Political headlines in the U.S. monopolized newswires in the third quarter as Congress argued over the budget and debt limit while The Federal Reserve wrestled with a decision of if and when to taper quantitative easing.
If the second quarter was all about the potential of a tapering of the Fed’s QE program, the third quarter was all about the lack of any tapering. The June 19th meeting led economists to forecast Fed tapering at the next meeting on September 19th as outlined in the chart below.
Source: Wall Street Journal survey of economists
However, the markets were surprised when no taper was announced and equity markets appreciated 4-12% across the globe and most bond yields tightened as investors were reassured that the Fed would continue to pump liquidity in to the system. While this signals that the economy is not yet on stronger footing as many had hoped, it was clearly positive news for markets.
The Dow Jones Industrial Average and the S&P 500 Total Return indices reached all-time highs during the quarter. The S&P 500 was up 5.25% during the quarter and is now up 19.79% for the year. The S&P 500’s performance this year represents the 10th best performance for the first nine months to start a year since the index’s inception. Growth names generally outperformed value names in the quarter as investors believed that QE would continue to spur growth on a global basis. This is further evidenced by the top performing sectors during the quarter. Materials and Industrials are generally more cyclical sectors and both were top performers for the quarter after underperforming for most of the year. The chart below outlines the performance by S&P 500 sector for the quarter and on a year to date basis.
While domestic equity had a good quarter, international equity as defined by the MSCI EAFE Index performed even better notching a 10.94% gain for the quarter. The index still lags domestic markets on a year to date basis but gained significant ground during the quarter outperforming by nearly 475 basis points. Emerging markets were also positive during the quarter but are still down on the year. During the month of September, some emerging market indices were up 6-8% following the Fed’s announcement; it is clear that in the short term, Bernanke’s statement alleviated fears that emerging markets would slow without Fed stimulus.
The following chart summarizes various equity market indices in the third quarter:
Bottom Line: After another strong quarter for equities, we remain positive on the asset class especially for portfolios with time horizons of greater than 5 years. As we predicted at the beginning of the year, growth strategies have outperformed value strategies. We continue to be overweight growth equities and expect to continue to increase allocations to international developed and emerging market stocks. As we approach further turmoil in Washington at the January and February deadlines, volatility may reappear offering more opportunities to increase exposures.
Fixed Income Markets
Ten year yields peaked at 2.99% on September 5th and then dipped down to 2.61% at the end of the quarter when no taper was announced. Across all bond markets, longer duration securities sold off during the second quarter quite substantially but recovered to a small degree in the third quarter. This dramatic selloff created an opportunity for fixed income managers to increase credit quality (without paying up for it) and extend duration (where longer dated assets were oversold). Mutual funds continued to experience redemptions during the quarter as taxable bond funds saw roughly $30 billion in outflows and municipal bond funds experienced approximately $29 billion in outflows.1
Municipal bond issuance remained low as state and local governments continued to be cautious with their capital raises. Puerto Rico and Detroit continue to worry investors as Detroit was the biggest single default in the municipal bond market’s history and Puerto Rico’s financial situation is incredibly dire. Debt as a percent of GDP in Puerto Rico currently stands at approximately 50% with pension liabilities representing 35% of GDP. The combination of these factors and the fear of a Fed taper have led investors to exit municipal bonds at a record pace. That being said, the vast majority of the municipal bond market is in excellent financial condition after cutting back on expenses, refinancing debt at lower rates post 2008, and collecting stronger tax revenues more recently.
High yield and loan funds have been the market darlings within fixed income. Both have garnered significant investor attention on the year as investors have reached for yield in an otherwise low yield environment. We continue to monitor flows into these asset classes closely. For example, we are becoming increasingly concerned about the pace at which leveraged loan funds are receiving inflows: to date, leveraged loan mutual funds have seen over $38B worth of inflows. It is our understanding that both retail and institutional investors remain active and the hedge fund community may be applying dangerous levels of leverage to this asset class. Moreover, we maintain concerns about loans with weak covenants.
The following chart summarizes performance for various fixed income indices in the third quarter:
Bottom Line: Bonds will not be a meaningful contributor to returns and longer dated securities are dangerous, especially where active management is absent. We remain of the “better safe than sorry” mentality while recommending short duration's and high credit quality for client allocations. We continue to maintain our belief that active management, with a strong focus on fundamental credit research, remains the best way to allocate capital in the space.
Third quarter performance across hedge funds strategies was strong and those that were most equity oriented or long biased delivered the highest returns namely long/short equity, event driven, and distressed. Most long/short equity managers generated alpha on the long side of their books by outperforming most equity indices. Those that lost the least on their short books demonstrated the strongest net results for the period. While the last four years have been a difficult short environment for long/short managers, 2013 has become marginally better despite the market rally. Correlations have broken down somewhat which has been good for fundamental analysis. Global macro continued to be the worst performing hedge fund strategy as technical and momentum driven trading struggled to be profitable during a mostly straight up market.
The following chart summarizes performance for various hedge fund indices in the third quarter:
Bottom Line: hedge fund returns were strong for the quarter but risk managed strategies will continue to underperform equities in bull market rallies. Hedge funds will continue to dampen volatility in multi-manager multi-asset class portfolios as they protect on the downside via their short exposure or portfolio hedges. In addition to hedge fund allocations, private equity, private debt, and global distressed offer very attractive return profiles within the alternative space. We continue to be very active in sourcing and allocating to illiquid alternatives for client portfolios as we believe the burdensome financial regulatory reform has created opportunity for investors that can afford to wait for returns to materialize.
Conclusion and Outlook
Since we are well in to the fourth quarter at the writing of this letter, it’s only appropriate that we comment on the activity during its first two weeks. On October 1st the US government shut down for the 18th time for a period of 17 days. During the shutdown, over 800,000 employees were furloughed and GDP growth was threatened. On the eve of the debt ceiling, both parties came to a “kick the can down the road” deal to extend government funding until January 15, 2014 while extending the debt ceiling until February 7, 2014. A recovering, (albeit slowly) domestic economy is overshadowed by an inability of our Congress to come to an agreement on the spending and borrowing habits of this country. Until substantive agreements are reached, confidence in corporate boardrooms will likely remain low and so hiring and capital investment will continue to lag.
1Source: Investment Company Institute
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