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Throughout the second quarter of 2014, stocks rallied from a chilly first quarter performance. Lackluster returns in the first quarter were feared to be the beginning of the long-awaited “correction” in global stocks. Instead, the slow beginning to the year turned out to be a temporary case of frostbite in the global equity market. Despite the recent substantial downward re-statement of U.S. GDP growth for the first quarter to -2.1%, equity returns gathered steam in the second quarter, especially in international equity markets.

The U.S. equity market saw gains through the second quarter, benefitting from improving economic data, continued low interest rates, and remarkably low volatility. Indeed, by one measure, stock market volatility was recently at a low point not seen over the last decade. Some believe this is a reflection of investor complacency in the face of major near term risks: conflict in the Middle East and the potential for a sooner-than-expected interest rate increase by the Federal Reserve. Alternatively, the lack of volatility may be attributable to market and economic developments that have roughly met investor expectations already “priced in” to stocks: decent growth in corporate earnings, low inflation, and the Fed’s reaffirmation of its projection to hold interest rates steady until at least mid-2015.

Stronger returns abroad were boosted by relaxed tension in Eastern Europe and by the European Central Bank (ECB)’s joining the “easy money” camp of the Japanese central bank and the U.S. Federal Reserve. In an attempt to jump-start the economy, the ECB reduced overnight lending interest rates to a record low of 0.15%. It also reduced its overnight bank deposit rate to -0.1%, meaning European banks now pay the ECB interest for keeping reserves on deposit. This is one monetary stimulus step further than the Federal Reserve has taken in this country, as the Fed pays interest to U.S. banks on reserve deposits (a policy first implemented in 2008).

U.S. large cap stocks returned 5.2% in the second quarter while small cap stocks advanced 2.1%. Oil prices rose in the second quarter as worries arose about stability in Iraq, which drove oil and oil services companies’ stocks higher. The energy sector as a whole was up over 10% in the second quarter. Mergers and acquisitions activity also bolstered stocks in the quarter. Health care companies such as Medtronic, a leading medical device maker, sought out international acquisitions for strategic and tax reasons. The utilities sector also saw increased takeover activity.

European stocks rose over 3% in the second quarter. Mario Draghi, the head of the European Central Bank, loosened European monetary policy during the quarter in an effort to spur bank lending and to ward off the threat of deflation. As deflation dampens demand and shrinks economic activity, falling price levels increase the relative debt service burden for countries with high levels of debt such as Spain, Italy, and Portugal. The IMF urged the Europeans to undertake a similar quantitative easing strategy to that implemented by the U.S. as another policy move to thwart deflationary pressures.

Like large oil company stocks in the U.S., energy company stocks in Europe such as BP and Royal Dutch Shell rallied strongly in the second quarter. Acquisition activity also helped returns in Europe. One example was Bayer’s purchase of Merck’s consumer products division for $14 billion, which includes the Claritin and Coppertone brands. The euro weakened in the second quarter relative to the dollar (-1%), dampening overall stock returns for U.S. investors.

In Asia, Japan’s equity market rebounded in the second quarter (up 5%). Investors in Japan have shrugged off the 3% national sales tax which took effect in the quarter. Japan also appears to be on target to achieve its goal of 2% annual inflation – a notable achievement, as the last year Japan experienced at least 2% inflation was 1991. The Hong Kong stock market rose over 8% for the quarter, driven by gains in shares of financial companies. Hong Kong’s primary stock exchange announced that it was establishing links with exchanges in mainland China.

Emerging market stocks rose sharply in the second quarter (+6.6%) after a string of quarters with relative underperformance versus developed markets. Again, rising oil prices helped markets in commodity driven countries like Russia, where stocks rose by 11%. India’s stock market also leapt by 15% as a pro-business prime minister, Narenda Modi, was elected with the promise of an end to years of political stalemate. The Thailand stock market gained 9% despite a military coup in that country. Brazil’s equity market rose by 8% in the quarter; it is a presidential election year in Brazil, where high inflation has led the Brazilian central bank to raise its key lending rate to 11%. Brazilians are left wondering if there was a policy prescription which could have addressed the Brazilian national soccer team’s performance versus Germany in the World Cup. The Brazilians had not lost a competitive home match since 1975.

Fixed Income

Meanwhile, in the U.S. bond market, the Federal Reserve continued tapering its bond purchases in the second quarter and announced in early July that it would cease purchasing bonds in October. Despite the ongoing exit by the Fed from the bond market, interest rates fell further in the second quarter. Longer-dated bonds had another strong quarter, as their prices benefit the most when interest rates decline. The overall U.S. investment grade bond market rose by 2.0% in the first quarter.

The low interest rate environment has provided ongoing incentive for corporate borrowing and refinancing of existing debt. Investment grade and high yield corporate bonds had a good quarter. Municipal bonds continued to rally in 2014 (+2.6%), as many state and local governments have seen upticks in tax revenues and stabilizing fiscal conditions.

