Second Quarter Market Perspective
After taking a breather in first quarter, financial markets resumed their torrid pace during the second quarter of 2014 with prices for all financial assets moving broadly higher. The S&P 500 appreciated +5.2% and overall global equities appreciated +5.0%. While equity markets have given back some of those gains so far in third quarter, markets are still in positive territory for 2014. The bond yield curve continued to both fall and flatten during the quarter, causing bonds, especially long-term, high yield and municipal bonds to perform well. Table 1 below shows a snapshot of how some of the major market indices performed during the quarter as well as their annualized trailing total returns.
Major Index Performance
|Annualized Trailing Total Return||Index||Q1||1YR||3YR||5YR||10YR|
|MSCI Europe, Australasia & Far East||4.1||23.6||8.1||11.8||6.9|
|MSCI Emerging Markets NR||6.6||14.3||-0.4||9.2||11.9|
|MSCI All Country World Index||5.0||23.0||10.3||14.3||7.5|
|Barclays US Aggregate Bond Index||2.0||4.4||3.7||4.9||4.9|
|S&P GS Commodity Index||2.9||10.4||0.2||3.7||0.1|
|Wilshire Global Real Estate Index||8.1||15.3||11.1||20.4||9.7|
Indices are unmanaged and have no fees. An investment may not be made directly in an index.
The Fed’s challenge: balancing intervention with organic growth
In evaluating both the effectiveness and ongoing need for “Fed Intervention,” the Fed has been monitoring two key economic variables: the labor market and inflation (as measured by the Consumer Price Index). The labor market acts as the key leading indicator of GDP growth. The assumption is that as more people go to work and earn wages, the better able they are to spend and save. On this front we’ve seen very steady improvement as the US economy has added roughly nine million net new jobs since 2010. More recently, payrolls have been expanding at an even faster rate of roughly 200,000 per month over the last year.
Meanwhile, inflation acts as the key lagging indicator of GDP growth. The assumption is that increasing consumer spending (which is the largest component of GDP) will, at some point, result in increasing prices. So far though we haven’t seen, nor do we expect to see, any concerning increases in inflation. However, as the economy continues to gradually improve we should also expect broad price levels to increase modestly.
Once the Fed is confident that the economy is stable enough to sustain its own growth (aka “organic growth”), it will begin reducing Fed Intervention, which primarily consists of two strategies. First, the Fed has been holding the Fed Funds rate to no more than 0.25% since late 2008. Second, it has purchased approximately $4.4 trillion of Treasury bonds, loans and mortgage securities in the open market since 2012. Occasionally referred to as quantitative easing or “financial repression,” the impact of these activities artificially lowers interest rates, which supports economic growth (See Chart 1).
Chart 1: US Treasury Yield Curve
Source: US Treasury, Aspiriant | As of 6/30/14
In assessing when and by how much the Fed will reduce its intervention (i.e., increase the Fed Funds rate and wrap up its bond buying program), the Central Bank recently adopted a more qualitative approach, saying it “will take account of a wide range of information” in deciding when to curtail support. Under its previous plan, the Fed pledged not to consider raising interest rates until the jobless rate fell to 6.5%, but the plan was scrapped after the rate fell more than policymakers anticipated (most recently to 6.5% in July). As of December 2013, the Fed did not expect to see unemployment near 6% until late 2015! As a result, the Fed has been tapering the bond buying program throughout the year (and is scheduled to end bond buying altogether by October), but it has “hedged its bets” related to when it will begin increasing the Fed Funds rate.
During a congressional hearing to the Senate Banking Committee earlier this month, Janet Yellen provided insight into the Fed’s future decision-making process. She stated, “If the labor market continues to improve more quickly than anticipated, then increases in the Federal Funds rate target likely would occur sooner and be more rapid than currently envisioned.” However, her comments made it clear that the “if, then” scenario is a causal relationship (the first thing must happen before the second thing would occur). In fact, she indicated that the Fed had been fooled in the past by “false dawns” that she hoped to avoid as the economy continues to stabilize and grow. She cited concern over low levels of laborforce participation as well as slow wage growth as indicators of “significant slack” in the job market. She reiterated her comments from previous sessions that the housing market has also shown little traction.
