The S&P 500® Index rallied during the last three weeks, closing at 1682 today, but between May 22 and June 24 it declined –7.5%. The price of the 10-year U.S. Treasury note dropped a similar –7.4% between May 22, when it fetched 98.77, or $987.70 per $1,000 in par value, and July 5, when it fetched just 91.50. The 10-year note closed today at 93.18. The price volatility in both the stock and bond markets was induced by Federal Reserve policymakers, who said the central bank may reduce the amount of its monthly bond purchases, or "quantitative easing," in 2013 and terminate the program by mid-2014, in part due to strengthening U.S. economic data. As my colleague Rex Macey pointed out in the June 17 edition of Market Notes, "Early signaling of Fed intentions may mean less disruption or volatility for markets than an abrupt change when the time for change arrives."
If investors, bank depositors, and borrowers finally see "normal" interest rates in 2015, or at least some hikes in the Fed's short-term interest rate target, which has been 0.00–0.25% for years, then 2013 likely represents a "transition year." An era of exceptional liquidity may be drawing to a close. Another reason for the early signaling of Fed intentions may have been to deflate speculative excesses. As far back as early February, Fed Governor Jeremy Stein cited over-heated speculation in high-yield bonds and some real estate investment trusts. The Fed can't be too displeased with recent developments: an important signal has been delivered to investors and some speculative excess has been removed from markets. At the same time, inflation expectations have declined, the real (inflation-adjusted) yields of some fixed income securities have moved from negative to positive territory, the U.S. economy has improved, and both equity and Treasury prices have rebounded from recent lows, albeit induced by Fed policymakers' assurances that easy-money policies will be maintained for some time. Also, the continued absence of global wage pressures provides monetary officials breathing room to maintain stimulative economic policies.
What do these recent development mean for investors? Although higher rates do not bode well for bond investors in the short term, equity markets could handle rate increases, provided they are gradual and accompanied by rising corporate earnings. Continued economic weakness in Europe, inflation-fighting measures in Brazil and India, and attempts by Chinese officials to reign in credit excesses may provide the backdrop for measured rate increases.
One near-term risk: Behavior of bond fund investors
According to New York City-based Empirical Research Partners, retail investors have poured over $1.3 trillion over the past 4 ½ years into bond mutual funds and exchange-traded funds, the bulk of which was invested when the 10-year U.S. Treasury yielded less than 3.0%. Empirical Research points out that although fund flows do not determine asset prices, crowd behavior in this case could materially affect the pace of change in asset pricing. The Barclays Capital U.S. Aggregate Bond Index, which tracks the overall domestic market of taxable, investment-grade bonds, has recorded negative quarterly total returns very infrequently since 1990. The second-quarter 2013 return of –2.4% may create additional bond market pressures.
International markets show signs of stabilizing
The late May increase in U.S. interest rates and the ensuing appreciation of the U.S. dollar precipitated an exodus from international markets, especially from emerging markets, to the United States. This outflow, which continued well into June, led to significantly negative equity returns for developed markets and even weaker results for emerging markets. However, international equities showed tentative signs of bottoming, if not reversing course, during the first two weeks of July. Contributing factors to the upturn included a modest decline in U.S. bond yields coupled with some depreciation of the dollar. There are country-specific factors as well.
The MSCI EAFE Index, which includes developed markets other than the United States, returned 4.4% month-to-date through July 12. A significant contributor to the positive EAFE return was Japan, where the central bank continues to expand its balance sheet. The MSCI Japan Index returned 5.8%.
With the European Central Bank and Bank of England now providing Fed-style, forward interest-rate guidance, the MSCI Euro Index and MSCI United Kingdom Index returned 3.7% and 5.0%, respectively.
Emerging markets also participated in the international rally, but to a lesser degree than developed markets. The overall MSCI Emerging Markets Index returned 0.7% month-to-date through July 12. Contributing to positive emerging-market performance since July 1 has been the Chinese authorities' easing of the liquidity crisis they engineered to discourage imprudent lending. As a result, since July 1, the MSCI China Index returned 1.2%. The Indian authorities took measures to slow further appreciation of the rupee; this helped produce a 2.5% return for the MSCI India Index. Additionally, the increase in oil prices due to the political events in Egypt enabled Russia to return 6.1%. Detracting from emerging-market performance was the Central Bank of Brazil's increase in short-term rates to tame rising inflation. Brazil has returned –4.4% from July 1 through July 12.
It is encouraging that the negative emerging-market returns of late May and June did not persist into the first two weeks of July. Nevertheless, at this juncture, it is not possible to project, with a high degree of confidence, either a positive or negative trend going forward.
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