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Market Roundup - September 2012
A September to remember?By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio StrategistBy John Manley, CFA, Chief Equity Strategist By James Kochan, Chief Fixed-Income Strategist Whoever said “Talk is cheap” never listened to central bankers. Whether they were comments from European Central Bank (ECB) President Mario Draghi or Federal Reserve (Fed) Chairman Ben Bernanke, they moved markets during the past month. September will likely see more words moving markets. Not only was there the ECB policy meeting on September 6, but there is also the Federal Open Market Committee (FOMC) meeting on September 12 and 13. However, September isn’t all about the bankers. There is an important election in Holland on September 12, the German Constitutional Court is expected to rule on the constitutionality of the eurozone’s permanent bailout facility (the European Stability Mechanism), and we could receive a status update on the Greek austerity program at some point during the month. If you take all of these events and mix in the U.S. Employment Situation Report on September 7 (which could sway the FOMC one way or the other on more stimulus) and the continued drip of data on the slowdown in China, September really could be a month to remember.> The economy The economyBy Brian JacobsenMarkets seemed to hang on every word from central bankers’ mouths. ECB President Draghi pledged to do “Whatever it takes.” The FOMC promised to “Act as needed.” These are strong words. In September, we’ll probably hear more strong words, though we don’t expect to see a lot of action. In Europe, the ECB decided on a plan to support the short-term government debt market for countries asking for funds from the European Financial Stability Facility (EFSF) or its permanent successor, the European Stability Mechanism (ESM). The ECB only announced the outlines of the plan because the life of the ESM hangs in the hands of the German Constitutional Court, which will rule on its constitutionality by September 12. The Dutch elections on September 12 may usher in a coalition government that supports relaxing some of the austerity conditions imposed on Greece as a condition of the Greek bailout. The political sentiment seems to be shifting from hard and fast reform to one of more soft and slow reform. The additional monetary stimulus from the ECB and the softer and slower pace of fiscal adjustment could prove to be a turning point in the eurozone debt saga. In the U.S., the FOMC has been sending a clear signal to investors that it will provide more monetary stimulus to the economy if needed. The FOMC’s behavior in presidential election years has not been any different than in non-election years, so it will likely do what it wants, when it wants, even if that is right before the presidential election. However, the form and timing of FOMC easing will depend on the economic data. One poor employment report (perhaps a reading of non-farm payroll gains of below 100,000) could trigger a new open-end bond buying program by the Fed. We expect that the September meeting would be too soon to engage in more bond-buying, but the FOMC might want to get itself out of the corner it painted itself in when it gave a date for how long it expects economic conditions to warrant exceptionally low rates. It could do this by stating that it will keep rates exceptionally low until the unemployment rate falls below 7%, provided inflation stays below 4%. That type of change would make its commitment conditional on the data rather than the date, giving the Fed significantly more flexibility in conducting monetary policy. The natural follow-up policy, which would only be triggered if there were poor employment reports in September and October, would be for the FOMC to commit to not only keeping rates low, but also buying $100 billion per month of agency or mortgage-backed securities or longer-dated Treasury securities until the unemployment rate dips below 7%, and as long as inflation stays below 4%. The FOMC is likely to include additional language that will give it flexibility to adjust the size and timing of the purchases as economic conditions warrant. Whether it’s the ECB or the FOMC, monetary policymakers are getting anxious to act, while fiscal policymakers seem to be dragging their feet. The slowdown in Europe is having a cascading effect on global growth. This is most evident in the slowdown in China. However, we think it’s important to note that China’s slowdown seems to be proceeding at a manageable pace, avoiding what some people have called a “hard landing.” Also, an easing of austerity in Europe should help. The Chinese government is going through a transitional phase. In 2011, the National People’s Congress endorsed the 12th Five-Year Plan, which focuses on promoting domestic consumption instead of relying heavily on export-led growth. In addition, the Chinese Communist Party’s Central Committee is going through a once-in-a-decade power change. The passing of the baton of power will not be completed for a few more months, which is likely stalling any new stimulus programs.
