Executive Summary

• Once again, U.S. stocks extended their rally in the month of February. Small caps led the pack, while emerging market equities sold off marginally amid the political unrest in the Middle East and North Africa.
• Treasury yields held steady, allowing traditional bonds to provide fractional gains for the month. Longer-term municipal bonds recovered nicely following the recent sell off.
• The pace of economic growth was revised downward for the fourth quarter, although personal consumption remained on the upswing.
• Energy costs continue to push headline inflation higher. Significant slack in the economy and tepid wage gains should prevent core inflation from rising to uncomfortable levels in the near-term.

Capital Markets

Life in the slow lane…

Speed limits in the U.S. have traditionally been set on a state-by-state basis and vary somewhat across the country. Many states differentiate between urban and rural interstates, but the range is quite broad – from 50 mph in parts of Hawaii to 80 in certain portions of Utah and Texas. It’s also not unusual for states to have lower limits for trucks, by as much as 15 mph below the posted speed for cars. The rationale for the variation in speeds between cars and trucks is primarily a factor of weight. As physics would explain, the greater the mass, the greater the stopping distance needed for an object in motion. Varying speeds results in comparable reaction times for the two vehicles. On the other hand, many states employ what’s referred to as high-occupancy vehicle (HOV) lanes (a.k.a. car-pool lanes), which purport to get you from point A to point B faster and more reliably, with the catch being that more than one occupant must be in the vehicle. So how is this relevant from an economic perspective? Outside of greater government revenues from violators of the posted traffic laws, we’d argue that the world economy is in a similar circumstance today with varying speeds of growth expected across the globe.

Gratuitously Unnecessary Perspective of the Month A Little or a Latte? Americans certainly love their coffee. However, according to Kiplinger, one of the first things consumers cut out of their budgets when they’re feeling pinched is that high-priced caffeine served up by their local barista. In accordance, Starbucks’ net revenues fell in 2009 as consumers remained in a savings mode. That reversed course in 2010, as revenues gained. This is good news or bad news, depending upon your view. On one hand, it’s yet another indicator that the economy is improving. On the other, it just means that, in 2011, we’ll likely have to listen to even more people place hard to understand orders like, “I’ll have a double ristretto venti half-soy nonfat decaf organic chocolate brownie iced vanilla double-shot gingerbread frappuccino, extra hot with foam whipped cream upside down double blended.” Remember when the only choices were regular or decaf in three basic flavors: black, with cream, and/or sugar? Source: Kiplinger

Trucks – Heavy mass, slower speeds

The U.S. and other developed nations represent the heavy trucks on the road operating now at somewhat slower speeds as compared with the rest of the world. In the event of an impending obstacle in their path, trucks have slower reaction speeds and, given their mass, tend to be less maneuverable than lighter weight cars. Acceleration can also be an issue, taking trucks sometimes a much longer time to pick up speed, particularly dependent on their load. As we have outlined in prior missives, there’s a long list of inhibitors to growth for the developed nations of the world. Debt, for many, tops the list as policymakers have little choice but to roll up their sleeves and make increasingly difficult decisions to address fiscal deficits and, in some cases, critical debt levels. High levels of unemployment and household indebtedness coupled with depressed housing markets in some regions will also act to constrain consumption. We expect it will be years before these economies are once again operating at full employment. Packed with such heavy loads, these economies will be challenged to grow even at longer-term historical “speeds.”


Source PMFA

While slower growth remains our secular outlook, we recognize that other powers are at play in the near term. Our current policy environment remains accommodative; low inflation and interest rates, an improving employment picture, and gradual improvements in consumer confidence provide the potential for growth at or perhaps even above trend from a cyclical perspective. The Fed appears likely to remain engaged in asset purchases designed to keep interest rates low, stimulate inflation, and encourage investment, with the hope that it ultimately spills over into the broad economy.


Source: PMFA

Their interventionist stance has been coined the “Bernanke put,” suggesting the Fed will step in to create an implicit floor for equities while they maintain their easing efforts. Collectively, these policies and economic fundamentals have supported equities, which have continued to move upward even amid the turmoil in the Middle East and North Africa and rising oil prices. Emerging markets, however, extended their losses on rising interest rates and growing concerns surrounding the implications of budding political unrest more broadly. Small companies, which experienced a slight correction in January, surged an impressive 5.5% for the month. The volatility in the Dollar continues to impact U.S.-based investor returns for international equities, contributing nearly 1% to index returns for the month.


Source: PMFA

The bond market remains a source of anxiety for investors as the Fed appears to be nearing the end of its easing cycle. Ultimately, as the economy continues to strengthen and inflationary fears mount, the Fed will begin tightening. Rising rates have been a headwind to bonds historically and will result in a challenging environment for fixed income investors. One defense is a greater focus on flexible strategies with the ability to capitalize on pockets of value as managers see opportunity. Last month, high-quality bonds provided marginal gains, given the low-yield environment and limited movement along the yield curve. Longer-term municipal bonds rallied following their recent sell-off as recent dire predictions worked their way out of the headlines and fears of widespread defaults ebbed.

High Occupancy Vehicles (HOV) – More people, faster speeds

If you’ve traveled solo on a congested freeway with a carpool lane, you’ll likely wish it wasn’t just you in the vehicle. HOVs will be cruising by in their designated lanes, while the rest of the freeway may be slow going. It’s these vehicles we’d equate to the emerging markets of the world, and the number of passengers does matter. Currently, 85% of the world’s population resides in these nations. Growth in these countries has contributed to the rise of a consumer class with higher incomes and increasing purchasing power, creating greater internal demand and reinforcing a virtuous cycle of growth. These economies are also not bogged down with the same weight of debt as most developed nations and can be more agile, benefiting from further integration of global trade and increased access to capital. Additionally, their fiscal dynamics are more favorable, as most are experiencing current account surpluses rather than the deficits plaguing most developed countries. The risks facing these nations are not to be minimized, as we’ve seen in recent months; but long term, they appear to be positioned for stronger growth as compared with the developed world.


