January 2012 Economic & Financial Market Analysis
Over the last twelve months there has been no shortage of events and headlines shaping the global economy. While the impact has been realized by many of the events, the uncertainty of the others remains. Following is a summary of those events and the related fallout:
- An 8.9 magnitude earthquake near the east coast of Japan and the tsunami it unleashed killed hundreds of people and caused massive amounts of destruction. World markets responded by trimming exposure to risk assets and waited to see if the crisis would escalate into a nuclear disaster. The major earthquake continued to have implications throughout the second quarter of 2011 as major supply chain disruptions reduced auto and other manufacturing production on a global scale. The negative hit to U.S. production was immediate as motor vehicle production fell 6.5% in April and 1.4% in May.
- In what became known as “The Arab Spring”, civilian protests and revolts erupted throughout the Middle East and North Africa as unrest occurred in 20 countries in the region. The regional unrest primarily started with Egypt but the majority of the focus centered on Libya as rebels attempted to overthrow Dictator Muammar Qaddafi, ultimately succeeding in October. Libya was the first major oil-producer materially affected by the unrest and oil prices skyrocketed as markets worried that conflict in Libya and other oil producing countries would lead to supply disruptions.
- On August 2nd, President Obama signed legislation to raise the debt ceiling by up to $2.4 billion in two stages, narrowly avoiding a U.S. default. Although ultimately avoiding default, the process was highly bitter and contentious leading to many in both parties being unhappy with the final resolution. Furthermore, the brinksmanship exhibited by U.S. lawmakers led to instability in capital markets as uncertainty caused investors to flee risk assets and seek security in safe haven assets such as gold and, ironically, U.S. Treasuries.
- On August 5th, Standard & Poor’s downgraded U.S. Sovereign debt to AA+ from AAA citing concerns over the Federal budget deficit and the rising debt burden. The rating agency also called into question the ability of American leadership to effectively deal with these issues after the political battle that brought the world’s largest economy to the brink of default.
- The euro zone debt crisis which started nearly two years ago with Greece and Ireland remains an unresolved issue. The focus has now moved from the periphery to core countries such as Spain and Italy. In the event Spain or Italy becomes the first major European economy to ask for a bailout it will severely test the EU’s, and especially Germany’s, ability to withstand the current crisis.
- The U.S. economy showed amazing resilience in 2011 despite the avalanche of challenging issues domestically and abroad. For example, earnings for S&P 500 companies grew by 14% in 2011. With flat returns this resulted in the average price to earnings multiple (P/E) dropping by 15%. In addition, the labor market has shown signs of strength in the fourth quarter with private sector employment increasing by 212,000 in December and 1.9 million for the year. The unemployment rate decreased in the fourth quarter and ended the quarter at 8.5%, down from 9.1% at the end of September. Finally, a pullback in commodities helped relieve some pressure on consumer spending as lower commodities prices translated to lower prices for gasoline as well as for many other goods and services.
- The uncertainty of the euro zone crisis made for a wild ride in stocks. Not only was 2011 the smallest annual price change in over 40 years for the S&P 500, it was also the most volatile ever. In August, daily price swings averaged 2.2%, the most for that month since 1932. The Dow Jones Industrial Average experienced daily gains and losses of more than 400 points six times that month. Over the course of the year, the S&P 500 traded in a range of 265 points climbing to a high of 1364 in April and then declining 19% to an intra-year low of 1099 in October. From July through the end of the year the average daily price change of the S&P 500 was +/-1.80% compared to +/-0.54% in the second quarter and +/-0.62 over the previous 60 years.
- Despite a lackluster return of near zero for the year (up 2% counting dividends) the S&P 500 ended up being a very tough benchmark to beat. The majority of stock market investors underperformed the S&P 500, including approximately three-quarters of professional U.S. equity managers.
Most foreign stock indexes suffered declines of over 10% as illustrated by the chart below. The MSCI EAFE Index lost 12.81% and the MSCI All-Country World Index (Ex.-U.S.) lost 13.7%. As a result, portfolios that included international exposure were sure to underperform the S&P 500. Even within the S&P 500, there was a large disparity in performance between sectors. Defensive sectors such as utilities and consumer staples all posted positive returns while the cyclical sectors of financials, materials, and industrials were the worst performing sectors for the year.
- Ten-year Treasury yields decreased significantly in 2011. The yield on the 10-year Treasury began the year at 3.30% and ended 2011 at 1.87%. The significant drop in Treasury yields underscores the U.S. Treasury’s status as the preferred safe haven for investors around the world. As the macroeconomic environment became more volatile there was a massive flight to quality that increased the demand for U.S. Treasuries.
