With the recent move in interest rates we thought it would be timely to discuss the bond market and how it relates to your individual portfolio.
Approximately 51% of the time the price of bonds and the price of stocks go in the same direction. Bond prices generally respond to interest rates. As rates rise, outstanding bonds will decline in price. Likewise, when rates decline bond prices rise. This past month serves as a reminder that interest rates do not always go in one direction. For the past 30 years we have been in a bull market for bonds. Recently, interest rates on the longer end have moved higher. The yield on the 10 year U.S. Treasury, which is used as a measure for much of the financial world, including mortgage rates, went from approximately 1.60% to 2.60% and the price dropped about 5.00%, while the rate on the 30 year U.S. Treasury bond went from 2.84% to 3.50% causing the bond to decline almost 12.00% in price. That is a considerable move, especially over such a short period of time.
We have said for some time now that the yields, in general, are so low that the risk-reward is just not there for owning longer term bonds. There are many ways to measure risk-reward, but for our purposes when rates were high we bought longer maturities and locked in the yield. As rates declined we bought shorter maturity bonds which generally have a lower yield than long-term bonds. To compensate for low returns we placed a portion of your bond allocation into dividend paying securities and a portion into higher yielding assets. As far as the core investment in bonds, we are at the lowest allocation position ever, with an average maturity of 4 years. And, in turn, cash is at its highest, which is a good thing. With bond yields starting to rise, this combination of shorter bonds (less susceptible to higher interest rates) and excess cash protected the fixed income portion of your portfolios from any significant losses. The fixed income portfolios are down less than 1.00% YTD, compared to the aggregate bond index which is down 2.44%. While the bond portfolio produced meager returns, the equity portion of the portfolio was up substantially.
While interest rates may continue to rise we believe they will not rise anywhere near their historic average. For example, in our opinion, the yield on the 10 year U.S. Treasury can rise to 3.50% before it would affect stock prices. We strongly feel the U.S. economy will continue to make strides and reduce its dependency on the Fed. Higher interest rates should accompany economic growth. Our higher than normal cash reserves may be used to buy bonds at higher yields and thus, lower prices. We see the economy strengthening over the next few years which again bodes well for our clients as we have a sizable portion of your bonds maturing over the next two to four years. These too, will have the likelihood of being reinvested at higher yields.
Portfolio management is a process. As your manager we need to change and adapt to the current and future market environment. That is what we have been doing, and we strongly believe it has worked in minimizing your risks while achieving excellent returns. The higher than average cash positions are not permanent and the risk-reward of holding bonds will, again, be a risk worth taking in the future.
The last three months were marked by more records and certainly more volatility for all the domestic equity markets. Despite the notable pull-back during the last month of the second quarter of 2013, it certainly did not look like investors “sold in May and walked away”, and Wall Street’s three major indexes finished the quarter with decent gains. Both the Dow Jones Industrial Index and the S&P 500 Index gained 2.91%, and the Nasdaq Composite Index advanced by 4.52%. The Russell 2000 Index, which tracks small-company stocks and is often seen as closely tied to the U.S. economy, rose 3.08% and surpassed the 1,000 mark for the first time. All the major equity indexes held onto their double-digit gains through the first half of 2013. The DJIA ended the second quarter just 3.20% below its record high set on May 28th and up 15.20% for the year, posting its best first-half performance for any year since the technology-driven bull market of 1999. The S&P 500 Index gained 13.82% for the first six months of the year, its best since 1998. The Nasdaq Composite and Russell 2000 Indexes booked 13.42% and 15.86% year-to-date gains respectively. Cyclicals have picked up steam, as the defensive companies led by utilities and telecom significantly underperformed in the second quarter, after doing reasonably well in the first.
Uncertainties about global growth prospects weighed more on emerging market equities and commodities. Concerns about China and geopolitical unrest brought the MSCI EAFE, the broadest index of developed markets outside the United States, down 2.11% for the quarter and decreased its six months performance to 2.18%. The MSCI Emerging Market Stock Index dropped 9.14% during the last three months, extending the year-to-date loss to 10.89%.
