2013 3rd Quarter Outlook

Review of Second Quarter

The second quarter was good for domestic stocks, albeit not as good as it was in the first quarter. U.S. large company stocks increased in value by 2.9% for the second quarter of 2013 – small company stocks did slightly better, increasing by 3.1%. International stocks did not fare as well – non-U.S. stocks in developed countries declined by 0.7%, while emerging market stocks lost 8.0%. Investment grade bonds fell by 2.3%, the worst three month decline in almost five years. The table below shows historical returns (all of the returns except for the past three months and six months are annualized):

The State of the Bond Market We usually begin with a discussion of the equity market, but it is bonds that are on most investors’ minds today. The last words in our 2nd Quarter Outlook were that “government bonds are subject to a great amount of interest rate risk.” In May, the Federal Reserve Chairman said that the Fed could reduce the amount of bond buying that it has been doing, which has been supporting the low level of interest rates. That announcement sent bonds, particularly Treasury bonds, into a decline that created the negative quarterly return. Interestingly, the announcement also created a stock market decline, but stocks have recovered since the announcement, while bonds have not. So the question is what will the bond market be doing in the future?

Central bank policy, both in the U.S. and abroad, has helped generate low interest rates and fueled strength in both the bond and stock markets. It has also created a lot of attention on predictions of future Fed actions, as we saw in May. While we don’t necessarily see a continual rise in interest rates for the rest of this year, the heightened attention on the Fed is likely to cause increased bond market volatility for the foreseeable future.

Even after the recent rise, interest rates are at abnormally low levels. Ten-year Treasury bonds are currently yielding 2.5% - the average yield since 1960 was 6.4%. Much of that lower yield is caused by the abnormally low level of inflation. However, even if we consider real yields (the nominal yield minus inflation), the current yield is 0.8% compared to an average of 2.5%. Over the long-term, it is difficult to believe that Treasury rates will not go up at some point, because both inflation and real interest rates are likely to increase. Those rate increases will cause the overall bond market to decline, because so much of the bond market index is made up of Treasury bonds. The Need for Bond Diversification A decline in Treasury bonds does not necessarily mean all sectors of the bond market will fall in value. Part of the risk of Treasury bonds today is that the yield is so low that even a small rise in yields, resulting in a modest capital loss, can make the overall bond return negative because there isn’t enough yield to cushion the loss. The abnormally low yield on Treasury bonds is not present in other sectors of the bond market. For example, the average spread between the yield on BBB bonds (bonds with moderate credit risk) and five-year Treasury bonds over the past 50 years was 2.1%; while that spread today is 4.0%. So an investment in corporate bonds, either investment grade or high yield, provides much more cushion against a rise in interest rates than an investment in Treasuries. The same can be said for other types of bonds, such as municipals and emerging market debt. Moreover, the correlations between other types of bonds and Treasuries are relatively low, which means diversification away from Treasuries can substantially reduce the volatility of a bond portfolio. It is also very important to diversify across bond managers – because different portfolio management strategies can subject investors to unique risks.

While the recent increase in bond volatility suggests that broad diversification is important, it does not suggest that investors should adjust their fundamental asset allocation between stocks and bonds. The main reason to invest in bonds has never been return – primary motives have always been preservation of capital and reduction of portfolio volatility. That is still the case today. Even though bond volatility increased in June, so did stock volatility, and stock volatility was still double that of bond volatility. So bond markets may be bumpier than in the past, but they will still be more stable than stocks. Equity Markets Investing in equities has been very fruitful in the recent past – stocks have generated an annual rate of return of 18.4% over the past three years. While we still consider stocks a good investment, investors should have lower expectations for the future. The economy is still recovering from the recession; individual sectors such as manufacturing and housing are improving, but the economy is only expected to grow at a level of 2% after adjusting for inflation, which is a bit lower than the average of 2.6% over the past 20 years. Unemployment is still dropping, but is still higher than its long-term average. Perhaps most importantly, the market average price-earnings (P/E) ratio for the market is close to its long-term average over the past 20 years – three years ago, the P/E ratio was considerably lower. That means three years ago we would describe stocks as “cheap” compared to earnings, whereas today we would describe them as fairly priced.

One area where stocks are cheap is overseas. The discount in prices of non-U.S. stocks is understandable because of higher risks, high unemployment, and sluggish growth. However, in moderation, and in the right composition, we still consider non-U.S. stocks to be an important diversifying part of an investor’s portfolio.

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