- In the early half of 2011 municipal bonds were under siege as famed market strategist, Meredith Whitney, forecasted “between 50 and 100 significant municipal bond defaults in 2011 totaling hundreds of billions of dollars.” The forecast triggered six months of selling in the municipal markets and a flight to quality such as general obligation bonds and revenue bonds. The premise of Ms. Whitney’s forecast was rooted in the belief that state revenues were going to fall far short of obligations such as health care services, education, salaries and pensions. However, defaults in 2011 were only a tiny fraction of Ms. Whitney’s prediction. Ms. Whitney’s analysis failed to recognize the sense of urgency municipalities embraced, resulting in more than 30 states raising taxes, 31 states reducing health care services, 29 states reducing services to the elderly and disabled, 34 states reducing funding for K-12 education, 43 states reducing funding for higher education and 44 states made cuts affecting their state work force.
Areas of Focus Going Forward
- There have been signs recently that the U.S. housing market is improving or has at least bottomed out. Home prices continue to decline, but homes are now extremely affordable, and it is now cheaper to own than rent in many areas. Construction should start to become a small positive for growth for the first time in years as high rent prices should spur construction of rental projects. The number of delinquent mortgages has been decreasing for some time now, and this should continue. It is clear that the housing sector remains weak but any improvement is a positive sign. The degree to which housing improves will depend heavily on other economic factors, especially employment. It is unlikely we will see any meaningful improvement in the housing market without any significant increase in employment. Regardless, the worst of the housing bust seems to be over.
- It is unlikely that the U.S. economy will significantly improve without improvement in the labor market. There have been signs of improvement over the last quarter of 2011. Initial unemployment claims have been trending lower, and the number of workers who lost their job over the past 12 months is lower now than before the recession. Small businesses have increased their hiring plans but they still remain below pre-recession levels. The current employment market seems to be a result of inadequate demand rather than supply, as even skilled and educated workers are struggling to find jobs. Long-term unemployment continues to be a problem as the share of unemployed workers who have been jobless for more than six months is at a post-WWII high. Overall, the labor market is improving, but it’s likely to be a slow climb back to pre-recession levels.
- As the world’s second largest economy, any slowdown in China’s growth is likely to have global implications. Throughout 2011 there have been signs that economic output in China is already slowing. A number of factors including a decrease in manufacturing activity, weak money and credit growth, and weakness in the housing sector suggest that China is already experiencing a cool down in a previously booming economy. The big question is whether the growth slowdown that we have seen so far in China is the start of something major or only the much hyped “soft-landing.” Most current data is pointing to a “soft landing”. Chinese authorities are well aware of the risks and have begun to respond accordingly. Reserve requirements have been cut, and further measures will be taken if economic conditions continue to worsen. Unlike the U.S. and Europe, China has plenty of fiscal and monetary ammunition to offset any decline in external demand.
- Of course the biggest story in 2012 is going to continue to be the European debt crisis. This remains the biggest downside risk to the global economy as sovereign debt and banking crises have accelerated and caused a marked slowdown in growth in most euro zone economies. The ultimate resolution is still unknown but a number of scenarios are possible depending on the measures taken by governing institutions within the euro zone. If the outlook for Europe continues to worsen there is an increased possibility that one or more countries may reintroduce national currencies or that the euro may be abandoned altogether. Although this risk is still somewhat remote, the possibility has increased over the last six months. The most feared result of the current crisis is that it escalates into a full-scale banking crisis. European banks hold an enormous amount of government bonds and are sure to be affected if the debt crisis escalates further. How this crisis eventually becomes resolved is still unknown and the uncertainties that continue to arise are sure to add to the volatility that we saw through much of 2011.
As 2012 begins we are cautiously optimistic that equity investments will offer solid returns for the year. Current conditions point to a moderate growth environment as reasonable valuations, low inflation, and low interest rates are likely to continue throughout the year. A degree of caution is warranted as there still remains a number of downside risks prevalent in the global economy and markets are likely to remain highly volatile. However, there is potential for the environment to become more favorable for equity investments over the coming months. We would become more bullish if there is further monetary easing in emerging economies (especially China) and if there are signs that the Euro banking crisis has peaked. Absent these conditions we recommend maintaining current equity exposure and taking advantage of pullbacks to add portfolio risk. If either of the above conditions does occur the environment will be much more favorable for adding risk at that time.