Second quarter commentary from Nathan Behan, Senior Analyst at Prima Capital.
U.S. equity: The second quarter opened up with high hopes and generally positive expectations for the remainder of the year. As noted last quarter, there was a wide variety of opinions on the strength of the recovery but a strong majority believed a recovery was in fact under way.
The Russell domestic style indexes exploded out of the gate in April, ranging from the Russell 1000 Growth Index up 3.6% to the Russell 2000 Value Index's 11% gain. This would, however, prove to be the peak for the quarter, as rumblings from Europe sent investors scrambling for cover over the next five weeks.
The indexes fell sharply over that period. For example, by the end of May, the Russell 2000 Value Index was down 2% for the quarter. Uncertainty continued to dominate the market in June, with weak economic numbers in employment, housing and consumer confidence.
The indexes were down again for the month, ranging from a decline of 6.6% for the Russell 2000 Growth Index to a loss of 8.4% for the Russell 2000 Value Index. For the quarter, the losses ranged from 9.2% for the Russell 2000 Growth Index to 11.75% for the Russell 1000 Growth Index.
With risk aversion driving investors' thought processes, it is unsurprising to find that the most conservative industries were the best performers in the quarter. Within the Russell 1000 Index, the utilities sector was the best performer, down just 3.8%, followed by telecommunications (-4.9%) and consumer staples (-8.5%). Among smaller companies, represented by the Russell 2000 Index, utilities (-3.2%) and consumer staples (-6.4%) were the leaders.
At the end of the first quarter, most managers were anticipating the end of the beta play in equities and were focusing on more-fundamentally sound and higher-quality companies. This was certainly the case during the quarter. The outlook for growth in the short term is mixed, reflecting the fading effects of last year's government stimulus, the sluggish state of the housing market and continuing high unemployment. However, some managers believe that the recent market pullback, combined with record low interest rates and high levels of cash on corporate balance sheets, have created the opportunity to buy these high-quality companies at very reasonable valuations.
INTERNATIONAL MARKETS
The international markets were roiled in late April when it appeared as though the Greek government was about to default on a significant portion of its outstanding debt. The Greek debt crisis not only shook the confidence level of investors in both the international and U.S. markets, but it had a big impact on the euro, which then further slammed returns for U.S. investors.
The eurozone markets were down anywhere from 4% in Germany to more than 34% in Greece in local-currency terms. But the nearly 9.5% drop in the euro relative to the dollar pushed those returns well below the domestic market returns for the quarter. The developed Asian markets fared only slightly better — down 9% on average — with only Singapore showing a positive return for the quarter.
The exchange rates had a much smaller impact in Asia, as the dollar depreciated or held relatively steady with the key regional currencies. Most of the managers with whom we spoke this quarter are still heavily invested in Europe, as it makes up a significant portion of the market and the common benchmarks. However, the focus not only has shifted to the higher-quality companies (much the same as in the U.S.) but also on those companies with significant export exposure to the emerging markets. Many money managers are forecasting slower growth in Europe than domestically, with the additional risk of further debt crises possible among the common-currency countries.
FIXED INCOME
The domestic taxable-fixed-income markets enjoyed a generally steady and profitable second quarter. The quarter was dominated by Treasury returns, particularly in those with the longest maturities. After a mild April, the Treasury market began to rally when the Greek debt crisis sent investors on a flight to quality. This rally continued through the end of the quarter, resulting in a much flatter yield curve than just a quarter ago. The two-to-10-year yield spread fell 46 basis points to 2.36%, from 2.82%, primarily on the 87-basis-point drop in the yield on the 10-year Treasury.
The Barclays U.S. Treasury Index was up 4.68% in the quarter, and the 20+ Year Index gained 14.97%. While the various spread sectors could not keep up with the Treasury returns, they were also positive for the quarter. The U.S. Corporate Index was up 3.42%, despite a small loss in May, and the MBS Index was up 2.87%.
Given the relative underperformance of the spread sectors in the domestic market, we would expect most active fixed-income managers to have underperformed in the quarter. The high-yield market was the one exception in the second quarter, as the Barclays U.S. High Yield Index was down 11 basis points. The index couldn't rally from the sharp losses in May (another result of the Greek debt crisis) and was dragged down substantially by the CCC and lower-rated credits. These are the very same credits that drove returns in the latter part of 2009 and in the first quarter of this year. The BB- and B-rated segments of the index actually had modestly positive returns for the quarter.
MUNICIPAL BONDS
Municipal issues had a somewhat disappointing quarter after getting off to a strong start in April. The Barclays Municipal Index finished the quarter up 2.03% but was up just six basis points in June. Municipal bond prices were essentially flat for shorter maturities for the month and down 40 to 65 basis points in maturities greater than 10 years. The Barclays 10-Year Municipal Index was the best performer for the quarter at 2.68%.
The municipal market's underperformance relative to the Treasury market in the second quarter is in part attributable to rising concerns over the credit quality of state and local governments.
In addition, the municipal market does not typically benefit from a global flight to quality at the same level the Treasury market does, which was likely responsible for a significant portion of the performance differential.
