Dear Friends and Clients:
While the past quarter was the most volatile three months in the global financial markets in quite some time (and particularly difficult for bonds), it is actually a return to more normal levels of market volatility. In this letter, we summarize our views on two key developments from the period: the rise in interest rates and the declines in emerging-markets stocks. Both developments are important from a big-picture perspective and in relation to our portfolio positioning and long-term return expectations.
Please note that we will be providing a much more intimate and personalized discussion of our views and current strategy at our annual Half Time Report scheduled for August 9, 2013. We hope you will join us. To register, simply click here: http://events.constantcontact.com/register/event?llr=nva5z8dab&oeidk=a07e7mmn2or6b890347
Our Perspective on the Quarter
After a relatively smooth ascent for most markets during the year's first quarter, volatility returned to global stock and bond markets during the later stages of the second quarter. U.S. stocks experienced their first monthly decline of the year in June, though they still managed to gain nearly 3% for the quarter and were in that sense an outlier, as most other asset classes were down for the quarter. Developed international stocks were down slightly for the quarter while emerging-markets stocks posted larger losses amidst concerns about a general slowdown in emerging-markets growth and disappointing economic data out of China. Also, bond prices declined in May and June on concerns about changes to Federal Reserve policy.
Given our focus on multi-year timeframes, we typically spend very little time discussing short-term performance. However, as mentioned, among the second quarter's trends were two developments that we think are worth reviewing more closely: 1) a spike in bond yields, and 2) a decline in emerging-markets stocks.
As you may know, we significantly reduced the durations of our bond holdings at the end of 2012 in anticipation of a rising interest rate environment. Specifically, we under-weighted intermediate term bonds (5 - 8 year durations) and over-weighted short term high quality bonds (durations of 2 years or less) with roughly 75% of our bond allocations. This shortening maneuver helped position our portfolios to better withstand rising rates (which hurts bond prices). Nonetheless, the declines in TIPS (Treasury Inflation Protected Securities) and in emerging markets stocks hurt our quarterly results. While painful, we view these declines as temporary and, accordingly, we are adding to these positions via our rebalancing activities.
Both of these developments connect back to concerns about the future direction of Fed policy and the uncertainty over what will happen as the Fed slows its monthly bond purchases and begins to exert less influence on interest rates. As we've noted, current Fed policy of "repressing" interest rates to all-time lows has lured investors out on the risk spectrum in search of higher returning, though riskier, asset classes. In our view, this has provided a significant boost to the U.S. stock market.
On June 19, Fed Chairman Ben Bernanke indicated that the Fed might begin to "taper" the pace of monthly bond purchases sooner than expected. Despite Bernanke's best efforts to manage market expectations and communicate that a potential tapering does not mean an actual tightening of monetary policy, investors responded with alarm. This resulted in an overall decline in bond prices and increase in bond yields. The yield on the 10-year Treasury bond rose from a year-to-date low of 1.6% on May 2 to 2.6% on June 24, before ending the quarter at 2.5%. Meanwhile, U.S. stocks also fell but rebounded fairly quickly. Higher U.S. interest rates and the Fed's tapering announcement were also cause for concern within emerging markets.
Our Positioning and Outlook
Our scenario-based approach takes into account many potential five-year environments including rising interest rates and short-term stock market declines. As a result, recent events have not materially changed our longer-term views or risk assessments and our portfolio positioning has not changed. In fact, we view the recent declines in emerging market stocks and in TIPS as buying opportunities that we are capturing by rebalancing portfolios to lock in gains in US stocks and acquire shares of emerging market stocks and TIPS at today's lower prices.
As we've previously written, the recent spike in interest rates is consistent with our longer-term expectation that rates will rise and that returns on longer dated bonds will be muted. As a result, the fixed-income portion of our balanced portfolios has been positioned for a long-term trend of rising interest rates. Importantly, three-quarters of our bond holdings consist of short-term, high-quality bonds so that our bonds fulfill their primary role of supporting your portfolio during stock market declines.
Overall, this positioning benefited our portfolios last quarter as bond prices declined and rates rose. Nonetheless, we saw declines in our TIPS position (DFA Inflation Protected Securities fund) which is the longest duration bond position we hold (DIPSX has an average duration of 8.3 years). We are using TIPS as an inflation hedge and while TIPS have not had a good year (down 8.16% YTD as of June 30th), other inflation hedges such as gold and silver have fared far worse. Gold was down 28% YTD as of June 30th and silver just posted its largest quarterly loss since 1980. Neither metal made (or has ever made) an interest or dividend payment. And, unlike gold or silver, the principal value of every Treasury Inflation Protected Security is guaranteed to be repaid, in full, at maturity, by the U.S. government. So, while the past quarter reminded us that TIPS carry interest rate risk, it is important to remember that TIPS do not carry credit risk (other than default by the U.S. Government - which we deem extremely unlikely).
While we continue to expect interest rates to move higher over the long term, we do not try to predict when that may happen or what the trigger might be. We don't think anyone can get this type of prediction consistently right. In fact, many bond experts believe that we could see rates ease back down in the near term. It is also possible that short-term market momentum and investor sentiment could drive rates higher in the near term, in which case we'd expect our overall fixed-income position to continue to perform relatively well.
With regard to emerging-markets stocks, we believe the markets are over emphasizing short-term concerns and giving less weight to the longer-term positive economic fundamentals and the potential for attractive absolute returns in this asset class. We continue to view emerging markets as attractive on a risk/return basis. Therefore, we are maintaining our full position in emerging-markets stocks and are adding to this asset class through our ongoing rebalancing activities.
So, market volatility has returned to more normalized levels. This does not mean we are entering another 2008. Rather than reacting with fear, we think it's wiser to embrace volatility and make the most of it. In fact, we believe this more normal level of market volatility can create good opportunities for objective globally diversified investors. We remain alert for opportunities to rebalance portfolios in order to lock in gains and pick up shares in asset classes that have temporarily declined. All the while, we are focused on two primary goals: managing overall risk and capturing compelling long-term investment returns for you.
Again, we hope you will join us at our annual Half Time Report on August 9, 2013 where we will provide a more detailed discussion and answer all your questions. For more information, click here:
http://events.constantcontact.com/register/event?llr=nva5z8dab&oeidk=a07e7mmn2or6b890347
