A Good Week for Emerging Markets and Bonds

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The global economy hit some speed bumps last week. In the U.S, we saw worse-than-expected results in both existing and new home sales, consumer sentiment, durable goods orders and initial jobless claims. Overseas, European manufacturing PMI, Japan’s all industry activity index and UK inflation data disappointed.

In the U.S. equity market, interest-rate sensitive areas—such as utilities and real estate stocks—were the best performers, as interest rates declined from their recent highs. The energy sector underperformed, however, as oil prices fell on news that Saudi Arabia and Russia will increase oil production later this year.

Internationally, emerging markets were the top performers—led by India and other emerging Asian countries—as emerging markets currencies stabilized. In contrast, developed markets underperformed—led by Europe, which is experiencing political uncertainty in Italy.

In the fixed-income markets, falling bond yields helped long-duration bonds outperform. (Longer duration bond prices are more sensitive to changes in yields than are shorter-term bond prices.) Political uncertainty in Europe caused international bonds to underperform.

GAIN: Active Asset Allocation
Last week was mixed for global stocks—with U.S. stocks flat, developed foreign markets down and emerging markets up.

In general, the markets (both stocks and bonds) are trading in a relatively narrow range with few signs of a major breakout in either direction. In the bond market, for example, the 10-year U.S. Treasury note has been moving between 2.90% and 3.10% recently.  Economic data has been mixed as well: We’ve seen GDP growth that’s been solid but not spectacular, inflation that’s shown some signs of perking up but nothing serious, and limited wage gains despite a tight labor market. We continue to favor corporate credits over Treasuries, and we maintain a shorter duration profile than the Bloomberg Barclays US Aggregate Bond Index.

We are heading toward summer, which is typically a low-volume period for the financial markets. A lack of volume can allow markets to drift higher or create air pockets that cause markets to drop suddenly. Therefore, the markets may continue to be range bound for some time.

PROTECT: Risk Assist
Future market volatility expectations rose modestly last week, as global markets fluctuated. Volatility expectations for emerging markets are significantly higher than for development markets—due largely to the strong positive correlations between the equity markets and the foreign exchange markets seen among various emerging economies recently.

The Risk Assist portfolios continue to be very modestly de-risked (by approximately 10% to 20%).

SPEND: Real Spend
Global stocks suffered their worst week relative to bonds since early April, as the yield on the 10-year U.S. Treasury note fell back below the psychologically important 3% level to end the week at 2.93%. Global stock weakness was driven primarily by poor results among developed equity markets. In particular, Europe fell on slower growth and concerns over Italian politics.

Year-to-date, however, global equities are outpacing the broad-based bond market by more than 3% (with bonds down -2% on the year). The one-year return spread between stocks and bonds stands at 13%, in stocks’ favor.

Despite falling bond yields and rising bond prices last week, market expectations for inflation actually increased—a development that might normally cause yields to rise. Expectations for longer-term U.S. inflation are up nearly 10 basis points this quarter alone, and the Fed has indicated it is prepared to tolerate inflation above its 2% target.

Many yield-focused strategies benefited from falling rates last week, with both long-duration bonds and U.S. REITs up by more than 2% for the week. In addition, preferred stocks were up by more than 50 basis points. However, a pullback in oil prices sent master limited partnerships down by more than 2.5%—their biggest loss this quarter.

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