Investment Review & Outlook: 4th Quarter Review

Performance Summary

Economic Review and Outlook

The economy seems to be shifting into a sustainably steady gear, albeit still a disappointing one compared to historical post-recession recoveries. Nonetheless, the improvement was broad-based in the fourth quarter, with data on consumer spending, manufacturing and housing all showing meaningful gains. After registering 1.3% and 1.8% annual rates of growth in the second and third quarter, fourth quarter GDP likely grew closer to 3% despite the uncertainty of the European crisis and a slowdown in China. Reflecting the marginally better environment, state and local government tax revenues consistently came in over budget, providing tangible evidence the recovery was taking hold. While certainly good news, challenges remain, and we forecast a slower than consensus 2% annual rate of growth in the coming year given numerous headwinds that could arrest the recent progress.

With our consumer-oriented economy, the resurgence of the retail sector was the most welcomed trend over the past few months. Until November’s weaker than expected increase of 0.2%, retail sales consistently surprised on the upside since mid-summer, and within November’s disappointing figures were sharp upward revisions to previous months’ data. In addition, according to the National Retail Federation, final sales were 9.1% higher than last year during the important retail weekend following Thanksgiving, driven by the secular advance in internet sales. Our worries on the consumer side stem from the apparent drop in the savings rate to maintain this heightened level of consumption. After peaking at 8.1% initially following the credit crisis, the savings rate dropped to 3.5% this autumn for the lowest pace since December 2007. Also, despite unquestioned improvement, household debt by any measure remains elevated, and additional debt accumulation to sustain spending seems limited.

We still see a modest degree of consumption growth continuing, but it is doubtful consumers can continue to run down their savings to support this rate of consumption without an eventual pick-up in wages, which actually dropped 0.1% in November. Though the pace of layoffs has been declining, to a three year low in the level of initial jobless claims, hiring remains sluggish. With the exception of September’s relatively strong increase, monthly gains in non-farm payrolls have stubbornly resided in the 100,000 to 127,000 range over the past five months, after barely positive growth in May and June. While certainly an improvement over the job losses posted a year prior, monthly hiring should be much higher at this stage of a recovery, and figures below 200,000 do little to bring down the true rate of unemployment. The unemployment rate did fall a significant 0.4% in November (to 8.6%), but the improvement masked concerns about a sharp decline in the labor participation rate, reflecting an increase in the numbers of discouraged workers giving up their job search.

Despite the negativity beneath the surface, we are becoming somewhat optimistic on hiring given the data on initial jobless claims, a real time measure of labor trends. Historically, improvement in claims precedes actual advances in hiring (see chart 1). Likewise, advancements in temporary hiring often foreshadow permanent labor additions should they coincide with durable demand. Temporary employment measures also exhibited strength over the past five months, leading us to believe hiring will improve, albeit at a conservative pace consistent with subdued growth. Recent deterioration in corporate productivity could signal companies have squeezed all they can out of current resources and need to add to the labor stock to meet current levels of demand. Meanwhile, personal income tax receipts remain in an upward trend, reflecting the better environment. Therefore, while labor improvement remains tepid and frustratingly slow, it seems the worst is over and job creation will continue absent a Europe-induced global retrenchment.

The biggest positive surprises over the past quarter were in the manufacturing and housing sectors. Manufacturing seemed to be signaling an impending recession as recently as October, when readings barely signaled expansion and new orders were in decline. Trading partners were on the defensive as China was managing an orderly slowdown of its economy while Europe was careening towards a recession at best and a financial meltdown at worst. However, the December Institute for Supply Management’s factory index signaled a sharp positive reversal as production surged to a six-month high and new orders were strong. While China’s role as a growth engine cannot be underestimated, modest growth within less notable emerging markets remains intact, to the benefit of US manufacturers. At the same time, the effects of the devastating tsunami in Japan are diminishing. Resultant supply chain disruptions created a dearth of inventory for many firms, and restocking to meet pent-up demand has increased. While the pending expiration of tax credits for business investment would provide headwinds for the sector, optimism abounds with purchasing managers forecasting a 5.5% increase in sales next year.

