Pendleton Street Advisors


insight & investment commentary


Investment Commentaries: First Quarter 2015

Index Returns 1st Quarter Trailing 12 Months
S&P 500 US Large Cap Index 0.95% 12.73%
MSCI All Country World Stock Index 2.60% 5.58%
Barclays Capital Aggregate Bond Index 1.52% 5.73%
US Core Consumer Price Index - (Inflation) 0.39% 1.69%

In last quarter’s commentary, we discussed factors we expected to be influential on markets and client portfolios in the coming year.  We focused on the possibility of higher short-term interest rates in the US, the divergence of global equity returns, the strengthening US Dollar, and the economic impacts of volatile oil prices. Market participants’ reactions to those four drivers and related events resulted in volatility and muted returns for many market sectors compared to last quarter, as well as heightened price volatility within and between market sectors. We expect market volatility to become more noticeable going forward; but focusing on fundamental measures of macro-economic and company-specific health, growth, and profitability will benefit investors in the long-term.

Volatility in asset prices remains moderate by historical standards, but stability is highly dependent on accommodative global monetary policy.  Although global markets have for the most part regained stability, monetary policy is still highly supportive to markets.  The European Central Bank recently announced that it will begin open-market bond purchases, and Japan’s massive quantitative easing program continues at full steam.  While central banks outside the US maintain or increase market intervention, the possibility that the Fed will raise short-term interest rates in the US as early as June this year has added uncertainty, and thus volatility, to global markets as investors weigh the impact of rising rates on valuations across asset classes.

It has seemed at times in recent years that the Fed considers positive market response to policy change announcements as a third mandate, but technically the central bank’s dual mandate is to maintain stable prices and maximize employment. To that end, the Fed has outlined two benchmarks it will monitor to consider raising rates: Price Inflation at or above 2-2.5%, and the Unemployment Rate at or below 6.5%.

As the accompanying chart illustrates, signals are mixed with Unemployment at 5.50% and Inflation at 1.7%.  Yet, minutes from recent meetings of the Federal Reserve Board of Governors indicate that they will raise rates sooner rather than later, if productivity and labor market conditions continue to improve as they have been.

The impacts of headwinds related to a sharp increase in the value of the US Dollar along with a sharp decrease in the price and demand for oil are reflected the most recent measures of US economic productivity, which point to mild deterioration over the preceding period but continued growth on a year-over-year basis.  In contrast, labor market figures continue to indicate both recent and year-over-year improvement, with the Unemployment Rate down to 5.50% and the Median Duration of Unemployment down to 12 weeks from 16 weeks a year ago.

Going forward, in addition to continued risks related to dollar strength and volatility in the oil market, we expect the current US economic expansion to be challenged by slowing growth in the global economy driven by over-investment in some developing economies, the evolving economic and political situation in the Eurozone, and economic and political destabilization in pockets of the Middle East.

Bond markets can provide a useful forward-looking perspective on how markets view changing economic conditions. Declining bond yields are accompanied by rising bond prices, generally due to expectations of lower returns on riskier assets going forward and/or a lack of supply relative to demand. The reverse is true for rising bond yields.  It is important to note that across all maturities, yields are at levels far below long-term historical averages.  Over the past 12 months, yields for longer-dated bonds have declined, while yields closer to the present have risen slightly.

Much of the rise in short-term yields can be attributed to the expected rate increase by the Fed.  The decline in longer-term yields in conjunction with a rise in short-term yields indicates a flattening yield curve.  This is a potential cause for concern, because a flattening yield curve has historically indicated an expected slow-down in the economy.  Because of where we are in the economic cycle, along with the distortions present in the bond market as a result of prolonged accommodative monetary policy, we do not believe a recession is imminent.

Perhaps a more pertinent observation at this time is that purchasers of long-dated US Treasury bonds are implicitly accepting yields that are just within the range of the Fed’s target long-term rate of inflation.  Beyond the fact that return on the bonds will likely only meet the return required to maintain purchasing power, at a current yield to maturity of 2.54% a 30-year Treasury bond would decline in price by close to 21% for each 1% rise in yield.  Thus, selling the bond after a 1% rise in longer-term rates would result in a principal loss of more than eight times its annual yield to maturity. This demonstrates that the current low-interest rate environment can and has compelled many investors to take significant interest-rate risk and possibly forego decades of opportunities in search of investment income.

There is a place for US Treasury bonds in a well-diversified portfolio, but it is important to acknowledge that default-risk is not the only risk to consider when evaluating bonds.  Other sectors within the bond market, as well as income-producing equities that also provide the potential for capital appreciation offer alternatives that we continue to consider.

Equity performance was mixed for the quarter, with US Small & Mid-Capitalization stocks as well as International stocks outperforming US Large Capitalization equities by a wide margin, reversing the dominance of large capitalization stocks that occurred last year. Broad fundamentals indicate that companies remain healthy, and growth in profitability continues to exceed analyst expectations. For commodities, futures prices for Energy-related assets have continued to decline along with Industrial Metals and Agricultural commodities, while Precious Metals have increased slightly so far this year.

While identifying and observing market drivers is a necessary part of our investment process, we recognize that those observations are only of value if we understand them within the context of your long-term objectives.  As a result, our investment process rests on consistent research and analysis with a long-term focus, carried out on a daily basis.  We appreciate the trust you place in us as advisors, and look forward to speaking with you soon.

Matt A. Morley, CVA
Chief Investment Officer