State of the Markets
Looking at the final numbers for the fourth quarter of 2012, one might assume the last three months of the year were uneventful. However, the flattish returns of equity and bond markets do not fully reflect the ups and downs of the quarter -- the pre-election rally, the post-election swoon, the December recovery, and the brief head fake during the Fiscal Cliff negotiations. After three months of movement, the equity and bond markets ended the quarter very close to where they started.
Despite this lack of direction in the fourth quarter, both U.S. and Global equity markets booked impressive (and nearly identical) gains for the full year. The total returns for major asset classes are below.
||MSCI All Country Index
||Barclays Aggregate Bond
For the year, the U.S. equity market responded to an increasingly sustainable U.S. recovery. Corporate profits are at an all-time high, partly due to efficiencies in the labor market (read: high unemployment), and U.S. companies are generally in good health. After 2011’s flat performance (2 percent for the S&P 500), 2012’s 16 percent increase approximates the growth in corporate profits over the past two years and should not come as a surprise.
Outside of the U.S., some countries had remarkable performance last year (Turkey up 65%, Belgium up 41%) while only three countries (Israel, Chile, and Morocco) had negative performance (in local currency). Like the U.S., global equity markets were making up for the ground lost in 2011, while fully reflecting growth in the global economy (predicted to be 3.2% for the year). Again, the result is welcome, but not surprising.
The Most Important News of 2012
The Federal Reserve has been implementing extremely stimulative monetary policies since the beginning of the last recession. Fed Policy has set short-term interest rates at zero, successfully lowered long-term interest rates, and dramatically increased the money supply to offset the decreased velocity of money moving through our economy. The Federal Reserve has received much criticism for its policies (some justified), but in the end, the Fed has two tools – a gas can and a fire extinguisher. (The gas can represents low interest rates and accommodative policy designed to stimulate growth. The fire extinguisher represents higher interest rates and restrictive policy designed to slow the economy and dampen inflation.) Since the last recession began, it has been using the gas can in full force. The question is and always has been when will they need to bring out the extinguisher and if they’ll be able to control the fire.
In early December, the Fed announced it will maintain the current zero interest rates policy until unemployment falls below a newly established threshold of 6.5 percent or inflation rises above 2 percent. The Fed had previously given no specific guidance as to when or how rates would increase. From an investment perspective, this is the most important news of 2012.
As depicted in the graph above, inflation has remained around the target for inflation. Unemployment, however, which peeked at roughly 10%, is currently 7.8 percent. This is above the target set by the Federal Reserve, but, the difference between 7.8 percent and 6.5 is not great, and a year of steady increases in the labor market could close that gap. More importantly, the bond market can and will anticipate the likely interest rate increases from the Fed in advance. The bottom line is we are expecting interest rates to trend higher - beginning soon.
The Paradox of Bonds
We have been talking for a while about the paradox of bonds at current interest rates. Investors need bonds to offset the risk of stocks in a portfolio, but bonds at current interest rates are not fully compensating investors for interest rate risk or inflation.
Going forward, investors may be well served to maintain flexibility in their bond allocation. This flexibility can come at two levels –by selecting managers who can act with broad enough mandates, and by varying the allocation to managers and strategies in response to big market shifts.
For clients of Century Wealth Management, a detailed discussion of how we are addressing these issues is available in our quarterly letter.