We believe that outlook may be somewhat optimistic, given that there are no guarantees China will return to double-digit growth or that Europe’s damage will be contained. Investors seeking refuge from global unrest create the potential for an appreciating dollar, which is a concern for domestic manufacturers. Nonetheless, recent improvement in the housing sector is providing a surprising lift, with construction spending rising and November’s significant 1.2% increase in expenditures for housing and commercial projects. Buoyed by continued demand for multi-family units as well as singlefamily projects, housing starts rose to a nineteen-month high in November, while building permits for future construction also were strong. Additionally, sales of existing homes, perhaps responding to the record low mortgage rates, exceeded expectations in November. It is important to note that overall activity is still at record low levels and foreclosures remain rampant, while prices are still under pressure. But growth is registered on the margin, and it seems likely that even small improvements in housing measures will help the employment picture and overall economic growth in 2012.

Equity Review and Outlook

After a poor showing in the previous quarter, world equity markets rebounded in the fourth quarter. The US market, as measured by the S&P 500, returned 11.8% during that time, bringing the full year performance, inclusive of dividends, to a modest 2.1%. Overseas markets continued to lag with the MSCI EAFE Index returning 3.4% to leave it down 11.7% for the year. As noted in our economic outlook, growth outside the US clearly downshifted while domestic activity firmed. This goes a long way in explaining the difference in the returns. The “on-again, off-again” nature of risk tolerance in the market was noticeable in sector returns as the third quarter’s laggards (Materials and Energy) led in the fourth quarter, while the previous period’s leaders (Utilities and Telecommunications) trailed. For the year as a whole, defensive sectors maintained their edge with utilities being the outperforming sector for the year. Financial stocks, once again, were the worst performing group.

Last quarter we noted that the US stock market seemed to be pricing in the possibility of an imminent recession and that, barring such an outcome, we believed the possibility existed for approximately 10% upside for domestic, large capitalization equities. As the fears of recession eased, the market did in fact rally. So where does that leave us? It still looks as though investors are skeptical of earnings sustainability and are pessimistic in the face of turmoil in Europe and a deceleration in China and emerging Asia. Yet Chart 2 shows that even after the recent rally, the US market is valued near 25-year lows on several measures, as last quarter’s price appreciation was accompanied by a slight increase in forward earnings estimates. We continue to believe that we will escape a global economic recession, but our call is not made with particularly strong conviction given that euro-zone growth may well turn negative. That leaves us biased toward equities over bonds with a continued emphasis on US large capitalization equities.

As to economic sectors, our comments regarding valuation are particularly germane with regard to technology stocks which are selling at a 30-year low price /earnings ratio. While the natural disasters in Asia (Japanese tsunami and Thailand floods) and global economic uncertainty caused a modest shortfall in sales, absolute growth rates for many of our companies were relatively strong. We believe these growth rates will be sustained, leading to superior stock performance in the future. There was a similar flight to safety in healthcare stocks, another area of emphasis for us. Many of our holdings sell at valuations no different from their peers, despite superior growth prospects. Most are what we consider to be “problem solvers” that can contribute to the needed reduction in overall healthcare spending. As with technology, we believe the superior fundamentals will be rewarded.

That said, the fact that some northern European equity markets now are selling at single digit multiples on projected earnings has caught our interest. However, these markets historically sell at a discount to the developed market average valuation (now around 11 times 2012 earnings) and are no cheaper relative to their historical norms than is the US market. Additionally, earnings projections for these countries may yet prove to be too high, especially true in US dollar terms if the euro continues to weaken. While we are not yet ready to reverse our underweighted stance on international equities, we are watching with renewed interest. Emerging market stocks slightly outpaced developed overseas markets for the quarter (+4.4%), but were down a significant 18.2% for the year. Valuations there have fallen as well, but as is the case with their developed brethren, earnings downgrades may be a prospect. However, the apparent shift toward easier monetary policy by many emerging market central banks may support equities, once lower earnings are discounted. In sum, it will be crucial to see if these emerging countries can engineer soft landings in their economies as was the case in 2008 and 2009.

