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We’ve seen significant trend changes from 2013 through the first half of this year. These trend changes are true across both equity and fixed income classes. Last year was a tough year for bonds with the 10-year Treasury moving from 1.6% in May to 3% by the end of the year. The dramatic move was fueled by the market’s shock and fear of a taper to the $85 billion monthly quantitative easing program. This pressured bonds with the BC Aggregate returning -2.03% for 2013. Other classes of bonds were impacted even more with Treasury Inflation Protected Securities (TIPS) at -7.85% and emerging market bonds at -7.27% on rising interest rates.
To the surprise of many, interest rates have moved down in 2014 with the 10-year Treasury currently at 2.5%. Bonds have universally rebounded this year with the biggest losers from 2013 being the biggest winners for 2014. TIPS are up 2.77% year to date while emerging market bonds are up 5.4%. Treasuries look expensive to us relative to corporates and eventual rising rates result in a negative outlook for TIPS at this current level in our opinion.
Emerging market bonds continue to look attractive to us. They maintain yields approximately equal to high yield bonds. Perceived credit risk for emerging market bonds has declined as indicated with the drop in credit default swaps. High yield bonds look less attractive to us than emerging market bonds at current levels. The historical mean spread for high yield versus the 10-year Treasury since 1987 is 415 basis points according to Ned Davis Research. It’s currently at 214 basis points as of the end of May. Part of this extremity is due to the absolute low interest rates levels; however, the spread continues to appear significant when performing a ratio analysis of high yield over 10-year treasuries.
Despite the surprising move in interest rates this year, we think a short duration bias continues to be prudent. We’ll discuss interest rates and the outlook for bonds in subsequent articles, but suffice it to say that expectations should be tempered at current interest rate levels.
The theme in equity investing for 2013 was to go domestic, go small, and ride momentum. Small cap stocks, as represented by the Russell 2000, have approximately 84% of their revenue generated in the U.S. compared to the large cap Russell 1000 at 70%. The relative strength of the U.S. versus foreign countries benefitted small caps in 2013 along with their generally higher betas and strong momentum. The Russell 2000 was up over 38% in 2013, with growth up 42% and value up 34%. The Russell 1000 was up 33% during this period. Relative valuations, however, got stretched setting small caps up to underperform for the first half of 2014.
While the overall market has rebounded from an early pull-back, small caps remain in negative territory for the year. The Russell 2000 is down about 2% YTD while the Russell 1000 is up 4.8%. The valuation spread is more reasonable, but the Russell 2000 still has a P/E of 21.7 as of the end of April compared to 18.2 for the Russell 1000. We are entering a period of time when we may experience seasonal weakness and when some investors are anticipating a correction in the equity markets. We think an overall defensive approach to equities at this point makes sense and we currently have a slight underweight in small caps versus large caps at this time.