Financial Markets Review and Outlook:
Fourth Quarter 2012
Managers Investment Group
January 9, 2013
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.
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.
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® Index returned 0.3%) and some modestly negative (the Dow Jones Industrial Average returned -1.7% and the S&P 500 Index returned -0.4%) for the quarter. Small-capitalization equities returned 1.9% outperforming the 0.1% generated by their large-capitalization counterparts, as measured by the Russell 2000® and Russell 1000® Indices, respectively. Outside the U.S., equity markets generated solid returns for the second straight quarter led by non-U.S. developed markets, which returned 6.6% as measured by the MSCI EAFE Index. Emerging markets also boasted a solid return of 5.6% for the final three months of the year as measured by the MSCI Emerging Markets Index. From a sector perspective in the U.S., the industrials and financials sectors were the best performers, while holdings in the information technology and telecommunication sectors detracted the most. Unlike a majority of periods over the prior several years, there was no clear leader or laggard sector(s) based upon an overall “risk on\risk off” theme and, generally speaking, performance within a sector was driven by fundamentals specific to that particular sector. From a style standpoint, value outpaced growth by nearly 3% for the quarter as measured by the Russell 3000® Value and Russell 3000® Growth Indices which returned 1.7% and -1.2%, respectively.
The resolution of the tax portion of the fiscal cliff temporarily alleviates a good part of market uncertainty as we enter the New Year. While addressing the most important immediate concern for the economy, Congress nevertheless simply “kicked the can” on several important issues that, if not resolved to the market’s liking, may serve as a significant cloud to the already tepid growth prospects here in the U.S. More specifically, spending cuts and yet another debt ceiling remain unresolved and almost all pundits believe even the new Congress will struggle to overcome bipartisanship in an effective manner and will likely walk us right up to, and possibly over, these cliffs as well. There is certainly evidence that shows hints of both optimism and pessimism among the U.S. populous. Even with the constant political bickering evident throughout the fourth quarter, for a majority of the quarter consumer sentiment remained surprisingly strong while market volatility was somewhat benign, at least until the final days of the fourth quarter. And, as previously noted, risk-based assets performed reasonably well despite the market uncertainty. We mention this in the context of setting expectations for the first portion of 2013 with the markets yielding the potential to overcome political uncertainty. That being said, there was evidence that companies in particular small businesses, continued to limit spending in the fourth quarter amid the uncertainty and we remain concerned that this trend will continue into 2013 as nervous business owners wait for more fiscal resolutions. This threatens to dampen GDP growth and any significant improvement in the job market, which consequently, will likely lead the Fed to continue their bond-buying programs for the foreseeable future.
Amid the uncertainty, however, risk-based assets continue to look very favorably positioned. Valuations across equity markets, on a global basis, look attractive on a historical basis and certainly in comparison to the opportunities available within fixed income markets. Valuations only appear “stretched” in higher dividend-yielding securities favored by investors who, hungry for yield have driven these valuations to levels not seen in some time. Fixed income securities and fixed income asset flows continued to defy the odds in 2012, despite historically low yields and compelling opportunities in other risk-based assets, as investors continued to seek return of their capital as opposed to return on their capital. As investors continue to grow weary of receiving no-to-negative real returns on these investments into 2013, and resolution occurs on some of the aforementioned issues, we believe the tide will, finally, start to turn in favor of more risk-based assets. The lack of enthusiasm for risk-based assets, and equities in particular, only serves as further support for these investments as investor flows tend to be a contrarian indicator. Finally, after many years of elevated correlations across investments within various asset classes, we began to see a breakdown of these correlations in 2012 that we expect to continue into 2013 as the market begins to choose amongst the so-called “winners” and losers.” This bodes well for active managers, in particular, who seek low-to-no correlation among the investments within their asset class, as this tends to be the best environment to show their skills and outperform passive benchmarks.
Please note that all performance data and comments are for the period from September 30, 2012 through December 31, 2012. Any sectors, industries, or securities discussed should not be perceived as investment recommendations. The views expressed represent the opinions of Managers Investment Group LLC and are not intended as a forecast or guarantee of future results. The information and opinions contained herein are current as of December 31, 2012 and are subject to change without notice. Information has been obtained from sources believed to be reliable, but its accuracy, completeness, and interpretation are not guaranteed. The S&P 500 Index is proprietary data of Standard& Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved. The Russell 1000®, Russell 2000®, and Russell 3000® Indexes are trademarks of Russell Investments. Russell® is a trademark of Russell Investments. All MSCI data is provided ‘as is’. The products described herein are not sponsored or endorsed and have not been reviewed or passed on by MSCI. In no event shall MSCI, its affiliates, or any MSCI data provider have any liability of any kind in connection with the MSCI data or the products described herein. Copying or redistributing the MSCI data is strictly prohibited. An investment cannot be made directly into an Index. Index returns do not reflect any fees, expenses or sales charges. Investment advisory services are offered by Managers Investment Group LLC. Funds are distributed by Managers Distributors, Inc., member FINRA. F011-1212
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