Investment Review and Outlook

Summer 2013

All of us could benefit by examining our inclination to invest with our hearts rather than our heads, especially when it comes to gold.

During the second quarter, investors reacted to comments from Fed policymakers indicating the Fed might begin reducing its bond buying program sooner than had been expected.

U.S. stocks suffered losses in June but ended the quarter with gains. Core investment-grade bonds fell 2% for their worst quarter since 2004. Other interest rate sensitive asset classes such as REITs were negative as well.

Our portfolios are positioned for a rise in interest rates (and a decline in bond prices), reflected by our underweight to core bonds and overweight to flexible/absolute return-oriented bond strategies. Our fixed-income positioning added value again this quarter.

 

Investment Review and Outlook

This quarter we examine the recent rush to invest in gold, and the resulting investment returns. We also discuss Federal Reserve actions and the poor performance of bonds and emerging markets during the second quarter.

Benchmark Returns

Benchmark Funds	Q2 2013	12 Months Ending 6/30/2013
U.S. Large Cap Vanguard 500 Index Fund	+2.9%	+20.4%
U.S. Large Cap Value iShares Russell 1000 Value Index	+3.1%	+25.0%
U.S. Small Cap iShares Russell 2000 Index	+3.1%	+24.3%
U.S. Small Cap Value iShares Russell 2000 Value Index	+2.4%	+24.6%
International Vanguard Total International Stock Index Fund	-3.3%	+13.5%
Emerging Markets Vanguard MSCI Emerging Markets ETF	-8.4%	+1.5%
U.S. REITs Vanguard REIT ETF	-1.6%	+9.0%
Investment-Grade Bonds iShares Core Total U.S. Bond Market ETF	-2.4%	-0.8%

Two market developments during the quarter are noteworthy: the spike in Treasury bond yields, and the sharp decline in emerging-markets stocks and bonds. Statements from the Federal Reserve about the future course of monetary policy and the Fed’s plans to begin “tapering” its quantitative easing bond-buying program both drove these developments to varying degrees. As we’ve discussed recently, the markets continue to have an unusually strong sensitivity to both real and perceived changes to monetary policy in the aftermath of the 2008 financial crisis.

A short-term speculative approach is not part of our investment discipline nor is it likely to yield consistent, sustainable success for most investors.

Interest Rates Spike Higher

Chairman Ben Bernanke indicated on June 19 that the Fed might begin to taper the pace of monthly bond purchases sooner than expected. This resulted in a bond market sell-off, with the yield on the 10-year Treasury bond rising from a year-to-date low of 1.63% on May 2 to 2.6% on June24, its highest level since early August 2011. It ended the quarter at 2.5%. (As a reminder, bond yields rise when prices fall.) U.S. stocks also fell, but rebounded fairly quickly.

Thirty-year fixed mortgage rates, which are a specific target of quantitative easing (QE), also jumped sharply. Thus, the Fed’s optimism about economic growth/recovery (which led Fed policymakers to conclude they could begin ending QE) might in fact become a headwind to that growth. Rising borrowing costs and falling asset prices could short-circuit the economic recovery and, in turn, the tapering process. This is just part of the broader challenge the Fed faces as it tries to unwind its unprecedented post-crisis monetary policies without causing any major market or economic disruptions. At best, we are confident in saying, the “exit” will be a very bumpy road, with meaningful risks of policy errors and unintended consequences.

Emerging Markets Bonds and Stocks Sharply Declined

Last quarter there was a sharp sell-off in emerging markets stocks and emerging markets local-currency bonds. While there were numerous drivers of this underperformance, the rise in interest rates in the U.S. and the Fed’s tapering announcements were key factors. Along with news that the Japanese central bank was not planning to further expand its own QE program, these developments triggered a general unwinding of the “carry trade” in which investors (mostly short-term traders and hedge funds) borrow the currencies of countries with low-yielding debt and/or depreciating currencies and invest in higheryielding/appreciating currency investments, such as emerging markets local-currency bonds. As the carry trade unwound, prices on emerging markets local currency bonds dropped, yields rose, and emerging markets currencies depreciated against the dollar. Thus, emerging markets local-currency bonds were hit with the double whammy of falling bond prices and falling currencies.

Emerging markets stocks were also affected by worries about reduced central bank liquidity, ongoing concerns about a general slowdown in emerging markets growth, and disappointing economic data out of China. In contrast, investors seemed to be getting more optimistic about economic and growth prospects in the U.S.

Bond Positioning and our Long-Term Performance Expectations

For the past few years, the fixed-income portion of our balanced portfolios has been positioned for what we expect to be a longer-term trend of rising interest rates. We have been tactically underweight to core bond funds and have a large allocation to more flexible, unconstrained and/or absolute-return-oriented fixed-income funds.

As a result of this positioning, our fixed-income portfolios held up better than the bond benchmark through the sell-off in the core fixed-income markets. Although our portfolios are underweight to core bond funds due to our expectation for a sustained period of rising rates, we have maintained some exposure to core bonds in our bond-oriented portfolios as a hedge against an economic downturn, deflation, or some unforeseen event that would lead to increased risk aversion among investors and a flight to quality assets (as core U.S. bonds are traditionally perceived to be). One of our actively managed core bond fund holdings, PIMCO Total Return, trailed the benchmark in the second quarter, hurt by its exposure to emerging markets bonds and TIPS. However, our overall domestic fixed-income positioning added value again for the quarter versus the benchmark. This has also been the case over the longer-term, multi-year periods that we’ve owned these alternative bond funds.

Concluding Comments

We will remain disciplined and patient in order to allow our investment decisions to ultimately pay off, as we have seen happen repeatedly over the long term.