1Q Financial Markets Review and Outlook
Managers Investment Group
April 30, 2012
Market and Economic Review
The first quarter featured a continuation of the increased optimism surrounding a potential resolution to the European debt crisis that we witnessed at the end of 2011. This was visible not just via strong double-digit equity returns globally, but also through the sharp reduction in global equity market volatility with the “risk on, risk off” trade that appeared to guide markets throughout the latter half of 2011 on a seemingly daily basis beginning to drift away.
The European Central Bank announced its second round of Long-Term Refinancing Operations during the quarter. While generally recognized by markets as an ineffective long-term solution, the injection of liquidity into the European banking system has been positively embraced. Meanwhile, in early March Greece agreed to restructure $266 billion of debt, providing some level of certainty that markets had been seeking for quite some time. Nevertheless, Greece still faces a deep and long recession, high levels of unemployment, and a still substantial debt burden. Later in March, the Federal Reserve announced the results of its stress tests on 19 banks with only four of these banks failing to maintain a capital level above a regular minimum in a so-called “extremely adverse” economic scenario. The announcement was met favorably by investors and further improved consumer confidence. Also during the quarter the Federal Reserve reiterated its pledge to keep rates low for at least two years while taking a pass on QE3, but continuing to keep the door open for such an action if, and when, economic weakness deems it necessary. Toward the end of the quarter, data showed that housing starts and building permits were on the rise with increased demand also evident in previously owned homes.
The VIX, a measure of the implied volatility of S&P 500 index options often used to measure “fear” in markets, continued to fall precipitously, after spiking during the summer of 2011, reflecting investors new-found optimism in the strength of the global economic recovery and the potential for a satisfactory resolution to the European debt crisis and a soft landing in China. In addition, correlations across equities and sectors continued to decline after spiking to historically high levels in the middle of 2011, benefiting active asset managers who had struggled to find alpha amid such a high correlation environment.
At the company level, Apple Inc. dominated the headlines at the beginning of the year driven by its soaring stock price, the introduction of the latest version of its iPad, its surprising March announcement it will begin to pay a dividend, and the increasing importance its stock plays in many institutional portfolios and various benchmarks due to its large market capitalization. More broadly, although earnings were generally solid for the quarter, forward looking estimates were lowered consistently throughout the start of the year.
Fixed income markets within the U.S. collectively saw only modest gains during the quarter, as measured by the Barclays U.S. Aggregate Bond Index which returned 0.3%, although with significant dispersion in returns among the various securities that compose fixed income markets. Consistent with the equity market rally, risk-based assets within fixed income markets rallied significantly during the quarter as well. High-yield securities, as measured by the Barclays U.S. Corporate High Yield Index, returned 5.3% while the BofA Merrill Lynch High Yield Master II Index returned 5.2%. Meanwhile, Treasuries generally struggled during the quarter amid the flight away from quality with longer-duration issues struggling the most, returning -5.6% as measured by the Barclays U.S. Government – Long benchmark. Outside the U.S., fixed income markets recovered from a difficult fourth quarter with returns of 1.2%, as measured by the Barclays Global Aggregate x U.S. benchmark.
Equity markets continued their sharp rally, which began in the latter portion of the third quarter of 2011 and continued through the end of the year. Strong performance resulted in major market benchmarks reaching multi-year highs and closing the quarter within shouting distance of all-time highs, continuing a remarkable recovery from the depths of the financial crisis just a couple of years prior. The Russell 3000® Index and the S&P 500 Index both returned 12.9% achieving positive double-digit returns for the second straight quarter. U.S. large-cap equities performed virtually in line with small-cap equities as they returned 12.9%, as measured by the Russell 1000® Index, compared to 12.4% as measured by the Russell 2000® Index. At the sector level, optimism benefited cyclically geared sectors the most with the best performers being information technology (20.8%), financials (19.5%), and consumer discretionary (16.7%) holdings. Meanwhile, markets abroad also rallied sharply after a difficult 2011 with emerging markets outpacing their developed market counterparts, returning 14.1%, as measured by the MSCI Emerging Markets Index, compared to the 10.9% return generated by non-U.S. developed markets as measured by the MSCI EAFE Index.
The broad shift in sentiment from investors across the globe is encouraging, but does not change our cautiously optimistic viewpoint, which we have expressed in prior outlooks over the past several quarters. While previously we have led our outlook commentary with the reason for optimism among prevailing investor pessimism, this time we will begin by highlighting reasons for caution despite our favorable longer-term outlook for the ongoing recovery of global capital markets.
Although recovery is certainly visible in the U.S. there is increasing concern about the sustainability of this recovery in the face of a European recession and an ongoing Chinese slowdown. The U.S. economy has increasingly become dependent on exporting and it would be naïve to think that a recovery can be maintained if the rest of the world continues to stumble. While jobs are certainly being created during the recovery, they are not keeping pace with job growth in previous recoveries and unemployment remains stubbornly high. In addition, the housing market continues to greet every step forward with another step back and the recent increase in mortgage rates, while admittedly marginal, could serve as a headwind to any momentum the housing market is able to gain. Meanwhile, rising gas prices threaten to take the steam out of consumer spending in the U.S. and the perpetual threat of a supply shock due to geopolitical risk in the Middle East remains. The uncertainty surrounding the presidential elections toward the end of the year will also likely serve as a headwind for markets as investors wait for a resolution to the political uncertainty and its potential impact on another extension of the Bush tax cuts, among other fiscal issues.
On the positive side, however, earnings continue to improve with top-line growth beginning to complement the cost cutting that had previously been the primary driver of improved margins for most companies in the years immediately following the financial recession. As a result of this improved earnings picture, valuations continue to look compelling for equities despite sharp price gains over the prior six months. In addition, the Federal Reserve’s consistent vow to hold short-term rates at their current levels for an extended period of time, along with reasonable inflation, make it unlikely we will see a rate hike anytime in the near future. This continues to push investors towards risk-based assets such as equities and corporate and high-yield debt for the foreseeable future. Lower volatility, as seen more recently, has historically also provided an environment more supportive of riskbased assets. Finally, we are also encouraged, at least in the near-term, that despite the three-year equity rally off the lows achieved in March 2009, investors have yet to be caught up in the rally and continue to view the recovery with a healthy bit of skepticism.
We will, once again, mention that we believe that investment opportunities exist, particularly for skilled active money managers that have the ability to take advantage of mispricings, wherever they may exist. In recent months, we have seen the return of strong performance from active management, with these solid results coinciding with a fall in correlations across markets and securities. More broadly we believe investors who can withstand the potentially higher volatility of risk-based assets will continue to benefit, as safe-haven assets such as U.S. Treasuries continue to offer historically low yields and negative real returns when factoring in inflation.
Please note that all performance data and comments are for the period from December 31, 2011 through March 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 March 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.
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