April 2012 Economic & Financial Market Analysis

Overview

• The first quarter of 2012 resulted in the best performance for U.S. stocks since 2009 and the major indices are up over 22% from the November 2011 lows.  The sizable gains in the first quarter can be attributed to solid earnings growth, better than expected U.S. economic data (jobs, manufacturing, consumer sentiment), an apparent resolution in the Greek debt crisis, and sentiment that the European debt crisis has stabilized.
• Gains in the S&P 500 and the tech heavy NASDAQ Composite can be attributed in part to shares of Apple which climbed 48% in the quarter.  The increase in Apple shares accounted for 15% of the S&P 500 gain and more than a quarter of the NASDAQ gain.  Other major contributors to the S&P 500 included Bank of America, JP Morgan and Microsoft.
• Earnings from large U.S. corporations have been a bright spot as the economy has begun to recover.  In 2011, earnings of S&P 500 companies grew by 14%.  Couple the earnings growth with near zero appreciation in 2011 and stocks became 14% cheaper last year.  Earnings are forecasted to continue growing in 2012 but at a much slower rate.  For the first quarter of 2012, it is estimated that companies within the S&P 500 Index will grow earnings at an annualized rate of 3%.  At first glance this number seems quite small compared to last year.  In reality, numbers are being compared to strong figures from a year ago when companies were able to take advantage of stringent cost cutting.  A growth rate of 3% still represents a healthy number considering the easy cost cutting has already been made.  Earnings season will be key to equity markets as expectations are modest and a disappointing season could lead to increased worries about the overall health of the U.S. economy.
• Estimates indicate U.S. Gross Domestic Product grew at a pace above 2% for the first quarter.  While this is well below historical norms, it still shows acceleration from 2011 growth and offers hope that economic growth will be strong enough to begin making progress on the systemic unemployment problems in the U.S..
• The labor market in the U.S. has shown signs of improvement over the first quarter.  The economy added 635,000 jobs in the first three months of 2012, unemployment claims are at four year lows, and job openings are at five year highs.  The unemployment rate has come down slightly from the beginning of the year to end the quarter at 8.3%. 

• U.S equity markets posted their strongest first quarter performance since 1998 with most major indices posting double digit returns.  The S&P 500 was up over 12%, the NASDAQ over 19%, and Russell 2000 index up over 12% for the quarter.  Non-U.S. equities were off to a strong start as well with MSCI EAFE index up 11% in the first quarter.

Economic and Financial Markets Analysis
The rally in U.S. equity markets that began in October 2011 continued in the first quarter of 2012 with most major indices ending the quarter with double digit returns.  The S&P 500 was up 12.59%, including dividends, for the quarter.  For the S&P 500 this was the largest first quarter gain since 1998.  Global indices participated as well, with only two countries, Spain and Slovenia, posting negative stock market returns for the quarter.  Emerging markets were especially strong with the MSCI Emerging Markets Index up over 14%.

The outstanding performance of the first quarter can be attributed to a number of factors.  Data from the first quarter continues to show the U.S. is on a slow but steady path of recovery.  The labor market is improving as 635,000 jobs were added in the first quarter.  Manufacturing activity and retail sales have also showed improvement thus far in 2012.  Additionally, U.S. corporations continue to report strong earnings while strengthening their balance sheets.  Consumer sentiment has also improved as the U.S. consumer has felt more secure about their employment and the U.S. economy. 

On a global level, there has been encouraging signs as well.  It appears that Europe has stabilized their debt crisis in the short term and the economic data from the first quarter was much healthier than anticipated.  Despite fears of a “hard” landing in China, the Chinese economy continues to operate at a very high level.  For example, Chinese industrial production increased by 11.4% in the first quarter – far ahead of most developed nations.

After such a significant run-up in equity markets many wonder if the current rally is sustainable.  Critics point to a number of headwinds that the market currently faces including continuing fears of a “hard” landing in Chinese economic growth, a resurgence in European sovereign debt issues, higher oil prices amid tensions in the Middle East, and fears of weaker U.S. economic growth.  Although there still remains a number of  downside risks to the current rally, it is reasonable to assume that U.S. equity markets can continue higher.  Historically, there is evidence to support this assumption.  Since 1975 there have been nine years in which the S&P 500 returns were greater than 7% in the first quarter.  In eight of these years the S&P 500 was up on average an additional 8% for the remaining three quarters.  Of these nine years only one year, 1987, showed negative returns for the remainder of the year. 

