04 January 2013
An eventful year, but one that investors can celebrate
December capped an eventful year for financial markets. Despite a roller-coaster ride on the political and economic fronts, the S&P 500 Index notched a 16-percent gain for the year, while international markets also performed well, as the MSCI EAFE Index returned 17.32 percent and the MSCI Emerging Markets Index posted a price return of 15.15 percent. The strong performance of equity markets across the board reflected general progress—an economic recovery in the U.S., led by the housing market; real political improvements in Europe, where the debt crisis appears to have largely been contained; and a successful leadership transition and apparent economic “soft landing” in China. Outside the U.S., the risks appeared to be much more manageable at the end of 2012 than at its start.
In December, markets fluctuated with news from Washington, DC. The defining event of the month, for both the real economy and the financial markets, was the fiscal cliff issue. On the final trading day of the year, a small compromise appeared to be in the making, with an agreement to raise income taxes for households making $450,000 or more per year, raise capital gains tax rates to 20 percent, and limit itemized deductions for individuals making more than $250,000.
The S&P 500 ultimately rose over the course of the month, by 0.91 percent, but the small change did not reflect the daily volatility. Markets rallied, slid, and finally recouped some gains. Politics dominated the economic and financial discussion and will likely continue to do so, as the next round of debt ceiling discussions comes around.
During the past year, midsized companies outperformed large- and small-capitalization companies, and value beat growth. On a sector basis, financial and consumer discretionary stocks did best, while the utilities and energy sectors lagged. Stocks have stealthily pushed higher over the past four years, with the S&P 500 now just 9 percent below its 2007 peak.
The strong performance of international markets continued in December. Through month-end, the MSCI EAFE and MSCI Emerging Markets indices rose 3.2 percent and 4.78 percent, respectively. These returns generally reflected an improving economic climate in emerging markets and a stabilization of European markets. These regions were also less affected by the fiscal cliff in the U.S. (see chart).
Fixed income markets also performed well in 2012, with the Barclays Capital Aggregate Bond Index showing a return of 4.22 percent for the year and the Barclays Capital U.S. Corporate High Yield Index returning 15.81 percent. High-quality bonds lost some ground in December, with the Aggregate Bond Index declining 0.14 percent. Yields on Treasuries traded in a relatively narrow range throughout the year, reflecting the generally high degree of risk aversion in the markets.
Valuations vary across asset classes
As we enter 2013, U.S. stocks appear to be fairly valued based on short-term indicators, such as the trailing 12-month price-to-earnings ratio, which at 14.5 is neither significantly above nor below historical averages. Stocks, however, appear less attractive according to other metrics, such as the Shiller P/E ratio. Currently, the most value to be found is in developed Europe and Japan, where stocks look particularly compelling from a price-to-book value perspective. Emerging market stocks also look reasonably attractive, particularly in more cyclical sectors.
From an absolute yield perspective, bonds on the whole look expensive. High-yield and municipal bonds rallied significantly in 2012. Though there may still be some opportunity with respect to their spread over Treasuries, they are less attractive now than they were at the beginning of the year.
A slow global economy spurred government intervention
The one overarching factor in all markets in 2012 was the influence of governments and central banks. The first quarter of the year saw markets rally as a result of the European Central Bank’s (ECB) Long-Term Refinancing Operation, designed to inject capital into troubled European banks. A continuation of the U.S. Federal Reserve’s (Fed) Operation Twist also aided the rally in risk assets. After a market pullback in the second quarter, the ECB took further action by announcing its willingness to buy sovereign debt of distressed peripheral nations. Not to be outdone, the Fed promised to engage in a third round of quantitative easing, this time with an open-ended time horizon and targeting an unemployment rate of 6.5 percent. European and U.S. central banks were also joined by their peers in the developing markets, as both China and Brazil cut lending rates during the year.
The backdrop for this extraordinary intervention on the part of central banks was a soft global economy. The eurozone fell into mild recession, the Japanese economy struggled, and global manufacturing stagnated. In the U.S., the economy continued to grow at a slow pace, largely as a result of an improving housing market and reasonable levels of consumer spending.
The willingness of the Fed and the ECB to serve as backstops caused investors to assign a smaller likelihood to the possibility of “really bad” scenarios, such as a disorderly dissolution of the eurozone, coming to fruition. This reduction in investor worries moved markets higher, even as the global economy struggled.
U.S. housing and consumer spending recover, business lags
In the U.S., 2012 was the year that the economic recovery started to get real. Housing slowly improved throughout the year, with home values reportedly increasing year-over-year for the first time since 2006. Inventories remained below historical levels, suggesting that prices would continue to rise. In many markets, buying became cheaper than renting, which further supported the housing recovery. In addition, there were signs that household formation was starting to recover and that the housing market would further benefit as pent-up demand moved into the market.
Employment also improved, with 2012 job gains seeming to be on a pace similar to that of 2011 and close to that of 2004 and 2006. Despite weakness in the second quarter, employment growth recovered in the third and fourth quarters, and the unemployment rate (U3) dropped from 8.5 percent at the start of the year to 7.7 percent near the end—a much larger improvement than had been expected.
Consumer spending followed the recovery in housing values and employment, tracking previous recovery levels and moving back above the peak of the previous cycle. Consumer savings rates fell but remained at reasonable levels, and consumer debt and debt service levels declined to multiyear lows, suggesting that demand would be sustainable.
Business spending was much weaker, driven by policy uncertainty with respect to taxes and federal spending. This remained the weakest part of the economy, and whether this will improve in the coming year is still unclear.
On to 2013
An economic recovery has taken root in the U.S., and domestic economic trends look encouraging. The political and economic risks in Europe remain but are significantly reduced relative to the start of last year. China and other emerging markets are showing signs of stronger growth after a slowdown.
A major risk for the U.S. is governmental dysfunction. A pending debt ceiling debate awaits early in the new year. In 2011, a similar debate almost led to default on U.S. government debt, resulting in a credit rating downgrade. Another risk is the reduced scope of the possible policy responses available to central banks. Now that monetary authorities have fully committed themselves to bolstering the recovery, investors will have to rely on individual consumers and businesses to drive the economy forward.
Nevertheless, even in the face of these risks, developments in the U.S. and around the world bode reasonably well for markets at the start of 2013. In the U.S., the risks are containable and the damage done by the fiscal cliff may well be limited. Cautious optimism is the appropriate stance. Investors should neither shun markets nor become overconfident but instead stay focused on their long-term strategic allocations and goals.
Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research associate, at Commonwealth Financial Network.
© 2013 Commonwealth Financial Network®