April 2011

 Executive Summary

• Against the backdrop of natural catastrophes, civil unrest, and resurgence of sovereign debt fears, equities proved resilient, providing strong gains for the first quarter.
• Traditional bonds were also fractionally positive in the first quarter, even as the yield curve steepened.
• Rising food and energy prices pushed headline inflation higher in March. Updated GDP figures revealed that economic growth accelerated in the fourth quarter boosted by strong personal spending.
• The labor market continues to show improvement with stronger job growth reported from private employers and a clear downward path in the unemployment rate over recent months.

Capital Markets

Of Austerity and Unrest: A Season of Change

It has been some time since we’ve witnessed events of such historical importance unfold in such a brief period of time and across such a wide geographic area as have transpired in the past three months. From natural disasters to revolutions, civil war to a nuclear disaster, the world has been buffeted by a series of events since the beginning of the year that have created fear, uncertainty, and reinforced the fact that we live in an ever-changing, globally connected world.

From a human perspective, the sheer toll of the massive earthquake that struck Japan, the ensuing tsunami, and the resulting crisis at the Fukushima Daiichi nuclear plant was catastrophic by any definition. At this point, the ultimate resolution and the long-term impact of the crisis remains a question, as crews continue to work to avoid a meltdown and bring the situation under control. Thus far, the strong aftershocks that plagued the region and a range of complicating factors have exacerbated the situation at Daiichi. In a disaster of this magnitude, there simply are no easy answers.

The geopolitical dynamics in the Middle East and Northern Africa are being realigned across a wide swathe of the region as a series of populist uprisings have toppled long-standing regimes, including some – like Egypt – previously believed to be safe and stable. From Tunisia to Egypt, Yemen to Bahrain, Libya to Syria and beyond, change is afoot.

As a result of the simmering instability in the region, Brent crude prices surged 24% during the first quarter. While oil prices did retreat in the aftermath of the earthquake in Japan as markets anticipated a marked slowdown in Japanese industrial activity and energy needs, they quickly reversed course by month end. Rising energy and food costs have quickly given rise to increasing concern about inflation, particularly in emerging economies.

In Europe, the governmental debt crisis encompassing a number of Eurozone economies is still developing. In Portugal, a proposed austerity plan by Prime Minister Socrates was rejected by the country’s parliament. Socrates subsequently resigned, even as the government appeared to move closer to the dissolution of its parliament and a call for new elections. As was the case in Greece and Ireland, a bailout looks increasingly likely. In Spain, the focus remains firmly on efforts to shore up their troubled banking system. While not part of the Eurozone, England’s efforts at addressing its own fiscal challenges recently led to massive protests in London against Prime Minister Cameron’s proposed austerity plan.

The scale of the human tragedy in Japan has not yet been fully absorbed and the unrest continues to spread across the Middle East, leaving the long-term implications of both largely unresolved. In general, natural disasters have tended to not have long-lasting negative economic repercussions for the impacted region. While Japan was already likely tipping into recession, these recent events exacerbated the slowdown in economic activity in the near term, but the eventual reconstruction efforts are also likely to provide a boost as the country rebuilds. Over the long term, Japan’s economic trajectory seems likely to be largely dictated by other fundamental factors.

Conversely, the changing face of the Middle East has the potential to have a much more significant impact on the balance of power in the region, modify the strategic geopolitical calculus for the region, and reshape relationships between those countries, the U.S., and the rest of the world. With the region still very much in a state of flux, it’s too soon to evaluate the scale of any strategic realignment, but this certainly remains something to watch in the months and even years ahead.

In China and other parts of the emerging world, policymakers are taking steps to attempt to cool the engines of economic growth as inflationary pressures are heating up. In many of these economies, food represents a much greater portion of consumer spending, and rising food prices have an even greater impact on the average family than is the case in the U.S. Moreover, the risk of an uprising – particularly in a world in which the winds of change are blowing – is a source of real concern for policymakers.

Against this backdrop of unrest and uncertainty, tragedy and hope, capital market volatility increased considerably in the latter half of the quarter. Despite the many trouble spots and sources of lingering uncertainty, volatility actually eased a bit and risk assets recovered in late March.


