Speculation that the Federal Reserve will soon be winding down its bond purchase program that have kept short-term interest rates near zero led to a sell-off of most major asset classes and a surge in volatility in the latter part of the second quarter, although the Dow Jones Industrial Average still finished the first half of the year with its best returns since 1999. The downside pressure seen towards the end of the quarter was prompted by comments by Fed chairman Ben Bernanke in which he implied that the tapering of the quantitative easing ("QE") program is a "possibility" later this year if the economy grows at forecasted rates and labor market improvements are sustained.
In this regard the Fed remains focused on unemployment and inflation. The Fed's new economic forecasts show that the unemployment rate, currently at 7.6%, will fall to between 6.5% and 6.8% by the end of 2014. When new entrants to the work force are estimated, this would likely imply the creation of well over a million new jobs. Our conclusion would be that if employment gains seen recently can be maintained, QE will be significantly pared back. This would imply upward pressure on interest rates and enhanced volatility in the equity markets. However, note that improved employment and increasing interest rates indicate strength in the economy. As seen in the most recent quarter, increased equity market volatility does not necessarily mean negative returns.
The Fed has tied the potential end of the QE program with economic metrics and made it clear they would only move in response to improving economic conditions. While equity markets might continue to come under periods of downward pressure when the Fed begins this process (indeed it may already have begun), this may be more the result of markets having a tendency to overcompensate for the loss of fiscal stimulus. The alternative would be that economic conditions were so weak that the Fed felt compelled to continue the bond purchase program and over the longer term we fail to understand how that can be a more favorable scenario for equity prices. If the economy can continue to expand, improved earnings in such an environment should imply improved equity pricing.
The Fed announcement aside, there were plenty of positive economic trends that continued during the quarter. Corporate earnings remain strong despite the fact that companies continue to sit on record cash piles and have been slow to hire new employees. U.S. consumers showed resiliency during the quarter despite being faced with higher taxes as spending, credit and confidence all rose. The housing market, propelled by low inventory and mortgage rates, saw prices rise at the fastest rate since 2006 and the pace of sales rise to the highest level in the last five years. Borrowing costs have risen in conjunction with the rise in interest rates, but home ownership affordability nevertheless remains favorable. Lastly, improving U.S. fiscal health has led to shrinking near-term federal deficits and all but eliminated talks for the time being of a long-term deal or "grand bargain" being reached this year.
The pending curtailment of U.S. stimulus has also boosted interest rates abroad and the ramifications globally are even more complicated and intertwined. Rising unemployment and tight credit conditions arising from continuing government austerity has led to Europe's longest recession of the postwar era with no near term signs of relief. Perhaps borrowing a page from Mr. Bernanke, Europe's central bank recently pledged that interest rates will remain at record lows indefinitely. It is an open point as to whether this heavier reliance on anticipated growth instead of definitive austerity will be as successful as it has been so far in the U.S.
China is dealing with the other end of the spectrum as Chinese policy makers aim to reign in financial speculation and real estate prices. The policy-driven liquidity crunch has contributed to slowing growth and it may be that periods of consistent double-digit growth which China has experienced over the last few decades may be tapering. This would be expected of a transition China is making from an economy that was overly reliant on fixed-asset investments such as infrastructure and real estate to a more sustainable and higher quality service/consumption-oriented economy.
While this may be beneficial for China in the longer-term, the near term consequences of a Chinese slowdown have an unfavorable impact among other emerging market economies. China is a major importer of commodities and capital goods and slowing demand has pushed down prices in this regard. This is good for developed countries that are heavy importers of commodities, but a drag on developing countries whose economies are heavily reliant on the exporting of commodities.
Despite a pullback during the quarter that saw Japanese stocks fall by 7.3% in one trading session, Japan's pursuit of ending deflation by easing monetary and fiscal policies and pursuing deregulation continues to be surprisingly successful. The Japanese stock market is still up nearly 40% in 2013 and GDP, exports and domestic demand are all rising. A byproduct of these policies is a falling yen, which increases competitive pressure on Europe and adds to that continent's concerns. A falling yen is also attracting investment toward Japanese equities and away from emerging markets.
In this linked-in age that we live, it is easy to get caught up in the 24/7 information availability of all types of data including governmental policies, economic reports and stock market forecasts. Although such information can be interesting and useful, it is quite fleeting and fluid in nature and should not be the basis for development of long term investment policy. Equity markets are complex mechanisms that continually discount the perceived impacts of all of this data. In the short term, the only accurate prediction is volatility. For this reason, we continue to espouse an investment policy that determines appropriate allocation with reference to a complete financial plan and then employs thorough diversification to further mitigate risk.
Urban Financial Advisory Corporation