Bond markets also rallied in Europe as investors reacted to the European Central Bank interest rate cuts. At the end of June, Germany’s 10 year note yielded 1.25%. Italy’s 10-year note yielded 2.85%, not far off the U.S. 10-year note yielding 2.53%. The extremely low interest rate levels abroad seem to be placing a “ceiling” on interest rates here in the U.S.

The low interest rate environment continues to be the defining characteristic of global capital markets. In 2013, the Fed tried to lower longer term interest rates using Quantitative Easing: a bond purchasing program with the intent to keep rates low and to thus stimulate the economy. The Fed has been buying $85 billion in bonds every month. In December, due to strengthening economic conditions in the U.S., the Fed announced a taper of purchases to $75 billion for its January purchases.

Bond investors are continually weighing the potential for higher interest rates against forces that keep rates low. As the market priced in the Fed’s future reduction of bond purchases, interest rates on longer term bonds rose in 2013. The 10-year U.S. Treasury note, an indicator of broad market interest rates, ended 2013 just above 3% whereas it began the year under 2%.

As the tapering of bond purchases begins in 2014, interest rates are falling rather than rising. The 10-year Treasury note is now below 2.7%. Forces keeping a lid on interest rates have begun to take precedence: U.S. dollar strength and the demand for less-risky assets, below-target inflation, and low short-term interest rate policy.

Emerging markets face a double-edged sword as it relates to the Fed’s Quantitative Easing program. Emerging market countries initially complained about Quantitative Easing as it weakened the U.S. dollar relative to their own currencies. This makes their exports less competitive. However, these same economies benefitted from Quantitative Easing as investors sought out their stock and bond markets in search for yield.

In January 2014, investors have been pulling money out of emerging markets and returning to the U.S. due to higher yields now available – which have come about as a result of the reduction in Quantitative Easing. Emerging market currencies have weakened which is good for their exporters, but those countries are now feeling the impact of capital flight in terms of higher inflation, higher interest rates, and weaker stock markets. This has led to general risk aversion at the start of 2014 which has crept into developed countries, generating declines in those stock markets.

Inflation and short-term interest rates in developed markets continue to be quite low. In 2013, inflation (CPI) in the U.S. was 1.5%. Euro zone inflation stands at 0.8% - the concern now is that Europe is entering a period of deflation. To meet its dual mandate of maximum employment and stable prices, the Federal Reserve has not wavered in its desire to keep its target short term interest rate at zero. The European Central Bank cut its short-term rate in November for similar reasons. These are all forces which may continue to keep interest rates low for an extended period. In such a low interest rate environment, stocks become attractive for capital growth potential. Along with strong corporate earnings and fair valuations, the low interest rate environment was a primary reason for the stock market’s low volatility and strong returns over the last two years.

This year marks the 25th anniversary of Indiana Trust Company, your experts in MANAGING WEALTH AND CREATING LEGACIES. For 25 years, Indiana Trust Company has been dedicated to providing independent, unbiased wealth management for our clients. We specialize in transforming assets into legacies – for your future and beyond; and will continue with the same focus and determination as we have for the past quarter century.

In celebration of its 25th anniversary, Indiana Trust Company will pay tribute to our clients and communities throughout the year by implementing 25 enhancements which either enrich the client experience or further engage us in the communities which we serve. A listing of these enhancements will be posted on our website and in our quarterly Advisor Newsletter. The first few are included here:

Thank you for allowing us to be your Trusted Advisor.

  1. ENHANCED ADVISOR NEWSLETTER  – We will now be featuring articles with broader topics including estate planning and financial planning advice as well as features on our staff so that you will get to know them better.
  2. QUARTERLY BRIEFING FORMAT  – We have changed our quarterly briefing format to an afternoon gathering that is more casual. In addition to the quarterly investment summary, you will enjoy food, beverages and socializing.
  3. WNIT SPONSORSHIP  – We are now featured on Public Television WNIT on Sunday’s Downton Abbey in the Michiana Area.
  4. UPGRADES TO TRUSTREPORTER/CLIENT INTERNET ACCESS (CIA)  – Interactive pie charts have been added with drill down capabilities to help our clients more easily understand their portfolio composition.
  5. ITC HOOPS  – A favorite in the Muncie office, is an informal networking event that offers an opportunity to show our appreciation to the Muncie community.

Developed market stocks around the world had an exceptional year in 2013. Stock market returns were driven higher by better-than-expected economic growth in the second half of the year in the U.S. and Europe, decent corporate earnings, and central bank stimulus.

Early in 2013, many investors were concerned that the Fed would taper its bond purchases (stimulus known as “Quantitative Easing”) too soon. The Fed ultimately announced its tapering schedule in the 4th quarter: bond purchases are to be reduced beginning in 2014, and the reduction of purchases will be very gradual. This policy decision, coupled with the Fed’s stated intention to keep its target for short-term interest rates at zero, buttressed stock markets in the 4th quarter. The confirmation of Janet Yellen as the next Fed Chairwoman was also viewed positively by markets, as her views have been interpreted to be similar to those of retiring Chairman Ben Bernanke.

