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After a strong start to 2013, volatility returned to stock and bond markets in May and June. Some of the volatility was undoubtedly generated by comments from Fed Chairman Ben Bernanke related to the potential tapering of the Fed’s monetary stimulus program. Markets tend to pore over every word from the Fed, as changes to U.S. monetary policy can impact global capital markets. At times, the Fed’s efforts at transparency on its decision making process can lead to misinterpretation and overreaction by investors. Seemingly “old news” from the Fed is sometimes treated like a “surprise” by markets and can generate market volatility over short time frames. The markets’ reactions to the Fed in late May and in June, along with sour economic news from emerging markets, drove most major asset classes into the red for the second quarter. The exception was the U.S. equity market, which ended the quarter in positive territory.

U.S. large cap stocks ended the second quarter up 13.8% for the six month period while small cap stocks were up 15.9%. These returns represent the best first half start for U.S. equities since 1998. Continued slow-but-steady U.S. economic progress helped buttress U.S. stocks in the second quarter, particularly relative to international markets. Reported corporate earnings have been average so far for the second quarter, with sales a bit lackluster.

While investors want to see sales growth play a more prominent role in boosting earnings, they appear to be settling for cost containment and share buy-backs as catalysts for recent advancement. Still, valuation metrics on U.S. equities continue to indicate stocks are in a fairly-valued range. Building on the first half of the year, July was a tremendous month in U.S. equity markets as large cap stocks were up 6%. International developed markets were likewise up 5.3%.

The first half of 2013 was very similar to the first half of 2012 when international and emerging market stocks trailed U.S. markets by a wide margin. (The second half of 2012 saw a dramatic reversal of leadership, with international leading the U.S.) Continued muted economic growth in Europe has been a wet blanket over markets there, although some markets such as Germany and Ireland have held up well. Foreign currency weakness translated into lower U.S. dollar returns as well. Currency depreciation was particularly acute in emerging markets. The Indian rupee, for example, reached all-time lows versus the U.S. dollar in the second quarter. Also weighing heavily on emerging market returns were revised-lower (but still robust) economic growth figures in China, as well as falling commodity prices.

Bond markets performed poorly across the board in the second quarter. This was in large part due to an interpretation of Ben Bernanke’s comments to mean that the Fed may wind down its monetary stimulus a bit sooner than expected (also known as the “taper” in the media). The 10 year U.S. Treasury Note, an indicator of broad market interest rates, increased from 1.7% in early April to 2.6% in late June as investors reacted to this news. As bond prices move inversely with interest rates, bond market prices – particularly investment grade intermediate and longer term bonds – were pushed lower. The U.S. Aggregate Bond Index ended down (-2.3%) for the quarter. Other sectors of the bond market, such as high yield bonds (-1.4%), held up marginally better, underlining the benefit of a multisector approach to fixed income portfolios.

Indiana Trust takes into consideration the potential for volatile interest rates when constructing fixed income portfolios. Generally, target portfolio duration is in the intermediate term range and is slightly shorter in average maturity than the broad U.S. investment grade bond market. Our recent strategic allocations to high yield bonds (both taxable and tax-exempt) in many fixed income portfolios as a complement to core investment grade bond allocations is one way to help manage interest rate risk and provide overall diversification. Also, we have adjusted bond portfolios to have a greater weight on investment grade corporate bonds compared to the market benchmark, and we continue to establish positions in investment grade international bonds. These bonds further diversify sources of bond return.

As we rebalance portfolios, given recent fixed income performance, we will be harvesting equity gains and adding to fixed income positions to bring allocations in both stocks and bonds back to target weights. Similarly, as international stocks have been outperformed in recent years by U.S. stocks, we have been rebalancing allocations to international stocks back towards their target weights in client portfolios. The rebalancing discipline across asset classes allows portfolios to capture relative value through time – put another way, it provides a “buy low, sell high” portfolio management discipline.

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Since late last year, the Fed has been actively buying intermediate term bonds in the open market in an effort to increase the supply of money – a program known as Quantitative Easing, or “QE.” The Fed buys bonds from U.S. banks, which are given money in return. This money, referred to as “bank reserves,” may then be lent by banks to their clients.

Many investors ascribe QE’s main goal to be lower interest rates available to consumers and companies, which, in theory, should boost borrowing and spending. Lower interest rates are a benefit but it is not the whole story – if that were the sole aim of QE, it would be known as “Interest Rate Easing” rather than “Quantitative Easing.” The main problem QE is attempting to address is the lackluster money supply growth (or, the quantity of money) in the economy, which is surprising considering that the Fed has created $2.7 trillion via QE programs since 2009. The reason for the low growth in money supply is that banks – who received bank reserves from the Fed in return for their bonds – are not lending those larger reserves to the broader economy. The borrowing and lending process is impaired. This helps explain tepid U.S. economic growth and is a reflection of many nuanced problems in the demand for loans (i.e., households deleveraging) and the supply (i.e., banks not lending because of stricter regulations). Ultimately, the creation of all of those dollars has not led to inflation.

