2010 Q4 Market Update

 

State of the Market

 

The second half of 2010 was marked by a collective sigh of relief as investors' concerns about the sustainability of the economic recovery diminished. This resulted in a strong fourth quarter rally, which turned an okay year for stocks into a very good one.

 

U.S. equities, as represented by the S&P 500 Index, advanced 10.8% for the quarter, and 15.06% for the year. The MSCI EAFE index of large, foreign companies showed gains of 6.6% for the quarter and 7.8% for the year. In fixed income, the Barclays Aggregate Bond Index, a representation of the entire U.S. bond market, lost roughly 1.3% in the third quarter but finished the year up 6.5%.

 

These results are welcome and add nicely to the recovery which began almost two years ago. However, the final numbers above don’t fully reflect the unrest and unease that permeated the economic and investment landscapes of 2010.

 

Year in Review

 

In the first half of 2010, equity markets continued to perform well driven by hopes of a strong recovery and reached an early peak in April. (See the chart below.) By May, hope had given way to fear as investors weighed the reality of a sub-par recovery and the many unresolved issues threatening the fragile upturn – European debt issues, stubbornly high unemployment, state budget crunches, a contentious political environment, and further housing weakness. Through most of the spring and summer, the U.S. equity market vacillated between breakeven and moderate losses.

 

 

 

The market for U.S. Treasuries discounted all the same information but with an entirely different result. The weak equity markets of summer were offset by very strong bond market performance. Some of this was due to a “flight to quality” as investors sought safety over risk. Some of it was a natural reaction to lower expected growth.[1]

 

By late summer the climate was so dour that economic weakness was becoming a self-fulfilling prophecy. The Federal Reserve, in an effort to keep the economy moving forward, embarked on a plan to further expand the money supply, often referred to as quantitative easing or QE2 (more on that later). This prompted an about face in both previously detailed trends. The equity markets turned up and the bond market turned down - a fully appropriate response to higher anticipated growth presumed to result from the Federal Reserve's efforts.

 

This “reversal of fortunes” surprised many investors who had turned to bonds for safety. A hypothetical investor who switched from stocks to bonds just prior to the Fed’s announcement, subsequently lost about 3.5% in bonds, while the U.S. equity markets rose 20% through year end.[2]

 

The Federal Reserve: Friend or Foe?

 

The Federal Reserve has come under much scrutiny for its role in managing the economy before, during, and after the credit crisis. Much of the criticism is well deserved, but some is misplaced.

 

The Fed is currently trying to stimulate the economy through quantitative easing (QE2). Quantitative easing involves the purchase of government bonds on the open market. This increases the money supply by replacing the purchased government bonds with cash. This is all in an effort to promote lending and increase liquidity.

 

It is often assumed that QE2:

 

 

 

 

 

 

 

 

 

 

 

 

 

  • is the equivalent of "printing money"
  • will be inflationary
  • will devalue the dollar
  • will hamper the government's ability to borrow
  • could undermine the recovery

 

The size of our economy is a function of our money supply (the actual cash in the system and money held at banks) and the pace at which that money moves through the economy (often referred to as the "velocity" of money). The credit crisis dramatically reduced the latter. People are saving more, paying down debt, consuming less. Companies are sitting on hoards of cash. Banks aren’t lending as freely. All these actions together have dramatically reduced the velocity of money over the last several years.

 

The Federal Reserve’s has needed to increase the money supply just to keep things on an even keel. Now, recognizing that the recovery is still fragile and not quite at a self-sustaining level, the Federal Reserve is again incrementally increasing the amount of money in the system.

 

Is there a risk that this could lead to inflation down the road? Yes. Is inflation inevitable? No. The Federal Reserve will monitor the pace of economic growth, the expansion of credit, employment levels, etc, and will adjust accordingly, shrinking the supply of money at some point in the future. Not an easy task, but not impossible either.

 

The Outlook Going Forward

 

As we look ahead, we are encouraged by the overall strength of the global economy (global GDP is estimated to be up 4.8% for 2010 according to a World Bank forecast), but believe we will see increasing divergence across economies and markets. Some economies are growing quickly and worried about inflation (China, Brazil), some are muddling through and still healing from the recession (U. S., most of Europe), and others (Spain, Greece, Iceland) are still in decline.

 

We believe this environment underscores the need for a globally diversified portfolio and suits our investment strategy well. Our equity strategy provides clients with tax-efficient exposure across all regions, countries, currencies and markets. We have balanced our traditional tilts towards small and value with exposure to high-quality, large-cap companies that should benefit from global growth. Our fixed-income managers are flexible, proactive and very aware of the risks of rising rates. 

 

 


 

 

[1] Bond yields, in part, mirror expectations for economic growth and inflation – the lower the growth and inflation expectation, the lower the yield on bonds. Since bond prices move up as bond yields fall, lower expected inflation often results in upward movement in bond prices.

 

[2] Based on price-only returns of Vanguard Intermediate Term Gov’t Bond ETF (VGIT), and the S&P 500 index from August 23rd 2010 through December 31st, 2010. This data is for illustrative purpose only and not intended to represent actual portfolio performance.

 

 

Posted by Jay Healy at 8:25 AM
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