The economic recovery that began in 2009 extended into 2010, thanks in part to a concerted effort by global governments to provide a framework conducive to growth and asset inflation. More specifically, government officials, especially those in the U.S., used monetary policy to keep interest rates low in order to incent corporations to spend and investors to allocate funds to risk-based assets. This accommodative monetary policy proved to be very successful in the short run as economies continued to recover and riskier assets appreciated substantially.

The effects of the policies were most evident in the financial markets during the final quarter of the year. Stocks posted strong gains while bonds fell sharply, as investors digested economic data and the Federal Reserve’s plan to stimulate the U.S. economy via another round of quantitative easing, also known as QE2. At its two-day meeting in November, the Fed provided the details of its plan, which included purchasing an additional $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. Equity markets, despite long anticipating the Fed’s announcement, rallied sharply on the news, rising approximately 2% on the next day of trading. Not all investors cheered when the Fed outlined its plan, however, as a few well-known market participants sharply criticized the Fed’s strategy to rejuvenate the U.S. economy. While the criticisms may be justified, the Fed is merely acting in accordance with its statutory mandate, which is to promote stable prices and full employment. With short-term interest rates at approximately 0%, a second round of bond purchases was the only remaining monetary strategy at the Fed’s disposal.

Meanwhile, international government officials, particularly in Europe, were also active during the quarter with their efforts focused on creating a bailout package for Ireland – the second PIIGS (Portugal, Italy, Ireland, Greece, and Spain) nation requiring a financial lifeline this year. Ireland has the dubious distinction of being the first country to tap into Europe’s rescue fund, also known as the European Financial Stability Fund (EFSF), which officials created after the ad hoc bailout of Greece earlier this year. The entire Irish loan will come from a few sources. The EFSF will join the European Commission and the International Monetary Fund in providing the Irish government with $89 billion to fund government spending and clear up the balance sheets of its troubled commercial banks.

Market and Economic Review

The U.S. economy muddled along during the fourth quarter at a pace that some people believe may not be strong enough to materially improve the weak employment picture, which is one of the reasons the Fed felt obligated to implement a second round of bond purchases. The Fed’s somewhat controversial actions showed that it is willing and able to implement programs designed to spur the economy. However, the Fed has stated that monetary policy alone may not be sufficient to improve the pace of the recovery. Congress needs to take decisive action as well. In an effort to keep the recovery going, both the House and the Senate approved the extension of the tax cuts put into effect during the previous administration. Congress also approved an extension of unemployment benefits, which some people believe will help to enhance economic growth.

Gross domestic product (GDP) increased at an annual rate of 2.6% in the third quarter of 2010, according to the estimate released by the Bureau of Economic Analysis, which was slightly higher than expectations but well below levels necessary to significantly impact the employment rate. In the second quarter, GDP increased 1.7%. The acceleration in GDP in the third quarter primarily reflected a sharp deceleration in imports and accelerations in private inventory investment and in personal consumption expenditures (PCE) that were partially offset by a downturn in residential fixed investment and decelerations in nonresidential fixed investment and in exports.

Meanwhile, the Federal Reserve, through its Summary of Commentary on Current Economic Conditions (“Beige Book”), said that reports from the twelve Federal Reserve Districts indicate that the economy continued to improve, on balance, during the reporting period from early/mid- October to mid-November. Economic activity in the Boston, Cleveland, Atlanta, Dallas, and San Francisco Districts increased at a slight-to-modest pace, while a somewhat stronger pace of economic activity was seen in New York, Richmond, Chicago, Minneapolis, and Kansas City. Philadelphia and St. Louis reported business conditions as mixed. Positive highlights from the report were found in the manufacturing sector where activity continued to expand in almost all districts with relatively strong growth in metal fabrication and the automotive industries. In contrast, the Districts reported that the housing markets remain depressed, with several Districts reporting further weakening during the past six weeks. Conditions in commercial real estate were mixed, and activity stayed at low levels.

On the employment front, the data for the first two months of the quarter was mixed with the Bureau of Labor reporting that 151,000 and 39,000 non-farm payroll jobs were added in October and November, respectively. The October employment report, in the context of the current recovery, was excellent and included upward revisions to previous months of 110,000 jobs. Unfortunately, the unemployment rate did not improve. The November employment report was disappointing with the number of jobs added falling well below expectations. The large difference between expectations and realized levels can be attributed to the service sector where just 65,000 jobs were created. In the prior four months, a total of 485,000 jobs were created. Overall, the number of unemployed persons was 15.1 million in November. The unemployment rate edged up to 9.8%; it was 9.6% in each of the prior 3 months.

With moderate growth and a weak employment market, it is not surprising that inflation expectations remained weak during the quarter. In October, the Consumer Price Index (CPI) increased by 0.2% on a seasonally adjusted basis. In November, the CPI rose by 0.1%, which was 0.1% below consensus expectations. As a result, the year-over-year increase was only 1.1%. The November report (as well as the October report) reinforces the Fed’s viewpoint that inflation is not problematic at this point, while the potential for deflation is the bigger concern.

On the real estate front, results for the quarter were generally mixed with disappointing numbers in October followed by a rebound in November. In October, existing home sales declined 2.2% to a seasonally adjusted annual rate of 4.43 million and are 25.9% below the 5.98 million-unit level in October 2009 when sales were robust prior to the initial deadline for the first-time home buyer tax credit. New home sales for October were also weak, falling 8.1% from the prior month and remaining 28.5% below last October’s results. In November, the real estate markets rebounded with both existing homes sales and new home sales rising approximately 5.5% from the October’s levels.

