3Q 2014 Market Commentary

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Market Commentary
By The Deighan Team

In September, markets stalled a bit limiting the gains for most worldwide stock funds for this past quarter and the year-to-date. US stocks eked out a small gain of 1.1% for the quarter, and most international stocks rose slightly as well. In other asset classes, investment grade bonds were generally flat for the quarter, while long-term Treasury Inflation Protected Securities (TIPS) and high yield bonds both dropped around 2%. Real assets pulled back too: natural resources, lead by oil dropped 7.8% for the quarter; global real estate and global listed infrastructure each pulled back just under 4%. But the biggest loser for the third quarter was gold, dropping 8.4% and wiping out gains for the year to less than 1%. On balance, returns for the year were diminished, but for most asset classes stayed positive. US equities closed the quarter up a solid 8.3%, and most bond results stayed positive in the 3.5% to 4.0% range. Natural resources were slightly ahead at 0.4%, but global real estate delivered a strong 7.2% return and infrastructure registered an impressive 11% gain year-to-date. Only the developed international markets delivered a tiny loss of -0.1% for the year, and that loss was due to an 8% surge in the US dollar that took positive results in local currencies into negative territory by the time they hit our quarterly statements on this side of the pond.

Like parents of a teen delivering a less than favorable report card, a little analysis is in order to understand what the “grades” mean. In short, they mean we are still winding our way out of the woods worldwide. Here in the US, the economy remains uneven, but overall, our economy has improved significantly. Overseas, especially in Europe, some progress has been made, but challenges remain. To help move the economy along, the European Central Bank unexpectedly cut interest rates twice driving Eurozone bond yields lower. Back stateside, the Federal Reserve Bank is moving in the opposite direction, announcing that it plans to cease bond purchases this month and hinting strongly that it may start to slowly, but actively raise rates by mid 2015.

A direct result of the divergence of the US and European central banks policies was the strong rise of the US dollar against most foreign currencies. During the third quarter, the currencies of most developed markets dropped between 7% and 8% against the US dollar. The British pound, Canadian dollar and emerging markets currencies held up better, dropping 5.2%, 4.7%, and 5% respectively against the dollar. While this resulted in disappointing results on international stock funds for this past quarter, the currency shift means foreign goods will sell cheaper in the US, possibly boosting the future earnings of foreign companies and stiffening competition for US goods. It also means that US citizens traveling abroad may notice their dollars stretching a bit further, and US parents may breathe a little easier if their college juniors spend a year abroad since we may not be swimming so hard against foreign currencies as we have in years past.

The best scenario for a stronger economy would be for low rates to continue for a while longer allowing businesses and homeowners alike to borrow favorably. Corporate merger and acquisition activity has increased recently and it would be nice if this could continue as well. The residential real estate market has certainly had its ups and downs, but transactions have increased and prices are starting to pick up a bit. The best scenario for a stronger economy would be for low interest rates to continue for a while longer allowing businesses and homeowners alike to borrow more favorably. Corporate merger and acquisition activity has increased recently and would be positive for the economy if it could continue as well. The residential real estate market has certainly had its ups and downs, but transactions have increased and prices are starting to pick up a bit.

While retirees looking for more yield on their bond portfolios might herald the return of higher rates, businesses and home buyers might see this as a cooling trend. Higher rates make it harder for businesses and would-be homeowners alike to borrow, and some worry that it may have a chilling effect on the overall economy. As the Federal Reserve Bank executes interest rate hikes in an effort to return rates to normal levels, the worry is that it may result in a market backslide. Northern Trust recently provided a historical analysis of financial market behavior during five recent Fed tightening cycles starting with 1986. They concluded that stocks generated positive returns in four of the five Fed tightening cycles between 1986 and 2004. Specifically, they said, “Risk assets typically fared well in the twelve months that straddle the first rate hike despite the tendency for some level of correction around the first hike.” In other words, following a brief period of heartburn, the US economy has been able to digest Fed rate increases. Northern did point out that defensive stocks; that is, those with characteristics of low volatility, solid dividend yield, quality and value, generally outperformed in the year following the start of a Fed rate hike. They further noted that both developed and emerging international equities have outperformed US equities during prior rate hikes possibly reflecting the mismatched policies of central banks. “Looking at future rate expectations, the market has priced a steady level of rate increases over the next one, three and five years – with the 3-month U.S. Treasury expected to yield nearly 3% by 2019. We believe that the rate normalization process will occur at a slower pace than the market believes and therefore do not anticipate material adverse price impacts.” In sum, as we march resolutely toward a Fed engineered, more normalized interest rate environment, we should expect moderate volatility. For those with medium to longer term time horizons, they will be best served by patiently riding through it. We invite clients who may require significant amounts of cash in the short-term to let us know, and we will prepare for it by maintaining adequate liquidity for you. Meanwhile, at least in the short-term, the dollar will strengthen possibly for sound business reasons as we regain some of our footing as an international economic leader.

On October 2, 2014, the “Oracle of Omaha”, Warren Buffett, said it all in a CNBC interview. Becky Quick queried him with, “There are so many concerns about what’s been happening with the stock market. The Dow dropped 230 points yesterday and volatility seems to be creeping back. What’s your view of what’s ahead?” Buffet said, “Well, we bought a business yesterday, and we would have bought it if the market had been up 200 points yesterday or down 200 points or up 1000 points last week or down 1000 points. The idea of what the market does on any given day is meaningless. What you really have to look at is what the business you are buying is going to look like five to ten years from now. It is what people do when they buy a farm or an apartment house or any other business. That is how we look at any transaction except purchasing stocks, and that is because you can look at stock prices minute by minute. That should be an advantage, but many people turn it into a disadvantage. I don’t know how to tell what the market is going to do, but I do know how to buy reasonable businesses.” Buffet concluded his comments by saying that in the short-term, he is delighted if a publically traded company he just bought goes down in price. He can buy more at cheaper prices. “Nothing is wrong with those companies.” Buffett is a seasoned and smart investor. As we look to the months ahead, let’s take a page out of his book, and resolutely ride through what may lie ahead confident that we have thoughtfully built, resilient portfolios.

Best wishes for a lovely Fall and holiday season, from the Deighan team!