Island Light Quarterly Commentary (June 2013)
Back to Basics
Global Equities were flat for the quarter and are up more than 6% for the year, as measured by the MSCI All Country World Index. Led by US economic growth and record corporate earnings, US equity returns were solid in the quarter, with gains coming in the first five months of the year. The S&P 500 returned 2.9% for the quarter and is up 13.8% for the year, the best performance of any major asset class. Reacting to a sharp rise in interest rates in May and June, U.S. Bonds fell 2.3% in the quarter and 2.5% for the year, the slowest half year of performance for bonds since 1994.
Non-U.S. Developed markets were off 1.6% in the quarter and are up 3.0% for the year. European equities were slightly down for the quarter and are up only 2.4% for the year, hurt by the strong dollar and continuing European recession. Pacific region equities gave back half their first quarter gains, leaving markets up 4.3% for the year. Emerging equity markets continued their divergence from US equity returns, down 8.1% in the second quarter and retreating 9.6% for the year. The dollar index rose nominally for the quarter and is up 4.3% for the year. A rising dollar lowers the international investments of U.S. domiciled investors. It is of interest to note that the U.S. represents about 46% of world equity markets while non-U.S. developed markets represent 42% and emerging markets represent about 12% of total market cap.
Keeping our eggs in many baskets did not contribute to increased risk-adjusted return this quarter and half year to date. Less traditional asset classes, such as gold, emerging bonds and US REIT had unusual but significant drops in value in the second quarter. Some of the earlier gains in these asset classes were due to increased liquidity and short-term traders seeking excess return. We witnessed the reversal of this “excess liquidity” trade in May and June. Actions of the central banks and monetary authorities have had a disproportionately volatile effect on many otherwise unrelated markets. As a consequence, it is easy to forget the considerable benefit of having and sticking to a long-term plan. Short periods of rapid increase and reversal are normal in a long-term investment program and so we continue to believe in the efficacy of our time-tested approach to creating long term wealth.
Near record low interest rates now appear to be a thing of the past. The most significant financial message of the second quarter is from Fed Chairman Bernanke who hinted in May that signs of a stronger economy might warrant a slowdown in monetary stimulus. In June, he followed that hint with an even bolder statement about improving economic growth and outlined a more certain timetable for the end of quantitative easing (“QE”) at the end of 2013 or early 2014. Interest rates immediately rose in response and most interest-sensitive instruments fell precipitously. The last week of June, other members of the Fed tried to back away from these statements, partly in reaction to this precipitous decline, but the jolt to low interest rate expectations was done.
There is good reason for the Fed to be optimistic about the U.S. economy. Consumer confidence in May rose to its highest levels since January 2008 and new U.S. single-family home sales rose to their highest levels in nearly five years. Despite the stubbornly high unemployment rate, much of it structural and not cyclical and therefore less affected by boosts in demand, which rose slightly to 7.6% in May, the U.S. is in the fourth year of an economic recovery that began in the middle of 2009. The real question is how and whether the Fed can continue to justify its commitment to monetary stimulus and whether the elimination of that stimulus will lead to a slow-down in growth. In any event, the rationale for maintaining low interest rates well below their historic averages seems to be weak.
What is good news for the economy is bullish short-term news for equities but is naturally unsettling news for bonds. A favorite investment saying is that “equity analysts are optimists by nature and bond analysts are pessimists.” Bond investors love difficult news. We’ve seen pretty good economic news. Our immediate concern is the impact of these expected interest rate increases on core fixed income investments, whose prices move in the opposite direction to interest rates.
While the U.S. economy is returning to normal growth rates and the U.S. equity market enjoys this buoyant period of optimism, the rest of the world is on temporary hold. In early June, the World Bank reduced its global forecast after emerging markets from China to Brazil slowed more than projected. Budget cuts and slumping consumer confidence deepened Europe’s contraction.
World equity markets, as measured by the MSCI All-Country World index (“ACWI”), returned 6.1% in 2013 and were down 0.4% in the second quarter. This index represents the developed and emerging markets equities. The U.S. counted for slightly less than half of the global equity markets weight at the beginning of 2013. The other major regions of the world are summarized below.
