EconomyThe second quarter of 2014 was not short on news. It started with a bang when first quarter GDP came in well below estimates and turmoil in Iraq, Israel, and Russia continued to dominate geopolitical headlines. The Fed continued to taper while both bond and equity markets rallied largely across the globe.US
With the exception of first quarter GDP data coming in well below expectations at negative 2.9%, economic data was largely positive for the quarter. Job growth for April, May and June registered gains of 234,000, 276,000 and 288,000, respectively; this represented the strongest three month period of growth since the first quarter of 2012. The nation’s unemployment rate (6.1%) is now the lowest since September 2008, when the nation was in the early stages of the financial crisis. The consensus is that first quarter GDP was an outlier due to the severely harsh weather across the country in January and February. It was the first negative GDP result in 11 quarters and the worst reading since 2009. The majority of the decline was due to a drop in exports (-1.5%) and inventory levels (-1.5%). Housing data was largely positive during the quarter as U.S. new home sales continued to increase at a steady pace. Auto sales and wage growth have also shown improvement. Wage growth, as outlined in the below chart, is one of the biggest factors to improved economic growth.While the rate of change may be modest, the trend is largely positive. Further wage growth (which is typically a harbinger of inflation) and CPI increases could lead to central bank policy rate tightening sooner than some expect. The market has already priced in a higher Fed funds rate of 0.35% by June of 2015 as evidenced in the forward rate curve.International MarketsThe ECB made a major commitment to extend loose monetary policy during the quarter by decreasing the discount rate to -0.10% for the first time in history. They also agreed to extend inexpensive financing to banks later this year in an effort to boost lending to the private sector. ECB President Mario Draghi also alluded to the potential for asset purchases down the road. European markets rallied and sovereign debt yields plummeted in the region. Despite continued accommodative policy from the ECB, there are still signs of weakness. For example, the Banco Espirito Santo in Portugal recently reported a loss in excess of €4B, leaving solvency ratios well below those required by regulators and prompting the formation of a rescue plan. Occurrences such as these make it clear that remnants of the European debt crisis still exist.There were ample geopolitical events unfolding throughout the quarter and many weighed on global energy prices. ISIS militants continued their push into Iraq and Pro-Russian forces occupied Eastern Ukraine while Putin jockeyed for greater world power. Towards the end of the quarter, and more formally earlier this month, the Israel-Palestine conflict intensified after the deaths of children in both regions reignited tensions.Equity MarketsEquities rallied across the globe during the quarter with emerging and frontier markets leading the way after experiencing a more volatile (in both directions) first quarter. Growth stocks also appreciated more in line with value stocks after lagging during the first quarter. Utilities, the worst performing sector of 2013, are up 16.42% YTD. The second best performing sector, Energy, is up 11.66% YTD following an 11.45% rally during the quarter due to tensions in the Middle East.Corporate America was quite active in the equity markets during the quarter. US IPO volumes and initial offerings count reached $21.5 billion and 89, respectively; levels not reached since 2007. As outlined in the below chart, M&A activity also picked up dramatically. Pfizer’s repeated offers for AstraZeneca and the AbbVie/Shire deal highlight a new wave of tax- driven M&A called tax inversions where US based companies can lower their overall corporate tax rates by reincorporating outside of the US. Global M&A activity reached $1.2 trillion and the number of deals nearly reached 8,000 during the quarter.
Nevertheless, many market pundits are concerned that corporations that have been aggressively cutting costs since the financial crisis may face lower profits in the face of increasing wages as discussed above. Moreover, the strengthening of the dollar as a result of the tapering of Quantitative Easing has put pressure on domestic export businesses. Each of these set of circumstances is worth monitoring in assessing the health of equity markets.
Frontier markets led the charge during the quarter gaining 12% and posting a nearly 20% gain for the year. Emerging markets registered a 6.5% gain after struggling during the first quarter of the year. Most major world equity markets were up 2-6%. The following chart summarizes various equity market indices in the second quarter:
Bottom Line: Equities are not cheap at their current valuations but neither are they overly expensive. Revenue growth will dictate the degree to which equity markets continue to rally. Marginal improvements in GDP growth could drive revenues higher. We remain positive on equity market allocations for long-term portfolios. July has seen the return of weakness in growth stocks and more recent volatility in fixed income markets has been unkind to the yield-oriented Utility sector. To us, this highlights the continued need for diversification within equity portfolios. We believe that world economies, namely the US, are on a path to improvement. That said, continued equity market strength could lead us to rebalance equity allocations at year-end.
