Asset classes across the board rose in the second quarter despite lackluster global economic growth, an uncertain outlook for global monetary policy, and geopolitical tensions in Ukraine and Iraq. The Vanguard 500 Index fund (our S&P 500 proxy) was up 5.2% for the quarter and 7% for the year to date, after rising more than 2% in June. Smaller-company stocks again lagged larger-caps as they have so far this year, though they posted a very strong 5.3% gain in June. Our small-cap benchmark rose 2.1% for the quarter and is up 3.3% so far this year. Our portfolios are tactically underweight small caps based on their historically high valuations and so the year’s relative underperformance has been a positive for our results.
In economic news, U.S. GDP data for the first quarter was revised further downward to -2.9%, marking the largest drop since the first quarter of 2009. Expectations are for growth to rebound in the second quarter (after a very harsh winter depressed activity in the first part of the year); however, the fact remains that the economic recovery continues to be subpar. Other indicators were more positive, including continued improvements in the labor market, though wage growth is still very slow.
Developed international stocks were positive as the European Central Bank took further easing steps as it combats concerns about long-term deflation risk while Japan’s Prime Minister Shinzō Abe continued his multi-pronged effort to generate healthy inflation and boost Japan’s economy. Despite these efforts, though, both economies are mired in uncertainty. After a poor first quarter, emerging-markets stocks rallied. Our emerging-markets benchmark rose 7.3% for the quarter and is now up more than 6% for the year. Among larger emerging markets, China’s growth outlook remains a source of investor uncertainty while India’s newly elected prime minister was viewed favorably among investors and the country’s stock market staged a huge second quarter rally.
Core bonds shared in the gains as Treasury prices rose and bond yields continued to fall—a surprise to many investors—with the 10-year Treasury yield ending the quarter at 2.53%, down from 3.04% at the end of 2013. The Federal Reserve remained consistent in its message: while gradually scaling back its monthly bond purchases (announcing another $10 billion reduction in June) it has also indicated a lack of urgency in raising rates based on what it sees currently on the jobs and inflation fronts. The Fed updated its growth projections in June, revising slightly downward its expectation for 2014 growth, and while most measures show signs of inflation ticking up, it remains below the Fed’s target. For the quarter, we saw positive bond fund performances across the board as the Vanguard Total Bond Market (our core bond benchmark) was up 1.9%. High-yield bonds again posted strong gains as investors sought higher yields. Floating-rate loans (a tactical allocation in our conservative portfolios) and municipal bonds rose as well.
One thing that stands out about the past quarter amidst the record-setting highs of the S&P 500 is the very low stock market volatility. By late June (6/19/14), the VIX, a volatility index that measures expected 30-day volatility of the S&P 500, had dropped to 10.6, a level last seen in February 2007. (The recent VIX readings were in the first percentile of lowest daily observations since 1990, and within two points of the VIX’s record low on 12/22/93.)
Another indicator of the markets’ state of calm is the recent all-time-low level of the St. Louis Fed Financial Stress Index, which measures the degree of financial stress in the markets based on a compilation of 18 weekly financial market data points.
While low volatility and high stock prices reflect the market’s apparent lack of concern about risk—likely buttressed by a belief that the Federal Reserve will continue to support financial markets with accommodative monetary policy—this seeming complacency is causing us some near-term concern because it suggests a market more vulnerable to negative surprises.
The more investors are expecting and positioning portfolios for a benign or optimistic environment—using leverage and pouring money into riskier and/or less liquid assets to ramp up their near-term returns—the more likely it is that there will be a negative shock relative to these market expectations, and the more disruptive it will likely be if and when the shock happens. The chart below shows margin debt as a percentage of stock market value near all-time highs, suggesting that investors are indeed positioned in accordance with a rosy outlook.
This shorter-term concern about potential market vulnerability is also consistent with what continues to be our longer-term view that stock market valuations in aggregate are discounting too optimistic an outlook. In sum, our view is that markets continue to be too dependent on central bank largesse, too short-term focused, and too complacent about the risks and imbalances that remain in the global economy in the aftermath of the financial crisis.
We are not predicting that there must be a near-term market shock, just that the investment risk is heightened when markets are complacent. A low VIX does not necessarily imply an impending volatility spike or stock market correction. Volatility can remain subdued for long periods of time (as seen in the VIX chart on page 2). And at least one investment manager we respect highly, PIMCO, is arguing for just such an outcome. As part of their “new neutral” secular (three- to five-year) investment thesis, PIMCO foresees a low growth/low volatility environment for the next several years, and they have positioned their fixed-income portfolios accordingly.
But what might disrupt the market’s calm? Unfortunately, geopolitical shocks are always a risk and one that we don’t try to anticipate. But even with this year’s events in Ukraine and the sectarian violence in Iraq (to name just two), markets in general have remained relatively calm (except for some short-term, temporary stock-market declines). To the extent there is a sustained geopolitical flare-up, we’d expect U.S. Treasurys and other high-quality bonds to benefit from a more sustained investor flight-to-safety at the expense of global stocks and other riskier asset classes. If a fear-driven market decline is severe, it could present a good long-term buying opportunity, enabling us to shift some of our lower-risk/defensive tactical investments back into riskier but higher-returning stocks.
We appreciate your confidence and trust.
-Your Capital Trust & Associates Research Team
As always, please feel free to call Sam or email with questions and comments to email@example.com
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