Investment Review and Outlook

Summer 2014

Asset classes across the board rose in the second quarter, despite lackluster global economic growth, an uncertain outlook for global monetary policy, and geopolitical tensions in Ukraine and Iraq. This reinforces that markets and the economy are not one and the same. In economic news, U.S. GDP growth was revised further downward for the first quarter, marking the largest drop since the first quarter of 2009. Other indicators were more positive, including continued improvements in the labor market.

As long-term investors, we are comfortable with the risk and return tradeoffs in the current economic environment. Patience and discipline are particularly critical now, even if over the shorter term it may not seem so as markets continue to hit new highs.

Investment Review & Outlook

For the quarter, large cap U.S. stocks were up 5.2%, small cap stocks lagged their larger-cap counterparts but were still up by 2.1%, and developed international stocks gained 5.0%. Core investment-grade bonds earned nearly 2% for the quarter, as Treasury prices rose and bond yields continued to fall.

Surprisingly Low Volatility

One thing that stands out about the past quarter amidst the record-setting highs of the S&P 500 is the very low stock market volatility. The VIX, a volatility index that measures expected 30-day volatility of the S&P 500, had dropped to 10.6 by late June, a level last seen in February 2007.

While low volatility and high stock prices reflect the market’s apparent lack of concern about risk—including a belief that the Federal Reserve will continue to support financial markets with accommodative monetary policy—this seeming complacency suggests a market more vulnerable to negative surprises.

The more investors are expecting and positioning portfolios for a benign or optimistic environment—using leverage and pouring money into riskier and/or less liquid assets to ramp up their near-term returns—the more likely it is that there will be a negative shock relative to these market expectations.

A wildcard to the disruption of the market’s calm is a geopolitical shock. But even with this year’s events in Ukraine and the sectarian violence in Iraq, markets have remained relatively calm.

Inflation vs. Deflation

Away from the geopolitical realm, a deflationary or inflationary surprise could be disruptive. In Europe, core inflation fell to a low year-over-year rate of 0.7% in May. In June, the European Central Bank initiated new monetary policies in an attempt to help reflate the economy, and also signaled that it would act more aggressively, if necessary, to prevent a deflationary shock in Europe from happening.

In the U.S. economy, deflationary and inflationary risks are more balanced. In her most recent policy statement, Federal Reserve Chair Janet Yellen expressed little concern about the recent uptick in inflation, referring to the short-term inflation data as “noisy.” Central bank policies have been a huge driver of financial market returns in recent years, e.g., driving down bond yields and pushing up stock market valuations. Monetary policy remains a key uncertainty, and its impact—both intended and unintended—on the markets and the economy must be taken into account in managing investment portfolios.

Macroeconomic Outlook

We continue to see the U.S. and global economies on a slow path of recovery from the 2008 financial crisis. Private sector balance sheets continue to strengthen, reflecting the U.S. household and financial system deleveraging that has occurred since 2009. This lessens the odds of another financial crisis.

Significant risks remain, however. In addition to global central bank policy and European deflation, another disruptive is the unwinding of China’s credit bubble. Inflation is a risk, given the recent increase we have seen in the United States over the past quarter and the strengthening (although still not strong) labor market, which at some point should start pressuring wages higher. Improved wage growth should be beneficial for consumer spending and the overall economy, and Yellen has explicitly said she wants to see higher wage inflation.

We see risk of the Fed overshooting in terms of accommodative monetary policy, keeping rates “lower for longer,” and allowing inflation to move above the 2% long-term target. This strikes us as a bigger risk than the Fed tightening too soon and snuffing out the tepid economic recovery.

Our Portfolio Positioning

The music is playing, the punch bowl is out, and the equity markets are dancing to the central banks’ tune. This party may continue for several more months or quarters. While inflation risk has increased at the margin, we have not made any portfolio changes because we don’t view the change in inflation risk as significant. Importantly, we have already positioned our portfolios’ bond allocations for the likelihood of rising interest rates.

Overall, our bond-oriented portfolios continue to be somewhat defensively positioned, with a significant underweight to core bonds in favor of short-term fixed income securities. Clients hold short-term bond funds to achieve a stable real return in excess of the rate of inflation, a flexible, absolute return-oriented fixed income fund to actively mitigate downside risk, and, where appropriate, muni bonds for clients in higher income tax brackets.

Closing Thoughts

Our client portfolios are positioned based on each client’s risk tolerance. In the current low-volatility, low-yield, high-price-to-earnings environment (where investors aren’t getting much in return potential for taking on risk), we don’t see any asset classes offering compelling fat-pitch returns relative to their risk. Instead, this remains a period in which patience and discipline are particularly critical, even if over the shorter term it may not seem so as markets continue to hit new highs.

There is a powerful behavioral inclination to chase markets and asset classes that have already performed strongly. Our investment process and discipline is based on longer-term analysis of fundamentals and broad, global diversification informed by economic and financial market history and cycles. This investment discipline has served our clients well over our firm’s 15-year history.