Economy

The economy showed encouraging signs of growth throughout the month of July as a number of major economic indicators came in positive. The Citigroup Economic Surprise Index (CESI) remained in negative territory throughout the month, but has trended dramatically higher into positive territory over the previous week. This expansion into positive territory indicates that economic data are exceeding expectations to the upside.

Of considerable note, the ISM Manufacturing Index climbed to 55.4 in July, the highest it has been since June 2011. This is a significant increase from the June reading of 50.9. A reading above 50 signifies expansion in the manufacturing sector. Thirteen out of eighteen manufacturing industries reported growth in July, with furniture and related products being the leading industry. The ISM Non-Manufacturing Index also came in positive as the index increased from 52.2 in June to 56.0 in July. Arts, entertainment and recreation, construction, and information were the leading industries.

  • Consumer sentiment continues to be a major growth mechanism for financial markets.
    • The Consumer Sentiment Index increased from 84.1 in June to 85.1 in July.
    • Consumer confidence decreased slightly to 80.3 for July, but still remains in territory not seen since 2008.
    • It is debatable on whether consumer sentiment is driving the market or being driven by the market.
  • The housing market continues to gain steam as the S&P/Case-Shiller home price index increased approximately 2.4% from April to May.
    • This resulted in a year-over-year increase of roughly 12.2%, marking the largest year-over year increase since March 2006.
    • Despite record low mortgage rates rising significantly earlier this year, it has yet to slow the rapid rise in home prices.
    • This rapid expansion in home prices over the past 12 months has many experts suggesting that a new housing bubble may be brewing, at least in some regions throughout the U.S.
  • Labor markets continued to improve, but at a rate that failed to meet expectations.
    • The unemployment rate dropped from 7.6% in June to 7.4% in July.
      • The 162,000 jobs added however, failed to beat economists’ expectations of between 175,000 to 185,000.
    • Failure to meet job growth expectations in July coupled with downward revisions to May and June unemployment numbers could bode well for markets, as the Federal Reserve may hesitate to taper its bond purchasing program prior to year end.

Central Banks

The U.S. Federal Reserve indicated that it will remain accommodative on the heels of tepid inflation and economic growth. The Fed provided a somewhat weak description of economic growth in July stating that economic activity had “expanded at a modest pace.” This is slightly less optimistic than its June statement describing the growth as “moderate.” The Fed also stated that inflation persistently below 2.0% poses economic risk, but is confident it will move towards the 2.0% target in the medium term. Stocks remained on a positive path as Bernanke’s comments suggested that a tapering of the Fed’s asset purchase program could be delayed beyond year end.

Central banking policy around the globe continues to remain dovish. Both developed and emerging economies have seen rates cut over the trailing 12 months. Emerging countries are finding the need to cute rates, not merely on the basis of inflation pressures, but in an effort to remain globally competitive. Emerging countries often depend on a weak currency as their producer-dominated economies rely on the consumerism of developed nations. Of the 300 policy decisions followed by Central Bank News, 24.3% led to rate cuts year-to-date, while only 4.7% led to rate increases.

Equities

After enduring nearly universal drawdowns in June on the heels of potential Fed “tapering” and China concerns, global equities staged a relief rally to begin the Q2 earnings season. Europe was the regional leader with positive economic surprises and earnings, while Japan lagged on underwhelming earnings thus far. News was relatively quiet on the developed market policy front, while central banks in emerging markets were particularly active. The dollar weakened against most developed market currencies, marking a reversal of trend. Correlations across equity markets began to rise, which was a reflection of investors’ focus on macro-level concerns rather than fundamental, company specific issues. Volatility decreased substantially, as the VIX ended the month below 14 after breaching 20 in June. Overall, it appears as though the global correction in equities has reversed course, at least for now.

United States:
The U.S. continued its gradual recovery, reflected by a number of positive macroeconomic releases. Second-quarter GDP came in strong at 1.7% (vs. 1.0% expected). However, it should be noted that the Q1 number was revised significantly lower. Consumer confidence (as measured by the University of Michigan survey) reached its highest level since late 2007. Manufacturing data continued to be supportive, with durable goods orders above pre-crisis highs. On the negative side, the labor market continued to disappoint, with July payrolls coming in below expectations. This should stave off additional near-term concerns about the Fed slowing asset purchases, and, more to the point, Bernanke essentially avoided any further discussion of “tapering” in his most recent public comments. The biggest concerns continue to be on the public policy side, and as President Obama returns to the campaign trail ahead of budget and debt ceiling battles in the fall, investors will likely be reminded of Washington’s impact on the markets.

