In May of this year the S&P 500 Index reached at an all-time high.  At that point, the index had already generated a 17% total return for the year.  The move upward for equity markets was remarkably steady.  The S&P 500 advanced for more than six months without a 5% correction.

The calm disappeared in late May, when Federal Reserve Chairman Ben Bernanke hinted that the Fed’s current bond buying program would begin to be “tapered” in the near future.  What happened next has been described as a “taper tantrum” by both the stock and bond markets which have become “addicted” to historically low rates.  The charts below show key trends during the quarter.

The 10-year Treasury note traded below a 2% yield on the day before Bernanke’s testimony.  Since then, the yield on the 10-year Treasury bond increased to as high as 2.66% and closed the quarter at 2.48%. In the weeks following Bernanke’s testimony the S&P 500 declined by 5.8% to its lowest level of the quarter on June 24.  After seeing how the markets reacted very negatively to Bernanke’s speech, the Federal Reserve went into “damage control” mode, with many Governors then making comments that suggested that the Federal Reserve was going to be very slow and careful when reducing or “tapering” the stimulus program.

Despite the Fed’s efforts to calm the markets, higher rates caused bond prices to drop, and investors yanked a record $60 billion in June from bond funds.  The volatility put a damper on quarterly returns, as shown in the following table.

Total Returns: Major Indexes for Periods Ending on June 30, 2013

The sudden increase in interest rates and bond fund outflows created losses in the bond market.  The Barclays Aggregate Bond Index, the broadest benchmark of the U.S. bond market, produced a loss of 2.3% for the second quarter and a loss of 2.4% for the first six months of 2013.  The yield on the 10-year Treasury bond ended the quarter at 2.48%, up sharply from 1.85% at the end of March and from 1.76% at the beginning of the year.  The likelihood that interest rates will continue to increase, especially as the Fed curtails its bond buying program, makes longer-term fixed income investments unattractive.  A rising interest rate environment will also create a headwind for stocks.

While U.S. stocks have produced very strong returns over the past three years and have recently reached new record levels, international markets have struggled.  GDP growth in both developed and emerging markets has been disappointing in 2013.  Europe is in a recession, with GDP declining for the sixth consecutive quarter for the block of 17 countries that use the euro as their currency.  While emerging market economies are forecasted to grow 5.3% in 2013, this is a much slower pace than most of the past decade.  Considering the long-term prospects for strong emerging market growth, this sector of the market appears to be attractive based on most valuation metrics.

Bernanke suggested the tapering could be expected due to an improving economy so apparently, good news for the economy can be bad news for the stock market when it causes rates to rise.  In fact, most economic indicators point to a slow but steady economic expansion.  Pending home sales in May reached a six-year high.  Auto production is now running at an annual rate of 15 million vehicles, up from 9 million at the bottom of the recession.  U.S. oil production increased at its fastest rate in decades. GDP grew a modest 1.8% in the first quarter, just below its 2.0% average since the beginning of the expansion in July 2009.

It is likely that quantitative easing had the effect of inflating asset prices, in particular home prices and stocks.  Lower interest rates kept borrowing costs low making it easier to buy a home.  Lower rates also made stocks more attractive when compared to lower-yield fixed income securities.  (While increasing the value of homes and stocks was not a stated objective of quantitative easing, the increase in household wealth helps to stimulate the economy and reduce unemployment.)  With quantitative easing winding down, there should be less upward pressure on asset values.  .

Despite rising stock and home prices, overall inflation remained below the Fed’s target of 2%. The price of gold has continued its decline, despite the concern that the Fed’s monetary easing would spur inflation and debase the US dollar.  At the end of the quarter, gold was $1239/oz, down 35% from its peak of $1921/oz in September 2011.  Higher interest rates and greater economic stability have made the metal less attractive.  We continue to avoid precious metals for now.

Considering that the major U.S. market indices have already produced double-digit gains in 2013 and that interest rates appear to be increasing, it would not be surprising to see stock performance moderate in the second half of the year.  Further market gains will likely require continuing positive developments in the U.S. economy, signs of a turnaround in Europe, and stronger growth from emerging markets.

Please contact us if you have any questions about the markets or your accounts.

— Tom Franks & Kirk Weiss