In the relatively slow-growth, low-inflation environment we envision, an investment in high-yield debt securities may be an attractive alternative to a portion of an investor’s equity allocation. As Chart 3 shows, high-yield bonds’ long-term return and volatility (i.e. risk) characteristics tend to have more in common with stocks than with high-quality bonds. This is especially true given that the historical returns associated with bonds are unlikely to be achieved in the next few years given the current low level of interest rates. Put another way, we do not believe the historic low volatility of bonds is apt to change, but returns will be depressed for at least the next several years. High-yield bonds also may provide some measure of risk mitigation should economic growth prove slower than we expect. This is due to the higher income these securities generate versus common stocks. This is an important consideration since, while we reiterate our “no recession” forecast, any deviation from that forecast is more likely to be to the downside. We advocate moving a modest portion of equities into high-yield bonds, where appropriate.

Fixed Income Review and Outlook

US Treasury yields resided near record lows as 2011 came to a close. Despite recent data on the economy showing noticeable improvement, ten-year Treasury yields refused to move meaningfully higher, finishing the year at 1.88%. Nervousness among investors regarding the European crisis and persistent volatility in the equity markets clearly supported prices, and the Federal Reserve provided a floor to longer maturity bond prices as it extended the maturity of its Treasury holdings via “Operation Twist”. Nonetheless, the final results for fixed income were impressive: the Treasury market tacked on an additional 0.89% in the fourth quarter, driving the 2011 return to 9.81%, the best annual performance since the credit crisis. The overall taxable bond market did not fare quite as well but still performed admirably, returning 1.12% for the quarter and 7.84% for the year. Corporate bonds responded positively to strengthening economic data late in the year and returned 1.93% during the fourth quarter, pushing the yearly advance to a robust 8.15%.

We believe uncertainty in Europe and the Federal Reserve’s involvement are the primary explanations for the current level of Treasury yields. Without these influences, yields likely would be considerably higher. A general rule-of-thumb is a ten-year Treasury yield close to the level of real GDP plus inflation. Third quarter real GDP grew at an annualized 1.8% rate, and the fourth quarter looks to be at least as strong (with many predicting growth north of 3% annualized); core measures of inflation reside in the low 2% range. Therefore, one would normally expect a ten-year Treasury yield to be at least 3.75% to 4.0%, much higher than the 1.88% as of year-end. Even our 2012 forecast of 2% economic growth with 1.75% inflation, a touch below consensus, would support those yields.

Yields on the shortest maturities remain anchored following the Fed’s September pledge to keep overnight rates near zero through at least mid-2013. In addition, throughout the fourth quarter the Committee conducted “Operation Twist”, the sale of $400 billion of short maturity Treasury securities to fund identical purchases through June 2012 of longer maturity Treasury securities. This strategy enables the Fed to lengthen the average maturity of its balance sheet, as opposed to adding to its size, as was the case during its earlier easing campaigns. The impact of the most recent policy seems more meaningful and less controversial than QE1 and QE2, although the ultimate effect is difficult to discern since the chaos in Europe is supporting Treasuries as well. Events in Europe have had a material effect on the Treasury market for all but the longest dated bonds; therefore, its resolution will be our focus in 2012. While a recession in Europe seems certain, the US economic recovery should be able to withstand this scenario. Though not insignificant, softer trade with Europe is not an insurmountable economic obstacle given improving conditions at home and better trade prospects with China.

More worrisome would be a European banking crisis, given the minimal progress European banks have made shedding non-performing assets and bolstering capital. On a positive note, US banks today are far better equipped to handle a crisis within the European banking system and have little direct exposure to larger sovereign economies such as Italy and Spain, currently experiencing tremendous stress. In the end we expect a resolution which will avoid a full-blown credit crisis in Europe. We would like to see the IMF become more meaningfully engaged in a solution, since we believe the resources they bring to the table would go a long way toward crafting a solution. Likewise, the ECB has done little outside of a token 0.50% interest rate cut after November’s change in leadership from Jean- Claude Trichet to Mario Draghi. It is still publically loath to use aggressive strategies, suggesting they exceed the authority of the ECB Committee. Perhaps surprising to some is our belief that Germany will eventually acquiesce and facilitate a deal; few benefit from the EU more than Germany, as its export-driven economy thrived under the common currency. As a result, while Greece and perhaps Portugal and Ireland may end up leaving the EU, we believe disaster will be averted.

