First Quarter 2013 Market and Economic Review

Market Returns First Quarter 2013

The rally in the equity markets continued in the first quarter, with small and mid-sized companies leading large cap and international stocks. Investors are developing more appetite for risk, finally moving some funds out of cash. Stock and bond mutual funds are on track to gather more cash than any quarter on record, and equity inflows have exceeded bond inflows by close to 19% through the end of February.

Bonds have remained subdued after solid returns the past few years. Investors are gaining confidence in the slow economic recovery, and heeding the rumors of the Federal Reserve may slow or end quantitative easing towards the end of the year. If the Fed stops buying as many bonds (the quantitative easing program), there will not be as much support for bond prices, meaning interest rates could start going up.

We are keeping a close eye on interest rates and the potential for inflation. You may remember from Econ 101 that the Federal Reserve has a dual mandate to keep interest rates and inflation at moderate levels while promoting maximum employment in our economy. Interest rates have been rock-bottom the past few years as the Fed has aggressively expanded its balance sheet (buying Treasurys and mortgage-backed bonds) and targeted the Federal Funds rate at 0-0.25%. Inflation has also been running below historical levels. The challenge, of course, is that our unemployment rate has been quite elevated since the financial crisis.

The unemployment rate is at its lowest level since December 2008 but it is still at 7.7%. The Fed’s target rate is 6.5% and it has promised to keep stimulative measures in place until the target is reached. We could see inflation creeping up before then. The Producer Price Index, which represents the price changes for finished goods by manufacturers, was elevated in both January and February. Changes in the PPI usually trickle down to the Consumer Price Index as goods are sold.

When inflation and interest rates start rising, investors must be cautious about the impact on their fixed income investments. Many don’t realize that rising interest rates cause bond prices to go down.

Price Impact of One Percent Rise in Interest Rates

To reduce the risk of rising interest rates in our clients’ portfolios, we build diversified portfolios with bonds that have only a few years to maturity.  You can see from the chart that longer term bond prices can fluctuate dramatically with only a 1% rise in interest rates.

Another trend we’re watching is the Bank of Japan’s actions to combat deflation. Japan is often overlooked in economic news coverage partially due to decades of stagnant growth and deflation they have endured. But it is still the third-largest economy in the world and is a major trading partner of the U.S., China, and other Asian countries. Japan’s new prime minister and newly-confirmed head of the central bank are much more aggressive than their predecessors about pushing Japan out of its deflationary spiral. Haruhiko Kuroda, the head of the Bank of Japan, has pledged to use “whatever means available” to achieve a 2% inflation target and is willing to print yen and purchase assets (including long-term government bonds and even exchange-traded funds). These actions, along with more government spending, could push down the value of the yen, increase prices, and force investors out of savings accounts and bonds into the stock market. These steps could finally stimulate growth in the Japanese economy.

A revived Japan could have profound implications for the rest of the world. However, there are reasons to be cautious about the actions taken by the Bank of Japan. Japan has a rapidly aging population and offers high levels of social services to its citizens. This has resulted in mounting national debt that has surpassed 233% of the country’s GDP, making the U.S. ratio of about 85% look healthy. If the market perceives that Japanese debt is becoming more risky due to these moves, any increase in interest rates will have a significant impact on the government’s ability to repay its bonds. We will continue to monitor whether these actions result in a long-awaited Japanese economic recovery or a vicious spiral of increasing interest rates and inflation that cause long-term damage to the economy.