Executive Summary

• Equity returns were mixed in the final month of the year. Domestic equity returns were relatively flat but sufficient to cap a strong fourth quarter on a positive note. International stocks lost ground for U.S.-based investors in December, adding to double-digit losses for the year.
• High-quality bonds finished the year in strong fashion, rallying in December as long-term Treasury yields fell. The Fed maintained its accommodative stance during its December meeting, continuing its bond purchases under “Operation Twist.”
• The economy grew at a moderate pace in the third quarter, but the rate of growth was again revised lower in December. The fourth quarter appears to have potentially been the strongest quarter last year. Headline inflation continued to slow, while core indicators once again ticked upward in November.
• The employment situation appears to have gained some momentum as the economy continues to add jobs at a moderate pace. The unemployment rate ended the year at 8.5%.

Gratuitously Unnecessary Observation of the Month I Want My $2!  The $2 bill, featuring Thomas Jefferson, was introduced in 1862, only to be discontinued in 1966 due to lack of use. Although the bill was reintroduced in 1976 (as part of the U.S. Bicentennial celebration), $2 bills comprise less than 1 percent of all U.S. currency in circulation today. It’s easy to see, then, how the $2 bill got its reputation for being rare. Those Americans who have collected them hoping to reap the financial benefits of that relative scarcity, however, have been disappointed. The $2 bill hasn’t appreciated at all and continues to be worth – drumroll, please – a mere two dollars. At least that’s better than other collectibles that have lost money as interest has waned. And, unlike most collectibles, you could still trade a $2 for a cup of coffee.  Source: CNBC

Capital Markets

A new year, an old set of worries

Like a riveting novel, 2011 had plenty of suspense and drama. Given its abundance of peaks and troughs, it proved to be a memorable year. From the demise of dictators and terrorists to royal weddings, from toppled regimes to natural disasters, and from debt-crippled nations to political dysfunction, 2011 was not short on meaningful developments or memorable events.

Unfortunately, many of the headlines that peppered the news last year were left unresolved or only created new questions, bequeathing to the New Year an old set of worries. Three prevailing “Ps” from last year are likely to remain dominating stories as we move into 2012: public debt, the politician, and the protester.

Public Debt

“If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.” This quote from John Maynard Keynes draws a fitting picture of the issues confronting the Eurozone. Matters of liquidity and solvency for multiple Eurozone Member States have been a growing concern, driving interest rates higher across the Eurozone’s peripheral countries. Their debt crisis was a dominating story throughout 2011. The crisis, which began in Greece, quickly spread to Ireland, Portugal, Spain, and Italy; by the fourth quarter, it was threatening the existence of the European Union at its core. The crisis has toppled several governments, and the bandages applied in the form of bailouts and austerity measures have proven inadequate to solve the underlying issues. Deleveraging, deficits, and the Eurozone crisis are sure to be themes that follows us into 2012 and beyond.


Source: PMFA, Bloomberg

Signs of global slowing became clearer last quarter, which is an undesired development for countries already facing strict austerity measures and high deficits. Although some domestic economic data surprised to the upside in the fourth quarter, slowing international growth and a downturn in the industrial sector globally has increased the risk in an already volatile environment. In acknowledgement of this slowdown, multiple central banks have been easing, as demonstrated by rate cuts by the European Central Bank and the Reserve Bank of Australia. The Peoples Bank of China refrained from lowering rate in December, opting instead for a reduction in its reserve requirement to help counteract the slowdown. Other central banks, including the Federal Reserve, are at or near zero bound and continue to turn to unconventional means to provide stimulus.

The Politician

Winston Churchill once said, “A politician needs the ability to foretell what is going to happen tomorrow, next week, next month, and next year. And to have the ability afterwards to explain why it didn’t happen.” While the same quip could be said of economists, we suspect the 2012 presidential election campaign will resonate with the familiar themes that rise like a phoenix every four years. Promises of change and hopes of a better tomorrow will be mingled with criticisms and accusations directed at those on the other side of the political divide.

The dysfunction in Washington (as well as throughout the Eurozone) was another prominent theme in 2011. The political wrangling that led to the down-to-the-wire decision to raise the debt ceiling last year was a clear example. The delays and threats to block the increase resulted in mass speculation about the ramifications of a potential government default or shutdown and increased market volatility, before ultimately becoming the catalyst for Standard & Poor’s to downgrade the credit rating of the United States to AA+ status. Meanwhile, the ultimate deal only set the stage for future failure and even more politicking with the formation of the debt supercommittee, which ultimately also failed to reach its goal of meaningful steps to reduce the budget deficit over a multi-year period.


Source: PMFA

In spite of the high volatility that to a degree characterized the year, returns for the S&P 500 Index for 2011, while muted, remained positive at 2.1%. International equities were not as hardy last year, falling by more than 12%. In the fourth quarter, domestic equities provided solid double-digit returns across all market caps. International equities were also positive but significantly trailed their domestic counterparts.


Source: PMFA

Traditional, high-quality bonds outperformed equities in 2011. The Barclays Aggregate Index rallied 7.8%, as long-term interest rates moved down over the course of the year despite the prevailing view early in the year that the greater risk was for rising rates. Municipal bonds, which were an object of investor worry at the onset of the year due to fears of widespread defaults, also ended the year ahead of equity indexes. High yield bonds were more volatile as investors shifted between “risk off” and “risk on,” but finished the year strong. The Barclay’s High Yield Bond Index returned more than 6% in the final quarter, pushing the benchmark toward a 5% return for the year.


