In last quarter’s Thoughts on the Current Outlook, we spent a great deal of time talking about the price risk in bonds. Our view was that the US economy was gradually improving and that this would lead the Federal Reserve to cut back (and ultimately eliminate) its bond purchase program. This cutback would result in bond yields rising and prices falling as the Fed would no longer be the principal buyer. We expected this adjustment to be gradual as a stronger, self-reinforcing recovery was by no means assured.

Well, we were wrong about all the gradual stuff. Bond investors, a notoriously impatient bunch, made the adjustment shockingly fast. In May, the Fed hinted that it was considering reducing its bond buying and rates jumped about 4/10 percent. In June, Fed Chairman Bernanke outlined a very specific timeframe for bond buying cutbacks, conditioned on continued improvement in the economy, and bond investors promptly ignored the conditional and pushed rates up again as much.

Finally, the June report on non-farm payrolls, released on July 5th, was a solidly positive report and bond yields rose sharply yet again as investors became convinced that the end of Fed bond buying was a done deal. From the lows in April, the 10 year Treasury yield rose nearly 1.1 percent.

Normally, this type of rapid increase would cause stocks to fall as investors mark down future earnings with a higher discount rate. Wrong again. With just a two day hiccup, stocks resumed the 2013 rally. However, emerging market stocks were hit hard on worries about negative currency flows, adding to already prevalent concerns about slowing growth and high inflation.

The good news is that the US economy does appear to be doing somewhat better, if we look past the second quarter in which GDP growth will likely have been pretty anemic (think 1-1.5%). The employment picture is positive even though many of the jobs being added are low-paying, part-time or both. Consumers and small businesses are more confident than they have been since 2008 and consumers are even expanding their use of credit.

With changes in future Fed policy now squarely on the table, we hope that stocks and bonds begin trading on more fundamental factors like future earnings prospects, economic growth and inflation expectations, rather than being artificially altered by Fed stimulus. Now that interest rates have moved so far so fast, we think that selected areas of fixed income show attractive value. In particular, high yield corporate bonds are now trading at somewhat wide spreads to US Treasuries, even though default rates are still trending down (as one would expect if the economy is doing better).

US stocks have streaked ahead of the rest of the world so we are being cautious in investing new cash here. Outside the US, valuations are far more reasonable but there are reasons for concern. In China, the new regime is working hard to rein in the shadow banking system that has created much more credit than is healthy. While very necessary, their efforts run the risk of slowing China’s economy – the world’s second largest -- sharply.

Other emerging markets have been hit hard by falling stock, bond and currency prices. While the proximate cause of these quick declines is the knock-on effects of changes in US monetary policy, each major emerging market suffers from its own set of unique challenges with the common themes of slower growth and higher inflation.

Europe has shifted out of crisis and into chronic problem mode. There are a few bright spots on the horizon, but these tend to be of the “less bad” news variety. But recoveries are made out of “less bad” gradually changing over to good. We expect the road ahead to continue to be bumpy, with many setbacks along the way, as the Eurozone puts in place the structural reforms needed.

With all of these headwinds, non US stocks are now significantly cheaper so we have begun selectively adding to international investments for the first time in a long time. Over the next few years, we expect the US to lead a global recovery which should be good for stocks around the world.

Bond investors need to become nimble, after thirty years in which being a sedentary bond investor was the best strategy. Within our general underweight in bonds, we believe there will be opportunities for reasonable total returns as current coupons compensate for inflation and periodic emotional reactions – like what we have just experienced -- drive prices to bargain levels.