The Bond Portfolio performance led the way in June with its best monthly performance of the year coming in at +1.44% (gross). The Limited Risk Portfolio performance was hurt in the last 6 days of trading in the month and went from a gain to a loss of -1.08% (gross) as all risk markets did an about face in response to signs of economic slowdown in China and commitments to global deficit reductions by European nations. The S&P 500 Total Return equity market index was down -5.23% for the month of June after the very poor showing in May. The Barclays Aggregate Bond Index (“BABI”) was up +1.57% for the month of June driven by performance in the long-term US Treasury and long-term Corporate sectors, as spread widening abated and interest rates plummeted.
June saw a flurry of economic “news” as the US Financial Reform Bill was agreed upon (though not yet enacted), China agreed to revalue its currency (though it did not state the pace), and EU nations came to the G-20 summit in Toronto stating that they would cut their deficits significantly by 2013, while seeking a balanced budget by 2016 (though they did not say how). Volatility stayed persistently high through the month of June with the VIX volatility index repeatedly touching levels of 36%, though off from the 46% highs in May. The Dow Jones Industrial Average closed the month well below 10,000 at 9,774 and this time nobody was blaming “fat fingers”, only fat Portuguese, fat Irish, fat Greeks and fat Spaniards (aka fat “PIGS”). In the bond markets the deflationary camp won out over the inflationary camp in a landslide as residential mortgage rates hit their lowest levels since this data started being tracked 40 years ago and the 10 year US Treasury crossed below the “psychologically Japan-esque” level of 3.00% yield ending the month at 2.95% yield. The Fed reiterated their “low for long” interest rate policy and cited the global economic slowdown for the first time. However, given the view that 2Q10 earnings are going to come out quite favorably for the large financial firms, especially in their fixed income divisions, it is the view of this manager that equity markets have come down too far too fast and are poised for a bounce back up to 10,000 levels on the Dow for the near term. Similarly, interest rate markets are poised to bounce from current yield lows as well in the near term. Longer term it will remain to be seen how much impact the deficit cutbacks will have on the global GDP slowdown and to what extent the consumers can come to fill the void of government spending. Some analysts are calling for a global slowdown in the magnitude of -1.0% of global GDP in 2011 due to the deficit reductions, but that would still keep global 2011 GDP in positive growth territory. We expect to see some large gyrations in global equity markets in 3Q10 as investor sentiment regarding the magnitude of the growth effects from deficit reduction keep shifting. We will also closely watch the direction that legislative changes are taking such as tax policy (AMT, dividend taxation, estate tax) in the leadup towards mid-term elections this November.
In the Limited Risk Portfolio, risk was managed through the month by (i) cutting the short EUR position when it dipped below 1.20 (sold tkr: DRR), (ii) legging into India and out of China, given the concerns from the collapse of the onshore A-share market; (iii) replacing the energy sector ETF (tkr: XLE) with a straight oil ETF (tkr: USL), given the concerns around the effects of the offshore drilling regulation; (iv) layering on hedges on portions of the equity risk through use of a short-biased Russell 2000 ETF (tkr: RWM), and (v) selectively layering in long equity positions in the financial sector (tkr: UYG) and switching the short position to a long position on the Russell 2000 (tkr: IWM) when markets appeared to have overshot towards the end of the month. The active trading allowed the Limited Risk Portfolio to fare much better (down only -1.08%) than the overall equity markets (S&P 500 index down -5.23%) with gains coming from short positions and MLP positions added on the dip at the end of May, while losses were concentrated in the financial sector (Citi Preferreds, Goldman Sachs, Morgan Stanley and UYG) which looked very oversold by month end.
In the Bond Portfolio, the US Treasury yield curve continued to flatten significantly in June with long end Treasury yields coming down sharply. 10 year US Treasury yields came down from levels of 3.30% towards the end of May to 2.95% by month end June. Both the investment grade and high yield credit spreads widening trend abated resulting in long-end Corporates and long-end Treasury sectors being the best sector fund performers (see Vanguard comparative fund table below; VUSUX was top performer at +4.68% followed by VWETX in close second for the month at +4.10%). However, the decision was taken to scale back duration in the Bond Portfolio as yields dropped below 3.20% given the outright low level of interest rates and the view that risks are now weighted more to the downside than the upside unless convincing data were to come out to argue for long-term deflationary trends. Given the volatility that resulted from thinly traded interest rate swap markets ahead of feared legislation that at times was suggesting that swaps desks be spun off from banks, long duration and short duration ETFs were utilized (tkrs: TLT and TBT) to take advantage of opportunistic interest rate moves while keeping overall duration risk through the month at lower levels than the benchmark Barclays Aggregate Bond Index.
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