Through this lens, the rise of interest rates in June based on comments made by the Fed related to its potential tapering of QE is a bit of a head-scratcher. The Fed did not say it was raising interest rates. The Fed has no intention of raising interest rates in the near future – some estimate not until 2015 or beyond, thanks to the Fed’s dual mandate of stable inflation and full employment.

As bond investors normally look to be compensated for expected inflation, an end to QE – an end to the program whose goal is to create money supply – may cause inflation expectations to fall. That may actually lead to interest rates falling, which is a positive development for bond prices and is in fact what happened when the Fed ended previous QE programs.

Interest rate volatility does have an impact on the valuation of many assets, with the primary impact on bonds but with similar impact on other income generating assets such as preferred stocks, dividend paying stocks, and REITs. However, interest rates remain very low, and as mentioned above, the Fed has no current plan to increase interest rates. It may be that the market overreacted to the latest comments from the Fed, which affected bonds and these other income-producing assets. It is far from inevitable that interest rates move substantially higher from here in the near term – even if the Fed were to taper its bond purchases in 2013.

Global equity markets picked up the new year where they left off in 2012 – with solid upward momentum. After subdued growth in the 4th quarter, economic growth in the U.S. has strengthened. Combined with gains in residential real estate, consumer sentiment and employment, these factors have helped to fuel strong equity market returns in domestic markets through the first quarter and into the second quarter. Generally, small cap stocks outperformed large cap stocks and value style has outperformed growth strategies. After posting a strong 10.6% return in the first quarter, the S&P 500 has continued to climb into the second quarter, reaching new highs and breaking the psychological 1600 level.

Despite the lofty returns, valuations remain quite reasonable from a historical perspective. Current year earnings estimates for the S&P 500 at quarter-end were $117/share. As of quarter-end, the current-year P/E ratio for the S&P 500 was just 13X. In comparison, the long term average P/E ratio of the S&P 500 is 14-15X. Valuations appear to be in a fairly valued range.

Solid corporate earnings growth has been one of the primary drivers of equity returns in recent quarters. For the first quarter of 2013, companies in the S&P 500 continued to report earnings growth, in general, and 72% of companies beat earnings expectations. As state and federal governments continue to cut spending and corporate earnings continue to grow, corporate profits have reached 50-year highs as a percentage of GDP. The historical average of corporate profits as a percent of GDP is 6.2%, and it currently stands at 9.9%.

The other primary driver of solid equity returns in recent quarters has been Federal Reserve action affecting interest rates (Operation Twist, QE 4). As rates of longer maturity fixed income securities have declined to historically low levels, return prospects from bonds and other interest-bearing assets are relatively less attractive than equities and other riskier asset classes. Not surprisingly, this environment has been and continues to be quite favorable to the equity markets. In fact, the first quarter of 2013 saw U.S. equity mutual fund inflows of $52 billion, the highest quarterly inflow in nine years.

Given the current valuations and recent market performance, the question for investors is: what should we expect for equity returns going forward? Current earnings reports (for Q1) are beating estimates at an impressive rate, despite weak sales growth which has caused earnings estimates to be revised downward for the remainder of the year. Even with tepid sales growth, the corporate earnings growth story remains intact for 2013 and 2014 because U.S. companies have become very productive. The other growth factor is Federal Reserve policy, which will likely remain in place for some time. Both earnings growth and equity market inflows may temper their pace throughout the remainder of 2013, but for long term investors, stocks play an integral long term growth role in portfolios, particularly when compared to other asset classes.

Continuing recession in the Eurozone and declining growth and export levels in China have led to international developed market and emerging market stock returns trailing domestic stock markets recently. While international stocks outpaced U.S. stocks over the last six months of 2012, U.S. markets have handily outperformed in the most recent quarter and trailing twelve months. In the first quarter, U.S. large cap stocks outperformed developed international market stocks and emerging market stocks by 5.5% and 12.2%, respectively. As economic conditions improve overseas, the relative returns are likely to reverse as international stocks continue to be inexpensive relative to U.S. equities on a variety of valuation metrics. Both emerging markets and developed market P/E levels are currently well below their historical averages. Additionally, long-term economic growth prospects for emerging market economies continue to be much higher than those in the U.S.