…some investors are moving into riskier assets in search of better returns, which may be adding vulnerability in pockets across the financial system.
Even if the Fed does move, it will likely be an incremental approach, with the Fed increasing the Fed Funds rate to 1% by the end of 2015. In her testimony, Ms. Yellen acknowledged that low interest rates are causing an unintended negative consequence: some investors are moving into riskier assets in search of better returns, which may be adding vulnerability in pockets across the financial system. She specifically cited high yield corporate bonds and leveraged loans as potential problems being monitored.
…& false profits
Artificially low borrowing rates have another unintended consequence: they contribute to artificially high profit margins. In fact, Chart 2 below indicates that corporate profitability is at an all-time high . . . similar to the peak reached before the implosion that was the Global Financial Crisis.
Chart 2: Aggregate Profitability of the S&P 500
Source: Bloomberg, Aspiriant | As of 6/1/14
We acknowledge (and have written about) a number of contributing factors (including globalization and technological improvements) that have increased the ability of corporations to maintain elevated levels of profitability for prolonged periods of time. However, so long as capitalism still works (a key premise being that extraordinary profitability will eventually be competed away in a free economy), we do not believe the current level of corporate profitability is sustainable. Instead, we believe that it will likely revert back toward its seven-year moving average (which captures a complete business cycle).
Valuations: a (potential) double whammy
Chart 3: Shiller Price-to-Earnings Ratio
Source: Bloomberg, Aspiriant | As of 6/1/14
Record profitability has led to very strong equity values. As shown in Chart 3 above US equity valuations as measured by the Shiller Price-to-Earnings Ratio, which is an inflationadjusted 10-year moving average, are currently at/above their long-term fair value range (which is indicated by the two light gray lines on the chart). Since 1936, the long-term average has been approximately 19x. Today, the Shiller PE of the S&P 500 is north of 25x.
As we wrote in our first quarter Insight, the combination of elevated levels of corporate profitability along with elevated valuation levels will likely result in lower equity returns going forward. For US equities, we cautioned investors to “proceed, but proceed with caution.” In fact, we are recommending that investors underweight US large cap equities by 12% relative to their global market capitalization. We are reallocating that capital to other asset classes that we believe face fewer headwinds moving forward and may even benefit from some tailwinds. We’ll soon publish another Insight dedicated to discussing these changes.
Some people believe that a suppressed yield curve benefits bonds but has little impact on equities. Au contraire. The fact of the matter is all risk assets (equities and bonds alike) benefit in a low rate environment. The Fed has already telegraphed its plan to discontinue holding down both the front-end and the back-end of the Treasury yield curve (see Chart 1). As a result, we expect the curve to slowly drift upwards over time, and we are positioning our client portfolios in light of this view, with the enduring goal of generating attractive risk-adjusted, after-tax net returns over time.
…we expect the curve to slowly drift upwards over time, and we are positioning our client portfolios in light of this view.
After five plus years of very strong equity market performance, these adjustments will require realizing deferred capital gains and paying any associated taxes. While we never enjoy paying taxes,doing so is a direct result of having made successful investments. We much prefer to pay taxes today in order to make successful investments tomorrow than to hold onto our winners until such time that they become our losers… and we no longer have to worry about paying taxes! Plus, there are steps we can take to minimize the tax impact of portfolio changes, including selling assets in tax-deferred retirement accounts and using appreciated assets for charitable gifts… these are among the considerations that your client service team will discuss with you in the coming months as we roll out updated investment portfolios.
1Bureau of Labor Statistics, “Change in Total Nonfarm Payroll Employment” (June 2014).
Important disclosures: Past performance is no guarantee of future performance. All investments can lose value. Indices are unmanaged and you cannot invest directly in an index.
S&P 500 is a market-capitalization weighted index that includes the 500 most widely held companies chosen with respect to market size, liquidity, and industry. The volatility of an index may be materially different than that of a model. You cannot invest directly in an index. Index returns assume the reinvestment of dividends and capital gains. The MSCI ACWI All Cap Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. It is not possible to invest directly in an index. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
S&P GSCI: The S&P GSCI© is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment.
Wilshire Global RESI: Is a broad measure of the performance of publicly traded global real estate securities, such as Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs). The index is capitalization-weighted.