This table shows the last ten years of equity returns for the three major global equity regions, ranked by return. Note that the largest returning asset for the last decade, emerging markets, grew at more than twice the rate of the other developed markets with much more risk and volatility. The emerging markets story is that these economies grow at a faster rate than the developed markets and investors, long term, are rewarded for their patience if they can withstand the volatility of returns. In 2013, this volatility contributed to portfolio loss.
While we anticipate that the next decade will be unlikely to duplicate these outsized emerging market returns seen in the 2003-2007 period, we believe that exposure to emerging markets is a necessary and appropriate investment policy. Note that the US Large is the Russell 200 Mega Cap Index.
As we noted previously, the S&P 500, increased 2.9% in the second quarter and is up 13.8% for the year. Small-cap and Mid-cap stocks have done a little better than Large-cap stocks, and value stocks have outperformed growth stocks by 4%.
The current macro environment remains a positive for U.S. equities as the economic data remains strong enough to give investors confidence in the continuing economic recovery. As Sir John Templeton observed, “Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” It does not appear that we have moved into the euphoria stage of the bull market. June’s pullback represents some venting of steam which is appropriate given the previous seven months of positive returns.
To further bolster the case for U.S. equity market optimism, corporate earnings per share set a new record in the first quarter. They are poised to top that high when second quarter results are in, and are expected to grow 13% next year. The market is priced at about 14.8 times expected 2013 earnings, a ratio below its historic average of 18.8 (1988-2012).
Tempering this optimism, beginning in May, we observed a sharp increase in volatility with the VIX Volatility Index rising above 20 for the first time since the end of 2012. We will expect this market volatility to continue through the summer and fall. In general, higher volatility in markets leads to increased uncertainty and diminished expectations.
As we observed above, International equity markets, as measured by MSCI World ex-US, were off 1.6% for the quarter but remain up 3.0% for the year. The best returning regions of the world for the year thus far are the Pacific, up 7.8% in dollar terms and Japan up 16.6%. ‘Abenomics’, the Japanese equivalent of QE, created enormous optimism in Japan in the beginning of the year, although some of that euphoria has diminished recently. Europe returned 2.2% for the year and was off 0.5% for the quarter. Germany and France are up about 3% each for the year so far, with the U.K. essentially unchanged.
Emerging markets, as measured by MSCI Emerging, declined 8.1% for the quarter and are off 9.6% for the year. China, Russia and Brazil were all off by more than 11% for the year, due to slowing growth prospects in Brazil and Russia primarily resulting from weakening commodity demand, as well as decelerating growth in China as fears of a credit crisis dimmed investor expectations. Much of the decline in emerging markets has come since May 21, the date of the first Fed meeting. Until that time, emerging markets were flat for the year, but since then the asset class has lost nearly 10% in value.
Foreign monetary authorities have not indicated any slowdown in monetary stimulus measures. Both the Bank of Japan and the European Central Bank have recently made further commitments to continue pumping liquidity into their markets and the Bank of England has made no commitment to change its accommodative policies. With Europe still slogging through recession, until we begin to see some growth in exports or change in sentiment, it is likely that European GDP growth will remain in limbo. But equity valuations of foreign markets appear to be relatively attractive today versus the U.S., and we won’t be surprised if foreign markets have stronger returns in the remainder of 2013. A weaker dollar would also help overseas investments.
Fixed Income, Interest Rates and Inflation
We noted previously that the U.S. Aggregate bond index fell 2.3% in the quarter and 2.5% for the year to date, the most sluggish half year of performance for bonds since 1994. Longer duration bonds of all types fell off even further.. U.S. bonds are a large component of our portfolio weights, and we look to fixed income for stability and safety. A decline in fixed income principal, and fears of future declines, are therefore at the top of mind. Since the beginning of the year, and again in the second quarter, we have re-positioned our portfolios to increase exposure to safer, lower duration fixed income instruments, at the expense of current yield. When fixed income yields become relatively attractive again, we expect to return to longer durations. Change and uncertainty always loom ahead, but our investment tools provide the prudent way to navigate consistently and ride out the waves over the long voyage.
