Quarterly Commentary

Fourth Quarter 2011 Market Commentary

 

Environment
Oktoberfest
For most people, Oktoberfest is the internationally known German festival with the famed beer gardens.  The event originated in the Bavarian capital city of Munich more than 200 years ago but is now celebrated in numerous other cities around the world as well.  However, while the festival actually begins each year in late September and concludes in early October (spelled ‘Oktober’ in German), Wall Street celebrated its own version of the event over the full month of October 2011.  US stocks experienced an explosive rally which pushed the S&P 500 to its best monthly gain in 20 years.  Stocks benefited from news of yet another supposed plan from European leaders to resolve the region’s debt crisis, and from improving US economic data.

 

However, in late October Europe’s debt troubles hit home for brokerage firm MF Global, which declared bankruptcy after taking a hit from its investments in European government debt.  The news spooked investors and raised concern about what other firms might have exposure to European debt.  The region’s seemingly never ending debt crisis continued to fester despite policy makers’ repeated attempts to address the problem.  In addition to its financial impact, the crisis also exacted a political toll, as the leaders of Greece, Italy and Spain were all replaced. 

 

Europe remained front and center during the quarter.  After October’s huge equity rally, stocks bounced up and down over the next two months as sentiment seesawed back and forth between optimism that the crisis would be resolved and worries that it would deepen.  In December, the S&P 500 moved lower over the first half of the month but then jumped 4.3% over roughly the last two weeks of the quarter.  That rally was eerily similar to the last two weeks of the second quarter, when the index climbed 4.4%, and the last two weeks of the first quarter, when the S&P 500 surged 5.5%.

 

Meanwhile, although the commodity market as a whole moved higher, the seemingly unstoppable price of gold finally fell, by 3.7% – its first quarterly loss in more than three years.  The big winner was crude oil, which soared 24.8% during the quarter amid concerns about tensions with Iran and some improved economic US data.  Elsewhere, the Dow Jones-UBS Industrial Metals Index rose 1.5%, while the Dow Jones-UBS Agriculture Index added 1.4%.  In the currency markets, the US dollar continued to strengthen as it rose another 2.1% against a basket of six major foreign currencies, finishing near a 12-month high.

 

Domestic Equity
Right Back Where We Started From
Following October’s massive rally, stocks eased slightly lower in November and then rose in December.  The S&P 500 finished the fourth quarter with a very impressive gain of 11.2%, with most of that occurring in October.  But for the year, the S&P 500 performed very much like a roller coaster, in more ways than one might think.  At the beginning of the year, investors stepped off the platform and took their seats, then went for a wild ride over the next 12 months, and at the end of the year stepped off the ride back onto that very same platform.  In other words, the S&P 500 finished 2011 almost exactly where it started the year.   The index began 2011 at 1,257.64 and finished at 1,257.60 and so was virtually unchanged for the year. 

 

Among the sectors, performance represented a case of role reversal.  The best performers in the fourth quarter were among the worst performers in the third quarter, and the worst this quarter were among the best performers in the third quarter.  Half of the ten S&P 500 sectors racked up impressive double-digit percentage gains, led by Energy (which soared 17.6%), Industrials (up 15.7%) and Materials (up 14.7%).  At the other end of the spectrum, the “worst” performers were Telecom (up 6.4%) and Utilities (up 7.2%).

 

Fixed Income
Treasury Bonds Slow While High Yield Issues Glow
As a whole, the bond market posted a modest gain, on a total return basis, though not nearly as much as it did in the third quarter.  The Barclays Capital US Aggregate Total Return Bond Index added 1.1%, compared to an impressive 3.8% jump the previous quarter.  The lower return reflected a more muted performance by US Treasuries, which represent a large percentage of the index.  For the quarter, the iShares Barclays 7 to 10 Year US Treasury ETF gained a modest 1.3% on a total return basis, well below its third quarter return of 10.4%.  For the year, the Barclays Capital US Aggregate Total Return Bond Index gained 7.8% on a total return basis.

 

Treasuries’ modest returns reflected a combination of somewhat better US economic data and investors’ moderating concerns about the broader macro environment.  Treasuries were also less volatile during the quarter.  The yield on the 10-year US Treasury bond, after a nearly eight-month slide which included an especially sharp decline in August, stabilized during the quarter.  The yield reached its 2011 high of 3.73% on February 8 and eventually plunged to 1.72% by September 22; then after a brief spike higher during October’s huge equity rally, the yield eased down again and finished December at 1.88%.  That was virtually unchanged for the quarter but down sharply from the 3.29% at the beginning of the year.