EquitiesBy John ManleyDespite the conventional wisdom of the dog days of summer, the weather in August usually starts off hot and then cools as Labor Day approaches. It appeared that way this year, and the U.S. stock market seemed to take its cue from the thermostat. The S&P 500 Composite Index rose 2.0% in August but put more than 100% of that gain in place before the middle of the month. Performance was sharply divided, not only by time, but also by sector. Almost every sector with economic exposure outperformed, while almost all of the “safe havens” slipped in absolute terms. The mega-cap Dow Jones Industrial Average (DJIA) rose 0.6% in the period, with a front-end load and an end-of-month 90-point pop that saved it from a posting a flat month. The DJIA has lagged the S&P 500 Index for most of 2012. The smaller, more aggressive stocks performed better in August, which can be inferred from the 3.5% rise posted by the Valueline Composite (Arithmetic) in the month. Clearly, investors were willing to take on more risk as central bankers in the U.S. and Europe seemed increasingly willing to inject funds into their respective economies and, through them, equity markets. However, growth seemed to outdraw value as the Russell 3000® Growth Index returned 3.5% in the month, while the Russell 3000® Value Index returned 3.0%. That both of these indexes bested the S&P 500 Index is testimony to the participation of smaller companies in the rally. Also of note was the 4.3% gain posted by the Nasdaq Composite. As an index dominated by information technology (IT) and biotech names, it seemed to be a perfect host for investors’ greater appetite for risk. Economically sensitive sectors clearly dominated the American equity market last month. IT (which we favor) gained 4.8% in August as the market digested generally favorable second-quarter results and looked forward to 2013 prospects. The consumer discretionary sector followed closely behind with a 4.2% rise. The housing market seems suddenly more stable and less heavy, and American consumers seem as resilient as ever. The financials sector also outperformed in August, with a 3.0% gain. While we still believe that this sector has asset-quality and earnings-power issues before it, we must admit that a more stable housing market in the U.S. and a more pragmatic political environment in Europe have lifted it to outperformance in the past three months. We still believe that it is too early to emphasize the area or to believe that the market will rise above its current trading range. Investors did not seem too concerned with safety or certainty in August. The consumer staples group dipped 0.6%, while the telecommunication services sector dropped 2.5% and the utilities sector fell 4.8%. While we believe that consumer staples may offer a temporary, lower-risk way to gain exposure to emerging markets, we think it could be time to look for direct exposure to emerging market consumers. Outside the U.S., equity markets were mixed. Emerging markets slipped or at least lagged the S&P 500 Index. Resource markets generally kept pace or slightly bettered the U.S. equity market. On balance, Europe outperformed, but safe and stable countries were slight laggards, and the “problem children” posted significant gains. That latter fact may mark significant progress on the immense problems facing the continent. In the emerging markets space, Mexico, China, and Hong Kong were under pressure, with respective local currency declines of 3.2%, 2.7%, and 1.6%. (Currency fluctuations reduced China’s and Mexico’s losses by 20 to 30 basis points in U.S. dollar terms.) China continued to deal with slowing industrial production and a reticence to aggressively expand monetary policy. India, which gained 1.1% in August, recently has shown resilience in its manufacturing sector. All of our monitored emerging markets are down significantly for the past year, and all but Brazil (in U.S. dollar terms) continued to lag the U.S. last month. We have not been aggressive buyers here, preferring to gain exposure selectively and through large-capitalization, multinational consumer staples companies. The developed markets are of greater interest. All of these markets have lagged the U.S. over the past year, with Spain, Italy, and Greece posting double-digit losses. Recently, however, the markets have begun to rebound and outperform the S&P 500 Index. While much remains to be done both politically and economically, we sense that the ECB’s more aggressive policies and rhetoric may be placing a floor under these markets and actually setting the stage for a longer period of superior performance. We know Europe’s problems, Europe knows Europe’s problems, and, most important, the markets are forcing European decision-makers to begin to stabilize volatile situations and make needed structural changes. In some respects, this places Europe ahead of the U.S. in the long process of reducing or eliminating the excesses of the last several decades. That this is happening with the U.S. equity market up and Europe’s down appears to be a compelling opportunity.
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| Market | 2010 | 2011 | Q1 2012 | Q2 2012 | August | YTD |
| Broad market index | 6.80 | 7.80 | 0.37 | 2.17 | 0.11 | 4.10 |
| Corporate | 9.52 | 7.51 | 2.44 | 2.37 | 0.40 | 8.25 |
| Treasuries | 5.88 | 9.79 | -1.29 | 3.00 | -0.14 | 2.61 |
| Agencies | 4.61 | 5.27 | -0.02 | 1.38 | 0.16 | 2.22 |
| Mortgages | 5.67 | 6.14 | 0.60 | 1.11 | 0.10 | 2.62 |
| Asset-backed | 5.02 | 1.43 | 0.76 | 0.70 | 0.32 | 2.15 |
| High-yield | 15.24 | 4.50 | 5.15 | 1.83 | 1.21 | 10.44 |
| Municipal | 2.25 | 11.19 | 2.08 | 1.98 | 0.22 | 6.00 |
| 2-year Treasury | 2.28 | 1.45 | -0.10 | 0.10 | 0.01 | 0.21 |
| 5-year Treasury | 6.76 | 9.20 | -0.52 | 1.94 | 0.10 | 2.28 |
| 10-year Treasury | 7.90 | 17.15 | -2.23 | 5.81 | -0.20 | 4.95 |
| 30-year Treasury | 8.65 | 35.50 | -7.57 | 12.60 | -1.56 | 6.61 |
A similar pattern of returns is evident in the municipal market. The A/BBB sectors returned 0.30% in August, versus a return of 0.11% for the AAA/AA sectors. Thus far in 2012, the performance differential is 310 basis points in favor of the A/BBB credits. The BBB sector has outperformed the AAA sector by 500 basis points thus far in 2012.
