Markets were choppy in the first quarter with strong returns in February sandwiched between weak results in January and March. In the end, the global investment markets were still able to move higher with the S&P 500 Index posting a gain for the 5th consecutive quarter. The European economic recovery continues to progress with the Central Bank in Europe openly communicating a “willingness to act” if warranted. Fixed income markets outperformed stocks as investors struggled to digest escalating tensions in Ukraine and a change at the helm of the Federal Reserve. Brutal winter weather conditions created problems for some economic metrics, though most pundits fully expect things to thaw in the months ahead. Finally, a last minute enrollment surge enabled the White House to meet its original target for the Affordable Care Act.
The overarching narrative which drove markets to record heights in 2013 struggled to find its footing in January before gaining traction in the back half of the quarter. Despite the slow start to the year, the S&P 500 Index was able to produce a positive result for the quarter, up 1.8%, on better than expected earnings data, continued support from government entities and improving economic conditions. Large cap stocks outperformed small cap companies while value names outpaced growth by a notable margin across all capitalization ranges. Some of the relative softness in the growth leaning segments was likely the result of stretched valuations following protracted price increases in the prior period. Despite the relative weakness, the Russell 2000 Index finished higher for the seventh consecutive quarter, marking a new record for the small cap U.S. benchmark.
Non-U.S. developed markets, as measured by the MSCI EAFE Index, underperformed the U.S. by nearly 1.2% after posting a meager 0.7% uptick during the quarter. That said, much of the weakness in the international benchmark index can be attributed to the poor performance results in Japan. The largest developed market in Asia, with a 19% weighting within the benchmark, fell 5.6% in the 1 st quarter as investors grew concerned that a rise in the consumption tax rate negatively impact economic conditions. On April 1st, the sales tax rate was increased for the first time in 17 years from 5% to 8%.
Emerging markets, as measured by the MSCI Emerging Markets Index, rose 3.1% in March, trimming its quarterly loss to 0.4%. Unsurprisingly, Russia was the worst performing country, dropping 14.5%, as the geopolitical developments with the Ukraine polarized investors. Outside of Europe, emerging markets generally performed well with strong showings in India, Brazil and South Africa. Investors in India grew increasingly optimistic about the prospect for change as the world’s largest democracy turned to the polls to elect a new government. While in China, the government announced a modest stimulus package aimed at railway investment and tax cuts for small companies. The government has maintained its projected 7.5% annual growth target and the latest efforts illustrate a continued willingness to hit that objective.
The U.S. Federal Reserve remained an integral part of the overarching market narrative as it reduced the size of its asset purchase program by $10 billion each month during the quarter on the back of improving economic data. After being sworn in on February 3rd, Fed Chair Janet Yellen, presided over her first meeting on March 19th. Following the meeting, the Fed hinted that it could wind down the asset purchase program by the fall and start raising the federal funds rate from zero approximately 6 months later. Despite expectations of a continued rise in yields, the rate on 10 year Treasury note actually dropped from 3.0% to 2.7% during the period as concerns over global growth and heightened equity market valuations pushed yields lower.
Given these developments, the bond market, as measured by the Barclays Aggregate Bond Index, generally outpaced equity markets with a strong 1.8% uptick. As yields fell, fixed income securities with longer maturities posted the strongest returns. High yield bonds and investment grade corporate bonds paced the market for the quarter with 3.0% and 2.9% moves, respectively. Municipal bonds posted a 3.3% advance during the first quarter, marking the best start to the year since 2009 on supply constraints and improving fundamentals.
Managers employing an alternative mandate struggled to keep pace with their traditional market brethren as macro trends swung wildly throughout the quarter. With that as a backdrop, the Morningstar Multialternative Category average produced a flat 0.0% result during the quarter. Managed futures strategies (a trend or momentum driven approach) were the worst performers, a reversal from the prior quarter. Long biased fixed income and equity managers led the way as traditional markets generated positive results during the period. The continued upward trajectory in the market has proven difficult for managers to navigate as the use of hedging has generally been a losing endeavor. The persistent headwinds facing the traditional investment landscape have a tendency to create exploitable opportunities for most alternative strategies. The liquid alternative space continues to grow with new institutional quality entrants coming to market. That said, central bank policies across the globe are certainly testing the true mettle of the overall alternative investment landscape.
An extremely cold winter has been blamed for a spate of soft data the past few months, though the weather’s effects are beginning to abate. The Case-Shiller Home Prices Index experienced its third monthly drop in a row, the longest consecutive period of sequential declines since March 2012. The growth rate in home prices, though still strong, appears to be moderating slightly after a torrent upswing the last several quarters. Employment data continued to improve with nonfarm payrolls exceeding expectations on top of upward revisions to prior month results. The unemployment rate continued its downward trajectory from 7.0% to 6.7% in the U.S., while the participation rate inched slightly higher to 63.2%. Consumer confidence jumped to 83.5 as good news on the employment and housing fronts buoyed data. Following a blistering 4.1% GDP print in the 3rd quarter, the 4th quarter GDP figure dropped to 3.2%. The annual growth rate in 2013 was 1.9%, notably lower than the 2.8% pace recorded in 2012. Economic strength domestically was matched by good news elsewhere. The Eurozone continued to grow, reporting a 1.1% advancement in the 4th quarter as it emerges from six quarters of economic contraction. In Asia, the Bank of Japan voted to maintain its pledge to increase its monetary base at a 60 trillion yen annual pace as business sentiment continues to improve.
Discipline and focus on long-term objectives continues to drive our investment thesis. Coming into the year, our thematic views of rising rates and modest earnings growth domestically were shared by market pundits. As the market pendulum swung in the opposite direction we reevaluated our views on the market. One of the hallmarks of our investment process is a willingness to employ a flexible approach and open mind to the changing market conditions while adhering to the tenets of a long term viewpoint. Despite market vacillation, the economic data remain supportive of our expectations for modest equity returns and minimal bond returns in 2014. The U.S. is the most attractive risk-adjusted market based on economic growth and overall stability. That said, valuations in international markets remain rather enticing. If the U.S. economy continues to show strength, non-U.S. market investments may be propelled forward as well.
Additional gains in U.S. stocks will pressure future returns as valuations become stretched. This was clearly the case in the 1st quarter as last year’s winners, biotech and social media, pulled back significantly. The consequence of which may result in the return potential of international equities becoming too attractive to ignore. To that end, emerging market stocks continue to trade at the lowest relative level to the U.S. in well over a decade. While emerging markets assets may struggle as the market re-prices expectations for global growth and monetary policy, we believe that the longer term trend remains on track. Even with moderately lower Chinese growth, emerging market countries are still expected to grow four times faster than their developed brethren this year and account for approximately 80% of global growth.
Bonds continue to offer unattractive risk/reward characteristics. In this environment we continue to prefer investments which are less sensitive to rising rates, primarily floating rate bank loans, high yield bonds and alternatives. In 2014, bond portfolios will continue to face significant headwinds with volatility elevating and rates likely trending higher, albeit at a slightly slower pace than 2013. Given the prevailing market environment, we currently maintain lower than benchmark allocations to core fixed income positions and alternative investments will continue to play an integral role within the portfolio.
We continue to work diligently to help you achieve your investment goals. Please contact us if you have any questions.