in a 2-month period (May and June) from 1.67 to 2.48. To say the move in bond markets during the quarter was unprecedented would be an understatement. While the potential for lower yields to return still exists, investors have finally come to terms with the possibility of Fed tapering QE becoming a reality. During the month of June alone, bond outflows from mutual funds were $86 billion. Below is a table outlining the outflows during the second quarter across various fixed income markets.
While we believe the spike in yields was extreme, we are still negative on fixed income going forward, especially as inflation concerns begin to resurface in response to a rising interest rate environment as GDP growth improves. That being said, this drawdown did provide an opportunity for credit and long only fixed income managers to increase credit quality while not sacrificing yield.
The following chart summarizes performance for various fixed income indices in the second quarter:
Bottom Line: While we may have been early to the trade, our fears regarding the bond markets finally came to fruition. We remain negative on the asset class and think the selloff might continue albeit at a much slower pace than the one witnessed this quarter. We will continue to keep portfolios at the low end of the range of their asset allocation while maintaining high credit quality and low durations. Opportunistic credit also plays a role for those who can withstand slightly more volatility from this asset class.
In April, gold saw its largest one-day sell-off in decades at over 9%, sparked by slowing growth concerns in China. The decline in April represented a five standard deviation event and the decline in gold prices was the largest in US Dollar terms in the last 30 years. Gold extended its decline in June on worries that the Fed would taper its quantitative easing program. From April 1st through June 27th, the SPDR Gold Shares ETF (GLD) declined 25.04% both due to the decline in the price of gold bullion and in the lack of demand for the ETF during the period.
Second quarter performance across hedge funds strategies was mixed with the long/short credit strategies performing the best and global macro strategies performing the worst. However, thematically speaking, the short components of portfolios that had underperformed for the last 18 months finally paid off in June. Many of our long/short equity managers had significant positive attribution on the short side in June which helped to cushion losses or yield absolute returns. Residential Mortgage-Backed Securities (RMBS) managers and Global Macro managers were not as immune to the selloff in June as their strategies demonstrated higher net exposures and were therefore subject to the market volatility.
The following chart summarizes performance for various hedge fund indices in the second quarter:
Bottom Line: Hedge funds continue to be over scrutinized as returns have struggled to keep up with rising equity markets. We continue to believe in their risk managed approach to investment management as global easing subsides and fundamental, as opposed to trading oriented, investment strategies start to work again.
Conclusion and Outlook
Volatility has clearly reemerged and Fed action could subside as growth prospects improve. We hope that decreased central bank activity will lead to a more normalized investment environment. While rising rates are hard on bond portfolios, they generally indicate a stronger economy. As we approach normalcy, fundamental research will begin to drive investment performance once again. We remain committed to client specific asset allocation plans that incorporate diversified investment strategies and vehicles to navigate all market environments.
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