One thing that stands out about the past quarter amidst the record-setting highs of the S&P 500 is the very low stock market volatility. By late June (6/19/14), the VIX, a volatility index that measures expected 30-day volatility of the S&P 500, had dropped to 10.6, a level last seen in February 2007.

While low volatility and high stock prices reflect the market’s apparent lack of concern about risk—likely buttressed by a belief that the Federal Reserve will continue to support financial markets with accommodative monetary policy—this seeming complacency is causing us some near-term concern because it suggests a market more vulnerable to negative surprises. 
This shorter-term concern about potential market vulnerability is also consistent with what continues to be our longer-term view that stock market valuations in aggregate are discounting too optimistic an outlook. In sum, our view is that markets continue to be too dependent on central bank largesse, too short-term focused, and too complacent about the risks and imbalances that remain in the global economy in the aftermath of the financial crisis.

But what might disrupt the market’s calm? Unfortunately, geopolitical shocks are always a risk and one that we don’t try to anticipate. But even with this year’s events in Ukraine and the sectarian violence in Iraq (to name just two), markets in general have remained relatively calm (except for some short-term, temporary stock-market declines).

Away from the geopolitical realm, a deflationary or inflationary surprise could be disruptive. In Europe, core inflation fell to a low year-over-year rate of 0.7% in May (headline inflation, which includes food and energy, was only 0.5%). Several smaller European countries are in outright deflation. However, the markets have been worried about European deflation for a while now, and the latest CPI number was in line with consensus expectations. Meanwhile in June, the European Central Bank initiated new monetary policies in an attempt to help reflate the economy, and also signaled that it would act more aggressively, if necessary, to prevent a deflationary shock in Europe from happening.

In the U.S. economy, deflationary and inflationary risks are more balanced. While inflation, and importantly, inflation expectations remain under control, it has recently been ticking higher. Core CPI hit 2% on a year-over-year basis in May. The inflation measure the Fed focuses on, the core personal consumption expenditures price index, rose to 1.5% in May, which is still below the Fed’s long-term inflation target of 2%.

Inflation obviously bears watching, and no one is watching it more closely than the central banks. But that doesn’t mean the financial markets will necessarily agree with central bankers’ assessment of the inflation risks or that the central banks’ assessment will be correct. Central bank policies have been a huge driver of financial market returns in recent years, e.g., driving down bond yields and pushing up stock market valuations. Monetary policy remains a key uncertainty, and its impact—both intended and unintended—on the markets and the economy must be taken into account in managing investment portfolios.

Investment Review

Asset classes across the board rose in the second quarter despite lackluster global economic growth, an uncertain outlook for global monetary policy, and geopolitical tensions in Ukraine and Iraq. This reinforces that markets and the economy are not one and the same.

In the U.S., larger-cap stocks were up 5.2% for the quarter and 7.0% for the year to date. Smaller-cap stocks lagged their larger-cap counterparts in the quarter, as they have so far this year. Developed international stocks gained 4.4% in the quarter as the European Central Bank took further easing steps as it combats concerns about long-term deflation risk while Japan’s Prime Minister Shinzō Abe continued his multi-pronged effort to generate healthy inflation and boost Japan’s economy. After a poor first quarter, emerging markets stocks rallied strongly in the second quarter, bringing their 2014 gain to 6.1%. Among larger emerging markets, China’s growth outlook remains a source of investor uncertainty while India’s newly elected prime minister was viewed favorably among investors and the country’s stock market staged a huge second quarter rally.

Core investment-grade bonds shared in the gains, earning nearly 2% as Treasury prices rose and bond yields continued to fall, a surprise to many investors. Emerging market bonds were the best performing bond category for the period, returning 5.4% for the quarter. Like their equity counterparts, emerging market bonds continue to benefit from being levered to the recovery in developed markets, especially Europe.

Alternative investments had a mixed quarter. Hedge funds in aggregated delivered modest results, with the HFRX Global index returning 0.64%. Gains were realized across strategies, but the muted returns are generally a result of lower absolute returns available in the underlying markets in which they invest. REITs returned 7.0%, continuing to benefit from an improving economy as well as individual company fundamentals—mainly stable balance sheets and growing dividend yields. Commodities were mixed, as gains in crude contracts were offset by weakness in livestock and agricultural commodities on concern of oversupply.

Portfolio Positioning & Outlook

Overall, our macro view and assessment of the risks and returns across the major asset classes has not changed meaningfully since last quarter. We continue to see the U.S. economy—and the global economy more broadly—on a slow path of recovery from the 2008 financial crisis. Private sector balance sheets continue to strengthen (reflecting the U.S. household and financial system deleveraging that has occurred since 2009). This lessens the odds of another financial crisis and is a key support for the recent increase in our estimate of fair value for the stock market as we discounted a less stressed macro environment.

Given this, we have not materially altered our portfolio positioning. We remain marginally overweight equities at the expense of fixed income, though we have slightly increased hedged equity exposure given the potential for a downside shock. In fixed income, we remain underweight core bonds and interest rate risk given the expectation of volatility as we approach a period of rising short-term interest rates. In the alternatives allocation, we have introduced a real asset strategy into more conservative portfolios in order to protect purchasing power in an inflationary environment.

As we consider the range of potential outcomes, we are comfortable with our positioning and the risk and return trade-offs we are making. Unfortunately, in the current low-volatility, low-yield, high-P/E environment where investors aren’t getting much in return potential for taking on risk, we don’t see any asset classes offering compelling returns relative to their risk. Instead, our tactical positioning is more on the defensive, risk-management side. We know we sound like a broken record, but this remains a period in which patience and discipline are particularly critical, even if over the shorter term it may not seem so as markets continue to hit new highs. There is a powerful behavioral inclination to chase markets and asset classes that have already performed strongly. In contrast, our investment process and discipline is forward looking—based on longer-term analysis of fundamentals and valuations across multiple scenarios, informed by economic and financial market history and cycles, yet with a recognition that history does not exactly repeat. This investment discipline has served our clients well over our firm’s history, which is one history we do hope to repeat.

We appreciate your confidence and trust in us. As always, please feel free to contact us with any specific questions about this letter or any of the investments that we manage on your behalf.

This material is provided for informational purposes only and does not constitute an offer or solicitation by HFS, or its subsidiaries or affiliates, to invest in these indices or their constituent products. The data contained herein are from referenced sources which HFS believes to be reliable. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. The views expressed are those of HFS. They are subject to change at any time. These views do not necessarily reflect the opinions of any other firm. Investing involves a high degree of risk, and all investors should carefully consider their investment objectives and the suitability of any investment. Past performance is not necessarily indicative of future results.


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