The third quarter of 2014 saw downside volatility return in earnest across asset classes as familiar “big picture” geopolitical issues (ISIS militants, tension in the Ukraine) were joined by new potential tail risks (Ebola pandemic, Hong Kong protests). Additionally, economic growth concerns continue to persist among the world’s major economies leading to further market uncertainty. Against this backdrop, both bond and equity markets posted muted results.
The third quarter began with some very promising data regarding the US economy: reported GDP growth for the second quarter was in excess of 4%, a figure that bested consensus estimates while simultaneously matching the highest observed growth rate in the nation’s recovery from the 2008 financial crisis. This positive result seems to confirm the thesis that disappointing first quarter GDP results were truly an outlier event caused by an exceptionally harsh winter.
Additionally, the labor market continued to show signs of improvement with the unemployment rate dipping below 6% for the first time since July 2008. Job creation continued to trend positive with employers adding 212,000 jobs in July, 142,000 jobs in August and 248,000 jobs in September. Moreover, as highlighted in our last quarterly market newsletter, wage growth continues to take place (albeit at a modest pace), a further sign of improvement in the US economy.
The Federal Reserve was once again front and center as Chairwoman Janet Yellen delivered much anticipated remarks in September. As expected, the US Central Bank remained committed to its tapering course and further reduced asset purchases; the Fed’s Quantitative Easing measures will be fully wound down by the end of October. Furthermore, while the Fed maintained its highly accommodative “considerable time” language pertaining to interest rate increases, equities and credit responded in mixed fashion.
Markets may have been rattled by sentiments/projections from within the Fed that interest rate increases could happen sooner (and to higher levels) than were formerly anticipated. As is often the case, several Federal Reserve governors spoke publicly in an effort to assuage the markets’ fears while the subsequent release of the September FOMC meeting minutes provided clear indications that the Fed is sensitive to avoiding premature rate increases that could stifle economic growth. Nevertheless, this type of “back and forth” highlights the difficulty the Fed faces in seeking to provide forward guidance to the markets on future policy measures.
As the Fed steps away from quantitative easing, the central banks of key international economies are moving in the opposite direction in an effort to spur lackluster growth and/or battle deflation.
After weeks of rampant speculation, the head of the European Central Bank, Mario Draghi, took major policy steps to combat deflation and slowing growth in the Eurozone by announcing a surprise rate cut while simultaneously laying the path for outright asset purchases. Draghi’s plan took further shape in the early weeks of October when the ECB agreed to a legal framework that allows the bank to engage in open market asset purchases of covered bonds. Sovereign yields across the Eurozone ground lower throughout the quarter while the dollar price of the Euro fell by over -7% from its June 30th closing price. Market expectations are for Draghi to aggressively engage in QE in the fourth quarter as Eurozone inflation stands at only 0.3%, a figure well shy of the stated 2% goal.
In Asia, the Japanese economy continues to struggle with the country posting an annualized GDP decline of over -7% in the second quarter according to data released in September, a figure that surprised to the downside and raised questions about the efficacy of the Bank of Japan’s current policy initiatives. Speculation that the BoJ would initiate even more aggressive quantitative easing measures caused the yen to fall by over -8% relative to the dollar during the third quarter as yields on Japanese government debt drifted further into negative territory. China also continues to show evidence of slowing growth (though the Chinese economy is still growing at a rate in excess of 7%) leading many to wonder whether significant easing measures will be undertaken in size in that region as well. Following the quarter end, the People’s Bank of China did indeed inject 300 billion Yuan into the country’s banking system in an effort to spur lending activity; further activity on this front is expected as the Chinese central bank seeks to facilitate the country’s high growth rate.
