Markets Update: Second Quarter 2015

In unfamiliar fashion, bonds ended the quarter in negative territory while stocks posted very modest gains. The period came to a close on a sour note with the dramatic re-escalation of the Greek crisis. In addition to the uncertainty surrounding Greece and the European Union (EU), a slowing China and the impending rate hike here in the US also made headlines. If history serves as any guide, these events should continue to be with us for the foreseeable future.

Bond yields rose (therefore prices dropped) across most major bond markets. The increase in yields was accompanied by heightened volatility, driven largely by expectations that the Fed will finally be raising interest rates in the US and stronger economic data in the Eurozone. Yields on 10-year US Treasuries went from 1.92% to 2.35% and the broad based Barclays US Aggregate index was down -0.14% for the quarter. Short-term, high quality government and corporate bonds were essentially flat with a return of 0.01% as investors supported the prices of these safer assets. Municipal bonds also experienced selling pressure due to the aforementioned drivers and dropped -0.64%.

Global equities ended the quarter with very modest gains. Prior to the Greek crisis re-emerging there were a few areas of relative strength. Developed equity markets were trending between the 2-4% level and emerging markets were fairing even better. However, the last week of the quarter took much of that away. At the end of the period, US stocks were up a mere 0.15%, international developed stocks managed to earn 0.70% and emerging market stocks returned 0.82%. Small caps in developed equity markets outperformed and value (i.e. cheaper) stocks underperformed. In emerging markets, both small and value stocks managed to outperform the broader benchmark. The clear standout to the downside were Real Estate Investment Trusts (REITs). Collectively, global REITs declined -7.65%. Here in the US, that number was even worse at -10.35%. REITs have had an exceptional run over the last 5 years so this drop is not all that surprising, especially since interests rates (one of the drivers of REIT performance) do appear to be on the rise in the not so distant future.

Global economic growth remains lackluster. Commodity prices have largely stabilized, removing one item of uncertainty from the equation, but there is plenty of uncertainty to go around – the situation in Greece, rising interests rates in the US and the impact that will have on global growth, weak consumer demand, etc. In the US, first quarter GDP growth was revised downward to a negative rate of -0.2%. As we have seen in years past, economists attribute the weakness to the severe weather experienced in much of the country throughout the winter months. This analysis appears to be correct as most of the data released since has pointed to a rebound back to the trend we have been experiencing, though the trajectory is still muted. Across the Atlantic, the EU’s Quantitative Easing (QE) program built on gains from the first quarter and continued to generate favorable results. However, that positive data does not diminish the fact that Greece defaulted on debt owed to the International Monetary Fund (IMF). The risks surrounding the situation in the EU are very real. Exactly what the outcome will be and its impact on the economic bloc and the world at large is unknown. Elsewhere, China attempted to stimulate their economy yet again to reverse weakening economic data and mitigate pains associated with the continued transition to a more consumer oriented economy. Their economic balancing act continues to wobble but stay upright and the country is gaining much more influence on the global stage. Nearby in Japan, data was also mixed but key metrics are pointing to positive wage growth and a return to low inflation. As a result of this global backdrop, many economic forecasters have lowered global growth projections but still expect to see positive numbers for the year.

Gravel Road Investing

Owners of all-purpose motor vehicles often appreciate their cars most when they leave smooth city freeways for rough gravel country roads. Highly diversified portfolios can provide similar reassurance.

In blue skies and open highways, flimsy city sedans might cruise along just as well as sturdier sports utility vehicles. But the real test occurs when the road and weather conditions deteriorate.

That’s why people who travel through different terrains often invest in a SUV that can accommodate a range of environments, but without sacrificing too much in fuel economy, efficiency, and performance.

Structuring an appropriate portfolio involves similar decisions. You need an allocation that can withstand a range of investment climates while being mindful of fees and taxes.

When certain sectors or stocks are performing strongly, it can be tempting to chase returns in one area. But if the underlying conditions deteriorate, you can end up like a motorist with a flat on a desert road without a spare.

Likewise, when the market performs badly, the temptation might be to hunker downcompletely. But if the investment skies brighten and the roads improve, you can risk missing out on better returns elsewhere.

One common solution is to shift strategies according to the climate. But this is a tough, and potentially costly, challenge. It is the equivalent of keeping two cars in the garage when you only need one. You’re paying double the insurance, registration, and upkeep costs.

An alternative is to build a single diversified portfolio. That means spreading risk in a way that helps your portfolio capture what global markets have to offer while reducing unnecessary risks. In any one period, some parts of the portfolio will do well. Others will do poorly. You can’t predict which. But that is the point of diversification.

It is important to remember that you can never completely remove risk in any investment. Even a well diversified portfolio is not bulletproof. We saw that in
2008–09, when there were broad losses in markets. But you can still work to minimize risks you don’t need to take. These include unduly exposing your portfolio to the influences of individual stocks, sectors, or countries—or relying on the luck of the draw.

An example is those people who made big bets on technology stocks in the late 1990s. These concentrated bets might pay off for a little while, but it is hard to build a consistent strategy out of them. And those fads aren’t free. It’s hard to get your timing right, and it can be costly if you’re buying and selling in a hurry.

By contrast, owning a diversified portfolio is like having an all-weather, all-roads, fuel-efficient vehicle in your garage. This way you’re smoothing out some of the bumps in the road and taking out the guesswork.

Because you can never be sure which markets will outperform from year to year, diversification can help increase the consistency of the outcomes and help
you capture what the global markets have to offer. Add discipline and efficient implementation to the mix, and you may get a structured low-cost, taxefficient

Just as expert engineers can design fuel-efficient vehicles for all conditions, we construct globally diversified portfolios to help you capture what the markets offer in an efficient way while reducing the influence of random forces.

There will be rough roads ahead, for sure. But with the right investment strategy, the ride can be a more comfortable one.

Adapted from “Gravel Road Investing” by Jim Parker, Outside the Flags column on Dimensional’s website, May 2015. Dimensional Fund Advisors LP (“Dimensional”) is an investment advisor registered with the Securities and Exchange Commission.