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Mid-Year Update

2Q - 2014 SAVANTalk excerpt

Similar to the television ratings of World Cup soccer matches, global markets ended the second quarter of 2014 on an upswing. The World Cup, a quadrennial (every 4 years) tournament, has billions of soccer fans around the globe cheering for their home countries. At the same time, global stock and bond returns have global investors cheering when they review their mid-year statements. There are several themes at work this year that have driven solid returns for most asset classes.

The most dominant story for U.S. investors has been the continued recovery of the U.S. economy. The first quarter reading of U.S. GDP showed the economy shrank by 2.9%, but this was largely shrugged off by markets and economists who attribute the contraction to temporary factors such as the extreme winter weather. Also more economic data has been released since March that points to a continued normalization in U.S. economic activity. For example, in the last six months, the economy has added nearly 1.4 million jobs. Hiring at that level is consistent with modest economic growth of around 2% to 3% a year, not an economy that is contracting. Furthermore, average paychecks have grown, causing consumer confidence to climb to its highest level since the recession. This upward momentum in consumer-related activity will hopefully continue as U.S. consumers are in a nice sweet spot with modest wage increases, low inflation, and low interest rates all creating a healthy backdrop for rising purchasing power.

In terms of interest rates, it has been a mild environment this year, and yields have drifted lower. The 10-year Treasury began the year at 3.0% and is now close to 2.6%. Many pundits expected rates to slowly drift upward as the Fed continued its plan of buying fewer bonds. However, demand for bonds has remained high among institutional investors, and the supply of Treasury bonds has actually decreased this year as the U.S. has needed to issue fewer bonds due to reduced spending.

Outside the U.S., returns were positive, but several stories have developed that have sparked volatility. While China’s economy has continued to grow, it has shown signs of slowing down, and the Chinese government and central bank have responded to stave off any deflationary trends. At the same time, Japan has finally seen some positive economic growth as a result of stimulus by the Japanese central bank. On a different front, geopolitical tensions have risen in Iraq and Syria over insurgent attacks which have affected the price of oil and other commodities.

With all these forces at work, investors have experienced very favorable returns so far this year (see figure 1). Stock returns were led by U.S. large caps with international developed and emerging markets following closely behind. U.S. small cap stocks have been the clear laggard this year. Bonds experienced modest gains with the dip in interest rates. Alternative assets such as REITs and commodities outpaced most stocks and bonds by considerable margins.

Asset Class Returns Year-to-Date (US Large Stocks, US Small Stocks, Int'l Stocks, Emerging Market Stocks, Real Estate, Commodities, Bonds
Data Source: Morningstar Direct. Indices used are the same as the ones used on the front cover.

As we head into the third quarter, there are several themes at work:

  1. First quarter U.S. economic growth (GDP) disappointed on many fronts, but the second quarter is shaping up for a swift rebound based on recent economic data releases.
  2. The Federal Reserve is expected to continue tapering its quantitative easing efforts by purchasing fewer bonds but is still committed to keeping interest rates low. As a result, interest rates could start to drift upward if the economy continues to grow, but that is very good for the long term.
  3. Outside the U.S., developed economies have continued to recover, but China has experienced headwinds that could cause slower economic growth and volatility.
  4. Geopolitical tensions are on the rise in the Middle East which may add volatility and uncertainty to the price of oil and other commodities.

More detailed information on the U.S. labor market and inflation is illustrated below.


IF THE ENTIRE POPULATION OF THE U.S.
Was 100 People...

Total Population Labor Statistics Infographic. Source: Bureau of Labor Statistics 

The unemployment rate continues to decline – it is 6.1% today, down from 10.0% in 2009. Yet, there is mixed sentiment on the overall health of the labor market due to a statistic called the labor force participation rate. Today, 63% of the population participates in the labor force, which is a fairly low rate relative to its historic average. However, less than 1% of the population is considered a “discouraged” worker – someone who has given up looking for work. This suggests that demographics are the most likely cause of the declining participation rate. One view is that this is a result of the aging population, with many from the “baby boomer” generation retiring. Another possible factor is the increased emphasis to stay in school longer before young workers enter the labor force. In either case, the labor market is indisputably stronger than a few years ago.

LABOR FORCE PARTICIPATION RATE

Labor Force Participation Chart from January 2000 to May 2014

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