After a benign first quarter, global markets picked up steam during the three months ended June 30th. It was a solid quarter for stocks with the S&P 500 returning 5.2%, reflecting both a rebound in economic activity after first quarter’s soft patch and investors’ growing appetite for risk. Year-to-date through June 30th, the S&P 500 has returned 7.1%. Overseas, we also saw good gains with the MSCI EAFE advancing 4.3% and emerging markets (as measured by the MSCI EM index) returning almost 7% for the second quarter. Rolling the world’s equity markets up, we saw global equity returns (MSCI ACWI) up 5.0% for the quarter and 6.2% for the first half of 2014.
Bonds markets extended their gains from the first quarter as interest rates continued to decline and credit spreads tightened. During the quarter, the bellwether 10-year Treasury yield fell to 2.52%, close to its lowest level in the past 12 months. The yield curve flattened, with longer-dated rates declining more than shorter-dated ones, driving an outsized 5.2% return in the 30-year Treasury versus a 2.7% return in the 10-year.
Looking forward, we think that interest rates will likely rise moderately as the Fed concludes its tapering of stimulus in October and investors turn their attention to when the Fed will begin to raise rates. But determining exactly when they’ll act is difficult. Most strategists are calling for the Fed to tighten in the second half of 2015. However, if the first half of 2014 taught us anything, it’s that consensus views do not always prevail. Most investors came into the year convinced that interest rates were on the rise and that bonds were destined to fall. The markets defied consensus. We think this may happen again with the Fed’s decision to tighten. Fed Chair Janet Yellen will likely want to see sustained evidence of a 2.5-3% percent GDP growth rate and a healthy jobs/wage picture before raising short-term rates. We wouldn’t be surprised if the Fed’s move to raise rates is pushed out beyond the consensus expectation.
On the international front, the Eurozone continues its slow, uneven recovery with the European Central Bank standing ready to support the economy and fight deflation. In Japan, Abenomics has shown early signs of reviving the county’s moribund economy; however, Abenomics remains somewhat of an experiment. In an upside surprise, China’s June PMI (a measure of business activity) rose to a six-month high following a series of small measures taken by the country’s leadership. Second quarter also saw ongoing violence in the Middle East and Ukraine, which, as of this writing (July 30th), has heated up dramatically.
One notable aspect of the quarter was the extremely low level of volatility that we experienced in stocks. Regardless of the headlines, either positive or negative, stocks were able to march upward to make successive highs. Anecdotally, during the final 51 days of the second quarter, the S&P 500 failed to increase or decline by more than 1% from the prior day’s close. That marked the longest such streak since 1995.
Below, we’ve included a chart of the VIX, an index that measures volatility, because we feel it’s a good visual representation of how market volatility has trended lower over the past five years. In particular, with the VIX having fallen to the low teens and below in recent months (the 15 year average is approximately 21), there’s been a growing discussion surrounding the complacency of investors and whether this is something we should be concerned about. Bill Dudley, president of the NY Fed and a member of Fed Chair Yellen’s inner circle, said recently that he was a bit nervous that people are taking too much comfort in this low-volatility period. He posited that as a consequence, they’ll take more risk than what’s appropriate.
Source: Russell Investments
Investor complacency was a topic at First Western’s late-June Investment Policy Committee (IPC) meeting. IPC members voiced their concern over investors’ somewhat blasé reaction to negative news headlines. It indicated to us that market risk may be rising. Yet when we stepped back to assess the overall economic and financial landscape, we felt that key market drivers like future GDP growth, corporate profits and projected interest rates remain supportive of higher stock prices. And, despite having been in an easy money environment for years, most risk assets like stocks are not exhibiting bubble valuations.
However, as stock valuations move higher, we can’t help but become somewhat more cautious. We haven’t had a 10%+ correction in the market (an annual event on average) for nearly three years. That makes us overdue. Much as most of hate to see stock prices decline, even temporarily, a correction in stocks may actually be healthy for the market longer term. A bit of fear and skepticism tends to extend the length of bull markets.
As disciplined, long-term investors, we advocate focusing on fundamentals and valuations and riding through the normal ups and downs of the market. Market timing is a losing investment strategy. Numerous studies have shown that trying to time the market to avoid declines results in greater opportunity costs (missing out on upward moves) than savings from missing an actual correction. Given that the market has been up 73% of the years since 1926, it’s easy to see how attempting to market time would end up hurting investor returns over time.
As always, thank you for the trust and confidence that you place in First Western and please contact us if we can be of help in any way.
Debbie Silversmith Warren Olsen
July 30, 2014 July 30, 2014