Source: PMFA

As we navigate through this multi-speed world, we remain focused on the overall risk assessment for portfolios given the greater variability of outcomes on the horizon. Diversification remains a core consideration for portfolios. Alternative investments specifically can provide low correlations with traditional asset classes, meaning they will act differently. Investments in multi-sector bonds, unhedged global bonds, convertibles, hedged strategies, precious metals, and commodities have over time enhanced the risk-return characteristics to portfolios. Greater flexibility, active management, and a balance between adequate exposure to risk assets while being attentive to risk management remain key themes in our current implementation strategy.

Economy

GDP

Economic growth was slower than originally reported for the fourth quarter of 2010. GDP was recently revised downward to 2.8% from the first estimate of 3.2%. This result was just slightly above the third-quarter rate of 2.6%. Downward revisions to both personal spending and state and local spending contributed to the downward adjustment. Even after the revision, personal consumption was a strong 4.1%, as we see the fatigued frugality chorus continue for consumers. Another noteworthy number was final sales which rose 6.7% during the quarter, the largest such increase in 12 years.

Estimates for growth this year are north of 3.0%, as expectations point to continued strength in the manufacturing and service sectors, strong earnings growth for companies, and accommodative monetary policy through at least the first half of the year. The expansion appears likely on a path that can be self-sustaining, although the timing and nature of the Fed’s exit plan will be closely watched.


Sources: PMFA, Bureau of Economic Analysis (BEA)

Interest Rates

The FOMC had a reprieve from formal meetings in February, but will again assemble on March 15 to reevaluate the state of the economy and monetary policy. The minutes from their January meeting indicated that they remain dedicated to continuation of QEII, their long-term Treasury purchases of $600 billion. Given that the “progress toward its objectives has been disappointingly slow,” the Fed’s second endeavor at quantitative easing is an attempt to put more steam in the recovery. The assumption is that purchasing long-term Treasuries will result in downward pressure on yields, among other things; however, the opposite has actually occurred.


Source: PMFA, U.S. Treasury

Over the last year, short-term yields have traded in a relatively narrow range of just 11 basis points. Further out on the yield curve, yields have been more volatile. The 10-year Treasury yield has swung 160 basis points over that same time period, from a high of 4.01% in April to a low of 2.41% in October in anticipation of the announcement of QEII. On February 28, the 10-year Treasury yield reached 3.42%. This is an increase of over 100 basis points since additional security purchases began, and the outlook for the economy has improved dramatically over that time. While the predominant argument for engaging in QEII was maintaining a low yield environment to encourage borrowing and investment, the sharp rally in risk assets and improved economic outlook are likely attributable in part to the Fed’s stated willingness to intervene.

Inflation
 
The multi-speed world theme has an impact on the inflation front as well. Domestically, inflation has been at uncomfortably low levels for some time. More recently, we have seen commodity prices rise, but expect that inflation will remain tame given the lack of wage pressures, high unemployment, and moderate capacity utilization. Many of the same variables hold true to varying degrees for other developed countries, and when you factor in the deleveraging process still playing out in many countries, we expect that many developed economies will be challenged going forward. 


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

Turning the focus toward emerging countries, the story is much different. Healthier balance sheets, favorable demographics, and growing globalization have led to a much quicker pace of economic growth than in the developed world. Given this rapid growth and the emergence of a consumer class in many developing countries with desires for an improved standard of living, inflationary pressures have proven to be a much greater concern. The Food and Agriculture Organization’s Food Price Index rose to record highs in February, and expect further pressures may lie ahead if global growth places continued pressure on the supply/demand balance for energy, food, and industrial commodities.


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

Monthly headline inflation increased sharply in February, as the PPI was up 0.8%, although price increases were not as extreme at the consumer level. On a trailing one-year basis, the result was mixed, with pace of price increases per the Producer Price Index easing fractionally, while the Consumer Price Index edged up to 1.6%. Core inflation rose across the board, both on a monthly basis and the 12-month change, as core consumer inflation edged closer towards the Fed’s implied target.

Employment
 
The recession ended more than a year and a half ago, yet job creation has been “disappointingly slow.” The employment situation in February provided relatively good news, reporting the highest job growth in five months with 192,000 new jobs created during the month. Meanwhile, positive revisions for prior months also accompanied the release. The unemployment rate ticked downward marginally to 8.9%, clearly an improvement from the 10.1% peak in October 2009 but distorted by the falling labor force participation rate. This rate, which measures the portion of the U.S. population that is part of the workforce, has dropped from 66.0% when the recession began in December 2007 to just 64.2% in February. This migration of individuals out of the workforce, even as the U.S. population continues to increase, has contributed significantly to the downward trend in the unemployment rate in the intervening period. If the labor force participation rate was held constant at 66.0%, the current unemployment rate would be approximately 11.4%.


Source: PMFA, BLS

As other indicators continue to point toward an improvement in the pace of economic growth and earnings remain strong, companies will be more encouraged to break out of their hiring hold. Given that the employment rate is a lagging indicator, as the economy has begun reaccelerating over the last six months, we’d expect to see continued improvement on the employment front looking 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.