2Q Financial Markets Review and Outlook
Managers Investment Group
July 9, 2012
Debt and growth issues dominated the headlines again causing a muted version of the “risk off” trade to return to prominence. Greece was the main culprit due to elevated debt levels, rising yields, social unrest and two elections. The first Greek election on May 6 was unsuccessful so a much-anticipated second election was held on June 17. There was much uncertainty as the second election approached. Preliminary polls were unclear whether an anti-austerity and anti-bailout party would win. This elevated concerns about a Eurozone collapse, an end to the Euro and possible contagion. To the delight of many, disaster appears to have been avoided as the pro-austerity party won. Greece has a long road ahead, but this was a positive step forward to begin efforts to decrease debt levels and spur growth.
Unfortunately, Greece is not the only problem child in the Eurozone. Spain and Italy also saw their borrowing costs fluctuate, typically higher, during the quarter. These are greater threats to the global economy because both represent a larger percentage of global GDP than Greece. For this reason, the issues in Italy and Spain are less likely to linger unaddressed. Not coincidentally, shortly after the Greek election in late-June, key European leaders reached agreement to establish a “super” bank to oversee the Eurozone. The preliminary agreement is another first step to address austerity, support problem banks and spur economic growth. This increases the probability the Eurozone and Euro will survive. However, many questions remain unanswered and the Eurozone crisis will continue to influence markets for the foreseeable future.
Domestically, the first quarter ended with a surprisingly disappointing jobs report. This turned out to be a harbinger of future disappointments. Many U.S. economic indicators reversed course during the quarter. For example, ISM Manufacturing PMI fell to 49.70, which signals contraction, and is at its lowest level since 2009. Additionally, only 77,000 jobs were added during April and 69,000 during May. This is well below the over 500,000 jobs created during the first two months of 2012. Lastly, the Confidence Board’s consumer sentiment index has also been trending lower with the most recent reading at 62.10.
Concern about Europe and discouraging U.S. data caused another mid-year pullback in equities. This is similar to what happened during 2010 and 2011. So far the sell-off has been less dramatic than past years. The S&P 500 returned -2.8% during the second quarter with a year-to- date max drawdown (peak to trough return) of -9.6%. This is a more muted sell-off than during 2010 and 2011 when max drawdowns were worse than -15%. As domestic equities struggled, U.S. Treasuries and similar “safe haven” debt issues were in high demand. Conversely, commodities continued to fall. In particular, crude oil fell more than $15 during the quarter and as much as $25 before a small late-quarter recovery.
Volatility also increased during the quarter. In particular, it increased during April and May before decreasing in late-June. It is nowhere near the elevated levels seen during 2010 and 2011 and a fraction of what we experienced during 2009. Correlations across asset classes remain elevated. Perceived risk has been the key performance differentiator over recent years.
Within the U.S. equity market there were two noteworthy events. The first was the Facebook IPO. The IPO drew attention from even unsophisticated investors. The IPO had numerous issues and trading was slightly delayed. The stock has struggled since its initial offering due to questions about Facebook’s ability to generate future growth. Another newsworthy event during the quarter was the huge trading loss at JP Morgan. The initial estimate was about $2 billion due to bullish bets on corporate defaults. Essentially a department of JP Morgan that invests excess reserves and manages risk made aggressive bullish bets by selling baskets of credit default swaps on corporate debt. These bets did well during the first quarter but soured during late-March and early-April. The latest loss estimates are as high as $9 billion. This was a black eye for what many perceived as the “safest” bank. It was a failure of JP Morgan’s risk control system and raised questions about whether banks are any safer today than prior to the onset of the Financial Crisis.
Fixed income markets within the U.S. collectively saw gains during the quarter, as measured by the Barclays U.S. Aggregate Bond Index which returned 2.1%. U.S. Treasuries and TIPs performed best as Europe and poor U.S. economic data drove investors to safety. The Barclays U.S. Government – Treasury Index returned 2.8% and the Barclays U.S. Treasury – U.S. TIPs Index returned 3.2%. Within the U.S. Treasuries market, long Treasuries led the way with the Barclays U.S. Government Long Index returning 10.3%. Spread products also generated positive returns for investors due to falling rates across the curve. In particular, U.S. Credit produced decent returns and intermediate municipal bonds benefited from the flight to quality.
Fixed-income returns outside the U.S were less favorable. The Barclays Global Aggregate Bond Index returned 0.6% in U.S dollar terms. The low absolute return is partly attributable to U.S. dollar appreciation, but the European crisis was the overriding factor that hurt non-U.S. fixed income returns.