Source: PMFA

While policymakers have an abundance of issues to contend with, economic conditions in the U.S. appear to be on a sustainable path. The pace of growth picked up in the fourth quarter to a revised 3.1% annualized pace. The first formal look at Q1 GDP won’t be released until late April, but the expectation is that the pace of aggregate output in the U.S. may have slowed marginally from the fourth-quarter result. As the economy settles in from its recent shift from recovery to expansion, some deceleration is likely.

As the U.S. economic expansion advances, domestic equities continued on their positive path to start the year. Despite the uptick in market volatility in March, the broad domestic equity market as measured by the Russell 3000 Index managed a fractional gain for the month, sufficient to push its first-quarter performance to over 6%. Higher beta mid-cap and small-cap stocks performed better on a relative basis and continue to lead the blue chip S&P 500 on a year-to-date basis. International stocks were challenged to a greater degree, perhaps not surprising given the headwinds outlined earlier herein. However, the falling dollar boosted results for U.S.-based investors during the quarter.


Source: PMFA

The same volatility that was visible in stocks during March was apparent in bond markets as well. Despite a brief rally, Treasuries lost ground across the curve in the first quarter as anticipation of a continuation of economic growth and signs of increasing inflationary pressures pushed yields higher. Ultimately, this is likely to result in further narrowing of spreads between Treasuries and other bonds, as well as various degrees of upward pressure on yields across the range of bond sectors. We continue to believe that in such an environment, implementing with more flexible strategies and focusing fixed income exposures on spread products while de-emphasizing exposure to Treasuries remains advisable.

Against the headwind of rising yields, traditional bonds posted marginal gains for the quarter. High yield bonds have continued their positive pace, a quarterly return of 3.9%. The state of the municipal bond market remains a cause for concern for many investors, although the headline risk has diminished somewhat given the shift in the focus of the press toward other matters. We recently completed a research paper entitled, “Municipal Bond Market Outlook: Stay The Course, But Be Prudent,” that outlines our current views on the municipal market, the risks that exist as well as those that may be overblown, and observations about how to invest in the current environment. If you are interested, the paper can be downloaded at our website – www.pmfa.com.


Source: PMFA

It was the growing fears surrounding escalating debt burdens, fears of rising inflation, and fiat currency devaluation that helped to push the DJ-UBS Precious Metals Index higher throughout the quarter. Silver led this rally with a 22% advance in the first quarter. Rising energy costs also contributed to the 4.5% year-to-date gain in broad commodities. Meanwhile REITs pulled back for the month of March, but quarter-to-date their performance remains in line with broad equities.


Source: PMFA

We are continuously surveying global events as we evaluate the risks and opportunities that may be created in the capital markets. It’s often noted that we increasingly live in a globally interwoven economy connected by systems of communication that allow for news and information to be transmitted nearly instantaneously around the world.

We also live in a world in which risk will always be present, some of which relates to slow-moving trends that can reasonably be foreseen, while others – even with the best sources of intelligence – simply cannot. Even then, assessing the impact of the crosscurrent of events on capital markets is a daunting challenge. Implementing with strategies that have a flexible, actively managed mandate can help in navigating the path. At the same time, maintaining a long-term perspective within the context of a well-devised investment policy that is appropriately sensitive to one’s long-term return objectives and tolerance for risk provides a framework within which decisions can be made. The events and capital market performance of the last three months once again illustrate that point.

Economy

GDP

The economy grew at a 3.1% annualized pace in the fourth quarter on accelerating consumer spending, an upturn in residential housing, and an increase in net exports. The strength on the consumer side helped pull inventories down for the quarter, but the result was a drag on GDP. Although depleting inventories detract from GDP growth, in real time, it tends to be a positive future indicator as businesses will need to increase production to replenish their stock. Corporate balance sheets are strong and companies remain in a position to ramp up spending. Their trepidation has been on the strength of the demand-side pull of this cycle, which, until this quarter, was relatively subdued. The positive response to the Fed’s most recent quantitative easing initiative helped to push the manufacturing and service sectors towards strong readings of expansion by various measures.


