The markets performed remarkably well the first half of 2014 despite dismal economic activity and continued geopolitical drama around the world. All major equity markets around the globe posted gains except for Japan and Hong Kong. The S&P 500 gained +5.23% in the quarter leaving year to date gains at +7.14%. The market gains were very broad based with consumer discretionary being the only sector that was in the red with a minimal loss of -.13%. Utilities and energy names topped the gains for the first half of the year while consumer discretionary and telecoms lagged.
In the bond market the Fed continued its reduction in quantitative easing (QE) for the fifth consecutive meeting. Currently monthly bond purchases are down to $35 billion from a peak of $85 billion. QE is on pace to end in the fall of 2014 although reinvestment of the Fed’s portfolio will continue well into 2015.
For the quarter, rates on the 10 year Treasury fell by about 20 basis points to 2.53% as bond prices continued to rise. Year-to-date rates have fallen by an even 50 basis points, having begun the year at the high so far of 3.03%. For the twelve months ending in June rates are essentially unchanged, having started July of 2013 around 2.48%, although the volatility has been pronounced, with rates twice having touched 3% and having been at or below 2.50% on five separate occasions. For the second quarter the Barclay’s Intermediate Government/Credit Index was up +1.23%, bringing year-to-date returns to +2.25%.
Historically such broad based equity gains would suggest the global economy is improving. This isn’t so much the case currently. The U.S. economy retracted -2.9% in the first quarter. Some of the contraction can be blamed on the all the snow and bad weather we experienced this past winter but the magnitude of decline was even greater than most expected. In Europe things aren’t any better. The ECB committed to a more stimulative monetary policy as concerns about sluggish growth and deflation also plague that area. Analysts and economists have been busy cutting economic growth estimates for 2014 and beyond for both the U.S. and most of the other developed and emerging markets around the globe.
Earnings have continued to grow in 2014 even though the economy shrunk in the 1st quarter. However market gains continue to outpace earnings growth, which has caused valuations to continue their expansion as we experienced in 2013. The S&P 500 started the year trading at 16.6x earnings and now currently trades at 18x earnings. As I write this (July 1st) the markets are hitting new all-time highs. It’s easy to argue better economic news and corporate profit growth will be needed to sustain further gains in the equity markets. At this point we wouldn’t consider valuations excessive, but we never like to see the market advance too much ahead of earnings growth since this is not a sustainable scenario. We believe economic growth strengthened in the second quarter and are hopeful earnings growth will be strong enough to justify and support the recent market gains. Although we’re now 5 ½ years past the start of the great recession, the economy is still healing. We expect muted economic growth and low (but rising) interest rates to be the norm for the next several years. In this type of environment we believe patience and discipline will reward investors over the long term.