As we move toward the half-way point of 2014 the financial markets have provided some interesting results so far.
Global equities have continued to move higher with one notable exception – U.S. small caps – on the expectation that economic growth will improve as the year unfolds. Although (as of the end of May) the U.S. S&P 500 Index has logged the highest return year-to-date since the end of the first quarter, international stock markets have out-performed U.S. benchmarks. Valuation differences are not in themselves a catalyst for trend change but they do mark differences in return potential. We think the discount available with international markets compared with U.S. stock levels – particularly in the emerging markets – reached extreme levels early this year, driving capital into those markets. The pullback in U.S. small cap stocks was also likely driven by relative valuation; however, in this segment of the market, valuations had reached historically high levels relative to their own history – as well as compared with their large cap brethren – and investors have taken some profit.
The real surprise so far this year is the rally in high quality bonds, particularly U.S. Treasury securities of intermediate and long-term maturities. Back in December and early January expectations were wide-spread that yields would likely move higher throughout 2014 with the Fed tapering and the economy improving but the opposite has transpired. The benchmark U.S. Treasury 10-Year Note yielded near 3.00% to start the year, today the yield stands at roughly 2.50%. Credit spreads for investment grade bonds have also tightened as demand for yield has been consistently strong – particularly in municipal bond markets.
So what changed? At the beginning of the year expectations were high for acceleration in global economic growth. Through the first five months of the year the actual results have been less than convincing. The chart below shows U.S. GDP which actually shrank by 1.0% in the first quarter. Although some of this weakness can be explained by the harsh winter weather experienced by much of the country, there have been other factors that have not developed as expected; in particular: acceleration in business capital investment, consumer spending and export growth.
Since the end of March the majority of economic data has come in slightly better than forecast, indicating that the global economy has gotten back on track. Whether this is the early stages of a sustained period of faster growth or just a spike caused by pent-up demand is still in question.
In the near future we will be paying particular attention to economic data points that provide evidence of the pace of underlying growth. This in turn will help drive tactical decisions in portfolio allocations. Today, we are being very selective and cautious with both bond and stock investments but we are positioning ourselves to take advantage of buying opportunities. If one asset class falls out of favor it may provide more palatable entry levels for long-term investors.
We’ll keep you posted throughout the coming weeks as data is available and trends emerge.
Jack E. Payne, CFA, CFP
Chief Investment Officer