Thursday, June 27, 2013

US Equities Aside, Global Markets Have Struggled in 2013

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.


Asset Class

May 1 - June 24


(thru 6/24/13)


(thru 6/24/13)


Developed Intl Equities





Emerging Intl Equities




Russell 1000

US Large Cap Equities




Russell 2000

US Small Cap Equities




Barclays Aggregate Bond

US Intermediate-term Bonds




Barclays Global Aggregate Bond

Global Bonds




Merrill High Yield Masters II

US High Yield Bonds




DJUBS Commodity






Emerging Markets Bonds




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.