Earnings season has been broadly positive, with 73% of companies in the S&P 500 (reporting thus far) posting earnings above estimates. The negative surprise level of 2.2% was quite low. Financials have represented the bulk of earnings growth in Q2, up 29% year-over-year.

In terms of market cap and style analysis, there was much less dispersion amongst the major U.S. indices in July. Smaller cap stocks continued to lead, but all segments were strongly positive. Growth remained ahead of value in small cap, while the reverse was true in large cap. As has been mentioned in previous reports, multiple expansion likely will not continue for much longer, and it will be important for fundamentals to become the driver for equity performance.

International:
Europe led in July, with Spain (+12.9%) and Italy (+10.3%) surging higher. The Eurozone benefitted from positive economic indicators, including improving PMIs and business confidence. The currency bloc appears to be gradually exiting its recession, and continued to be helped by increased corporate investment and exports. Earnings season has been strong throughout Europe, and investors have been bidding up equity prices in response. Japan (+0.6%) was the laggard amongst developed markets after a very strong run, as earnings from some of the larger Nikkei-listed firms (i.e. Canon and Nissan) disappointed. The lack of consistency in earnings may be undermining fundamental confidence in the Japanese market. On the macro front, CPI continued to trend upward and exports remained strong with improvements in U.S. demand, but concerns over a China slowdown continued to weigh heavily on sentiment.

Emerging markets recovered a bit during the risk-on rally, with the MSCI EM Index posting its second positive month (+1.1%) since December 2012. China (+4.1%) rebounded strongly as investors adjusted to the impact of the economic slowdown and the new normal (i.e. sub 8% GDP growth). Second quarter GDP came in at 7.5%, prompting a “mini-stimulus” of tax cuts, easing of the customs process for exporters, and solidification of financing for railway development. Monetary policy remains tight, and the PBoC is likely to avoid any high profile easing unless they see a significant drop in domestic demand. PMIs were down across Asia in July, with the biggest drop coming in South Korea (49.4 to 47.2). Exports and industrial production continued to trend downward in the country, which is now battling both a devalued yen and depressed demand from China. India was the weakest of all major markets in July, falling 2.8%. Falling industrial output has exacerbated stagflation in the country, and the sharply depreciating rupee has prompted the Reserve Bank of India to take measures to tighten liquidity and reign in currency speculation.

Fixed Income

Central banks around the world adopted a more dovish tone in July. The Fed expressed some remorse over the volatility it injected into the fixed income markets. Bernanke’s public comments during the month were dovish, with an emphasis that tapering was not preset but rather data-dependent. In its official July statement, the FOMC acknowledged that inflation was running below its objective and could pose deflationary risks. Meeting minutes also revealed discussions around markedly higher mortgage rates with concern the burgeoning housing recovery could stall. Across the Atlantic, the ECB mimicked the Fed by introducing foreword guidance. Mario Draghi announced the ECB expects to keep benchmark rates at present levels or lower for an extended period of time. The Bank of England, which just installed a new governor, is expected to adopt the innovation imminently.

Taxable Market:
In review of specific fixed income sectors and markets:

  • TIPs bounced back from the punishment taken in Q2 as inflation expectations widened across the curve. TIPs returned to their long run tendency of outperforming nominal Treasuries in rising rate environments. The Fed added some support via its suggestion that low and falling inflation expectations may be harmful to the economy.
  • Agency MBS lost 0.1% in July. Current coupons, which are disproportionately supported by the Fed, continued to underperform. This area of the market has become extremely duration sensitive. Rising mortgage rates have slowed refinancing rates for these securities and valuations are now more heavily influenced by market expectations of Fed purchasing.
  • Non-agency MBS recovered slightly from a trough in June. Performance was still somewhat sluggish compared to other credit sectors, such as high yield corporates. Market expectations of home price appreciation are softening with higher mortgage rates. Fannie Mae is also steadily selling bonds as it reduces its MBS portfolio.
  • Corporate bonds gained 0.7% during the month. Higher yields and some price appreciation from falling spreads relative to Treasuries helped the sector outperform.
  • High-yield bonds bounced back to post a healthy gain of 1.8% in July. Yields in the sector rapidly spiked to 7% in June from a May nadir of 5%. After heavy redemptions, investors are now putting money back into high-yield bonds with extremely strong inflows in mid-July.
  • Leveraged loans continued to post solid numbers in July with a 1.1% gain. Retail investors poured money into the sector with $40 billion worth of inflows year to date; in comparison, high yield bonds experienced a $9 billion outflow year to date.
  • Convertible bonds returned 4.5% in July as a reflection of robust equity markets. While still shrinking, the size of the market is beginning to stabilize.

