The first half of 2013 was the best for domestic stocks since 1999. The second quarter generally produced positive returns until late May when Fed Chairman Bernanke spoke of the approaching time in which the Fed will reduce its bond purchases. After that point, markets backed off and volatility increased. For stocks, the declines eroded much of the second quarter gains (while leaving most of the first quarter gains intact).
Bonds, on the other hand, declined in value in late May and June such that year to date bond returns for most bond categories are moderately negative. After yielding less than 1.7% in early May, the ten-year Treasury yield jumped to nearly 2.7% now. That’s a very rapid increase in interest rates, particularly given that inflation expectations declined over the same period, as measured by significant price drops in gold and other commodities. This means real interest rates (i.e., rates after inflation) have recently risen even more than nominal rates. In more normal circumstances, that might cause concern about economic drag, but given that rates have been so repressed, this move in interest just brings us closer to normal.
In spite of the fiscal headwind of tax increases and the federal spending “sequester”, the economy has continued to slowly advance. Globally, financial pressures in much of Europe have abated even as it remains mired in recession, but concerns about weakening growth in China (against a backdrop of apparently significant overinvestment and a shaky banking system) along with political unrest in Turkey, Egypt and Brazil have pressured emerging market stocks and bonds. This year to date, emerging market stocks have underperformed the S&P 500 index by 23%, while European stocks have underperformed by nearly 15%. Therefore, the attractiveness of international stocks has significantly improved this year relative to domestic stocks.
Yields have also moderately improved for bonds, which is good. But interest rates continue to be artificially low and that heightens risks. We consider these significant enough that we continue to focus primarily on reducing risk in portfolios. We’re pleased with the significant gains portfolios have produced this year even as we have maintained a cautious stance.