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Second Quarter Market Summary By: Lisa Thuer – Senior Trading and Research Specialist and Michelle Smalenberger – Director of Client Services and Financial Advisor Dear Friends, Among the quarter’s economic news, U.S. GDP growth—one of the primary indicators used to gauge the health of the country’s economy—was revised further downward for the first quarter, marking the largest drop since early 2009. Expectations are for growth to rebound in the second quarter (after a very harsh winter depressed activity in the first part of the year); however, the fact remains that the economic recovery continues to be subpar. Other indicators were more positive, including continued improvements in the labor market, though wage growth is still very slow. Global monetary policy continues as a significant swing factor affecting financial markets and the trajectories for geopolitical conflicts (in Ukraine and Iraq most prominently) are a further unknown. Private sector balance sheets continue to strengthen (reflecting the U.S. household and financial system deleveraging that has occurred since 2009). This lessens the odds of another financial crisis and is a key support for the recent increase in our estimate of fair value for the stock market as we discounted a less stressed macro environment. For investors, though, the second quarter was positive. Larger-cap U.S. stocks were up 5.2% for the quarter and 7.0% for the year to date, after rising more than 2% in June. Smaller-company stocks again lagged as they have so far this year, though they posted a very strong 5% gain in June. Developed international stocks rose 4.4% as the European Central Bank took further easing steps to combat the risk of long-term deflation while Japan’s Prime Minister Shinzō Abe continued his multi-pronged effort to generate healthy inflation and boost Japan’s economy. Despite these efforts, though, both economies continue to struggle with structural impediments to achieving sustainable private-sector growth. After a poor first quarter, emerging-markets stocks rallied, gaining 7.3% for the quarter and more than 6% for the year. Among larger emerging markets, China’s economy continues to face risks stemming from its huge run-up in debt after the financial crisis, while India’s newly elected prime minister was viewed favorably among investors and the country’s stock market staged a huge second quarter rally. Core U.S. bonds shared in the quarter’s gains as Treasury prices rose and bond yields continued to fall—a surprise to many investors—with the 10-year Treasury yield ending the quarter at 2.53%, down from 3.04% at the end of 2013. The Federal Reserve remained consistent in its message: while gradually scaling back its monthly bond purchases (announcing another $10 billion reduction in June), it has also indicated a lack of urgency in raising rates based on what it sees currently on the jobs and inflation fronts. Current Views and Portfolio Positioning Overall, our big picture view and assessment of the risks and returns across the major asset classes has not changed meaningfully since last quarter. We continue to see the U.S. and global economies on a slow path of recovery and, as we detailed last quarter, we’ve upgraded our view of economic fundamentals based on the progress we’ve observed since the 2008 financial crisis. We have noticed a shift in the dependence of market strength being driven from the Federal Reserve to Economic and Corporate Fundamentals being the drivers of growth. In fact, one thing that stands out about the past three months amidst the record-setting highs of the S&P 500 is the very low stock market volatility. While low volatility and high stock prices reflect the market’s apparent lack of concern about risk, this seeming complacency could suggest a market more vulnerable to negative surprises. In terms of what might disrupt the market’s calm, geopolitical shocks are always a risk and one that we don’t try to anticipate. A deflationary or inflationary surprise could also be disruptive. We are becoming more attuned to inflation risk, given an uptick we have seen in the United States over the past quarter and the strengthening (although still not strong) labor market, which at some point should start pressuring wages higher. Importantly, we have already positioned our portfolios’ bond allocations for the likelihood of rising interest rates, consistent with some increase in inflation. More than half of our fixedincome exposure is in funds that have significant flexibility to manage their inflation and interest-rate risk as compared to core investment-grade bond funds, which would likely do better in a deflationary environment. We also continue to own positions in diversified higher-quality floating-rate loan funds in our most conservative portfolios to further benefit from and protect against rising short-term rates and unexpected inflation. As we look forward and consider potential outcomes ranging from optimistic to pessimistic, we are comfortable with the risk and return trade-offs we are making. Our portfolios reflect our risk-management priorities, but have also been able to participate broadly in the market’s gains. As always, we appreciate your confidence and welcome questions about your portfolio. Best regards, Kabarec Financial Advisors, Ltd. www.kabarec.com 2