Given our expectation for further growth within the US economy and a non-cataclysmic resolution in Europe, it seems US Treasuries are somewhat vulnerable. Our forecast is for ten-year Treasury rates to rise to 2.75% by year-end, mostly as a result of unwinding the flight-to-quality bid related to Europe since a somewhat better US economy is likely priced into the yield curve. Likewise, the Fed seems willing to err on the “easy” side with inflationary pressures in retreat until a meaningful improvement in the labor market, which we judge to be at least a year or two away. A rise in tenyear yields to the 3.75% to 4.0% level that one would usually expect in this environment seems unlikely until the Fed normalizes policy. Any economic surprises are likely to be negative ones, although positive for bonds, given uncertainty overseas and the still tenuous state of the domestic recovery.

Therefore, within our taxable bond portfolios, we remain slightly below benchmark duration given our cautious rate outlook. With our constructive outlook for the economy and the solid position of corporate balance sheets, we favor corporate bonds over Treasuries. To enhance yield, we are increasingly looking towards taxable municipal bonds and are utilizing high-yield products in appropriate client portfolios. Should a rise in rates come sooner than expected, we will look to add to duration given the benign outlook for inflation and the Fed’s commitment to an attractive lending environment.

Municipal Bonds

Municipal bond performance was one of the more pleasant surprises in 2011. The overall market returned an astounding 10.7% in 2011, helped by a solid 2.12% advance during the fourth quarter. The longest maturities, in short supply for much of the year, drove performance as bond fund outflows slowed and eventually reversed by year-end. Short and intermediate maturities also performed well during both the quarter and year, as the 3- and 5-year indices advanced 3.46% and 6.93% respectively in 2011. The pace of new issuance was near its slowest in nearly ten years for much of 2011, causing a buildup of demand. Tax revenues increased, reflecting both improvement in the economy and tax increases in certain cases, stabilizing the sector after predictions of a meltdown within the finances of local governments. By December, tax-free yields resided near forty-five year lows, with five-year AAA bonds yielding 0.85% and ten-year AAA bonds yielding just 1.83%.

Challenges remain for the sector despite the strong momentum heading into 2012. Even after successfully closing $100 billion in budget gaps in FY2012, states still face nearly $40 billion in shortfalls for FY 2013. Tax collections continue to exceed forecasts and have increased for eight straight quarters through September, yet remain approximately $20 billion below the pre-crisis high, with most easy budget cuts having already being made. Also, rumblings out of Capitol Hill aimed at limiting the tax-exemption of municipal bonds will not go away, although the rhetoric has cooled substantially. Our view is that the economy will remain strong enough to maintain meaningful growth in revenues and the exemption of tax-free interest will be protected, barring a significant re-write of the tax code, which seems unlikely at this time. Therefore, traditional analysis of relative value and trends related to supply and demand should drive the market going forward. We expect municipalities to become more active in the market in order to fund capital needs, leading to a marked increase in new issuance in 2012 and high refunding volume given the low absolute level of yields. While high supply normally pressures the market, refunding volume creates cash for investors to reinvest as bonds are called away. Furthermore, municipal bonds remain cheap relative to taxable bonds with longer maturity yields in excess of 100% of equivalent Treasuries, a remnant of the earlier taxability scare.

While isolated credit disasters like that of Harrisburg, Pennsylvania will still generate press, further credit deterioration seems to be behind us. Fitch’s recent removal of the state sector from negative credit watch acknowledged improvement in revenues and deficit reduction of nearly $325 billion since 2007, giving further support to our view. Next year we anticipate a similar amount of defaults as in 2011 and 2010, $2.6 and $2.8 billion respectively. Within the context of a $3.7 trillion market, these numbers remain low and are far better than one would find in the investment-grade corporate market for similarly rated credits. As a reminder, the record default number for one year was just over $8 billion in 2008.

