The second quarter of 2013 was nothing if not eventful. Equity markets continued the advances of the first quarter, led by the U.S. with international markets following in its wake to varying degrees. By the middle of May, U.S. and global equity markets had reached highs for the year. Then stock and bond markets around the world reacted negatively to comments Ben Bernanke, the Federal Reserve Chairman, made before Congress about the foreseeable end of the Fed’s bond buying (quantitative easing) programs.
This “news” prompted a swift sell-off in stocks and bonds around the world, and the remainder of the quarter was filled with a volatile mix of up and down moves as the Fed re-stated their intentions and short-term traders repositioned their portfolios as they saw fit. By the end of June, the U.S. stock market had given back some of its prior gains but ended the quarter up almost 3%. Equity markets outside of the U.S. finishing the quarter down 4%. Global equity performance was slightly negative for the quarter and up 6% overall for the first half of the year.
Interest rates rose dramatically in reaction to the Fed’s news, and the selloff in the bond market (bond prices are inversely correlated to interest rates) resulted in a negative return of just over 2% for the quarter and year to date.
Taper – The Beginning of the End of Monetary Stimulus
As mentioned above, a key inflection point for financial markets this year has been the Federal Reserve’s acknowledgment that a) there will soon come a time when the U.S. economy will no longer need to rely on the hugely accommodating monetary policies that have been in place since 2008, and b) there is a thoughtful plan to rationally unwind those policies over time.
The Federal Reserve has broadly outlined a plan that will involve three phases over the next several years:
- A decrease in purchases of bonds from the current rate of $85B per month
- An eventual elimination of these purchases all together
- An eventual increase in short-term interest rates, currently targeted at 0.25%
To anyone who has been concerned about the Federal Reserve’s monetary policies (i.e. motivations, long-term consequences), this should be perceived as good news. However, the Fed Chairman’s May 22nd remarks to Congress, which articulated these points, were ill received by the financial markets. Changes in direction by the central bank have historically caused short-term disruptions - the stock market does not like change.
In this case, however, the willingness of the Fed to withdrawal stimulus should be positive for stocks as it signifies a growing, stable economy and a transition from a liquidity driven market to one based on fundamentals. This is all good news for rational, long-term investors.
While the stock market’s reaction to the shift in Federal Reserve policy may be a short-lived correction, the bond market may be experiencing a permanent shift in the direction of interest rates. In the second quarter, the yield of 10-year Treasury Bonds increased from roughly 1.9% to 2.5%. As bond prices move inversely to interest rates, this resulted in a 4.6% loss in value for 10-year Treasuries.
We have been talking for some time about this impending move towards higher rates, the negative consequences it would have on our fixed income investments, and how portfolios could be managed through this period. A brief review of our observations and conclusions follows.
- High quality bonds serve a unique role in offsetting the volatility of equities in a diversified portfolio
- However, in the current interest rate environment the return potential of fixed income as an asset class is greatly reduced and could even be negative during this transition
- In response, exposure to bonds could be reduced in favor of alternative strategies serving as bond replacements
- Overall duration of fixed income exposure can be reduced, which should decrease the negative influence of rising rates
- Diversification within fixed income to sectors can be increased, which should provide better long-term protection from rising rates, even though this may increase short-term volatility
- Active bond managers who have a history of successfully managing portfolios through periods of rising interest rates can be used to navigate this difficult terrain
We began making these adjustments in late 2012 and finished earlier this year, which left us well positioned for the increase in rates during the second quarter. That said, we did not come away unscathed. The shifts in allocation, and shorter duration worked to our advantage, but some of our reliance on active managers worked against us. Overall, our bond exposure performed better than the market, and significantly better than if the changes detailed above had not been made. The short-term underperformance of active managers, while disappointing, does not change our conviction of their ability to navigate through a complete cycle of rising rates as they have done in the past.
Emerging market stocks continued to significantly underperform U.S. stocks and are down almost 10% for the year. Given the disparity of returns between emerging markets and the U.S. it is worth revisiting our allocation to this assets class.
Our exposure to these markets is important but measured (a typical balanced portfolio would have a 6% position in emerging market equities overall). This exposure is important because emerging markets are part of the global landscape of investable equities. The chart above indicates that emerging market stocks make up roughly 12% of the value of global equity markets. Having less than 12% of our equity exposure allocated to emerging markets is essentially betting against them.
While a bet against them would have been a winner so far this year, it is important to note that in the fifteen preceding years emerging market equities (as measured by MSCI EM Index) delivered a 9.2% compound return compared to just 4.5% for U.S. stocks (as measured by the S&P 500). Additionally, the chart above also demonstrates that while emerging markets make up about 12% of global equity markets, they represent almost half of global GDP, a number which is expected to grow. The relationship between GDP and market capitalization is loosely related, but it does serve as a directional indicator. Over the coming decades, as emerging market countries continue to develop, there should be increasing parity between the level of economic activity and share of the global equity market. This is a trend I would not want to bet against.