The volatility experienced by the financial markets during the spring continued in the third quarter, though equity returns were quite good. Fixed income returns were again negative, though the benchmark 10 year US Treasury bond pared its losses to close at a yield of 2.61%, after touching 3.00% just after Labor Day. There was no shortage of news headlines to cause markets to move this past summer. Rumors that former Treasury Secretary Lawrence Summers would become the new Fed Chairman turned out to be just that, as Summers removed himself from the running early last month. Instead, Vice Chairman Janet Yellen, Wall Street’s preferred choice, was recently nominated for the top spot. Fears of an imminent taper of the Fed’s QE (quantitative easing) program proved to be misplaced, as the September meeting brought forth no change in policy. Also, due to the current partial government shutdown, any tapering will probably be pushed out to at least yearend at the earliest. Regarding the current status of the budget negotiations, it now appears that the President and Congress will likely reach at least a temporary agreement to lift the debt ceiling for the next several weeks. While a permanent solution is not yet in the works, the fact that there has been movement by both sides to avoid a total government shutdown is encouraging. All previous episodes of debt ceiling debates in the 1990s and 2011 featured similar drama and theatrics before their eventual resolution.

Until the recent Federal budget impasse, the U. S. economy had been slowly but steadily improving, with manufacturing and employment indices leading to achievement of the long elusive “escape velocity”, where real GDP growth would finally accelerate to the 2.5-3.0% range. At that point, the economic recovery would become self-sustaining and the Fed could finally exit from its stimulus programs. The latest Washington induced hiccup will likely cause some damage to consumer confidence and the economy over the next quarter or two. However, absent a complete breakdown in talks and a government default, economic growth will continue to hover in the 1.5-2.0% run rate, with an eventual lift after the effects of the slowdown wear off.

Foreign economies remain mixed. Developed countries such as Japan, the UK and major Eurozone nations such as Germany are seeing a pick-up in growth, aided by accommodative central bank policies. We remain constructive toward those markets. Meanwhile, a “one size fits all” strategy of investing in all emerging markets no longer makes sense, as many countries such as India, Brazil, Malaysia, Indonesia and Turkey suffer from structural problems that will take time to solve.

Regarding domestic fixed income, the current “flight to safety” rally may last a little longer due to the Federal budget row, but after its resolution rates should begin to creep higher over time and we would refrain from purchasing municipal bonds until the 10 year Treasury is in the 3-3.20% range. Even so, we will concentrate on the shorter maturities with higher coupons known as “cushion” bonds that offer downside protection in a rising rate environment. Puerto Rico debt has come under pressure after Detroit’s Chapter 9 bankruptcy filing. We feel that fears of a Puerto Rico bankruptcy are overblown. First of all, being a territory, it is precluded from using Chapter 9 as a remedy for its indebtedness. Additionally, although its economy has not recovered from the last recession, Governor Padilla has taken numerous steps, including raising pension contributions and taxes, to bolster the island’s finances. The Federal government is also following the situation closely and has numerous indirect tools in which to help stimulate the island’s economy. We are holding our Puerto Rico bonds, but will continue to closely monitor the Puerto Rico situation and stand ready to take the appropriate action if conditions there deteriorate significantly.

U. S. equities should maintain their upward climb, as valuations at 15 times forward earnings are not stretched and there are few investment alternatives with interest rates being so low. We remain overweight stocks in portfolios and believe that a new secular bull market has begun, though it is unlikely to last as long or increase as much as the 1954-1966 or 1982 -2000 markets, due to the fact that valuations are not deeply undervalued and debt levels in the economy are higher than at the start of previous secular bull markets. Nevertheless, all major indices are now meaningfully above the 2000 and 2007 peaks, and the economy is on sounder footing with no new financial bubbles such as the dot com or housing bust lurking in the foreseeable future. The average investor is still cautious and is just beginning to return to stocks after being burned twice during the secular bear market of the last 13 years. Typically, secular bull markets end with overvalued (greater than 20 times forward earnings) conditions and extreme overconfidence on the part of investors. Of course, unexpected events such as a new war, particularly in the Middle East, can preempt our forecast.  However, historically bull markets have climbed a wall of worry, and as the legendary investor Sir John Templeton once said, “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.” We agree with his observation.