Therefore, our strategy remains intact for the coming year. We will continue to put money to work selectively in periods of weakness, mindful that absolute yields are low. By nature, the municipal market is highly segmented and inefficient at times, but even in unattractive interest rate environments opportunities arise. We realize that clients look to bonds for stability and income; given our view that Treasury yields will move higher this year, principal preservation is always important. A bond portfolio combining shorter maturities to take advantage of any increases in interest rates and longerintermediate bonds to augment income still seems the appropriate approach for the coming year.

Commodity Review and Outlook

Commodities finished the fourth quarter essentially flat but declined 13.4% for the year, as measured by the DJ-UBS Commodity Index, the first annual decline since the depths of the crisis in 2008. As with other assets, the 2011 ride was a bumpy one. Commodities rose strongly in the beginning of the year, peaking in April, before the same worries that affected other risk assets began to impact this group. Signs of diminishing growth in China and the euro-zone overrode the usual steady demand in the developed world as well as the longer-term trend of demand growth in emerging markets. Oil and gold both posted positive returns for the year, gold up 10.2% and oil up 8.2%, but the annual returns belie the degree of volatility. As has been the case recently, gold reacted differently than other commodities to world events. Early in 2011 gold hit its low price for the year ($1318/oz) as economies seemed to be strengthening, but by August, with battles playing out in Washington and in Europe, gold hit a high of $1888/oz.; it gave back 10% of that gain in December as the dollar strengthened. The negative returns in gold were somewhat surprising given investors’ weak faith in paper currencies and the likelihood of continuing central bank easing that contributed to positive returns throughout the past year. Oil prices were already up early in the year when the trend was boosted by civil unrest in the Arab world last spring. US oil prices rose 25% to $113.93/bbl at the peak in April, followed by a double-digit pullback as growth slowed and the Libyan conflict subsided. During the last quarter, oil prices rose nearly 25% as the focus in the Middle East shifted to Iran and its threat to cut off oil supplies by closing the Strait of Hormuz. This was the result of pressure by the US and European Union on Iran to end its nuclear program or face boycotts on Iranian oil exports. Natural gas prices, under pressure for several years due to ample supplies, hit their lowest point in almost two years, as mild weather throughout much of the US reduced the need for natural gas to heat homes and offices.

The factors we have mentioned throughout this piece are still in place to drive commodity returns in 2012. Consistent with our modest outlook for global growth, we do not believe there will be substantial commodity price inflation as a result of economic strength in the first half of 2012. Lack of a timely euro-zone solution will weigh on commodity prices since lower demand in that region weighs on export activity in China, thus reducing that country’s need for metals. A continuing slowdown in China’s housing market is likely throughout early 2012, further reducing demand. Barring an Iranian confrontation, we anticipate oil will stay in the $100 range in 2012 as low global growth rates are offset by OPEC’s need to keep the price of oil in this range for social stability. We continue to expect gold returns to be more a function of geopolitics than commodity fundamentals. While we still believe it will take some time for commodities to regain their highs, we have not changed our broad, long-term view: resumption of growth in all emerging markets, not just China, and more normalized economic growth around the world will increase demand for raw materials and drive commodity prices higher in the future. Despite the late 2011 declines, prices are up substantially in the last two years, reflecting tight supply levels. Once current economic woes start to recede we expect the long-term trend of higher prices to resume.

Conclusion

We maintain our view that economic growth in 2012 will be modestly positive. Our below-consensus outlook calls for US GDP of 2% and a 1.75% core rate of inflation. We believe interest rates will stay at historically low levels but slightly above where they are today, with a ten-year US Treasury rate in the 2.75% range by year-end. Therefore, we are moderately favorable towards equities, predominately US large-cap stocks, partly due to valuation levels and partly because of a lack of any potential for decent returns in bonds. We are neutral on commodities and other alternative investments but see the potential for using high-yield bonds, where appropriate, in place of a portion of an allocation to equities. Our neutral view on cash leans towards an underweight due to the lack of any return in this low income environment. The biggest risk to our outlook is further deterioration in Europe, as well as political gridlock in the US as we head towards the presidential election. On the positive side, economic data in the US has been slowly improving; with investor pessimism at such high levels today, even marginally good news on labor, housing, or Europe may give a strong boost to risk assets that would be a welcome surprise.