Municipal Market:
June was a historically tough month for munis and the weakness filtered into July. Outflows from retail funds continued into July – investors have pulled $24 billion since June. High-yield and long-duration muni funds experienced the brunt of the redemptions which is reflected in their weak performance numbers. In comparison, short muni funds remained on more solid footing with comparatively light outflows. The discrepancy in demand across maturities is leading to an exceptionally steep muni yield curve.

International Markets:
EM debt showed signs of stability after a torrid June. Outflows slowed to $5 billion in July from $20 billion in June. Dollar-denominated EM outperformed local as EM currencies were still spotty relative to the dollar. Performance was more idiosyncratic with peripheral European countries outperforming while under performers included Brazil, Malaysia and Indonesia.

Alternatives

Hedge Funds:
Beta-oriented solutions performed well in the month as equity markets rallied sharply. Equity hedge solutions saw performance rebound following a tough June in which long/short funds lost more than the market. Strategies in the category were able to capture half of the market return with approximately a third of the exposure, based on measures of market sensitivity entering the month.

  • Event-driven continues to be boosted by distressed and activist-oriented solutions, which tend to be unhedged and are benefiting from idiosyncratic corporate developments in 2013.
  • Merger arbitrage faired okay, generating 0.70% return despite its hedged nature and a general dearth of corporate deal activity.
  • Market-neutral and absolute return strategies added 0.60% each, but relative value solutions were flat.
  • Systematic trend followers were once again the standout loser, as strategies generally lost money in every sector but equities.

Liquid Alternatives:
Alternative investment mutual funds posted slightly better performance than their hedge fund counterparts in July. This was likely due to greater embedded beta exposure in a number of mutual fund strategies.

  • The multi-alternative category rebounded from a disappointing second quarter to gain 1.1% in July. The category was negative in May and June as a number of underlying strategies apparently had more interest rate sensitivity than investors had hoped.
  • Long/short equity funds rose 2.6% during the month, in line with their hedge fund peers. Performance was achieved, however, with generally more equity market sensitivity (approximately 0.56 beta over the trailing three years per Morningstar data).
  • Market-neutral funds generated similar results to LPs, with a 0.70% gain in the month. Arguably these results are more impressive, as funds in the space generally do not employ leverage like the hedge fund universe due to SEC restrictions.
  • Managed futures mutual funds faced similar headwinds as on the hedge fund side. Reversals in precious metals, currencies, and certain bond and commodity contracts proved difficult for intermediate-term trend followers. Equities continue to be one source of consistent profitability.

Liquid Real Assets:
In May, Fed comments sent yield assets into a tailspin. Recently, more dovish wordplay from the Fed has righted market expectations. REITs and MLPs, the yield proxies for the Liquid Real Asset space, rebounded by nearly 5% in the last week of June, and spent much of July range bound. Commodities were the relative winners, rising for the first time in four months, despite investor bearishness.

  • Energy proved to be the exception to the speculative interest trend, with investors piling into WTI at a record pace before the summer driving months. The result was crude oil topping all other major commodities with a +9.2% July return. Natural gas, on the other hand, fell as temperate weather set in for much of the U.S.
  • Gold recovered 7.1% after suffering its worst quarter in nearly a century. ETF outflows slowed, and eventually became inflows in the latter half of the month, while the futures market saw a round of short covering prior to the latest FOMC statements. Silver also saw increased demand with more than 500 tonnes flowing into ETFs in July, completely offsetting the outflows from the first half of the year.
  • Industrial metals trading was mixed, with the aggregate complex slightly higher. Copper and aluminum rose less than 2% on no real change in fundaments, signifying potential short covering.
  • With pre-distribution buying tailwinds exhausted in late June, MLPs closed July effectively flat. The first half of the earnings season was basically in line with expectations, with the majority of MLPs raising distributions between 1% and 2%.
  • Domestic REITs rose 1% in July, as earnings came in near expectations: i.e. an aggregate upside surprise of less than 2%.

Disclosures

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.

There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.