Source: PMFA

Alternative investments also had mixed performance in 2011, demonstrating the breadth of the asset class. Broad commodities experienced a sharp contraction (particularly in the latter half of the year), which helped ease inflationary concerns as the year progressed. Real estate investment trusts (REITs) rallied with other risk assets in the fourth quarter, but with substantial volatility to yield-hungry investors that may turn to REITs as a source of income. Precious metals sold off sharply in December, as both gold and silver prices retreated, but still outperformed equities for the year.


Source: PMFA

The Protester

Each year Time magazine announces its “Person of the Year,” the person (or persons) the magazine feels most affected or influenced the news and events during the year. Time’s 2011 Person of the Year was “the protester,” an intentionally vague selection meant to encompass the many individuals known and unknown around the world who took to the streets (literally and figuratively) to effect change. This tumultuous year began with unrest spreading across the Middle East and North Africa (MENA). Three governments were forcibly toppled, while several other leaders voluntarily stepped aside in what became known as the Arab Spring. Protests, however, were not limited to the MENA region. The Eurozone periphery also witnessed protests in defiance of the severe austerity measures implemented to curtail spiraling deficits. Even the United States was not immune to protests, as activists from across the political spectrum – most notably the Tea Party and Occupy Wall Street movements – gained momentum and made their respective presence known across the country.

Unified people with similar goals have proven to be a force to be reckoned with. The changes spurred from one cohesive voice of the people have been staggering, and that voice is unlikely to be quieted in 2012 as many of the issues that drove these movements remain unresolved.

While these three “Ps” are far from representative of all the challenges that lay ahead, it’s clear that the year has not begun with a clean slate. As we acknowledge the present risks, investors should also recognize that opportunities exist despite uncertainty (and sometimes assisted by it) and that volatility is not limited to the downside. Specific risks and opportunities change over time, and portfolio positioning and investor expectations should also adjust over time. The constant, however, is the philosophical framework for success: disciplined decision-making with appropriate attention to one’s risk tolerance and investment time horizon remains a prudent approach to investing in any market environment.

Economy

GDP

The economy grew at a 1.8% annualized pace in the third quarter, according to the final estimate of Gross Domestic Product. This was somewhat lower than the previous two estimates of 2.5% and 2.0%, respectively, but was the strongest quarterly result year-to-date. Spending on both the consumer and business side accelerated, a trend that’s expected to carry over into the fourth quarter. Currently, economists expect that fourth-quarter growth is likely to be north of 2%; however, as we’ve seen in recent quarters, revisions after the first estimate can be meaningful.
 

Source: PMFA, Bureau of Economic Analysis (BEA)

Fourth-quarter earnings season has already kicked off, and analysts broadly expect moderate improvement in earnings for the quarter. Beyond the actual earnings results, investors will once again pay close attention to corporate expectations for future quarters.

Inflation

The headline Consumer Price Index (CPI) eased further in November as the declines in energy once again offset increases in the food and core indexes. More recently, the growing tensions in Iraq have pushed oil prices higher, which will likely be reflected in December’s announcement. Producer prices reversed October’s decline, increasing 0.3% in November. Over the last 12 months, pressure on headline inflation has proven transitory, and measures have been easing since their summer peaks.


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

All core measures of inflation ticked up consistently by 0.1% for the month. The one-year change for the core CPI was 2.2% in November, while the core Personal Consumption Expenditures Deflator reflected a more muted 1.7%. The Fed’s implied target for core inflation is a range of 1.5%–2.0%. Overall, core measures of inflation are close to the Fed’s implied target, while the Fed’s tolerance level for inflation is likely higher against the backdrop of an 8.5% unemployment rate.


Source: PMFA, BEA, BLS

Interest Rates

The Federal Open Market Committee (FOMC) determined to stay the course at its December 13 meeting. Its statement acknowledged that the economy appears to be “expanding moderately, notwithstanding some apparent slowing in global growth.” The FOMC maintained its program, coined “Operation Twist,” to extend the Fed’s average maturity of security holdings, while also continuing to reinvest principal payments to hold steady its balance sheet size. At its next scheduled meeting beginning January 24, there will be some rotation in voting members of the committee. This change in composition could reflect a slightly different tone as more hawkish members are replaced by those with a more dovish stance and could lower the threshold for additional easing if economic conditions in 2012 do not materially improve.


Source: PMFA, U.S. Treasury

On the surface, the Treasury yield curve appears relatively unchanged over the last quarter, but that’s not to say interest rates haven’t fluctuated. On September 30, the 10-year Treasury yield was 1.92% before rising 50 basis points to 2.42% by the last week of October. Subsequently, yields have fallen back into the sub-2% range, ending the year at 1.89%. Rates have been relatively unchanged at the shorter end of the curve, as yields remain range bound near historical lows. The three-month Treasury ended the month at 0.02%, just one basis point higher than November. Interest rates are expected to remain low for some time, as the Fed attempts to encourage investors to seek higher yields in risk assets and spur economic growth.

Employment

Recent improvement in the employment market continues to be a bright spot for consumers and the economy. The employment release surpassed expectations in December, as the economy added 200,000 new jobs last month, while weekly earnings and hours worked also improved slightly.


Source: PMFA, BLS

The unemployment rate ticked down to 8.5%, approaching a three-year low. The recent momentum in the jobs market should provide a bit of a boost to consumer sentiment. Ultimately, that progress will need to be extended for several quarters to continue that momentum and generate meaningful improvement in personal income.
 



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.