Among mortgage categories, while agency-backed mortgages have returned 2.6% YTD, the commercial mortgage-backed securities (CMBS) market has returned 9.9%.
The Treasury market struggled during most of August, primarily because the markets in Europe were quiet. Treasuries have performed best when the European markets were in disarray. While there is the potential for renewed turmoil in the weeks ahead, it now appears that a consensus is developing among eurozone leaders over strategies for preventing yet another market crisis. It is possible, therefore, that the Treasury market might not enjoy the strength of demand from foreign investors that was so important during the first half of this year.
The strong performance records of the corporate and municipal markets thus far in 2012 reflect a quest for income by domestic investors. Flows into high-yield and investment-grade corporate bond mutual funds have been strong all year. In the face of this demand, corporations have been able to issue record amounts of bonds at the most favorable terms in modern times. Flows into municipal mutual funds have been steady, and that has been sufficient to keep yields relatively low because the volume of issuance in the municipal market has been less than the amount of bonds maturing thus far in 2012. Those who worry about bubbles in those two markets are concerned about what might happen if those mutual fund flows were to turn negative. But, until the fixed-income markets offer attractive alternatives to the income offered by corporates and municipals, that is probably not a serious risk.
Equity recommendations
Strategic recommendation |
Tactical recommendation |
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Developed equities/emerging markets equities |
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Balanced, with 30% emerging and 70% developed. We prefer strategies that are bottom-up, especially those not tracking the benchmarks, which tend to be dominated by Chinese financials. |
Balanced, though we prefer a 20% allocation to emerging because we are concerned about the trajectory of the Chinese, Brazilian, and South Korean markets. With capital controls, we fear global investors could be disappointed. |
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U.S. equities/non-U.S. developed equities |
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Overweight U.S. equities, which will likely grow faster than other developed countries. Europe and Japan are likely in for a tough journey, but investors may be underestimating the power of monetary easing. |
Overweight U.S. but with selective European industrials and IT exposure. The U.S. will likely grow faster than other developed countries, but industrials appear to have attractive valuations in non-U.S. equities. |
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Value/growth |
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Heavily overweight growth, only because financials tend to dominate the value indexes and financials could underperform with the enhanced regulatory scrutiny they face. This could create significant uncertainty about the sector’s outlook. We also think investors will pay up for real growth, which could be hard to find. |
Unbiased between value and growth, provided the value portion of a portfolio is not benchmarked to the financials sector. There are short-term opportunities in the traditionally “defensive” sectors like consumer staples and health care. |
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Large/small |
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Overweight large-cap stocks because they tend to have the dominant market share and cash to survive a volatile environment. |
Large-cap stocks are attractive, but some large-cap companies may be tempted to overpay for acquiring small-cap companies. |
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Strategic recommendation |
Tactical recommendation |
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| Fixed-income duration | ||
Intermediate-term, although we think yields could rise after June 2013, despite the Fed’s statement that it projects conditions will warrant keeping rates exceptionally low until late 2014. We do need to remind investors that “exceptionally low” does not necessarily mean zero. Even 2% would be exceptionally low. |
Intermediate-term, because rates won’t likely rise until the middle of June 2013, but abating fear could push Treasury yields higher. There seems to be a decent cushion in corporate and municipal spreads to withstand a move up in Treasury yields. |
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Credit risk exposure |
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High yield. Default rates appear to be low. We believe they will dip lower as the global economy slowly improves. |
High yield. Clip coupons while you can, considering default rates are low and likely to remain low. |
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Fixed rate/floating rate |
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Fixed rate. Rates will likely rise, but when? Sitting on floating-rate notes for a year or so seems to be overly cautious to us. Floating-rate notes involve paying for insurance that is probably not needed. |
Fixed rate. With floating-rate securities, investors are paying for a feature they probably don’t need. It’s unlikely that short-term rates will rise significantly any time soon. |
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