On a fundamental basis, second quarter earnings reports throughout July and August were largely positive with EPS growing at a double digit rate and revenues growing by over 4%. Global M&A activity also continued to roll along with the third quarter posting overall deal volume of approximately $889B, the third highest quarter on record since 2007. Tax inversions (deals where a company acquires a target in a more favorable tax domicile to achieve a better corporate tax rate) remained a hot topic, especially in healthcare, with US-based Abbvie’s proposed $52B July offer for UK-based Shire marking one of the largest such proposals seen to date. While this deal has since broken apart as of the time of this writing and speculation rages as to whether the Treasury department will limit deals of this nature in the future, most market participants expect further activity on this front. Capital expenditures and share repurchases also continued to tick upward during the quarter as companies continue to seek ways to deploy their ample cash balances to spur earnings growth.
However, macro concerns and the divergent policies of the world’s major central banks led to a volatile quarter for equity markets. After a long period of trading at suppressed levels, the CBOE Volatility Index (“VIX”) ramped sharply in the third quarter, increasing by over 40% as equity markets whipsawed back and forth.
This volatility was particularly unkind to riskier regions and market capitalizations. Global small cap equities (as measured by MSCI) declined approximately -6.5% in the third quarter and are in the red for the year. Larger capitalization securities continue to outperform their smaller cap counterparts by a significant margin on a year to date basis.
International markets similarly declined approximately -5.8% as growth concerns weighed heavily on equities. Emerging markets also struggled, with the region declining over -3%, though the entirety of these losses occurred during a disastrous September when the region shed approximately -7.4%. Frontier markets continue to be a market leader after gaining over 1% in the third quarter as the region continues to benefit from increased attention and asset flows from the broader investor community.
The Fed’s tapering and uncertainty abroad sparked a significant rally in the US Dollar during the quarter. While this movement raises concerns about companies’ profit potential in the face of a stronger currency, it also weighed heavily on commodity markets and oil in particular. The following chart highlights the 2014 price activity in the dollar and oil:
Oil prices have also been negatively impacted by news that Saudi Arabia is seeking to use lower prices to pressure fellow producers. As the price of oil plummeted, energy markets posted significant declines in excess of -9%. After being a leading sector for the first half of the year, energy is now among the worst performing sectors year to date. Commodity price declines have persisted into October at the time of this writing leading to a further selloff in energy markets. Interest rate volatility was also a negative for the Utilities sector, which was another major laggard in Q3, while Healthcare (+5.0%) and Tech (+4.3%) posted strong quarters to claim the number one and two spots, respectively, in the year to date sector performance rankings.
The following chart highlights third quarter performance for various equity markets:
Bottom Line: While unpleasant in the near term, we believe that this market correction in equities is healthy after such a dramatic multi-year rally. Volatility creates the potential for attractive entry points. We further maintain our belief that fundamentals will dictate the degree to which equity markets will post gains going forward. We remain positive on equity market allocations for long-term portfolios, especially when considered in light of the return potential offered by traditional fixed income securities. We also continue to emphasize diversification within equity portfolios.
Fixed income markets were also subject to volatility in the third quarter. Both the Barclays Global Aggregate and Global High Yield indices posted declines of over -3% in the quarter as a result of geopolitical uncertainty and negative asset flows. More liquid securities were generally among the hardest hit by selling activity and, somewhat surprisingly, shorter duration assets underperformed their longer duration brethren.
Municipal bonds decoupled from the broader fixed income markets to lead the pack in the third quarter. After a difficult 2013, the muni market has advanced +7.5% year to date and is one of the best performing asset classes through September 30th. Emerging market bonds fared better than domestic bonds and yielded only modestly negative results in the third quarter.
In contrast to corporate debt, Treasuries continued to rally: US 10 Year yields declined to 2.4% in the quarter as investors likely sought a safe haven amidst the broader market volatility. The continued rally in Treasuries may also be a simple function of relative value. Compared to other stable developed nations such as Germany (10 Year yield of 0.95% as of 9/30) or questionable peripheral sovereigns such as Spain (10 Year yield of 2.14% as of 9/30), US T-Bills may represent a veritable bargain at their current levels.
