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Financial Markets Review and Outlook: Fourth Quarter 2012

January 9th, 2013

by Team

of Managers Investment Group


Market and Economic Review

As expected the fourth quarter economic landscape was dominated by the U.S. Presidential and Congressional elections and their collective impact on the fiscal cliff. After the elections were completed, markets nervously awaited the outcome of the fiscal cliff negotiations as economists generally predicted dire consequences for the U.S. economy in 2013 if a timely resolution was not reached by the end of the year. Despite a resolution on the tax aspects of the fiscal cliff not being reached until just beyond the final hours, equities and other risk-based assets generally delivered flat performance overall for the quarter after difficult performance leading up to the elections. Meanwhile, Hurricane Sandy exerted not only a tragic human toll, but threatened to serve as another headwind for economic growth, at least in the short-term, here in the U.S. After a busy third quarter, which featured the launching of "QE3," the Federal Reserve (the Fed) remained largely out of the business news cycle in the fourth quarter as their bond-buying programs continued in earnest. That being said, a more divided Fed appeared to rear its head toward the end of the year with officials split on how long to continue their bond-buying programs amid no significant improvement in the U.S. job market.

During the third quarter, U.S. gross domestic product (GDP) grew 3.1% on an annualized basis up sharply from the disappointing GDP growth posted during the second quarter. Meanwhile, the ISM Manufacturing PMI Index, which serves as a measure of manufacturing growth, rose in December after a disappointing mid-quarter reading. A reading of 50 generally signifies growth and a reading below 50 is a sign of contraction, with the Index at 50.7% by the end of the quarter. There was more mixed news on the jobs front in the fourth quarter, with the U.S. economy ending the year by adding 155,000 jobs in December, albeit with the unemployment rate remaining unchanged at 7.8%. This was broadly in line with economists' expectations and the last jobs-related data of the year represented an improvement over November after a somewhat anomalous reading related to the temporary impact of Hurricane Sandy. Economists generally see little hope for short-term optimism with regard to hiring or additional job creation as ongoing business uncertainty related to unresolved fiscal cliff issues should keep employers on the hiring sidelines for the immediate future.

Meanwhile, the housing market continued to build on its positive momentum. Various metrics, including both new home construction data as well as sales in existing home sales, showed signs of improvement. New construction fell slightly from October to November but was still 21% higher than a year prior and may have been temporarily impacted by Hurricane Sandy in much of the Northeast portion of the U.S. Nevertheless, the combination of ongoing record low mortgage rates, increasing use of government programs to allow more potential homebuyers access to these rates, falling foreclosures and a somewhat improving economy have served as a backdrop for the recent turnaround in housing, which could play a significant role in 2013 GDP growth and beyond.

Despite the ongoing uncertainty around the fiscal cliff, market volatility, as measured by the Chicago Board Options Exchange's Volatility Index (VIX), remained surprisingly low for the majority of the quarter while investors remained cautiously optimistic. The VIX only spiked briefly toward the end of the quarter when political posturing appeared as though it would inhibit any deal from being completed by the fiscal cliff deadline. At the stock level, Apple Inc. was the dominant name in the news, as its' shares fell by 20% after release of the iPhone 5, only a quarter after becoming the largest U.S. company from a market-capitalization perspective. Apple stock had been up nearly 70% from the beginning of the year and tax selling by investors played a part in its decline.

Outside the U.S., equities rallied in Europe again as markets took comfort in efforts earlier this year to save the Euro and to keep the sovereign debt crisis issues impacting Greece and Spain from spreading across the continent. Nevertheless, many still see recent market strength in Europe as nothing more than a "relief rally" and continue to view Europe as an area fraught with structural issues that will take years to overcome, with many competing forces that could lead to further geopolitical instability similar to what we saw in 2012. In China, a sharp rally in December closed the year on a positive note, albeit well behind the equity markets of the majority of the rest of the world, as skepticism remains about Chinese officials' ongoing ability to effectively manage a slowing economy.

Bonds

Much like equities, fixed income markets within the U.S. collectively saw modest gains during the fourth quarter, as measured by the Barclays U.S. Aggregate Bond Index, which returned 0.2%. For the second straight quarter, high-yield bonds were the best performers, returning 3.2% as measured by the BofA Merrill Lynch US High Yield Master II. Credits, in general, performed well for the quarter while Treasuries, particularly longer-dated issues, lagged amid an increased appetite for yield in other areas of the market. Outside the U.S., fixed income markets had difficult performance after a solid third quarter, returning -1.0% as measured by the Barclays Capital Global Aggregate x-U.S. Index in U.S. Dollar terms, partially driven by a strengthening U.S. Dollar.

Stocks

Despite the uncertainty that overhung markets during the end of the year, equity indices performed reasonably well. Broad U.S. equity benchmarks had mixed results with some modestly positive (the Russell 3000

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