There was considerable bloodletting in the fixed income markets. As the yield on the U.S. Treasury 10-Year note rose to 2.49% from 1.84% on April 1st and from the low of the quarter of 1.63% on May 2nd, the price on the 20+ year U.S. Treasury fell by 5.80%, showing the worst performance over the last 10 quarters, and the six-months losses widened to 8.52%. The Barclays Investment Grade Corporate Bond Index fell 3.60% during the first half of 2013, most of it (2.85%) during the last month of the second quarter.
The economic data, particularly consumer-driven, is sending an encouraging message of recovery, led by the housing sector. Housing starts rose 6.70% in May, while existing home sales rose 4.20%, reaching their highest level since 2009. Additionally, the median price for those sales was up 15.40% year-over-year, helping bolster net worth and consumer confidence, which soared to a five year high in June.
Labor markets, the primary focus of domestic monetary policy, are also improving. Job growth is averaging about 190,000 new jobs so far this year, while weekly jobless claims have largely been below 350,000.
In many ways, the U.S. economy has proven remarkably resilient. We would argue that the GDP growth remains impressive even after a downward revision to 1.80% in Q1 2013 considering that we lost about 1.5% of growth from tax increases and the sequestration.
The strengthening U.S. economy and the dollar’s status as the world’s “key reserve currency” contributed to Standard & Poor’s decision to reverse its unprecedented downgrade of the U.S. credit rating which caused a political and economic firestorm in 2011. In early June of 2013, two years after its controversial downgrade, S&P has upgraded its outlook for the U.S. economy to “stable” from “negative”, stating that “…the U.S. monetary authorities have both the strong ability and willingness to support sustainable economic growth and to attenuate major economic or financial shocks”.
The U.S. economy still faces many challenges, but the underlying fundamentals look increasingly positive. While fiscal headwinds kept economic growth below 2.00% for the first half of the year, we expect gradual strengthening in the second half of 2013 and into 2014. After many years of secular decline, the U.S. dollar appears well-positioned for recovery and attracts foreign investors to dollar denominated assets including stocks. The U.S. budget deficit is falling thanks to spending cuts and rising tax revenues. This is a medium-term trend. The Congressional Budget Office projects the deficit will shrink to 2.10% of GDP in 2015 versus 10.10% in 2009.
During the June meeting, the Federal Reserve noted that the downside risks to the economy that prompted the extension of QE3 last fall have diminished and that if the economy continues to expand broadly in line with Fed expectations, it can begin tapering sometime in the next year.
While the market backed off its highs and Treasury values declined rapidly as yields rose on this news, it was a clear example of market “overreaction” associated with the old paradigm of higher interest rates being bad for equities. We believe it simply does not hold in this case. Historically the Fed was increasing interest rates in order to slow the economy and deliberately reduce consumption, inflation and, indirectly, earnings. Today’s situation is the exact opposite. Various forms of quantitative easing, adopted by the Fed after the collapse of the credit bubble, provided a “life support” for our economy, and anticipated QE tempering will prove that the U.S. economy is strong enough to fully eliminate its dependency on it. As the Fed made it clear it does not change its mandate toward a highly accommodative stance and raise the target range for the federal funds rate from the current 0% to .25% for as long as the unemployment rate remains above 6.50%, this tapering will certainly be good news for the markets. Large cash positions still kept on the sidelines by large institutions and pension funds represents overhead supply for bonds and should slow the increase in interest rates and growing confidence in economic strength and an anticipation of rising corporate profits should outweigh the negatives of marginally higher interest rates for equity investors.
The second half of 2013 may act as a bridge to a new path for policy, the economy, and markets: The aggressive stimulus from the Fed over the past five years is likely to begin to fade, the government as a portion of the U.S. economy may shrink to its lowest levels in a decade, the economic drag from higher taxes and spending cuts implemented in the first half of 2013 starts to diminish, and corporate profit margins may reach all-time highs. The four-year-old recovery in the economy and markets is unlikely to be the end of the path, but instead a new beginning that may refresh the pace of growth in the coming years.
Dumont & Blake Investment Advisors, LLC
June 30, 2013