Fixed Income Markets
Ironically, fixed income markets rallied in tandem with equity markets during the quarter. Some suspect that this may have been due to a continued rotation out of equities into bonds in an effort to rebalance after strong equity performance. Others believe that fears of higher interest rates have largely been subdued for the time being causing many to seek higher yields in longer duration securities (hence the rally relative to shorter duration securities). The Fed continued its taper program by decreasing bond purchases to $35 billion and still plans to end QE3 altogether by year-end. Emerging market debt led the charge with a 4.5% rally as measured by the Barclays Emerging Markets Debt Index. Most other debt markets were up between 2-3% during the quarter and are safely in the black for the year. The US ten year Treasury declined modestly during the quarter from 2.8% to 2.5% after reaching a two and a half year peak above 3% at the end of 2013. Consensus estimates forecast a 3.0% ten year rate at the end of 2014 and a 3.61% ten year rate at the end of 2015.
One area of concern for us has been the large retail participation in debt markets relative to dealer inventories as evidenced by mutual fund and ETF flows. One of our credit managers highlighted this concern in his recent monthly letter and we’ve included an excerpt below:
“Last but not least, the third issue is what we have started to call ‘the other L word’ ‐ liquidity. We are referring here to transactional liquidity. Much has been made of the fact that the financial system and counterparties to the system are not as levered as in 2008 and this is touted as a source of stability. The dirty secret no one wants to talk about is that, in our opinion, the structure of the market today is completely different from 2008. The effect of the new regulatory environment, regardless of one’s opinion as to whether the regulations are good or not, is that transactional liquidity is bad. Banks are no longer intermediaries in the transfer of risk. We think regulation has prevented this and the traditional roles that Banks could play as a shock absorber in times of stress are gone. While many rejoice that ‘prop trading’ is gone, in the next liquidation they may wish to revisit their stance. The reality is that insurance companies, mutual funds, hedge funds and private equity firms will play the part of intermediaries of risk. Without becoming dramatic, we believe that the clearing price for risk will be a lot lower than it was last time, and consequently a lot lower than many people think. Our point here is that the effects of the system being less levered may be equaled and perhaps outweighed by the lack of transactional liquidity or ‘someone to take the other side.’”
We don’t know when this will become a problem but do suspect it will catch markets off guard. We’ve insulated fixed income portfolios by keeping durations low and credit quality high but are prepared for price volatility nonetheless.
Bottom Line: While we don’t expect much in the way of returns from traditional fixed income, we continue to believe that it will be a volatility dampener if and when volatility returns to equity markets and a source of liquidity to increase equity exposures as opportunities arise.
Hedge fund performance was strong on an absolute basis during the quarter but lagged equity markets generally. Commodity managers have had a very strong start to the year but more broad-based Global Macro strategies continued to struggle as some of the more popular currency trades worked against them. The largest gains came from Event Driven and Distressed managers as M&A activity benefited these strategies and positive developments in the Lehman Brothers trade unfolded. While long/short equity returns were largely positive for the quarter, the dispersion in returns was wide yet again with some managers experiencing a second straight down quarter. Equity long/short strategies have surprisingly struggled year-to-date despite the drop in correlations among individual equity securities. One driver of performance has been the volatility in growth equities, which has caused some equity strategies to struggle as high quality long positions underperformed while lower quality growth names rallied. The volatility in small and mid-cap securities year to date has also represented a headwind to performance in both the long and short portfolios of many strategies. However, despite this near-term underperformance, the opportunity set for equity long/short as part of a diversified alternative portfolio remains attractive. The following chart summarizes broader performance for various hedge fund indices in the second quarter:
Bottom Line: Hedge funds have been and will continue to be under heavy scrutiny while more passive, cheaper investment vehicles deliver stronger returns in a seemingly straight up market. Until volatility returns and correlations normalize, hedge fund returns could underwhelm. With equities at all-time highs and traditional fixed income representing unattractive return potential, we continue to believe that hedge funds will be the risk-managed component of client portfolios capable of generating higher after- tax returns than most non-equity strategies regardless of market activity.
Conclusion and Outlook
Global central bank intervention over the last six years and heightened geopolitical risks more recently create a backdrop for future volatility. With volatility comes opportunity. We remain steadfast in our belief that a disciplined approach to asset allocation and a commitment to long term performance will in fact lead to the intended results across client portfolios.
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