What Happened in May?

Dear Client Investor -

While there’s a good chance that the May selloff in bonds and dividend paying stocks along with the recent equity drop was and is just a “blip”, it certainly got the attention of the global market watchers. However, the fundamentals remain very positive for economic growth and market performance in the near, intermediate and long terms, and our clients’ diversified portfolios should be well-positioned to perform well in the coming months.

An interpretation of May 22nd comments – many feeling to be a mis-interpretation -- by Federal Reserve Chairman Bernanke suggesting that the Fed’s stimulus might be tapered down, led to an unexpected sell-off of bond and other interest-generating investments, including utility stocks, preferred stocks, real estate and other assets in late May, and equities in early June Volatility in the bond markets has been rising for some time, and as we’ve been indicating in past newsletters, we’ve been expecting increasing pressure on historically low bond yields as the economy showed continued signs of recovery and a reduction in Federal Reserve action was anticipated. The bond markets, on a bull run really since mid-2006, were poised for a pullback. Indeed, once 10 year Treasury yields rose to over the 2% annual yield triggered by the Fed Chairman’s comments last month, that, combined with comments from the Bank of Japan spooked many hedge funds and created a somewhat panicked global marketplace.

What was unexpected was this: Bernanke had, for years now, indicated that the Fed would maintain its stimulative action plan until it had a clear sense that the economic recovery had solidified and that unemployment had dropped to at least a 6.5% level, considerably lower than its current level of 7.6%. Why Bernanke used the words he did is speculation, and analysis of other information seems to lead to a very different conclusion. But for the already touchy bond and equity markets, the result is that almost all interest generating vehicles took losses during the month from between .5% for short term investments, to over 5% for some longer duration, or real estate vehicles and utility stocks – something quite a surprise to investors accustomed to consistent portfolio appreciation and the general rise in stocks. Even so, almost all the bond investments are positive for the year, and both real estate, and dividend paying stocks are up over 10% even after last month’s pullback.

As we see it, the bottom line is this: we expect this bond sell-off mostly to be an overreaction in the short term during what we expect to be a long inflexion phase of slowly rising interest rates. The bond markets were looking for a reason to sell off after such a long run, and the stock market, too, is set for a modest correction after such a strong run this year. However, we don’t expect inflation (and interest rates) to rise significantly in the near term – in fact, most inflation measures are showing a reduction in inflation, particularly as commodity, oil, and even health care costs have been dropping. And as we anticipate continued slow economic growth for the rest of the year, we don’t expect the Federal Reserve to take its foot off the accelerator significantly until 2014, particularly as Bernanke has promised to keep the Fed Funds rate around 0% until that time. And as Bernanke has subsequently commented, the economy is not growing robustly, and any tapering off of Fed stimulus action would be based on data that the economy’s recovery is on solid ground. We’re simply not there yet.

Other factors, besides low inflation and slow-to-modest economic growth also suggest that interest rates are not likely to rise quickly in the short and intermediate term. Wage growth is very, very slow, meaning the ability to spend is only slightly increasing. The budget deficit is shrinking at a very rapid rate, reducing the amount the Fed needs to borrow and helping to keep interest rates low. Finally, funds from other countries continue to flow in to the United States, as the US remains the most reliable economy for the foreseeable future, something which also keeps a foot on rising interest rates.

Even though we feel that these recent bond market spasms will abate, as our readers and clients know, we’ve been anticipating a slow rise in record low interest rates for some time, and over the past year we rotated many bonds into dividend paying stocks, and reduced durations of other positions to reduce volatility. This has, on the whole, paid off as increased exposure to equity markets has resulted in strong returns over the past year, and even bond holdings largely remain in positive territory for the year. Perhaps surprising to some, rising interest rates could present opportunities for us down the road.

With the economy continuing to grow, albeit slowly, we believe that the fundamentals for equity growth – particularly in the US -- remain very sound, and feel that diversification of asset types – including bonds, real estate, and perhaps even commodities – will help mitigate portfolio risk on the whole. That said, we see equity market volatility continuing to increase over the next few months along with periodic bumps in interest rates. Our crystal ball refuses to tell us if, when, or how much, but with the underlying elements sound, in our estimation major portfolio changes are not appropriate at this time. We will continue to manage risks on the interest sensitive investments and remain vigilant to issues that may result in substantial negative impacts. Certainly we will keep you posted on further issues that might change our overall perspective. Our recommendation is for investors to sit tight, and ride through the near term ups and downs. Barring a radical set of events, we should be in good shape as we continue through the year.

We will discuss these and other issues in an upcoming newsletter.

As always, please call with any questions. In the meantime, enjoy Summer.

Peace,
Ron Stein, CFP

Good Harvest Financial Group
631.423.6501
rstein@goodharv.com