The following chart summarizes credit market performance in Q3:
We continue to be concerned with the liquidity of corporate credit markets and the third quarter highlighted how quickly technical factors can exacerbate market declines in the absence of bidders in the market. As discussed in previous Massey Quick communications, we also believe that the Fed’s exit from QE will have a further impact on liquidity within sections of the broader fixed income markets. The consensus has adjusted to thinking that the first Fed rate hike will shift from March of next year to June or even September. We expect that speculation on the Fed’s policy decisions will continue to engender future fixed income market volatility and we continue to monitor these circumstances closely.
Bottom Line: We continue to believe that traditional fixed income offers muted overall return potential. Fixed income should still serve as a source of liquidity to increase equity exposures as opportunities arise. Our positioning remains in line with our long-term thesis: an emphasis on short duration and higher credit quality.
Hedge funds saw mixed results in the third quarter though most strategies effectively protected capital during periods of market volatility. The following chart summarizes quarterly performance for select hedge fund strategies:
The return of said volatility was a boon to macro strategies as these advanced +1.4% during the quarter. The strengthening of the dollar and see-sawing commodity prices likely facilitated profits for these managers. Rate volatility also provided a tailwind to alternative credit strategies.
In contrast, more directional Distressed strategies (down -2.4% for the quarter) largely struggled as riskier assets sold off. Event-Driven strategies, which also declined over -2% in the third quarter, were hurt by both equity and credit exposures and adverse rumors that the Treasury would step in to limit tax inversions, a popular trade in the hedge fund community. Long/Short Equity strategies posted more modest declines of approximately -1% in Q3. The “risk on” / “risk off” mentality seen from July through September led to increased correlations among individual securities; these heightened directional moves inhibited effective long/short stock picking as prices often disconnected from fundamentals over the short term. Additionally, as recently cited by Bloomberg, more crowded hedge fund positions have been among the hardest hit as multiple firms frequently sought to reduce risk in response to market volatility; this activity further increased short-term correlations among individual securities.
Hedge funds continue to remain under scrutiny from investors. September saw news break that the California Public Employees’ Retirement System (“CalPERS”) would be eliminating its $4B hedge fund allocation from the portfolio. CalPERS backed its decision by noting that its hedge fund allocation had failed to meet performance expectations while incurring too much by way of fees. While hedge funds represented less than 2% of CalPERS total portfolio, the entity’s decision sparked debate as to whether other large allocators to alternatives would follow suit. To date, however, the market has yet to see significant activity on this front and the hedge fund industry reached a record size of $2.8 trillion in total assets this year.
Bottom Line: We continue to stress the role of alternatives as part of a diversified portfolio: these allocations are meant to deliver risk-managed returns through long-term compounding. Investor scrutiny of hedge funds is warranted and we believe that there are positive trends taking place in the industry involving increased transparency and improved fees to the benefit of investors. Our focus remains on identifying managers that offer unique portfolios comprised of idiosyncratic risk/reward investment opportunities.
Conclusion and Outlook
We noted in our second quarter newsletter that “volatility creates opportunity” and as September’s sell off has spilled into October, we believe there are a plethora of newfound opportunities for talented active management. We expect additional volatility as global central bank intervention continues to diverge. Nevertheless, 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.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Massey, Quick & Co., LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Massey, Quick & Co., LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Massey, Quick & Co., LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. If you are a Massey, Quick & Co., LLC client, please remember to contact Massey, Quick & Co., LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of the Massey, Quick & Co., LLC’s current written disclosure statement discussing our advisory services and fees is available upon request.
Historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings correspond directly to any comparative indices
Indices included in this report are for purposes of comparing your returns to the returns on a broad-based index of securities most comparable to the types of securities held in your account(s). Although your account(s) invest in securities that are generally similar in type to the related indices, the particular issuers, industry segments, geographic regions, and weighting of investments in your account do not necessarily track the index. The indices assume reinvestment of dividends and do not reflect deduction of any fees or expenses.
Please Note: (1) performance results do not reflect the impact of taxes; (2) It should not be assumed that account holdings will correspond directly to any comparative benchmark index; and, (3) comparative indices may be more or less volatile than your account holdings.
Please note: Indices are frequently updated and the returns on any given day may differ from those presented in this document.
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.