The economy showed positive signs of growth through Q2 as economic data appeared to stabilize. Volatility, as measured by both the S&P standard deviation and the VIX, picked up in the second half of the quarter as the Federal Reserve discussed tapering its bond-purchasing program. The Citigroup Economic Surprise Index (CESI), which measures actual economic data prints relative to expectations, spent most of the quarter in negative territory. By late June, the index moved towards the breakeven point, indicating data is coming in mostly in line with projections.
The ISM Manufacturing Index, which monitors employment, production, new orders, and supplier deliveries of more than 300 manufacturing firms, reversed its downward trend in June. The index ended June at 50.9, implying an expansion in manufacturing activity. However, on a quarter-over-quarter basis the index trended down, dropping 0.4 points from its March reading of 51.3. Despite the slight drop, the index still remains in expansion territory.
- Labor markets continue to improve at a steady pace.
- Despite the unemployment rate increasing from 7.5% in April to 7.6% in May and June, the economy added jobs at a pace that exceeded expectations.
- Nonfarm payrolls increased 199,000 in April and 195,000 in both May and June.
- Average hourly earnings rose alongside payrolls.
- An increase in consumer confidence was a major highlight of the quarter.
- The Consumer Confidence Index, which measures consumers’ optimism with respect to both current conditions and future expectations of the economy, increased from 61.9 in April to 81.4 in June. The index increased in all three months of the quarter for the first time since Q4 2010, and now stands at a recovery high.
- The housing market continues to provide positive headlines as housing prices moved higher.
- The S&P/Case-Shiller Index, which measures housing prices through the U.S., increased 12% year-over-year in April and roughly 2.5% from March to April.
- Additionally, both new and existing home sales continued their positive uptick since bottoming in 2010.
- However, the recent rise in the U.S. interest rates has negative implications for housing markets, as it increases the cost of credit and refinancing for new and existing homeowners.
U.S. central bank activity dominated headlines throughout Q2. Volatility returned as the U.S. Federal Reserve hinted at a possible winding down of its bond-purchasing program. Federal Open Market Committee (FOMC) minutes released on May 22suggesting as much caused the largest one day market move since February. Fed Chairman Bernanke and other Fed officials have reiterated in recent weeks, however, the Fed tapering is contingent on positive economic data going forward.
Developed economies continued with accommodative policies during the second quarter. The Bank of England (BOE) maintained its Bank Rate of 0.5% and bond purchasing program. In a more dovish shift, the European Central Bank (ECB) recently stated they will continue to boost economic growth through easy monetary policy “as long as necessary.” The group is under pressure due to deteriorating growth in the Eurozone, which recently posted a sixth straight quarter of negative GDP.
The Bank of Japan (BOJ) remains confident that its bond purchasing program (7 trillion yen per month) is having positive effects on the economy, stating the economy is “picking up”. They maintained the program despite recent volatility in the market. In late May and early June, the Nikkei 225 dropped over 20% into bear market territory as 10-year government bond yields spiked. Governor Kurdoa of the BOJ, stated that the rise in rates was a healthy indication of inflation expectations. The BOJ remains optimistic that inflation expectations are increasing in alignment with the 2% inflation target.
Global equity markets further diverged in Q2 of 2013, with may of the developed markets pausing after enjoying strong gains YTD, while the emerging markets continued to underperform amid slowing economic growth. Japanese and U.S. equity markets retained their global leadership as accommodative monetary policy, stable corporate earnings, and improving economic momentum drove both markets higher. However, both markets retreated from May highs as disappointing policy guidance from the BOJ and Federal Reserved caused a rapid rise in bond yields and an unwinding of the “yield carry trade”. With confidence in global central bank policies waning and volatility rising, upcoming economic and earnings data will be increasingly important catalysts in determining the next move in global equity markets.
U.S. equity markets did lose some momentum in Q2 but continued to deliver favorable relative returns due to the perceived stability of corporate earnings and the U.S. economy.
- The NASDAQ Composite gained 4.2% in Q2 as its tech and consumer discretionary components rallied, outperforming the 2.4% gain in the S&P 500.
- The Dow Industrials Average kept pace with a 2.3% gain, but the Dow Transportation Average lagged with a decline of 1.9%.
