Market Recap:

As markets enter the second half of 2014, our measures of risk conditions remain significantly below historical norms. Across the board, the second quarter continued to feature low volatility within asset classes and low correlations among assets. While systemic risk rose modestly in April, it soon stabilized and was followed by further easing in June.

Average volatility stood at only about a third to a fourth of the volatility that major asset classes have historically exhibited. Notably, risk conditions were little affected by news of the ISIS drive across Iraq and continued confrontation in the Ukraine. Nor did speculation about shifts in the Fed’s stance or quickening inflation move the needle on risk gauges.

In these quiet risk conditions, global equities rose 5%, and global real estate produced significant gains in the quarter. Emerging markets generated solid returns in both equity and fixed-income.

A decline in 10-year Treasury yields boosted performance of long-duration securities within fixed income, with particular strength in inflation-linked securities. Commodities remain largely flat in the quarter.

Outlook:

The low-volatility environment has some market participants concerned, but our risk measures and assessment of conditions suggest this period is more comparable to 2005 than 2007-2008. While we are positioned for a continued benign risk environment, we are keeping a close watch on the markets’ inflation expectations. Inflation is at the foundation of our portfolio construction process, which makes our commodities and real estate exposure important elements in our overall strategy.

In the meantime, we are keeping our eye on a gradual increase in our measure of global risk conditions. We believe the increase reflects the rising valuations in developed markets and uncertainty about the growth in emerging markets. Should our risk measures show further increases, we are prepared to move more assets into defensive fixed-income positions.

In fixed-income markets, US corporate bonds and emerging market bonds offer more opportunities in the current risk and interest rate environment.  On the other hand, intermediate and long-term US government bond yields are unattractively low and interest rate risk unacceptably high.

On the currency front, we view investments in the US dollar relatively attractive to the Euro and the yen. The dollar tends to benefit from outbreaks of volatility, so this can add a measure of stability to a portfolio.

We believe the uncertainty about growth in emerging markets and rising valuations in developed markets has led to a gradual rise in the global risk environment. We continue to monitor these conditions as they change.