 

High yield bonds were the big winners in fixed income, with the iBoxx High Yield Index posting a total return of 8.0% for the quarter.  The index had sunk 6.2% the previous quarter, and when it reached a 12-month low on October 4, bargain hunters started moving in, and a series of improving economic reports also helped fuel the rally (high yield bonds typically benefit from a stronger economy).  Investment grade corporate bonds were next, with the iBoxx Investment Grade Index climbing 2.6%, followed by emerging market debt, where the JP Morgan GBI Emerging Market Global Diversified Index added 0.5%.

 

International
Debt?  What Debt?  European Stocks Climb
Overseas stocks also saw strong performances, although the gains overall were significantly less than in the US.  The MSCI EAFE Index of developed markets climbed 3.4% in US dollar terms (up 4.1% in local currency), led, interestingly, by Europe: the region as a whole climbed 5.5% in dollars.  Stocks in Ireland – one of the recipients of bailout funds from the European Union and the International Monetary Fund – soared 22.4% in US dollars (after plunging 20.6% in the third quarter), while the UK, which has moved aggressively to reduce its budget deficit, surged 9.0%.  Scandinavian countries Norway, Sweden and Denmark – which all have sharply lower levels of government debt than countries like Italy – also did very well with gains between 8% and 10% for the quarter.  Among the weakest major developed markets was Japan, which fell 3.9%.  For the year, the EAFE Index lost 11.7% in dollar terms.

 

Emerging markets fared somewhat better than developed, with the MSCI Emerging Markets Index rising 4.5% in dollar terms (up 4.9% in local currency).  Latin America led the way with a gain of 8.8%, followed by Asia with a 3.3% advance.  Emerging Europe was the laggard with a gain of only 0.5%, well below the performance of the developed European markets.  For the year, the Emerging Markets Index lost 18.2% in US dollars.

 

Looking Ahead in 2012
Investors wondering where to focus their attention this year may want to keep a globe nearby, as the issues that could affect the financial markets may originate from all over the world.  One of the biggest issues, like a broken record, will again be the ongoing European debt crisis.  Italy and Spain combined have more than $620 billion of debt coming due this year that will need to be refinanced, and now the concern is spreading to the larger European economies: France will need to refinance about $340 billion of debt in 2012.  Recent weak economic data in Europe has raised concern about whether the region will slip into recession, which could worsen the debt crisis and weigh on the broader global economy.

 

Moving back to this side of the Atlantic, the US economy has recently shown signs of improving.  A key issue will be whether that improvement can be sustained; while manufacturing and employment numbers have looked somewhat better, the housing market continues to struggle.  The Federal Reserve will also be closely monitoring the US economy, and the debate continues within the investment community regarding whether the Fed will implement another stimulus program, as it did with Quantitative Easing (QE) I and II.  In addition, the US also continues to grapple with its own massive federal debt. 

 

Continuing across the Pacific, China’s economy remains an important factor in the broader global economy.  While the country’s economy posted a solid 8.9% annualized growth rate for the fourth quarter of 2011, this represented a further slowing  from the earlier peak growth rate of 11.9% reported in the first quarter of 2010. But inflation has been moderating in China, potentially giving policymakers there more leeway to loosen monetary policy to boost the economy if needed.

 

Politics will also loom large around the world in 2012.  The US will hold presidential and congressional elections, and France will also hold a presidential election, which could be especially important given that current French President Nicolas Sarkozy has been working closely with German Chancellor Angela Merkel to try to resolve the European debt crisis.   Other countries that will hold presidential elections this year include Russia, Finland and Mexico.

 

Adding to the political uncertainty are North Korea and Iran.  North Korean leader Kim Jong Il died in December, and his son Kim Jong Un then took over as his successor.  Analysts are wondering how this will impact the country’s already tense relations with South Korea and what if any actions the new leader might take to assert his new power.  Meanwhile, increased tensions between Iran and the US and its allies have raised concern about potential hostilities in the Mideast.  That could in turn drive oil prices even higher, extending their recent advance.