The 10-year Treasury rate increased nearly 1% in the last two months since May 1 (see chart), bringing rates to levels not seen in almost two years.
With growth prospects improving in the latter half of 2013 and into 2014 and beyond, the rise in interest rates was expected, and we believe that this trend will continue, albeit in fits and starts. The ten year treasury rate, at 1.6% on May 1, rose to 2.5% at the end of the quarter. However, the real interest rate yield is about 0.8% above core inflation, versus an average real yield of roughly 2.2% for the last ten years. If core inflation remains around 2.0%, we should expect to see the intermediate term interest rate rise to a more realistic 3.5% to 4.5% over the next two or three years.. We believe that the likelihood of an interest rate increase to 4.0% is more likely than a return to the 1.5% rate seen as recently as August 2012. This possibility will trigger continuing weakness and loss of principal in intermediate and longer duration fixed income instruments.
This table summarizes fixed income returns for the quarter and year, with current SEC yields and the effective duration of the fixed instrument.
Duration measures the potential impact of a 1% move in interest rates for bonds of different maturity. Longer maturity instruments have more duration risk and are therefore more sensitive to changes in interest rates.
Gold, often a diversifying asset and the best performing asset of the last 15 years until this year, has lost 25% of its value from Dec. 31, 2012 ($1657) to July 1, 2013 $1243), with 10% of that loss coming in one day in April and a drop of 14.5% in June, contributing to a 25% decline in the second quarter amid heavy volumes of trading. While some of the drop in gold can be attributed to an increase in margin requirements by the futures exchanges and increase in tariffs by India, accelerating losses point to some degree of panic selling away from the risk trade. The decline in both physical and paper gold prices is particularly puzzling, given its historic role as alternate currency. Our holdings in GLD, the ETF that tracks the gold market, have been pared back, although we retain our modest (2-3%) allocation.
Real estate investment trusts (“REITs”) are also sensitive to interest rate increases and were buffeted in May and June, suffering a 12% loss from the middle of May, reversing most of the gains made in January to April. The real estate sector itself, however, is returning to normalcy in many major urban markets.
One of our diversifying assets, a broad based hedge fund index ETF from IQ Index, lost some value in June and was down 1.6% for the quarter and is up 2.0% for the year. Exposure to this asset class provides low-risk diversified exposure to a broad range of other assets as it tries to replicate hedge fund strategies.
Because of the wide dispersion of outcomes in major asset classes in this atypical investment environment, most of the Island Portfolios are modestly up for the year-to-date. We have outlined some of the major causes of that interim result. We are not alone in this regard, with the Morningstar Moderate Allocation Index, a domestic equity biased index, up an average of 5.9% for the year and down 3.0% for the month ended June 28. The ranges of outcomes for asset allocation portfolios for the year is dramatic, with the best performing funds in the category up 13% and the worst down more than 6%. The World Allocation Fund category has returned 0.4% for the year with the slowest growing fund down 23% and the fastest growing fund up 13%.
As you know, our portfolios are global asset allocation portfolios, and are designed to benefit from economic growth from all segments of the global economy. Most of the time, this structure has worked well and kept our clients in good stead, with recovering equity markets since the Great Recession of 2008 and a generally favorable fixed income environment as interest rates sank to the lowest levels in a generation. In the long term we hold firmly to the reliable formula that long term wealth comes from a well-diversified portfolio of global equities, US bonds, and alternative asset classes.
During the second quarter, in response to and anticipating some of these market changes, we substantially reduced our allocations to gold and commodities, emerging markets equity and fixed income, REITs, long duration US fixed income, and similar assets that have grown temporarily out of synch with the realities this year. We also have shortened the duration of our US fixed income portfolios so that we secure some protection from any future interest rate increases. Right now, we are in protection mode, as the long anticipated increase in interest rates stemming from the Federal Reserve’s curtailment of quantitative easing seems more certain for the end of 2013 or beginning of 2014. This will likely lead to a continuing correction in the fixed income markets, and we have modeled this scenario in our portfolio optimization so that the current allocations have a heavy bias towards floating rate, mortgage backed, short credit and short duration inflation-protected bonds. This allocation should serve us well if fixed income markets continue to swoon.
