May was a strong one across equity and fixed income markets, it was a particularly strong month for emerging market stocks with one of the best months in several years US stocks had a strong month again hitting new highs small. And bond markets surprised both analysts and traders as intermediate and long term interest rates on treasuries dropped sharply.
With the markets reflecting an outlook for continued low interest rates the stock investors displayed confidence although in a far more restrained manner than last year. Small cap stocks which had led the rally including extremely highly valued ipos and other social media stocks fell back to earth. The small cap stocks which has led the rally up until recently underperformed for the month and have underperformed year to date.
European Stocks underperformed equities in other parts of the world as concerns over the Ukraine produced a positive return but lower than those other markets. Nonetheless the major European indices are at or close to record highs and are outperforming US stocks. Optimism towards the economies indications remains. ECB European (Central Bank) policy statements indicate a commitment to lower interest rates which should be a positive
Strong demand for bonds from Italy and Spain reflecting more confidence in their. While Italy and Spain showed negative returns for May their year to date returns have well exceeded those of the rest of Europe. Spain is up 14.3% and Italy 15.2% ytd vs 8.3% for Europe as a whole
The volatile emerging markets have shown a sharp reversal to the positive this year. Emerging market currencies sand bonds have recovered helping dollar based investors. The optimism carried over into stocks as well. Conventional wisdom about China and India seems to have shifted. Significantly lower valuations vs both historical levels and US stocks has made emerging markets attractive for long term investors. Emerging markets are always volatile and characterized by short term “hot money performance chasers’. This is clearly evident at this point as emerging markets stocks and funds have seen large inflows.
Returns for selected stock ETFs
category symbol May Ytd. 12 mos.
Europe FEZ 1.1% 8.3% 27.8%
Emerging Asia GMF 3.7% 6.5% 7.2%
S+P 500 SPY 2.3% 5.8% 20.3%
VTI Us Total Market VTI 2.1% 5.2% 20.5%
Large Cap Value PRF 1.7% 5.9% 20.3%
Small Cap Value PRFZ 1.0% 0.3% 19.6%
Bond markets both in the US and globally have shown extremely strong performance. As noted above expectations of low and possibly lower interest rates in Europe and optimism for economic stability –as well as yield chasing sent European bond prices higher (yields lower). The extreme pessimism on political and economic stability in emerging markets strengthened currencies and bonds.
US bond markets have confounded the experts this year with long term interest rates moving sharply lower the 10 year treasury yield reached. Expectations that the Federal Reserve will be slow to raise short term interest rates due to continued weakness in the US economy may be cited as the rationale for this move by some observers. However, moves of this type can’t be explained with such rationales.
It is clear that this is a trader dominated market: many have been caught on the “wrong side “of the market in expectations of higher rates and reversed their often leveraged positions. Trend followers have doubtless jumped into the long side of the bond market. The bond market has experiences a “melt up “in prices (lower interest rates).
It is hard to see a rationale for a long term investor to purchase ten year Treasury bonds with yields at 2.5%...but that does not mean that traders could push prices up/yields lower. Corporate and high yield bonds have had significant price increases as investors “search for yield”.
Our preference in bond allocations has been to add short term high yield bonds rather than extend maturities. The result has been better longer term returns than the aggregate bond index with lower volatility during periods of extreme market movements.
Performance of selected bond ETFS
category symbol May ytd 12 mos.
short term high yield HYLD 0.6% 4.9% 11.6%
short term high yield HYS 0.3% 2.0% 6.5%
Short term investment grade corporate vcsh 0.1% 1.6% 2.6%
short term US govt vgsh 0.4% 0.3% 0.6%
US Aggregate Bond Index AGG 1.0% 3.7% 2.8%
With US stock valuations high we remain cautious towards US stocks. The positive for US stocks is lower interest rates and positive momentum. But the strong rally in bonds (lower interest rates) shows the "message' of the bond market is for a weak US economy which doesn’t justify high valuations for US stocks. There is potential for a "correction" in US stocks as prices fall to more reasonable levels. Our expectation for the US markets of at best 6-7% returns (with a bias on the downside0 remains in place. European stock prices particularly in Germany have returned to more reasonable valuation levels "peripheral markets" such as Spain and Italy still have some undervaluation even after strong rebounds but will remain volatile. Investors and traders seem to be adding investments in emerging markets after long periods of pessimism. Given the tendency of these markets to have extreme performance chasing by "hot money"= that chases trends this could be the beginning of some further positive moves indicated by large recent inflows. Another factor in the positive outlook is that on a fundamental basis these are the most undervalued markets in the global equity universe.
In the bond markets it is totally conceivable that the “melt up” in longer term bond prices will continue as traders and short term investors further fuel the rally. But with 10 year rates at 2.5% or below longer term investors might look to tilt their bond to short duration bonds with a possible allocation to high yield short term bonds to boost yield.
This reduces the volatility of longer duration bonds. It would also limit should the bond market reverse course (higher interest rates lower prices).