2013 Second Quarter Market Statistics (Mar 29, 2013 to June 28, 2103):

• Standard & Poor’s Stock Index:  1606 vs. 1569, up 2.36%
• Ten-year US Treasury Note yield:  2.48% vs. 1.85%, up .63% (63 basis points)
• Crude Oil:  $96 per barrel vs. $92, up 4.35%
• Gold:  $1,232 per ounce vs. $1,596, down 22.8%

After climbing in the first half of the second quarter on moderate economic growth and ultra-accommodative monetary policy, stock and bond prices declined during the second half.  In May, the US Federal Reserve began to indicate that it would likely begin tightening monetary policy by reducing Treasury and mortgage bond purchases, often referred to as quantitative easing or QE, later in the year and eliminating them outright by the middle of 2014.  In response, the bond market sold off hard with yields soaring, while dividend/income oriented stocks, such as utilities, master limited partnerships (MLPs), and real estate investment trusts (REITs), declined substantially.  Gold also suffered, as low inflation and higher interest rates make holding non-interest bearing gold less attractive.  The Federal Reserve took investors by surprise in announcing their intention to begin “tapering” bond purchases.  They had previously stated that they would only begin reducing bond purchases once the labor market showed “substantial improvement.”  While the labor market has indeed improved, monthly increases in non-farm payrolls of 175,000 and an unemployment rate of 7.6% indicate an improvement that is far from substantial.  This inconsistency on the part of the Federal Reserve jolted the market and sent stock, bond, and commodity prices lower across the board.

Heading into the second half of the year, the markets face numerous risks.  Premature monetary tightening by the Federal Reserve is perhaps the greatest risk.  The economy, although improving, is not robust.  Inflation is well below the Fed’s long-term goal of 2%.  In such and environment, higher interest rates are a negative for the economy, for corporate profits, and make stocks less valuable relative to bonds.  A mitigating factor that has perhaps been overlooked by the market is that Federal Reserve Chairman Ben Bernanke and other Fed officials have said bond purchase tapering was not certain, and would be dependent on further strengthening in the economy.  To the extent that higher interest rates slow the economy, an actual tightening in monetary policy becomes less likely.

Moving on, the global economy is weak, with emerging market growth slowing, the Chinese banking system in turmoil, and Europe remaining mired in recession.  Weak commodity prices and the bond market carnage unleashed by the Federal Reserve have exposed economic, social, and financial weaknesses in many emerging market economies.  On a related note, economic weakness in China brought on by distress in their banking system will have ripple effects throughout the globe.  A further deterioration in Europe from already depressed conditions is possible at any time.  Any of these scenarios, either alone or in combination, could weigh on US stock markets.

Finally, continued political dysfunction in Washington poses a threat to the US economy and markets.  After having blithely allowed damaging sequester spending cuts to go into effect, battles over raising the statutory Federal debt ceiling and the fiscal year 2014 budget loom.  If sharply contested, these issues could send the stock market markedly lower, as had the prior debt ceiling crisis in 2011.

Providing support to the stock market in the second half of 2013 is underlying momentum in the US economy.  Most significantly, the US housing market has been strengthening with prices moving higher and sales of existing and new homes increasing.  Even with mortgage rates moving higher on the selloff in the bond market, homes remain historically affordable, encouraging further gains in the sector.  A strengthening housing market is supportive to the economy through home financing activity, construction, building material manufacturing, transport, and an increased sense of wealth for homeowners.  Also benefitting from still low absolute levels of interest rates has been the automotive sector.  Pent up demand from the depressed levels of the past five years along with attractive financing has boosted production of cars and trucks.  Automotive manufacturing is a significant driver of economic activity because it touches many sectors of the economy including manufacturing, financing, transportation, and basic materials.  An additional support to the economy and stocks is increased domestic energy production.  This has kept energy costs in check while improving America’s balance of trade.  Imports of oil are falling, while exports of refined product are increasing.  This strengthens economic growth and improves the nation’s finances.

Returning to monetary policy, although the Federal Reserve has indicated that it would like to begin withdrawing monetary stimulus, it is a long way from actually being restrictive in its policy.  As stated before, Federal Reserve Chairman Ben Bernanke made it clear that overnight interest rates would likely remain pinned close to zero well into 2015.  He said the Federal Reserve would not even begin to consider raising overnight interest rates until the unemployment rate reaches 6.5%, possibly even less, or inflation exceeds 2.5%.  Currently, unemployment is 7.6%, and inflation is trending close to 1%.  Such a policy should be supportive of stock and bond prices once the markets are done digesting the possibility of a reduction in bond purchases.

For the remainder of 2013, we see the S&P 500 stock index trading in a range of 1540 to 1740, with stocks finishing the year toward the upper end of the range.  We do not see a further significant deterioration in bond prices given low inflation and modest economic growth.  Higher interest rates have been a primary driver in weakness in gold, so stability in rates could underpin the price of gold, as well.  The price of oil has held up relatively well in the face of weakness in other commodities.  We believe this is primarily a function of the ability of Saudi Arabia to manipulate the price.  $90 to $100 per barrel seems to be a price they are comfortable with.