Second Quarter Market Perspective
Global equity markets continued to rally most of the second quarter…until an abrupt end in mid-June when the Federal Reserve announced a possible tapering of the quantitative easing program designed to keep long-term interest rates exceptionally low. Here is a snapshot of how the indices of several asset classes performed for the quarter and the past 12 months (through June 30, 2013).
2nd Quarter, 2013 Market Performance
Trailing 12 Month Market Perfomance
Source: Morningstar Direct. Past performance is not necessarily indicative of future performance. All investments may lose value over time. These returns do not reflect the deduction of Aspiriant fees nor fund manager fees and may or may not contain the deduction for the reinvestment of dividends and other earnings. Indices are unmanaged and have no fees. An investment may not be made directly in an index.
The Great Taper Tantrum
While the Market Snapshot usually focuses on equity markets, the notable action in this quarter was in the bond markets. In May and June, the yield on 10-year US Treasury bonds increased approximately 0.85% — a huge move, especially considering the rate started May at 1.6%. This dramatic change was largely driven by hints of a potential tapering of the Fed’s asset purchase program in future months. Bernanke’s posturing was in response to increasing evidence of modest growth and diminished downside risks in the US economy.
Importantly, Bernanke’s tapering comments were intended to be conditional, and should not be interpreted as an expectation the Fed would begin raising short-term interest rates in the near future. Rather, the Fed has been very clear regarding its commitment to keeping short-term rates very low until satisfactory levels of inflation and employment are attained. At the current rate of progress, many believe this timeline is closer to mid-2015, or possibly even later.
However, bond markets reacted violently, posting quarterly losses of -3.0% (municipal bonds) and -2.3% (broad investment grade taxable bonds) as longer-term interest rates jumped higher. In our view, the Fed’s acknowledgement of a recovery in the economy is good news, both for long-term equity returns (a healthier economic outlook) and bond returns (a higher reinvestment of coupon income). While the Fed is not tapping the brakes yet (and likely will not for some time), they are looking to let up on the accelerator a bit, as the US economy shows signs of strength.
No “Wild Turkey to Cold Turkey”
On average, 10-year Treasury bonds have yielded approximately 2.0% to 3.0% more than inflation over time. With the 10-year Treasury yield currently at 2.5% (versus inflation of approximately 1.0%) the market has begun to restore this equilibrium relationship. We think current levels discount the fact that the withdrawal of the asset purchase program will be gently managed and potentially reversible…or, as Dallas Fed President Richard Fisher more colorfully stated, “we’re not going from Wild Turkey to cold turkey.”
Indeed, after a tough week in mid-to-late June, bond markets moderated some of the previous week’s declines as a broader perspective took hold; US economic growth is still sub-par with inflation near 50-year lows, global demand is edging lower and Fed support isn’t going anywhere. Thus, we believe there are little, if any, fundamental pressures that would cause interest rates to move dramatically higher anytime soon.
All of this begs the questions, “Why are we taking any risk at all with our bonds?” and “Isn’t this our sleep-at-night money?” Those are fair questions. Aspiriant approaches fixed-income investing by: 1) recognizing its primary role of capital preservation and 2) acknowledging the secondary objective of earning a fair return on capital. These goals are often in conflict with each other. An investor concerned only about preservation would put all of their fixed-income holdings in CDs or money funds (or bury it in the backyard!), but this locks in a negative inflation-adjusted return (especially after taxes)…not an attractive outcome. The alternative answer is to strike more of a balance between the dual roles of the fixed-income, deliberately taking understandable and measured risks that are likely to be rewarded over time and prudent in the current environment. Of course, that reward does not come consistently, as we saw this quarter.
The recent bond market fireworks are not immediately driving us to change the way we currently position bond portfolios, which involves taking more credit risk and interest rate risk in an effort to achieve higher yields. (For an in-depth review of how we expect the interest rate environment to unfold and the impact on municipal bond values, see our recent Insight “Looking Back, Looking Forward”). We have been anticipating eventually higher interest rates for some time, and while we cannot define the exact date or rate of the increases, we continue to expect increases to occur over an extended period, reflective of current macro-economic conditions. The 2004-2006 interest rate cycle handsomely rewarded bond investors who took some measured risks, and we expect the environment to play out similarly in the coming years.
Stocks Up, and Up and Up…
US equity indexes hit a series of all-time highs in the second quarter. While passing these milestones created comfort and excitement in the late-1990s and mid-2000s, many people reacted to a 15,500 Dow with trepidation, a sign of the damage done to investors’ psyches during 2008-09. While we try not to pay much attention to the milestones themselves, the view under the hood is one that appears increasingly supportive of today’s seemingly lofty stock prices. We will publish an entire Insight on this topic in late July.