Market Review: June 2014
Written by: Steve Osterink, Jr.
By the end of May, the US stock market hit another record high. Now that winter is behind us and world events are less fraught, investors seem more willing to show confidence in the stock markets. However, it is important to note that this confidence should not be interpreted as an increased appetite for risk. Many investors are conflicted about the prospects for the US economy and they are not without justification. The stock market continues to climb, but it is starting to strain credibility. The economic data remains a mixed bag. In addition, the strength of the bond markets, especially in the US, indicates that investors are still carefully controlling the risk in their portfolios.
European stocks did not fare as well. In recent months, poor European performance could have been attributed to the situation in Ukraine, but economic data from the European Union (EU) continues to discourage. Across the EU, the core countries (e.g. Germany, France, etc.) are persevering through the difficult economic climate, but others (e.g. Spain, Greece, Italy) are still struggling.
Prices for consumer goods are starting to fall throughout the EU and threaten to push it into deflation. While falling prices sound like a good thing to individuals, they actually mean that companies are cutting prices in order to generate enough demand to sell their products. Those price cuts eat into profits and also affect the taxes that governments are able to collect from those sales. Understandably, this puts pressure on both the stock markets and the economies of those countries.
Meanwhile, the situation in Ukraine found a bit of equilibrium, although a dangerous one for its citizens. With Russia content to use more subtle forms of influence and Europe rendering economic aid to the tenuous government, the impact of that crisis seems contained for a while. However, this conflict still has the potential to cause more serious issues for the EU, particularly if Ukraine is unable to supply natural gas to the EU during the winter months.
The Chinese economy continues to be a cause for concern, but the People’s Bank of China (PBoC) is doing a skillful job of controlling the fallout of their debt crisis. Bond defaults remain rare and, while lending requirements tightened up smartly, banks are still lending money. We will probably see a few more bumps along the way, but the PBoC gives investors good reason to have confidence in the Chinese economy.
On a more uplifting note, India is riding a wave of optimism after electing a reform candidate, Narendra Modi, who ran on a promise of economic development. In the past decade, India experienced some periods of remarkable growth, in spite of inconsistent or confusion economic policy. Both foreign investors and Indian citizens seem excited by the country’s prospects in the wake of this historic election.
Both US and foreign stocks made gains during the past month, and US stocks pushed to new highs by month’s end. Investors seem content to ride the stock market to its peak, specifically in the US. Foreign equities have outperformed US since the beginning of the year, but have lagged over the last several years. This indicates that the foreign stock markets may not be at such heights compared to the US stock market. The dividend yields reflect this as well. Foreign stocks are paying roughly double that of US stocks over the last twelve months. Emerging market equities have exhibited oddly low correlation to the broader, global stock markets. We maintain exposure to this region, which has paid off since the beginning of the year as emerging market stocks have shown significant performance.
Bonds continue to defy expectations, specifically the higher quality and longer-term sectors. At a time when stock markets are at historic highs, we would expect that money would be flowing out of the bond market and into the stock market. Currently, that does not seem to be the case. This is yet another illustration that diversification is valuable. Our portfolios were able to benefit from the gains in the bond market, while many ‘market timers’ found themselves missing out as they attempted to outsmart the market.
Foreign bonds continue to benefit from the strength of the US bond market. So long as the yields on US bonds remain low, investors will seek out bonds in other markets. In particular, emerging markets bonds become most attractive when investors are struggling to find yield in the US or Europe. Those emerging bonds carry more risk, which may be a deterrent when yield is readily available elsewhere, but they do pay higher interest rates to compensate for that additional risk. Our portfolios have responded exceptionally well to these developments.
Hard assets suffered again in May. The strength of the bond market indicates that many investors are more pessimistic than the stock markets seem to show, but very little of that sentiment is trickling into hard assets.
Physical metals took another hit and finished the month in negative territory again. Regardless, we remain convinced that hard assets are critical, especially as we look forward from this time of equity market highs. We lightened this exposure at the beginning of the year and plan to adjust this as stock volatility rises.
Hybrids are another asset category that has benefited from investors’ uncertainties. By offering characteristics of both stocks and bonds, they allow investors to benefit from certain strengths of both asset categories. While they may not offer the full benefit of stocks during periods of rapid growth, we have been content with the respectable performance and reduced risk. Hybrids have been the single strongest asset category year to date.
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