Market Comment June 25, 2013

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1 A liquidity shock has rippled through global financial markets over the past month. Markets have reacted to a fragile global economy, the prospect of reduced government stimulus, and a sudden spike in bond yields. Global bond markets have been under pressure amid indications that central banks, most notably the Federal Reserve, are preparing to step back from quantitative easing (QE). Nearly all assets have been falling in tandem, which illustrates how important QE has been to the financial markets, and how difficult it will be for central banks to exit from the policy. Returns Through 6/24/13 Asset Class Last 30 days Year to Date Agency Mortgage Bonds Emerging Markets Government Bonds Long term Treasuries Intermediate Term Treasuries U.S. Corporate Bonds U.S. REITs Gold Foreign Stocks (ex. U.S.) Global Stocks (incl. U.S.) Emerging Markets Stocks U.S. Stocks U.S. Municipal Bonds U.S. Preferred Stocks U.S. High Yield Bonds It is tough to be an asset allocator these days, and maintain a diversified portfolio, when the diversifiers of a U.S. stock-centric portfolio are getting clobbered, with most showing losses year-todate. Diversification is intended to mitigate volatility, but lately it has magnified it. The vast majority of asset allocation approaches are challenged in such circumstances, especially over the past several weeks when virtually everything has gone down at once. Traditional correlations and valuation relationships suddenly break down, and fund redemptions, particularly in non-traditional asset classes, accentuate the dislocations. Copyright 2013 Agile Investments

2 U.S. stocks (the standout asset class for positive returns in 2013) finally succumbed in June to the bearish undercurrent in global financial markets and the sudden spike in bond yields and bond spreads. Ten-year Treasury yields and long-term U.S. mortgage rates have both jumped a full percentage point over the past two months. The strangest aspect of the recent decline in bond prices and the associated rise in bond yields is that it happened in parallel with a sharp drop in inflation expectations (see following chart, which shows the market s expectations of the annual CPI inflation rate over the next five years). The most logical explanation for the sell-off in the bond market is that previously high prices (and low yields) were dependent upon central bank buying, which is now in doubt. Not surprisingly, leveraged carry trades have been unwound. Absent a significant upward shift in inflation expectations, it seems unlikely that bonds will continue to sell off, given that yields are now more attractive and cash deposit rates will continue to be pegged at zero for the foreseeable future. Moreover, there is the possibility that there will not in fact be an exit from QE anytime soon. Agile Investments 2

3 The precipitous drop in emerging markets stocks and bonds in the past month has been disconcerting. Investing in such assets during times like this is psychologically a difficult thing to do. The nature of market psychology around important bottoms is that the bearish case is ubiquitous and the news is decidedly one-sided. The negativity and the recently awful performance become self-reinforcing. Investors should look beyond the immediate bad news, recall the reasons to be exposed to the asset class in the first place, and keep a long-term perspective. Someone selling emerging markets stocks today and redeploying the capital into U.S. stocks is selling a relatively cheap asset class (2013 P/E ratio of 10.4x) and buying a relatively expensive one (2013 P/E of 14.5x). The relative cheapness of emerging markets stocks indicates that markets have already priced in a dramatic change for the worse in the emerging markets backdrop. In light of relatively cheap current valuations and attractive longer-term growth prospects, emerging markets stocks will likely produce the best multi-year returns going forward among broad equity asset classes. But given the uncertainties in the world today, combined with the natural inclination to favor a home bias in one s investments, it is difficult to have a high enough level of conviction in emerging markets assets to add exposure, despite what appears to be a price overshoot to the downside in the recent free-fall. Holding current positions seems to be the best course of action. Turning to the gold market, I had hoped that the selling pressure was exhausted and that a low was in place around the $1325 level, which was tested in both April and May, but the recent break to new lows obviously indicates otherwise. Agile Investments 3

4 The recent jump in real interest rates (bond yields net of inflation expectations) has been a headwind for the gold price, as has the weakness in emerging markets. Gold has been positively correlated with emerging markets. Emerging markets consumers and governments have been a significant source of demand in recent years and now those constituents are facing challenges. Adding insult to injury (from the perspective of a gold investor), India s government has been actively suppressing gold investment, which it unfairly blames for its weak currency, high inflation, and high borrowing costs. It is impossible to know when the selling pressure will exhaust itself in gold. It already looks overdone, but markets have a way of surprising, and going farther than they should. My guess is that there is minimal downside from here, and that inflation expectations are at an interim low and real interest rates are at an interim high. Every asset class, it seems, has issues. In the current environment, with all of the well-publicized risks and uncertainties, it is difficult to say which of the major asset classes will outperform over the next months. The best approach is probably to stick with diversification, and maintain liquidity. U.S. stocks have been the favored asset class, and that trend may well persist. Notwithstanding the correction in the month of June, the strength of U.S. stocks in 2013 alongside what has effectively been a bear market in emerging markets and commodities is impressive. Investors looking to add to U.S. equity exposure on this correction could focus on nearby technical support for the S&P 500 between 1500 and 1550 (see following chart). Agile Investments 4

5 Will the Fed Actually Taper? Fed Chairman Bernanke has stated that the Fed will begin "tapering" its current $1 trillion per year QE program, with the aim of ending it by mid-2014, if justified by additional improvement in the economy. The key, here, is the phrase beginning with "if". In fact, Bernanke was careful to stress that what the Fed does in the future will totally depend on what happens to the economy in the interim. We have seen this movie before with the Fed taking steps toward less accommodation only to return to more accommodation. In short, the Fed will be reacting to financial market and economic events. What the Fed actually does with respect to QE will be dictated by events in the economy and markets it cannot predict. It will obviously be much easier for the Fed to taper its purchases (for example, to shift to a program of expanding its balance sheet by $750 billion per year rather $1 trillion) than end QE entirely. I would heartily welcome an end to QE (and zero percent deposit rates for that matter), regardless of the shortterm impact on the markets and the economy. We still seem to be a long way from that point. Agile Investments 5