“Back to Normal”-Michael C.
After five years of exceptionally accommodative monetary policy, the Federal Reserve has indicated its strategy is approaching an inflection point. Mr. Bernanke and other Fed governors are growing more confident in the durability of the recovery, and more eager to scale back quantitative easing (QE). As investors, we must balance the longer-term positive ramifications of a return to normal versus the potential for near term risks as the markets adjust.
Regarding the economy, the story remains the same; it is slowly improving yet it is clear that this recovery defies the contours and pace of previous ones. While industrial production and business investment in equipment & software have rebounded in line with previous recoveries, consumer spending, government spending, and private job creation have all lagged. Companies are willing to spend on technology, but hesitant to add new labor. Consumer spending should slowly strengthen along with employment prospects whilst government spending is probably subject to greater long-term restraint due to the past excesses of political largess.
Stock market volatility increased in the second quarter following an exceptionally strong start to the year. However, the action in the bond market was the real story in the quarter. The yield on the 10-year US Treasury bond jumped from 1.63% to 2.59%. Even though the Fed has been quite clear communicating that it would taper QE as unemployment declined, the bond market reacted to Mr. Bernanke’s comments as though no one wanted to be the last one left at the bond party. So what happens next? One possibility is that the bond market’s rapid move in the quarter reflects much of the near term impact of a Fed policy change and that yields will stabilize. Another possibility is that the interest rates are going to continue to rise as monetary policy returns to neutral. Because rates have been suppressed for so long, we believe the latter is more likely.
We have positioned your portfolios for this return to normal by lowering bond exposure over the last year and keeping bond durations short. During the second quarter we also sold a couple of equity holdings that have “bond-like” characteristics. Specifically, we sold client holdings in Peoples United Bancorp when it was trading at its 52 week high. We have been concerned that the bank’s return on equity isn’t sustainable and that its stock buyback program is negatively impacting its return on invested capital. We also sold client holdings of Plum Creek Timber REIT because we were concerned that it’s high valuation made it susceptible to selling pressure if interest rates continue to rise. Finally, we sold client holdings in Deere & Company in order to book a gain and also remove some portfolio risk to volatility in commodities.
On the purchase side, we bought shares of Aflac, a supplemental insurance company. The company’s stock has been under pressure in recent years due to some investment mistakes in its portfolio. Management fired the team responsible for the errors and has returned to a more conservative investment posture. We believe the company will benefit from expanding opportunities in the supplemental health insurance market that are likely to emerge as President Obama’s mandatory health insurance program is implemented. We added to client holdings of Celgene even though the company is selling near its all-time high because we were impressed with clinical data presented at the recent American Society of Clinical Oncology meeting in June.
As we head into the summer months, stock market volume typically declines, which increases the potential for greater volatility. We will remain focused on capitalizing on opportunities. We welcome the eventual return to a neutral monetary policy. The QE programs have suppressed interest rates for the last five years benefitting borrowers by giving many overleveraged people and institutions an opportunity to restructure. This has been at the expense of savers who have had to accept negative real rates of return on their savings. Getting back to normal is healthy. Thank you for entrusting Ayrshire Capital Management with the management of your money. We look forward to speaking with you during the coming quarter.
JM Sam Nevin, Jr.