- Implied volatility rose significantly entering the seasonally weak summer months, with the VIX rising 32.8% in Q2 to 16.9.
- The surge in the VIX and bond yields during Q2 was mainly a result of the Fed’s more hawkish guidance on a tapering of QE. This has driven a dramatic shift in the investment environment, and may portend a deeper pullback moving into Q3 as investors begin to imagine life without QE.
- Market segments with limited exposure to international growth headwinds continued to exhibit leadership in Q2.
- Microcap and small cap growth stocks notably outperformed as investors favored the niche focus and domestic growth leverage of these companies.
- Large cap growth stocks lagged the broader markets due to their high dependency on international growth as a component of earnings.
Though weak in June, France (+3.5%) and Germany (+3.4%) led all major markets (outside of Japan) during Q2 on the back of strong results in April and May. Industrial production is trending upward in both countries. The region has been relatively quiet on a policy front after the ECB rate cut in early May, and should remain so in anticipation of German elections in September. Japan was the only major market that was positive in June. It led all others for the quarter at +4.4%. The Nikkei entered a technical bear market in mid-June as the yen strengthened, bond market volatility increased, and investors took profits. The market has since stabilized, but the potential for volatility is present any time Japanese policy makers speak publicly. Australia (-13.9%) endured a very difficult quarter as commodities and the Australian dollar continued to slide. Weak Chinese demand will take its toll, and Australia faces the prospect of its first technical recession since 1991.
China (-6.5%) was the subject of much consternation, especially late in the quarter. A series of weaker than expected economic data in May led to the belief that the country’s leaders would acquiesce on inflation concerns (with CPI at a reasonable 2.1%) and implement short-term stimulus measures. Instead the central bank deliberately manufactured a credit crunch, by holding back liquidity from banks and driving the 7-day SHIBOR (Shanghai Interbank Offered Rate) up to 11% on June 20th. The expressed purpose of this tightening is to fight back against excess credit fueled by shadow banking, and a surge in property prices. Structural reform in the Chinese banking sector is welcomed and will be a long-term positive, but the short-term pain will be significant. The combination of China’s impact and the concern over potential Fed tapering led to dramatic drawdowns across emerging markets. Brazil (-17.2%) and Mexico (-11.2%) were the worst performers among the major emerging markets for the quarter.
With essentially no place to hide following Bernanke’s May 22nd comments, the fixed income markets realized a hefty period of losses in the later 6 weeks of the quarter as investors reset their rate expectations. Flow out of liquid fixed income investment vehicles was especially strong. Rates and credit spreads correlated as yields rose across the fixed income landscape bringing to the forefront the old adage “cash is king”. Beyond the near zero return on cash, the winners were short maturity munis down just 80 basis points from May 22 to the end of June, while the outright losers were long U.S. Treasury Inflation Protected bonds and Emerging Market Local Currency bonds, both down over 8%. During the same period, core taxable portfolios and tax exempt portfolios were down 2.2%. For the entire quarter, core taxable and tax-exempt bonds lost 2.4% and 1.9% respectively.
In review of specific fixed income sectors and markets:
- Q2 2013 presented the worst possible environment for TIPs as real yields rose and inflation expectations declined.
- Agency MBS lost 2.0% during the quarter. The performance differential between higher and lower coupon bonds accelerated from Q1 in the aftermath of the Fed’s public ruminations about cutting back bond purchases.
- Investment grade bonds lost 3.3% during the quarter. Corporates were hit with both a selloff in the Treasury market and a widening of spreads. Yields rose roughly 80 bps which led to price depreciation of -4.3%. Low absolute yields of 2.8% entering the quarter offered modest income protection against the selloff.
- High yield bonds lost 1.4% in Q2. Spreads widened approximately 100 bps during the rate sell off and the index yield increased from 5.0% to 6.7% over May and June. Price depreciation of 3.2% was mitigated by the inherently high coupons of the asset class.
- Leverage loans withstood the fixed income carnage to post positive returns of 20 bps. The coupon was enough to offset slight price depreciation.
- Convertible bonds returned 1.9% in the quarter. The market was a beneficiary of the equity markets that defied the broad bond sell off.
