The Fed’s QE program has continued to play an important role in equity and fixed income markets this year. However, this support appears likely to subside as the Fed looks for signs that the economy is strong enough to begin tapering its bond-buying program. After the June Fed meeting, Bernanke announced the Fed policy had changed from one of unconditional stimulus to conditional stimulus. The S&P 500’s reaction (a 3.9% drawdown) was the largest two day decline of the year. As we noted in our mid-quarter update, we believed this was an overreaction and that nothing had materially changed from an economic perspective.
During the second quarter, U.S. equity markets appreciated despite modest corporate earnings and GDP growth, and in contrast to most other assets classes. For the quarter the Russell 3000 was up 2.7% and 14.1% for the year. The U.S. economy appears to be transitioning toward a more self-sustaining recovery, bolstered by strength in housing, improving employment, and rising consumer confidence. Looking forward for the rest of 2013, we expect continued slow GDP growth and corporate earnings growth, albeit with increased volatility due to fear of or actual Fed tapering.
In International markets, economic performance was also mixed. While Europe remains in a prolonged recession, the MSCI Europe index was only down -0.1% for the quarter and is up 2.7% for the year. Growth rates in several key emerging market nations are slowing. China’s economy grew 7.6% in the second quarter, its slowest pace in three years. This has translated into poor equity performance for emerging markets, with the MSCI EM index falling 7.9% for the second quarter.
In Q2, bonds experienced the worst quarter since the depths of the credit crisis. The Barclays Aggregate Bond index fell 3.3%. TIPS and emerging market bonds were hit hardest, with both sectors depreciating over 6% for the quarter. As we near the end of quantitative easing, we expect interest rates to continue to creep upward, driving bond prices down. This has the potential to boost equity valuation as investors rotate out of fixed income.
Alternative investments delivered mixed results for Q2. Commodities were down during the quarter (the GSCI fell 5.9%) and were challenged by falling demand in China and other emerging market nations. REITS and other income oriented investments were hurt by concerns over future rising interest rates. The Dow Jones REIT index was down 3.3% for the quarter. Hedge fund strategies overall, performed well in April and May, but weak performance in June caused performance to be roughly flat for the quarter. Beta oriented strategies, such as event driven and relative value, performed best, while uncorrelated strategies, such as global macro and managed futures, performed the worst. Private equity continues to benefit from the relatively stable economic recovery and should be positioned to perform well as access to credit becomes more widely available.