Second Quarter 2013 Key Takeaways —
Federal Reserve policy has been a significant force driving market performance over the past few years and this was especially true during the second quarter as investors reacted to comments from Fed policymakers indicating the Fed might begin reducing its bond buying program sooner than had been expected.
Against this backdrop, U.S. stocks suffered losses in June but ended the quarter with gains (though stocks were down from earlier year highs). Core investment-grade bonds fell 2% for their worst quarter since 2004 and other interest-rate sensitive asset classes such as REITs were negative as well. Emerging-markets stocks and bonds lost ground both due to concerns about changes in U.S. monetary policy and potentially slowing growth in many emerging-market economies.
There were two second-quarter market developments we find particularly noteworthy: the spike in Treasury bond yields and the sharp decline in emerging-markets stocks and bonds. While our portfolios were helped (on a relative basis) by the first, they were hurt by the second.
Our longer-term outlook and asset class analysis has had us positioned for a rise in rates (and a decline in bond prices) for a while now, reflected by our underweight to core bonds and overweight to flexible/absolute-return-oriented bond strategies. As a result, our fixed-income positioning added value again this quarter as it has over the year and half during which we’ve owned these funds.
Although we do consider potential shorter-term risks in managing our portfolios, we don’t try to predict what markets will do over the short-term or position our portfolios for particular short-term outcomes. The events of the past quarter have not materially changed our longer-term asset class views or risk assessments, but now emerging market assets are historically cheap compared to US stocks.
With regard to emerging markets, we believe the recent sell-off is overdone and short-sighted, so during June we took advantage of the selloff and increased our positions in emerging market assets.
Second Quarter 2013 Investment Commentary
Our commentary will focus on two market developments during the quarter that are noteworthy at both a macro level and given our portfolio positioning: (1) the spike in Treasury bond yields, and (2) the sharp decline in emerging-markets stocks and bonds. Both of these developments had (to varying degrees) the same underlying driver: statements from the Federal Reserve about the future course of monetary policy, and specifically the Fed’s plans to begin “tapering” its quantitative easing bond-buying program. This is a theme we’ve written about a lot recently: the unusually heavy influence of monetary policy on the financial markets in the aftermath of the 2008 financial crisis, and the unusually strong sensitivity of markets to perceived changes to such policy. We’ve noted how Fed policy—by “repressing” interest rates to all-time lows and aggressively purchasing government and mortgage-backed bonds via quantitative easing—actively encouraged (if not forced) investors to move out on the investment risk spectrum, into higher-yielding but riskier asset classes.
We noted that this behavior could certainly continue in a self-reinforcing cycle as long as the markets believed two things: (1) that the Fed would keep up their stimulative policies and, (2) that such policies were necessarily positive for stocks rather than, say, indicative of the severity of our economic problems. If so, as the markets moved higher more and more short-term-oriented or performance-chasing investors would feel the urge to jump on the stock market bandwagon, propelling the market still higher and possibility divorcing it from its underlying longer-term economic fundamentals.
That short-term speculative approach is not part of our investment discipline nor is it likely to yield consistent, sustainable success for most investors. That does not mean that we ignore what the Fed is doing, how their policies might change, or what the implications might be for the economy and financial markets.
Development #1: Interest Rates Spike Higher
Chairman Ben Bernanke indicated on June 19 that the Fed might begin to taper the pace of monthly bond purchases sooner than expected. Despite Bernanke’s best efforts to manage market expectations and communicate that a potential tapering does not mean an actual tightening of monetary policy, investors reacted with alarm to the prospect of a less active Fed. This resulted in a bond market sell-off, with the yield on the 10-year Treasury bond rising from a year-to-date low of 1.63% on May 2 to 2.6% on June 24, its highest level since early August 2011, before ending the quarter at 2.5%. (As a reminder, bond yields rise when prices fall.) U.S. stocks also fell but rebounded fairly quickly.
Thirty-year fixed mortgage rates, which are a specific target of QE (quantitative easing), also jumped sharply. Thus, the Fed’s optimism about economic growth/recovery, which led Fed policymakers to conclude they could begin ending QE, might in fact become a headwind to that growth. Rising borrowing costs and falling asset prices could short-circuit the economic recovery and, in turn, the tapering process. This is just part of the broader challenge the Fed faces as it tries to unwind its unprecedented post-crisis monetary policies without causing any major market or economic disruptions. At best, we are confident in saying, the “exit” will be a very bumpy road, with meaningful risks of policy errors and unintended consequences.