Outside the U.S., Europe’s slow but steady economic recovery continued. Japan, the world’s third largest economy, also witnessed extraordinary stock market returns in 2013 as a result of forceful monetary and fiscal stimulus packages introduced there. Emerging markets, on the other hand, struggled relative to developed markets as languishing commodity prices, higher inflation, and concerns over economic growth took root in 2013. 2014 is off to a bumpy start in emerging as well as developed country stock markets due to the impact of the reduction of monetary policy stimulus in the U.S. and worries about weakness in Chinese growth. The U.S. stock market was off about -3.5% and international markets fell -4.0% in January.

U.S. large cap stocks returned 32.4% for 2013 while small cap stocks advanced 38.8%. Multiple stock market indexes reached all-time highs in 2013. All sectors of the U.S. stock market rose in the 4th quarter as corporations completed the most profitable calendar year in the 56-year history. Profit margins hit a record high in the third quarter 2013, and margins in the fourth quarter are expected to be even higher. Companies have become much more productive since 2008 and have been very cautious on hiring and capital spending, leading to strong profit margins. Small cap stocks witnessed strong returns as well, as a brighter outlook on economic growth helped smaller company stocks. Even with these strong returns, on a number of valuation measures U.S. equities continue to be in a fairly valued range, even with these strong returns on a number of valuation measures.

International developed markets had a strong 2013 (up 22.8%). European markets rallied as the euro zone pulled itself out of the longest recession in the post-World War II era. Previously beaten-down stock markets in Spain and Ireland led the way in Europe in 2013. In Asia, Japan’s equity market ended up 55% in local currency terms for the year as Prime Minister Shinzo Abe’s economic program (dubbed “Abenomics”) was introduced. Emerging markets was the underperforming equity asset class in 2013 (-2.6%). Emerging market stocks now stand below long term valuation averages.

In 2013, interest rates on intermediate and longer maturity notes and bonds moved higher. The rise in rates led to declines in total return for most segments of the bond market. The Barclays Capital U.S. Aggregate Bond Index ended the year down 2.0% for the year – the first calendar year loss since 1999 and the lowest return since 1994. Sectors of the bond market with more exposure to credit, such as high yield bonds, led the way during the quarter and throughout last year.

In late May and into June, stock and bond markets witnessed increased volatility. The trepidation in the market was mainly centered on comments made by Fed Chairman Ben Bernanke raising the possibility of an earlier-than expected tapering of the Fed’s bond buying program, known as Quantitative Easing. These monetary policy concerns were partially allayed early in the 3rd quarter, as the chairman reiterated the Fed’s desire to keep short term interest rates near zero. Any remaining worries in the market about Fed tapering were further relieved in September when the Fed announced it would delay any potential tapering of bond purchases until later in 2013 or possibly into 2014. Investor sentiment was further buoyed by optimism for the global economy. Europe appeared to be coming out of its recession. Geopolitical risks which had weighed on the market became less urgent, as the potential for a wider Syrian conflict in the Middle East became less likely. As a result of these dynamics, most equity asset class returns rose dramatically in the quarter as seen below. Stocks continued the trend through October with U.S. large cap stocks up 4.6% and international developed market stocks up 3.3% for the month.

U.S. large cap stocks ended the third quarter up 19.8% for the nine month period while small cap stocks were up a remarkable 27.7%. On an operating basis, large U.S. corporations are on track for the most profitable first three quarters in the 56 year history of the S&P 500 Index. Sales growth, which has been in the low single digits in 2013, margin expansion, and additional share buy-backs have been catalysts for the rise in earnings per share, leading to price appreciation in the U.S. equity market. Small cap stocks, which are typically more volatile than large cap stocks, have seen strong returns due to these factors as well. Even with the strong returns, valuation metrics on U.S. equities continue to indicate stocks are in a fairly-valued range.

International developed market and emerging market stocks trailed U.S. markets by a wide margin through the first half of 2013 – much like in 2012. Also similar to 2012, the second half of 2013 has seen a reversal of leadership, with international developed markets leading the U.S. in the third quarter by over 6%. European markets rallied 13% in the third quarter on signs that their seemingly endless recession actually ended over the summer. Major markets in Europe as well as the “peripheral” markets of Greece, Spain, and Italy performed well. In Asia, Japan’s equity market had a strong quarter and is up over 24% year-to-date. Another positive tailwind for international stock returns was the strength of foreign currencies versus the U.S. Dollar (a result of the Fed’s decision to continue Quantitative Easing). Local currency strength made a positive impact on emerging markets returns.

Bond markets struggled for most of the 3rd quarter. The 10 year U.S. Treasury Note, an indicator of broad market interest rates, briefly moved above 3%. The struggle ended when the Fed announced in September that it would maintain Quantitative Easing, continuing its monthly pace of buying $45 billion in U.S. Treasury Notes and $40 billion in agency mortgage-backed securities. The announcement triggered a rally in the bond market, pushing yields lower and bond prices higher. The Barclays Capital U.S. Aggregate Bond Index ended up 0.6% for the quarter, but the index remains in negative territory for the year (-1.9%). Sectors of the bond market with more exposure to credit, such as high yield bonds (up 2.3%), have led the way during the quarter and throughout the year.