It’s been a fairly eventful couple of months in the investment markets, highlighted by a marked increase in volatility and, for the month of June, negative returns across virtually all major asset classes. Much of this was driven by discussion of the possibility of sooner-than-expected tapering of quantitative easing efforts by the U.S. Federal Reserve and a sharply slowing Chinese economy. As a result, bonds and emerging market stocks felt the brunt of the relative weakness.
While July has seen a welcomed easing of interest rates and a sharp bounce in equity markets, given this volatility and broad macro events, some perspective of recent events is worthwhile as it highlights reasons for some of our recent strategies and the adjustments we continue to make in order to position our clients’ portfolios for the months and years ahead.
What Happened to Bonds and Emerging Markets in Q2 2013?
The increased chatter of the Fed tapering QE sooner rather than later rattled investors and caused interest rates to rise sharply. Since early May, the yield on the benchmark 10 year U.S. Treasury note backed up over 100 basis points, going from about 1.60% to nearly 2.60% in June. This had a dramatic negative impact on bond prices and investors with longer duration portfolios experienced declines.
In the second quarter of 2013, many domestic bond indices were down 2%-3%, bringing year to date returns into negative territory. International bonds, particularly those focused on emerging markets, were hit hard from both rising rates and recent U.S. dollar strength and were down over 3% for the second quarter, bringing year to date losses to almost 6%.
This rise in interest rates helped shift investors away from “risk” and increased broader economic concerns (i.e. the impact of higher mortgage rates), causing global stock markets to suffer in June as well. Emerging market stocks suffered the most as, in addition to higher rates and a stronger U.S. dollar, investors wrestled with the likely impact of what looks to be a sharply slowing Chinese economy.
How Have We Positioned Our Clients’ Portfolios?
While the likelihood for interest rates to drift higher seemed obvious, this recent move happened in fairly dramatic fashion. The Fed’s tapering comments caught many bond investors by surprise which never makes for steady markets. With interest rates being so low for so long, the temptation of many over the past few years – particularly “retail” yield seekers – has been to reach for yield by extending maturity and taking on greater credit risk. Many mutual funds and ETFs focused on longer-maturity bond investments experienced losses approaching double digits through the first 6 months of the year and even bond “gurus” like Bill Gross suffered with his largest fund, The PIMCO Total Return Bond Fund, which experienced losses over 3% through June.
Given that our biggest concern for bonds has been the risk of rising rates, we have positioned our clients’ portfolios in shorter-term municipal and corporate bonds with diversifying assets such as mortgages (i.e. DBLTX), senior-secured bank loans (i.e. EIBLX, FFRHX) and non-dollar emerging market debt (i.e. ELD). While these assets may sometimes experience more individual volatility, as a group we believe they reduce the risk of the portfolio as these securities are positioned to perform well in rising rate environments. The chart below highlights the municipal and treasury yield curves as of June 30th and the beneficial yield/duration relationship of some of the other assets we have included in client portfolios.
This strategy offered the benefits of not only keeping duration much shorter than the benchmarks to mitigate the risks of rising interest rates, but also increasing the portfolio yield and total return opportunities. As a result, the duration of our clients’ portfolios has been roughly half that of key benchmarks (i.e. Barclay’s Muni Bond or Barclay’s U.S. Credit) and therefore experienced more modest impact when interest rates spiked.
The result of this strategy proved favorable in the second quarter versus the larger declines of the U.S. Muni and U.S. Credit indices (-2.7%) and Barclay’s International Bond index (-5.9%). Within client portfolios, emerging market bonds have been a notable weak spot, given both the rise in rates and strength in the U.S. dollar, offsetting most of the gains they have accumulated since last summer. Mortgages (DBLTX) also gave up some recent gains but, with the offset of the coupon income, were down only about 0.4% year to date through June. Senior-secured bank loans, which actually benefit from rising rates, remain a positive return bright spot with gains of nearly 3.0% for the first six months of the year.
We continue to focus on growth in emerging markets (EM), both directly (by investing in well-positioned U.S. multinational companies such as consumer product names like Pepsi, McCormick & Colgate, all of which reap the benefits of their overseas operations) and through exchange traded funds (ETFs). Many of the ETFs we have utilized for direct EM exposure have weighed down overall growth returns in the first six months of this year given the challenging headlines (i.e. China risks, mobs in Brazil/Turkey, coups in Egypt, etc.). By design, our overall emerging markets exposure continues to be a much smaller part of growth portfolios than our U.S. stock selections – which are approximately three times the size of emerging market exposure in growth portfolios – and which continue to perform very well, helping to offset the weaker returns from EM.
What is Crestwood Doing Now?
Within client bond portfolios, our earlier adjustments and diversified strategy have together served clients well and we remain comfortable with the current positioning. While we would much rather have strong positive returns from bonds, we are pleased the that the shorter-duration portfolio strategy is performing as designed and protecting client portfolios, especially given the sharpness of the recent move higher for interest rates.
As for emerging markets, while the near term headlines, particularly those from China, will continue to be of concern, we think current valuations reflect these risks and we believe that exposure to this asset class will be a significant contributor to portfolio returns in the years ahead. With the secular growth in EM still very much intact, we have been using the recent weakness and volatility to more favorably reposition our holdings. Specifically, we have shifted the exposure to take advantage of both cyclical companies benefiting from longer-term industrialization and consumer-focused companies benefiting from the rising standards of living and greater discretionary incomes. We believe this approach will lead to more favorable results with less volatility in the years ahead.
Our current portfolio of individual stocks has performed well this year, though this asset class is also not immune from challenges. Many of our existing stock holdings are getting close to valuation levels where we would consider trimming or selling the position, and viable options for replacement remain scarce. This is mainly a function of weak fundamentals underlying the economy paired with strong market returns driven by easy money from the Fed. The result is valuation multiples that have risen significantly. While the U.S. stock market seems ripe for a pull-back, we believe that this environment of stock gains with slowing fundamental support can continue for some time, especially if the Fed continues on the QE path. With that in mind, we are being judicious about allocating client capital to new equity investments and we are maintaining our exposure to high quality companies that are leaders in secular growth industries.
We continue to focus on the segments of the economy that are bright spots. These include the recovering housing market and a hardening pricing environment in insurance. We believe these strategies will allow clients to participate in the rally while mitigating potential downside if fundamentals again begin to rule the day. While July has provided investors with a sharp bounce in global stock markets, this certainly is a time of rising investor anxiousness. Our disciplined approach, exemplified by the thoughtful portfolio adjustments described above, will allow us to successfully navigate the inevitable bumps experienced in investment markets.