Source: PMFA, Bureau of Economic Analysis (BEA)

The natural question to follow is will this strength continue? Recent indicators have suggested that some of the momentum we saw in the fourth quarter has slowed. The immediate result is being seen in downward adjustments to economic growth projections for the first quarter, which are now south of 3.0%. The dynamics that had been contributing to the recent strength in the economy, including an accommodative Fed, low interest rates, and muted inflation, are evolving. The Fed’s QEII initiative will wind down at the end of the second quarter, longer-term interest rates have ticked upward, and headline inflation has accelerated. Hefty price increases in food and gas have historically given consumers reason to pause. On the other hand, asset prices (outside of housing) have clearly appreciated, the employment market appears on the cusp of more meaningful job creation, and consumers once again have proven their resilience. We expect growth may slow in the midst of these interconnected variables at play, but continue to believe a sustainable path of growth remains the most probable outcome.

Interest Rates

In March, longer-term interest rates were relatively volatile amidst the events occurring around the globe. Investors plowed capital into U.S. Treasuries as perceptions of global risks increased, but that trend reversed in the latter half of the month. In the days following the Japan earthquake, the 10-year Treasury yield was driven down to 3.14% on an intraday basis at the peak of the flight to quality. Positive domestic growth and contained fears in the aftermath of the Japan crisis then buoyed sentiment and rates rose by over 30 basis points. The 10-year Treasury ended the month at a yield of 3.47%, marginally higher than where it entered the month. Shorter-term rates were relatively unchanged, with the three-month Treasury yield ending the month at 0.17%.


Source: PMFA, U.S. Treasury

The outcome for the fed funds rate was also unchanged at the March 15 FOMC meeting. The statement following their recent meeting noted that the recovery is on “firmer footing,” but “investment in nonresidential structures is still weak, and the housing sector continues to be depressed.” The “extended period” language was echoed once again, along with the intent to maintain the long-term Treasury purchase plans (a.k.a. QEII) through the second quarter of 2011.

Bernanke, as well as other committee members, has suggested that the hurdle is relatively high for QEIII. As the end of this second round of easing approaches and the global environment still appears fraught with uncertainty, the question the Fed must answer is, “Will the hurdle to initiating QEIII be greater than the hurdle for ending QEII?”

Inflation

One such hurdle against further easing will be the recent surge in commodity prices and its pass-through to broad measures of inflation. The Fed statement also acknowledged the recent price pressures from commodities, but with an expectation that its upward push on inflation should be transitory. The psychological effect of rising prices at the pump and the grocery store and its impact on the broad economy is a measure that’s difficult to quantify. In March, these price gains caused confidence levels to pull back materially. While this does not have a direct effect on spending patterns, as non-discretionary costs represent a larger portion of our incomes, worried consumers may certainly be less willing to open up their wallets.


Source: PMFA, BEA, Bureau of Labor Statistics (BLS)

Outside of economic growth, inflation is arguably the most important gauge for the broad economy, with the two very much intertwined. If inflation is too high, growth may be stunted, and if it is too low, price deflation is a risk. For February, headline inflation rose across the board. The Consumer Price Index (CPI) gained 0.5% for the month boosting the one-year change for the index to 2.1%. Rising commodity prices pushed the Producer Price Index (PPI) to a 1.6% increase for the month, which brought the index to a 5.6% year-over-year change. The historical volatility of the PPI relative to measures of consumer price changes illustrates that rising costs at the producer level are not always passed on to the consumer. If these increased input costs cannot be passed on to the consumer, corporate profit margins may contract, which will have a negative impact on forward earnings growth.

If these costs are passed through to the consumer, they will put upward pressure on headline and perhaps even core CPI.


Source: PMFA, BEA, Bureau of Labor Statistics (BLS)

Employment

There has clearly been improvement in the employment picture in recent months. The four-week average for initial jobless claims has now remained below 400,000 for over a month, a level that is indicative of stronger job creation. In March, companies added 216,000 jobs. This was the first time in five years the economy has seen back-to-back months of job growth above 200,000 within the private sector. On the other hand, state and local governments continue to pare back jobs in an attempt to balance budgets. This month was the fifth consecutive drop in payrolls at the state and local level.


Source: PMFA, BLS

The unemployment rate for March ticked down to 8.8%, a meaningful change from the 9.8% level of just four months ago. While there continues to be a slight disconnect between the relatively subdued pace of job creation relative to the rapid pace in declining unemployment, we believe the employment market has positive momentum to help push the virtuous feedback loop forward.



Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.