July 2013 Letter
To Our Clients and Friends,
Earlier this year we wrote how our brains are designed to concentrate more on bad news, danger and fear than good news. It is a tendency we must guard against as we are constantly bombarded by the media about all the things that can go wrong. There were several newsworthy events during this past quarter that contributed one bad week in an otherwise pretty good second quarter.
First – the global economy. Four years ago the global economy was in somewhat of a tailspin caused by prior excess. These excesses may have been the extension of credit to countries, real estate or other borrowers, but the economy crested in 2007 and remained in a recession into 2009, or so.
According to The Economist, a London based news magazine, Global Gross Domestic Product is now increasing at a decreasing rate. A year ago, the world economy may have been growing at a rate of 3.1% and it may now be closer to 2.1%. Though a recession is not being predicted, the slower growth can certainly impact markets. Another global influence was the sudden rise in interest rates that Chinese banks charge when one bank loans to another (the equivalent of the US Federal Funds rate). This was caused by illiquidity within its system and, if prolonged, leads investors to wonder how that country’s illiquidity would impact global investment markets.
The second announcement that caused investor nervousness mid-June was when the Federal Reserve Bank Chairman, Ben Bernanke said it may begin to taper its bond buying program by the end of 2013 and may end it all together in 2014. (When the Fed buys bonds, it is essentially holding interest rates down by providing liquidity and infusing cash into the domestic economy). Chairman Bernanke attached several conditions to this statement, but it caused bond yields to rise which pushed bond prices lower and made stock investors skittish.
This one leaves me scratching my head and reminds me of how our brains sometime focus on the bad news rather than continuing to see the bigger picture. Included in Bernanke’s comment was that the bond buying program would taper and end if the economy continued to grow at a rate that meets the Fed’s expectations. In other words, if the US economy regains strength without artificial support from the Fed’s bond buying program, then the Fed will quit infusing liquidity to the system. Though the market viewed it as a negative, I would say hurray that the economy is recovering without outside influence.
Today we face the same investment issues as the past few years, but we are beginning to see some areas of improvement. You are well aware of how interest rates are near record lows despite a slight increase the past few weeks. Money markets, certificates of deposit and short-term bond interest rates remain low and unattractive to us as do longer-term bonds and lower quality fixed income investments. Highly liquid investments (like money market funds) offer very low yield, but we feel compelled to hold some funds to maintain adequate liquidity in the event we choose to acquire a new position. Longer-term bonds will not perform well in an era of rising interest rates and rates may rise when the Fed ceases its bond buying and as the economy expands. Lower quality issues have become less attractive as many investors have bid up the price of lower quality in search of higher income.
Once we have interest rates at more attractive levels, we may begin to slowly move funds into the fixed income area but we do not anticipate doing so anytime soon. Remember that it took 30 years for interest rates to move to this lower level. In the meantime, we will continue to focus your portfolio on your long term goals and needs and make adjustments as we deem appropriate.
Please feel free to contact us at any time with any questions or issues. Thank you for the opportunity to serve as your investment manager.
John H. Conley, CFA