Fixed Income
The 10 Year Treasury began the year with a yield of 1.88% and ended the first quarter with a yield of 2.21%.  Rates peaked in March at 2.38%, a 32% rise from lows earlier in the quarter.  Despite rates remaining at historically low levels, the Federal Reserve has shown no inclination to introduce further easing or raise interest rates.  Although it is likely to remain a low rate environment for the foreseeable future, the increase in March showed rates are susceptible to market forces and any increase in rates will have an impact on the performance of bond portfolios.  As interest rates rise, bond prices decrease, with longer dated bonds experiencing an increased negative impact.  For these reasons, it is our recommendation to weight fixed income portfolios on the short end to avoid fluctuations in price and yield compared to the long end of the yield curve.  Additionally, we recommend purchasing high quality short-term positions inside of four years with sound financials as our philosophy on fixed income is safety before yield.

Areas of Focus Going Forward

• Concerns remain about the sustainability of China’s economic growth as a number of signs have pointed to a slowdown in Chinese economic activity.  Falling exports, slowing retail sales, and downgraded growth targets have contributed to worries China may experience a material slowdown in growth.  Overextended banks and a bubble in the Chinese housing market also pose additional risks to the Chinese economy.  Despite worries of a slowdown, China continues to grow at a pace much faster than the developed economies of the U.S. and Europe.   Additionally, Chinese households have high savings rates and low debt levels which are likely to help buoy any significant slowdown in the economy.  A slowdown in China’s growth is inevitable as the country continues to develop but at this point it is more likely to be a “soft” landing than the feared “hard” landing.
• The housing market has been slower to bounce back than the rest of the U.S. economy.  Without a thriving housing sector, many argue that the U.S. cannot sustain above trend growth in the economy and labor market.  On the other hand, a thriving sector would be a tailwind for accelerated growth.  Housing results have been mixed so far in 2012.  Homebuilder share prices have nearly doubled the return of the S&P 500 and home prices net distressed sales have started to increase.  Although overall prices have increased in some markets, home prices have continued to fall, albeit at a slower pace than previous periods.  The quantity of foreclosures put on the market is likely to be the key factor in the U.S. housing market, as any significant improvements are unlikely until inventory of existing homes is brought back to healthy levels.
• The European sovereign debt crisis continues to be a major concern for the global economy.  For now, the situation seems to have stabilized.  Greece was able to avoid a default by securing another round of financing and convincing private bondholders to take a lower return on their investments.  The European Central Bank (ECB) was also able to pump liquidity into the system through its Long Term Refinancing Operation, further easing tense situations in Spain, Italy, Ireland and Portugal.  However, risks do remain as it seems Portugal is in a similar situation to Greece.  Portugal and Ireland are both small enough to be rescued and a resumption of the crisis is most likely to manifest from problems out of Spain.  The perception, however, is that contagion is unlikely due to the ECB’s Long-Term Refinancing Operation and that at least for now the situation in Europe is under control.
• Improving U.S. economic conditions, as well as rising tensions between Israel and Iran, have led to an increase in oil prices during the first quarter of 2012. Israel has threatened a preemptive strike to end Iran’s nuclear program and Iran has threatened to close the Strait of Hormuz, which could drive oil prices considerably higher.  Higher oil prices continue to be a major risk to U.S. and global economies as it translates to more money spent at the pump and less money consumers are able to spend on other goods and services.  The likely resolution remains unknown and this remains a highly volatile situation.
• The November elections (presidential and congressional) are shaping up to be historical given the likely turnout of voters and the significant issues that have been in gridlock for over three years.  Among the issues that may be resolved by the November elections include the rising deficit, the expiration of the Bush-era tax cuts, healthcare, and energy programs.  While all of these issues could impact the markets, none have a greater impact than the scheduled expiration of the current tax structure.  Tax rates on dividends, capital gains and estates are all scheduled to move materially higher on January 1, 2013, and the outcome of the elections will likely determine if the rates will be renewed or allowed to expire.  The anticipated “electoral anxiety” will most certainly create volatility in the markets as the elections draw near.

Investment Conclusions
When considering the magnitude of the current rally in equity markets it is natural for markets to take a pause or even pull back before resuming the rally.  This remains the most likely scenario when looking forward to the balance of 2012.  Expect volatility to increase over the coming quarter or two as investors look to opportunistically take profits at elevated levels and add exposure on dips.  Absent any negative surprises, the environment remains favorable for equities to experience additional growth into the end of the year.  However, there remain material risks as outlined above that warrant some caution.  Because of these downside risks, our recommendation is use market volatility (material price swings) as an opportunity to raise or deploy cash.  We believe such tactical flexibility will be crucial going forward.