Third Quarter Market Perspective Oct. 2013
Over the last three months, the Eurozone economy edged out of its recession, the Federal Reserve slowed down its plans for tapering its economic support, and US economic growth continued a slow but steady advance, all of which supported a generally favorable environment for global equities. Here is a snapshot of how the indices of several asset classes performed during the quarter and the past twelve months (through September 30, 2013):
|3rd Quarter, 2013 Market Performance||Trailing 12 Month Index Performance|
|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 big story of the moment, of course, is the political standoff in Washington and its potential impact on global financial markets. Like most in the financial services industry, we are very uncomfortable that the full faith and credit of the United States – one of the keys to the country’s global economic and political preeminence – is being used as a bargaining chip for partisan political goals (as both parties have done frequently over the years). In the past this type of political theater hasn’t been taken too seriously, but the brinksmanship has, over the last few years, become more ominous in the context of a political system that looks increasingly dysfunctional and unwilling to govern.
One of the most frustrating aspects of this situation is that there actually seems to be a debate among some observers and policy makers about the impact of a US government debt default. Among financial professionals there is no debate – a default on US government debt would be a very bad scenario for all financial assets. In theory, the value of every financial asset in the world is calculated using a “risk-free” interest rate plus a risk premium. The risk-free rate is the rate on US Treasury bills; so, if all of a sudden the risk-free asset is itself assigned a risk premium, it would quickly roll through the valuation of every financial asset, causing steep declines in stock and bond values, frozen credit markets, and insolvent banks – a situation similar to the 2008 crisis, but much more difficult to contain because the world’s leading creditor, the US government, would no longer have the world’s confidence. In August 1998, Russia, a third-rate economy, defaulted on its sovereign debt and equity markets declined by approximately 25%…a US default would likely be much worse.
The markets currently seem to be assigning a very low probability to a default scenario which we think is appropriate. We believe the brinksmanship we’re seeing is more about the parties appeasing their respective political bases and setting the tone for the budget debates to come, and that this latest manufactured crisis will be resolved shortly before the deadline. However, we’re already far too close for comfort. While we’re confident that a default will be averted at the 11th hour, the very fact that default is even a discussion could, over time, create doubt among the nation’s creditors that leads to higher interest rates and less stable financial markets.
We’re happy to see some progress toward a resolution in the last few days, but we’re cognizant of how quickly that could unwind. As the clock ticks ever-closer to midnight we could see increased volatility as investors, on the margin, pull out of markets as a hedge against a catastrophe…a 10%-20% decline in equity markets is not out of the question if we get past the 17th without a resolution; of course, a move of that magnitude would certainly help to motivate action but we hope that it won’t come to that. We are not advising clients to change their investment plans. Despite the current events in Washington, the recovery in the global economy (led by the US) seems to be consolidating with stable, albeit slow, growth. We see the economic picture generally brightening, but that backdrop will continue to be punctuated by periods of stress as we are currently experiencing.
What’s going on with bonds? The last six months have seen unusual volatility in bond markets, as markets digested news that the Fed would likely soon begin tapering its extraordinary measures to keep long term interest rates low. The Fed surprised markets, however, when in September they announced that the quantitative easing program would continue unabated. As a result, Treasury and other bond yields declined sharply in late September, boosting bond values and reversing some of the losses that bonds experienced over the previous few months.
Uncertainty over the unwinding of the Fed’s easing and, eventually, questions about the timing of interest rate increases will continue to create some volatility in fixed-income markets. Although there has been much discussion in the headlines about the risks associated with bonds, a deeper understanding suggests that long-term investors should avoid hitting the panic button.
We think that the Fed’s decision to postpone tapering its support of low interest rates is timely given the political uncertainty and likely economic drag caused by the partial government shutdown and debt ceiling discussions. That said, the US economic recovery appears to be on solid enough footing that we expect tapering will commence in the near future, although we still don’t expect the Fed to increase short-term interest rates until 2015 at the earliest.
It is important to understand that gradually increasing interest rates are good news for the economy and investors, as they are likely to be accompanied by reduced unemployment, continued corporate profits, and strong stock prices. Rising interest rates are a headwind to bond values, but higher yields allow bond investors to reinvest coupon income at higher rates, thereby improving long-term returns; moreover, we expect that a general economic recovery will result in some capital appreciation in municipal bonds for investors whose approach, like Aspiriant’s, includes holdings in higher-yielding bonds.
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 GSCI7copy; 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.