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David B. Smith, CFA
Senior Vice President
Investment Management Group

July, 2013 

"There are no environments where you're only going to win, because life just isn't like that." - Bobby Orr, Bruins #4

While Orr's words probably seem painfully obvious to Bruins fans, they will also make sense to fixed income investors this quarter. Bonds declined 1.7%, as measured by the Barclays US Government/Credit index, its first decline since the fourth quarter of 2010. Comments made by Fed Chairman Ben Bernanke on June 19, after a regular meeting with Federal Reserve Presidents drove the sell-off. Bernanke painted a more optimistic economic outlook than many market watchers expected and said the Fed's program of bond buying (quantitative easing or QE) may end by mid-2014 if unemployment drops to 7%. The absence of QE could mean that interest rates will rise, introducing a headwind for fixed income investors.

Bernanke's comments suggest confidence in the Fed's GDP forecast of 2-3% growth over the next few years and an improving labor outlook. This would seem to be supported by corporate earnings. Almost 70% of companies in the S&P500 reported better than expected earnings in the first quarter. In addition, as discussed below, U.S. consumers appear to be in good shape.

Outside the U.S., markets generally struggled as Europe continued to suffer under European Union austerity measures and China experienced moderating growth as China's central bank attempted to rein in lending. Notable exceptions in each market were Germany, which is proving to have a very resilient economy and Japan, which is benefiting from "Abenomics", the stimulative economic policies of Shinzo Abe, Japan's new Prime Minister.

Traditional Asset Class Returns Q2: 2013 

 Asset Class  Benchmark  Q2: 2013  YTD: 2013
 US Stocks  S & P 500   2.91%  13.82%
 US Gov't Bonds Barclays Capital Intermediate Gov't  -1.37%  -1.23%
 Cash  3 Month T-Bill   0.01%   0.03%

US Economy

Since consumer spending accounts for roughly 70% of gross domestic product growth, we are cheered by the improvement in consumer health. Consumer confidence continues to move higher, and now stands at its highest level since January 2008. Also, key indicators of consumer health like retail sales and pending home sales continue to be positive and ahead of expectations while the labor market is stable. The other drivers of GDP growth, business spending and government spending, present a more mixed picture. Business fixed investment grew 2.1% in the first quarter and both shipments of core capital goods and capital spending plans reported in surveys have stalled recently. In addition, monthly reports published by the Institute for Supply Management (ISM), which measure the health of U.S. businesses, suggest a contraction in manufacturing activity but continued growth in the service sector. Government spending continues to be impacted by mandatory spending cuts commonly referred to as the "Sequester".

US Stocks

Equities continued to move higher in the second quarter. The S&P500 topped out at 1687 providing an impressive 164% return from the market bottom in March of 2009. However, since the high, the index has declined almost 3%, largely on the threat of an end to QE. Despite this drop, the S&P500 was still up 2.9% for the quarter. Utilities, a sector which is highly sensitive to interest rate changes, was the key under-performer in the quarter, down 2.7%, followed by commodity based sectors (Energy and Materials). Financials, which will benefit from higher rates, were the best performer, up 7.2% in the quarter. The Consumer Discretionary sector was close behind, up 6.8% in the quarter. Price earning (PE) multiples on S&P500 stocks suggest that stock valuations are generally fair with the index carrying a 14X PE ratio based on the next twelve month earnings, which is in line with its 10 year average.


US Bonds

For the quarter, the Barclay's intermediate government bond index declined 1.37%. Between June 19, the date of the Fed's statement and quarter end, the index declined 0.9%. The quarterly loss has not gone unnoticed among fund investors. Bond mutual fund outflows have been occurring since the beginning of June, indicating that June will be the first month of bond fund outflows since August of 2011. Monthly equity flows remain positive. While hardly the great rotation out of bonds into equities some market watchers have forecasted, it is indicative of a shift in the perceived risk of bonds. We continue to keep client portfolio maturities shorter than the benchmark while investing in diversifying fixed income asset classes. While not completely protecting clients from the potential of losses in a rising interest rate environment, we can certainly blunt the impact and position clients to take advantage of higher interest rates when (and if!) they arrive. It is also important to remember that individual high quality bonds play a critical asset preservation role in portfolios regardless of the interest rate environment as bonds held to maturity typically return their face value.

Diversifying Asset Classes
Asset Class Benchmark  Q2: 2013  YTD 2013
Foreign Stocks MSCI EAFE NR  -0.98%   4.10%
Emerging Markets Stocks MSCI Emerging Markets NR  -8.08%  -9.57%
US Mid Cap Stocks Russell Mid-Cap   2.21%  15.45%
US Small Cap Stocks Russell 2000   3.08%  15.86%
REITs MSCI US REIT -1.58%   6.36%
Foreign Bonds Citigroup Non-USD WGBI  -3.44%  -7.14%
US Inflation Protected Bonds BarCap US Treasury TIPS  -7.05%  -7.39%
Floating Rate Loans Credit Suisse Leveraged Loan   0.43%   2.81%
Commodities DJ UBS Commodity  -9.45%  -10.47%
US High Yield Bonds BarCap US Corp High Yield  -1.44%   1.42%
MLPs Alerian MLP    1.94%  22.07%
Preferred Stocks  S & P Preferred Stock  -1.60%   1.49%

Domestic equity classes ended the quarter with a positive gain, led by small cap stocks, as did Master Limited Partnerships (MLPs). However, all fixed income, except floating rate debt, posted losses along with commodities and foreign stocks. Emerging markets stocks and commodities fared the worst losing 8.1% and 9.4%, respectively. With the exception of MLPs, all diversifying assets sold off after the June 19th statement although, as noted, domestic equities still finished the quarter in the green.

Conclusion

It may take some time before markets adequately discount the possibility of higher interest rates. Fortunately, our emphasis on portfolio diversification ensures that, while some asset classes will inevitably be hurt in the short run by rising rates, others will compensate and perform well in the same environment. The pathway to higher returns is never a perfect line upward, but as this concluding quote reminds us, through patience and a disciplined investment approach, we can get the results our clients expect.


"Forget about style; worry about results." - Bobby Orr, Bruins #4

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