Investors often pay the most
attention to the markets in the country in which they live. This is especially
true in the US, home to the largest and most liquid stock and bond markets in
the world. As a result, they often extrapolate the performance of domestic
markets to their entire portfolio. It is not unusual for them to become nervous
when US equities plunge, worried about an erosion of their principal or to
become disappointed when their portfolio fails to keep up with double-digit
gains in US equity markets. This year has been an excruciating example of the
latter. Not only have other markets lagged the double-digit gains of domestic
equity markets, but many have posted significant losses. A look at performance
across global asset classes (see table below) indicates that is has been a horrendous year for
commodities and emerging stock and bond markets. While the losses are more
modest, it has been a negative year for investment grade US bonds and global
bond markets in general. In short, unless you have been dramatically overweight
US equities, 2013 has been a challenging year.
Benchmark
|
Asset Class
|
May 1 - June 24
|
QTD
(thru 6/24/13)
|
YTD
(thru 6/24/13)
|
MSCI EAFE
|
Developed Intl Equities
|
-8.11
|
-3.20
|
1.87
|
MSCI EM
|
Emerging Intl Equities
|
-15.77
|
-13.60
|
-14.95
|
Russell 1000
|
US Large Cap Equities
|
-1.44
|
0.34
|
11.34
|
Russell 2000
|
US Small Cap Equities
|
0.59
|
0.22
|
12.64
|
Barclays Aggregate Bond
|
US Intermediate-term Bonds
|
-3.87
|
-2.89
|
-3.01
|
Barclays Global Aggregate Bond
|
Global Bonds
|
-4.20
|
-2.87
|
-4.91
|
Merrill High Yield Masters II
|
US High Yield Bonds
|
-4.08
|
-2.26
|
0.52
|
DJUBS Commodity
|
Commodities
|
-5.39
|
-8.03
|
-9.07
|
JPM GBI-EM Bond
|
Emerging Markets Bonds
|
-15.08
|
-12.17
|
-9.42
|
It had already been a difficult
year for most asset classes prior to May 22nd, the day in which Fed
Chairman Ben Bernanke testified before Congress. True, domestic and developed
equity markets, the greatest beneficiaries of central bank largesse, had
rallied mightily and high yield bonds had performed reasonably well. However,
emerging stock and bond markets, commodities, and investment grade US fixed
income markets had largely been in the doldrums and most foreign currencies had
declined against the US Dollar. In
short, with the exception of stocks domiciled in developed nations and high
yield bonds, year-to-date performance had been weak. And after the
Chairman spoke, global markets got a much weaker still. When he took over as
Chairman of the Federal Reserve Board, Ben Bernanke promised a more open and transparent
Fed and indeed, he has been as good as his word. Unfortunately, Uncle Ben is
finding out that transparency comes at a price. Global markets, addicted to the
liquidity being provided by global central banks, have begun to parse every
word that central bankers speak for clues about the future of quantitative
easing programs. After peaking on May 21st, global stock and bond
markets have suffered trillions of dollars in losses through June 24th.
The slide began on May 22nd as Mr. Bernanke, speaking before
Congress, indicated that the Fed could reduce its quantitative easing program
(i.e. bond buying program) sooner than market participants anticipated. While
he also reiterated that ending the program too soon represented dangers of its
own, markets focused solely on the potential for an earlier than expected exit
from the program. Markets were disappointed further when the BoJ (Bank of
Japan) failed to add to its quantitative easing program. The BoJ program is
roughly 90% of that of the Fed despite an economy approximately 1/3 the size of
that of the US. As such, it is proportionately far larger, yet global markets
are apparently demanding that the BoJ provide even greater liquidity. The
Nikkei 225 fell more than 6% on June 12th, and while it is up modestly
since then, it remains 17% below its high for the year reached, not
coincidently, on May 22nd. Finally, after the Fed’s June 18-19
meeting, Bernanke once again indicated that the central bank’s bond buying
program could be reduced sooner than expected, but that it might also end
earlier than expected. Yet again the Chairman took pains to reiterate that the
slowing or ending of the program was data dependent, noting that anyone
interpreting his statements as indicating the program would end by the middle
of next year had “drawn the wrong conclusion.” Yet market participants remained
solely focused on the potential for an early end to the program and US equity
prices fell precipitously after his afternoon press conference and plunged
again the following day.
Over the last six weeks,
correlations across asset classes (the degree to which they move together
directionally) have risen and global stock, bond, and commodity markets have
declined. Emerging stock and bond markets have suffered the worst of it as
investors have become worried that an early end to quantitative easing programs
will reduce capital available for investment in higher yield emerging equity
and bond markets (note: in what is known as the “carry trade,” investors borrow
currencies in low interest rate countries and convert to the currencies of
countries offering higher rates of return). Developed stock and bond markets
and commodities have also declined, leaving investors with no true port to ride
out the storm other than cash or bear market funds. With the exception of
domestic equities, returns on every asset class we model are either negative or
modestly positive year-to-date. The losses in commodities and emerging stocks
and bonds are now approaching double-digits levels.
Many asset classes offer
challenging risk/reward profiles over the ensuing four-to-five years. Despite
their dramatic outperformance year-to-date, this is especially true of domestic
equities. Trailing price/earnings multiples reflect the dramatic, positive, yet
unsustainable impact of record government budget deficits on earnings. However,
earnings growth has slowed dramatically over the last two years and is likely
to slow further due to sequestration. Forward P/E multiples are problematic due
to dramatic inaccuracy of analysts’ earnings predictions. A look at more robust
valuation metrics (such as Tobin’s Q or the Shiller Cyclically Adjusted
Price/Earnings ratio) suggests US equities are much more richly valued than
rather simplistic P/E multiples.
If volatility remains elevated, correlations
across asset classes are likely to remain high. This poses a challenge for
traditional asset allocation and is one reason that we added exposure to
several non-traditional strategies at the end of the first quarter. Another is
the fact that we saw many traditional stock and bond asset classes as
over-valued. Most of these new strategies performed modestly better than
traditional, long-only strategies over the last six weeks. We expect that these
non-traditional strategies will remain core holdings over the subsequent four
or five years and that they will enhance returns while reducing volatility.
However, we will continue to monitor markets and strategies and alter the mix
of traditional and non-traditional assets as opportunities and risks present
themselves with the ever-present goal of maximizing portfolio returns while
prudently managing risk.