Yield changes in the municipal marketplace are always behind the broader fixed income markets. However, yields on generic AAA rated 10 year munis eventually increased around 105 basis points from the May bottom, a 56% increase. At the close of the quarter, 5 and 10 year AAA munis were offering yields in excess of U.S. Treasuries; on a ratio basis 5 year munis offered 112% of the like Treasury yields which was cheap relative to the 5 year averages.
Local currency EM debt as measured by the JPM Global Broad Diversified EM Index is living up to its volatile history, down 7% for the quarter. Drilling deeper, the loss reflects yields driving higher, up over 80 basis points to 6.4%, along with dollar appreciation versus EM currencies. A similar drawdown occurred in summer 2011 as the index fell over 10%. However, the 2011 drawdown and prior drawdowns were driven by a flight to quality, specifically investors dumping riskier assets and buying U.S. Treasuries.
Alternative investments generated mixed performance in the second quarter, as sharp market reversals in May and June caught many active managers off guard. While directional strategies continue to lead year-to-date performance, the second quarter saw a more heterogeneous performance profile. Hedge funds generally had trouble navigating a more turbulent second quarter, with Credit Suisse reporting that leverage declined to the lowest (2.48x) levels since last summer.
- Convertible arbitrage managers again led performance in the second quarter. While the underlying long-only convertible bond market has generated strong gains in 2013, managers also benefited from a pick up in volatility, which makes the option-component of the convertible bond more valuable.
- Event Driven strategies also performed well in the second quarter. Activist equity strategies and distressed funds, generally more unhedged in nature and perform better in strong equity markets, were contributors to the category. Merger arbitrage remains the weak link in the space, although second quarter results were somewhat improved.
- Equity strategies has a very poor second quarter according to HFRX data. Long/short strategies declined by 50 bps, while market neutral funds were essentially flat.
- Macro strategies struggled in the second quarter, and remain the only major hedge fund category in the negative territory for the year.
Alternative investment mutual funds posted mostly negative performance in the second quarter, in line to slightly behind their traditional hedge fund counterparts.
- Core strategies, represented by the Morningstar Multi-Alternative category, lost 1.8% and are now flat for the year. Performance for multi-manager solutions was largely dependent on directionality in the underlying portfolios, with some managers having greater directional credit exposure.
- Long/short equity was the best performing category, gaining 0.8% in the quarter – above the returns witnessed in LP’s. Like hedge fund solutions, long/short managers had difficulty navigating a more turbulent market environment, particularly one characterized sharp sector rotation during the quarter.
- Managed futures were the worst performer, with most of that loss occurring in the second half of the quarter. Again, sharp movements in government bond yields were the biggest detriment, followed by moves in Japans equities and currency. Some sharp reversals in the U.S. dollar have also caused some volatility for mangers in this space.
Liquid Real Assets:
Rising interest rates played a recurring role in Q2 performance for liquid real assets. Spread sensitive REITs and MLPs lagged broader U.S. equities, as their yield became less compelling vs. nominal risk-free rates. For commodities, a rise in real rates was the culprit, with inflation expectations falling across the futures curve. Additionally, volatility picked up, resulting in increased margin requirements for all commodity futures. Precious metals, for example, saw margin requirements increase by 25%. This resulted in many speculators reducing long exposure.
- Fundamentally, little changed in the oil markets in Q2 as sideways trading continued into a third year. Geopolitically, what was seen as a positive Iranian election result was offset by increasing tensions in Syria and Egypt.
- Natural gas sold off slightly after a strong start to the year as several nuclear power plans came back online, eliminating some of the heating/cooling related demand that propelled natural gas in Q1.
- For precious metals, gold (-27.0%) experienced its worst quarter in over 80 years, after Bernanke’s tapering comments. Silver, a commodity that is both a store of value and an economically sensitive metal, fell 32%.
- Industrial metals sold off in Q2 due to prevailing concerns about Chinese bank liquidity and corresponding credit conditions despite some positive news in May relating to falling inventories.
- MLPs were on pace for a down quarter, until a reprieve came in the last week of June when the index rose 4.7% in anticipation of a distribution season.
- Domestic REITs fell 1.9% in Q2 on the heels of rising interest rates. Long dated lease REITs lagged, with industrial/office off 7.1%, health care down 4.5%, and retail 2.2% lower.
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.
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