World Economy Summary
The US remains in the late stages of a weak economic recovery and we expect growth to remain in the 2.0% to 2.5% range for the year with modest improvement in GDP growth to 3.0% in 2014 and 2015. Recent data has sent mixed signals, with consumer sentiment gaining some momentum and housing in rapid recovery, albeit from a low base. However, manufacturing has declined and the labor market remains stubbornly weak with sticky unemployment rates in the mid-seven percent range.
European economies remain in recession, despite the ECB’s stimulus, and slowing GDP growth in emerging markets economies has lowered investor expectations for long-term investment returns. Japan’s expansionary monetary policy has dramatically improved Japanese consumer confidence but it is too early to tell whether this ‘doubling down’ on sovereign debt can lead to meaningful long term growth.
For more economic commentary, please review our second quarter update, which will soon be available.
The Case for Global Investing
With this backdrop in mind, we think it important to restate why we remain steadfast in our commitment to the wisdom of global investment. There is a large body of theoretical and empirical knowledge that supports global equity investing. Diversifying into non-US equity investments has helped to reduce portfolio risk over long periods of time. Markets have tended to become more integrated. National economies have become more closely linked, due to more international trade, increased investment flows and reciprocal international financial transactions. Some of the influences that contribute to increased market integration include: advances in information technology, development of global and multinational companies and organizations, deregulation of the financial systems of the major industrialized countries, explosive growth in international capital flows, and abolishment of foreign exchange controls. Individual asset classes may rise and fall in the short term, but the stability of the diversified global approach is solid and unquestioned for the long haul.
For many years, investors have invested globally in order to better manage the risks associated with investing and to seek higher reward by investing in faster growing economies in emerging markets. Most of the time, this strategy has resulted in better risk adjusted returns for the global investor than for the purely domestic investor. Investing in foreign equities became prevalent in institutional markets in the early 1980s. Investing in emerging economies became increasingly possible beginning in the 1990s. The long term impact of global investing, including emerging markets, has been to improve risk-adjusted performance over the last decade.
Going forward, we will remain globally invested. Our base allocation to equities remains at a 60% U.S. Equities, 30% International, 10% Emerging Markets allocation, which is a portfolio with a modest home bias from global market capitalization. We allow our portfolios to stray from these allocations by up to 20%, however, so that we can react to changing market environments. At this writing, we are modestly underweight in international equities relative to their domestic counterparts, while we have reduced our emerging markets exposure from previous levels. We remain invested in each of the market segments, however. We will be writing more on this topic in the next weeks and months.
We believe strongly that process, method and disciplined approaches to portfolio management, using proven techniques and tools to manage exposure to many asset classes, is the best road to grow and maintain wealth in the long run. Disciplined process reduces the risk of over-reacting to anomalous market events, but gives us the ability to react thoughtfully to changes in investment sentiment and regime change.
Our investment methodology emphasizes quantitative principles, proven investment practices and advanced statistical techniques, while accentuating asset allocation as the most important determinant of long-term success in investment planning. This approach is designed for the long-term investor. Our estimates of capital and security market expected returns and risks utilize advanced investment and predictive statistical techniques to optimally combine historical information and forward looking estimates. Effective forward looking estimates provide a consistent framework for incorporating new information into the investment process. In addition, our portfolios are constructed using patented portfolio optimization technology that is commonly identified as the most advanced commercially available framework available to institutional investors. Our expert knowledge of this portfolio construction technology is a unique and valuable additional benefit of working with Island Light.
For more information about our portfolio construction and investment methodology, or for further information regarding any of our portfolio construction, tactical overlay, estimation methods, performance information or anything else that comes to mind, please contact us at 508-687-0061 or email us at We are always ready to hear from you.
Matthew V. Pierce, President