The second key development last quarter was the sharp sell-off in emerging-markets stocks and emerging-markets local-currency bonds, and their continued underperformance this year relative to U.S. stocks. While there were numerous drivers of this underperformance, the rise in interest rates in the U.S. and the Fed’s tapering announcements were key factors. These developments, along with news that the Japanese central bank was not planning to further expand its own QE program, triggered a general unwinding of the “carry trade,” in which investors (mostly short-term traders and hedge funds) borrow the currencies of countries with low-yielding debt and/or depreciating currencies and invest in higher-yielding/appreciating currency investments, such as emerging-markets local-currency bonds. As the carry trade unwound, prices on emerging-markets local-currency bonds dropped, yields rose, and emerging-markets currencies depreciated against the dollar. Thus, emerging-markets local-currency bonds were hit with the double whammy of falling bond prices and falling currencies.
Portfolio Positioning and our Long-Term Performance Expectations
For the past couple years, the fixed-income portion of our balanced portfolios has been positioned for very low rates with an expectation of a longer-term trend of slowly rising interest rates. We have been tactically underweight to core bond funds and have a large allocation to more flexible, unconstrained and/or absolute-return-oriented fixed-income funds.
As a result of this positioning, our fixed-income portfolios held up better than the bond benchmark through the sell-off in the core fixed-income markets. Although our portfolios are underweight to core bond funds due to our expectation for a sustained period of rising rates, we have maintained some exposure to core bonds in our balanced portfolios as a hedge against an economic downturn, deflation, or some unforeseen event that would lead to increased risk aversion among investors and a flight to quality assets (as core U.S. bonds are traditionally perceived to be. Putting it all together, our overall domestic fixed-income positioning added value again for the quarter versus the benchmark as it has over the last eighteen months.
Turning to the equity markets, our position over the last several years to overweight U.S. equities versus international developed markets has been positive over both the long term and short term. Our decision to overweight emerging markets within our international position however, was negative for this past quarter as it has been year to date. First, we were hurt by the tactical position in emerging-markets local-currency bonds that we hold in our balanced portfolios (initially added to our strategies in 2010). Our emerging-markets local-currency bonds position is being funded from a combination of U.S., international stocks and fixed income because we view these bonds as having less risk than global equities (although significantly more risk than our other bond funds), but more attractive return prospects from current levels in our base case scenario. In most multi-month periods when emerging-markets local-currency bonds post significant negative returns, we would expect global stocks to perform at least as badly and likely worse, as has been the case historically. But as noted above, emerging-markets stocks and bonds meaningfully underperformed developed stock markets in the second quarter. We don’t expect this trend to persist.
The underperformance of international developed and emerging markets over the last three years has been significant as you can see in the chart. There are many reasons for this, most of which have been well documented regarding the issues around Europe and the Euro along with the slower growth in developing countries, specifically China, and potential inflation in emerging markets. Over the last year we have been discussing the how and when we should increase our International equity position. In the latter half of June we made the decision increase our position to developed international equities and emerging market stocks and bonds. This was certainly weighted towards emerging markets rather than developed international, primarily because it is easier to see the growth in emerging markets than in traditional developed markets today, even though both markets are relatively cheap. This move is not done simply because of the underperformance of emerging markets in the past quarter, but as the chart shows, it is due to the significant underperformance over the last three years.
As we write this, even though we have made tactical changes in our portfolios, the events of the past quarter have not materially changed our longer-term asset class views or risk assessments. Our reduction to U.S. stocks is not driven by a short-term view of the market, or by a specific concern that interest rates will continue to spike higher in the near-term or that even a moderate but sustained rise in rates should cause a sharp market downturn. Rather, our reduced allocation to U.S. stocks is driven by our analysis that International and emerging stocks and bonds are inexpensive relative to US stocks and bonds.
Just as interest rates might continue to spike higher driven by investor sentiment and market momentum, the negative impact on emerging-markets stocks and emerging-markets local-currency bonds could continue as well over the shorter-term. We believe however, the markets are over reacting to short term developments without taking into account the longer term positive economic fundamentals and attractive absolute return potential that these emerging market asset classes possess.
We are confident that taking tactical allocations only when highly compelling opportunities are presented to us, and by using managers we believe to be highly skilled, we can continue to earn above-average long-term returns while keeping our shorter-term downside risk within our loss thresholds. One consequence of our long-term tactical approach is that we know we will underperform over some shorter-term periods. As long as our positioning remains supported by our analysis of the evidence and facts (as we see them), we will remain disciplined and patient in order to allow our investment decisions to ultimately pay off, as we have seen happen repeatedly over JPH Advisory’s 20-year history.
Jon Houk, CFP®