Quarterly Market Letter – 2Q 2013

James300x300Although it may not feel like it given the recent volatility, the equity markets posted another positive quarter with the S&P 500 gaining +2.91% the last three months.  Gains for the year now stand at +13.82%.  2013 has registered the best first half start for the equity markets since 1998 in spite of the economy weakening a bit throughout the first half of 2013.  Healthcare, consumer discretionary and financial names led the way with all those sectors gaining around +20% so far this year. Materials, utilities and technology are the worst performing up only +2.95%, +6.30% and +6.66% respectively. 

The U.S. equity markets are one of the few bright spots for the year as most international markets are lagging by a wide margin.  The MSCI Worldwide Index is up only +8.82% with the U.S. accounting for +5.45% of that gain.  Excluding the US from the equation, the MSCI World Ex US Index is up only +3.37% year-to-date driven mostly by the +15.09% gain in the Nikkei (Japanese market).  Most other developed markets are flat to negative as the Eurozone remains in recession.  Emerging markets are having a particularly rough year with the MSCI Emerging Market Index down -9.40% year-to-date with -7.95% of the loss coming in the 2nd quarter.  China is a big mover of this index and the Shanghai Composite has lost -9.65% year-to-date as the country struggles with structural reforms, a slowing economy and troubling credit markets.

For the second quarter the Barclays Intermediate Government/Credit Index was down -1.70%, the majority of which occurred during the last eight trading days of June.  The month of June alone was down -1.20%.  YTD, the market is down -1.45%. 

On June 19, 2013, Federal Reserve Chairman Bernanke was kind enough to provide financial markets with some clarity on the eventual end of Quantitative Easing.  Unfortunately, the markets did not like what he had to say.  On June 18, the day before Bernanke’s clarity the yield on the 10 Year Treasury (10YT) was 2.19%.  Over the ensuing eight trading days the 10YT rose by 30 basis points (30/100 of 1%) to end the month of June at 2.49%.  In the five trading days from June 19 to June 25, the yield rose by 42 basis points to 2.61%, representing the fastest increase in interest rates since 1962, with rates rising to levels not seen since August, 2011.  Remember that as yields rise, bond prices fall.  It appears as though the rotation out of low yielding fixed income may have commenced as June has seen the largest outflows in bond mutual funds since 2008 (estimated at $40 billion) and the markets are starting to adjust to a long and inevitable return to a more normal monetary environment.

For perspective, the average yield on the 10YT has been 2.75% over the last four years.  For the Second Quarter of 2013 the yield on the 10YT went from 1.83%, dropping slowly into a May 2nd bottom of 1.63%, then rising rapidly to peak at 2.61% on June 25th, settling the quarter at 2.49%.  The intra-day peak was in the 2.65% range. 

Bond yields are not rising because of a spike in inflation, but because of the Fed’s comments to curtail asset purchases if the economy continues to improve.  No matter how volatile this makes the markets, it is a good thing, not bad. We have taken a small baby step back toward normalcy.  Even with reduced asset purchases, the Fed is still extremely accommodative and reiterated it was not tightening policy and the target rate should remain close to zero until 2015.  The Fed’s unwinding process will inevitably create volatility but will be healthy for the markets and economy in the long run.

There are some bright notes on the economic front.  Inflation remains at bay.  The most recent producer and consumer prices remain well below historical norms with the most recent increases clocking in at only +1.7%.  Gold, another inflation hedge has fallen dramatically and commodity prices are showing no signs of heating up. 

Housing has picked up dramatically and now is a positive contributor to growth.  Labor markets continue to improve albeit at a very slow pace. Consumer confidence and durable goods orders both topped expectations in late June.

Now is a great time to take a deep breath and a step back to reflect on why diversified portfolios are so important.  Bonds are used to produce income and lessen volatility, stocks produce greater returns through growth and income but carry more risk (i.e. are more volatile), international investments provide diversification.  Although different areas of the markets have posted vastly different returns recently, we continue to believe in the prudence of a well-diversified portfolio and believe it is the best path to achieving attractive long-term risk adjusted returns.


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