Most equity indexes generated negative returns during the quarter. Market preferences reversed course during the quarter. Generally speaking, U.S. equities held up best with the S&P 500 Index returning -2.8% compared to -7.2% for the MSCI ACWIxUS Index. Within the MSCI ACWIxUS Index Europe and Emerging Markets generated the worst returns. Similar to other “risk off” periods, U.S. large-cap stocks slightly outperformed their small-cap counterparts. The Russell 1000® Index returned -3.1% compared to 3.5%. Interestingly, domestic mid-cap stocks performed the worst as the Russell Midcap® Index returned -4.4%. This is a slight reversal since the Russell Midcap Index has a sizeable advantage over the Russell 200® Index and the Russell 2000® Index over the last 15 years. From a sector perspective, more defensive sectors performed best. Within the S&P 500 Index the best performing sectors were telecommunications (14.1%), utilities (6.5%), consumer staples (2.9%) and health care (1.7%). Conversely, more cyclical sectors like materials, industrials and consumer discretionary generated negative returns. The financials sector was the worst performing sector within the Index, which remains 55% off its October 2007 peak level. Domestic value indexes outperformed growth indexes even though they tend to have a larger allocation to financial stocks.
There is a lot to worry about as we begin the second half of 2012. The Eurozone remains in crisis as several European countries have serious debt problems that appear unsustainable. Additionally, Europe is likely already in recession, which has negative consequences outside the region for countries that export goods to Europe. Some initial steps have been taken to stabilize the region—most promising is the “super” bank initiative. Much remains to be resolved and the main issue is how do European countries address their debt issues with austerity and spur growth.
To complicate matters going forward, second quarter economic data has been lackluster. Emerging markets and the U.S. were expected to support the global economy during 2012 and 2013. While few predict a global recession in the coming quarters, the future is very unclear. Poor data from the U.S. and China has definitely increased the probability of another global recession in the coming months. The most likely outcome is a continuation of the muted growth experienced during the last 12 months. One major unknown in the U.S. is the “fiscal cliff.” At the end of 2012, numerous favorable tax rates expire and over $1 trillion could be cut from future Federal budgets. It is estimated this could hurt 2013 GDP by 2-3% and push the U.S. into recession. Given the looming November election, it is unlikely Congress will address these issues in the coming months. Most expect a compromise will be reached in late-2012 or early-2013 that includes a continuation of some tax cuts and more modest budget cuts than those currently mandated. Such a compromise would be only a modest drag on future economic growth, which should help the U.S. avoid a future recession. Historic political polarization, an uncertain presidential election, and ultimate control of the senate complicate matters during a crucial time in American history. Government officials need to act wisely to ensure the U.S. does not experience another recession due to inaction or political stubbornness.
While risks and uncertainty abound there are reasons for optimism. First, auto sales are up sharply from their depressed 2008 levels. The most recent reading of an annual rate of 13.7 million is up over 4 million from the bottom and fairly in-line with the historical average.
Lastly, equities appear attractively valued from a historical perspective. If a small recession appears, the downside should be limited. Most companies have valuations below their historical averages that present an attractive entry point for long-term investors. For example, the trailing price-to-earnings ratio, price-to-book ratio, price-to-cash flow ratio, and price-to-sales ratio on the S&P 500 Index are all solidly below their 15-year average. Additionally, the dividend yield is above average and equities look very attractive relative to the negative real returns many bonds currently offer.
The last few weeks have seen many governments and central banks act to spur economic growth. Just recently the ECB, BoE and China cut key interest rates. These moves may prove inflationary in the intermediate future, but should help economic growth in the short-term. The question is by how much? Some feel the Federal Reserve is already out of bullets. Interest rates are zero on the short-end and mortgage rates are already at historic lows. Since, high interest rates are not suppressing homebuyers, it is more likely a lack of equity in their existing homes, a lack of confidence in the economic outlook and banks’ unwillingness to lend. Lower interest rates will not solve these problems as we have already seen. Only time and an improved economic landscape will.
We continue to believe the U.S. will avoid another recession if politicians appropriately address the “fiscal cliff” before the end of 2012. Given historic polarization there is no guarantee this will occur. We also think equities are attractively valued for long-term investors that are able to handle continued volatility for the remainder of 2012. Other risky assets also offer attractive risk-adjusted return potential. We also encourage investors to evaluate their U.S.
Treasury holdings, which offer negative real return and are eventually poised to retreat.
Please note that all performance data and comments are for the period from March 31, 2012 through June 30, 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 June 30, 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.
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