Market Insight - Oct 9th, 2013
Markets began the third quarter in turmoil, with the Fed’s announcement of plans for an eventual “tapering off” of QE3, the 80 billion monthly purchase of Treasury and mortgage- backed bonds, and the suggestion that this could possibly begin in September. Markets fell into disarray, with stock and bond prices falling, and yields rising a full percentage point on the ten year treasury. Subsequent Fed comments seemed to make the September date less definite, and more subject to economic inputs. Still, when the FOMC met last month, there was scarcely any doubt about whether they would begin tapering, only about by how much. Of course, nearly everyone was wrong! It was a good object lesson in self-reinforcing group think on Wall Street, and a reminder from the Fed that the economy, while getting better, was not at all where it should be, and not quite ready to throw away the crutches.
Tuesday, the government went into a partial shutdown, for the first time since 1995. Markets reacted poorly. As Congress wrangles about funding day-to-day operations, we face a possible crisis later this month as we reach our debt limit, and require Congressional authorization to continue paying our obligations. The last time this happened, in 2011, it was bad news for financial markets, bad news for our credit rating, and bad news for our stature as a global economic power. Despite the slow sometimes halting pace of recovery, we have made real gains in repairing the economic damage from the great recession; it’s frustrating that there are still those determined to wrest defeat from the jaws of victory.
This has been a challenging year for the balanced, diversified investor, as strong gains in stocks were somewhat offset by a decline in bond prices. U.S. stocks have done well; the Dow has gained over 16% year to date, the S&P 500 nearly 19%. Smaller stocks, measured by the S&P Small Cap 600, advanced more than 28%, while the S&P Mid Cap 400 gained over 23%. Outside the US, developed markets recovered, adding 12.5%, while emerging markets fell some 7% from their January levels. U.S. real estate, measured by Cohen & Steers Realty Shares, added less than 2%.
While the bond market as a whole recovered modestly from the June panic, as dire predictions of a bond market crash proved again to be so much hyperbole, this year has been trying for the risk-averse investor. Worst hit were emerging market bonds, falling over 11%. Excluding interest, the Barclays 7-10 year treasury index was down 5.36% for the year, while the Vanguard Inflation-Protected Bond Fund fell nearly 8%. Tax free bonds, as measured by the Vanguard Intermediate Term Tax-Exempt Fund, declined 4%; municipal markets were burdened by interest rate fears as well as credit concerns over the high profile bankruptcy of Detroit. High-yield corporate bonds, measured by the Pimco High-Yield Bond Fund, were some 2% lower for the year.
Weakness and underperformance in asset classes for the most part present opportunity for our clients; we continue to scale out of areas showing exceptionally strong returns, trimming them back to normal levels, and use these funds to add to weaker sectors, including bonds and emerging market stocks.
There is no question that we have begun the slow multi-year process of winding down the post-recession era of monetary stimulus, where short term rates have been kept artificially low by the Fed. Yet there is spirited disagreement among the most astute analysts and economists as to how this will impact longer term rates (and bond prices) more than it already has. The drone of misinformation served up as investment wisdom on interest rates and bonds would be funny, if not misleading to so many investors. As the pundits and talking heads echo and regurgitate the same opinions they seem eerily similar to those passengers who, when the first wave hits, push and shove to crowd over to one side of the boat. Unfortunately, when things do tip, they’re the first to hit the water.
We continue to shape and evolve our investment strategy to this dynamic environment. This would include using laddered maturities of individual government, corporate and municipal bonds to provide funds for reinvestment in the future at higher rates, as well as using funds and reinvesting, wherever possible, in asset classes such as high yield bonds where broad diversification is key to safety. We are not at all reluctant to take advantage of higher yields available in the bond market to strengthen total return for our clients.