Outside the U.S., fears over sovereign debt and the potential for contagion resurfaced during the fourth quarter, with Ireland being the latest European country on the verge of a financial crisis. The $89 billion bailout for Ireland has a two-fold purpose, which is to help the Irish government with its public finances while it implements austerity measures and to shore up the balance sheets of Ireland’s troubled banks. The Irish banking crisis is not all that different from the recent financial crisis in the U.S . In both situations, cheap money led to extraordinary growth in the real estate market. Banks and other financial institutions provided loans to fuel this growth but without a credible system in place to ensure that the loans would be paid back. This resulted in the banks maintaining many bad loans on their books that jeopardized their financial viability. In Ireland, the fear was that without a rescue package, there would have been a run on the banks with customers pulling out large amounts of money. While many government officials and market participants supported the bailout, the plan had its share of critics who argued that it is not fair to cut jobs and increase taxes while money goes to banks with irresponsible lending practices.

Meanwhile, overall economic growth slowed modestly in Europe during the third quarter. According to Eurostat, the statistical office of the European Union, GDP increased by 0.4% in the Euro area1 and by 0.5% in the EU271, as governments’ austerity measures to cut record budget deficits dented the recovery. In the second quarter, both regions grew by 1%. Recently released fourth quarter data indicated that while Europe’s economy is still expanding, its rate of growth has moderated a bit. The Markit Flash Eurozone Composite Output Index (PMI) contracted modestly in December, hitting a two-month low at 55.0. The decline in Composite PMI was entirely attributable to weakness in the services component. Manufacturing in the region has remained strong. Nevertheless, the region’s growth has been rather uneven. The German economy has been strong, well outperforming the rest of the region while France continued to grow at a faster pace than the region’s average. Output growth for the rest of Europe, however, has slowed substantially.

Bonds

Fixed income performance was generally negative for the quarter despite the Fed’s attempt to lower long-term interest rates. The primary driver of performance was duration, with the longest-dated securities generally experiencing the steepest declines. Quality (or the lack thereof) also influenced returns with lower-quality securities outperforming higher-quality bonds. This is best illustrated by the -2.6% and 3.2% returns generated by the Barclays Capital Aggregate U.S. Treasury Index and the Barclays Capital U.S. Corporate High Yield Index, respectively. The broad market, as represented by the Barclays Capital U.S. Aggregate Bond Index, fell 1.3% for the quarter. Meanwhile, interest rates – except for the shortest maturities – generally rose, with the most pronounced advances occurring on the five- to ten-year part of the yield curve. Foreign bonds modestly underperformed their domestic counterparts, largely weighed down by European securities. The Barclays Capital Global Aggregate ex U.S. Index fell -1.3% for the quarter.

Stocks

On the heels of a strong third quarter, risk-based assets began the final quarter of 2010 on a positive note in October, as market participants enthusiastically awaited the Federal Reserve’s announcement regarding the details of its plan to energize the U.S. economy through another series of bond purchases. Securities markets took a breather in November after investors digested the somewhat mixed economic news of the period. Then in December, markets moved higher once again as investors embraced the deal struck between President Obama and the Republicans to extend the Bush tax cuts.

All domestic equity investment styles posted strong gains for the quarter although investors favored growth over value. Specifically, the Russell 3000® Growth Index, which measures the performance of stocks from all capitalizations, returned 12.3% while the Russell 3000® Value Index returned 10.9% for the quarter. Leadership across capitalizations changed again during the period, with small-cap stocks besting their large-cap counterparts by a wide margin as the risk trade was back in full force. On a year-to-date basis, small-cap stocks have outperformed large-cap stocks by almost 11%. Historically, small caps have had a performance advantage coming out of recession. With that said, the magnitude of the outperformance this year is somewhat surprising when considering that the contraction officially ended one and a half years ago. Within the Russell 3000® Index, performance differed notably by sector. Economically sensitive sectors such as energy and materials were the best performers, gaining 22.3% and 19.4%, respectively. Defensive sectors such as utilities and health care were among the laggards, adding only 2.2% and 5.1%, respectively. For the entire year of 2010, the Russell 3000 Index rose 16.9%, which comes on top of a 28.3% gain in 2009. Since the equity market’s trough on March 9th, 2009, stocks as represented by the Russell 3000 Index, have recouped almost 80% of the losses generated during the last bear market.

On the international front, stocks generally posted gains but underperformed their domestic counterparts by quite a bit, as concerns over sovereign debt and the potential for contagion in Europe tempered investors’ appetite for risk taking. Stocks from emerging countries outperformed their developed markets counterparts for the eighth consecutive quarter, with the MSCI Emerging Markets Index gaining 7.3%, thanks in part to strong performance from Taiwanese and South Korean stocks, which gained 17.4% and 12.8%, respectively. The MSCI EAFE Index added 6.6% for the quarter.

Outlook

Only time will tell as to whether the Fed’s attempt to stimulate the economy via continued accommodative monetary policy will prove successful. One of the Fed’s direct goals is to lower long-term interest rates, which in turn would potentially spark a pickup in borrowing and lead to increased economic activity. Manipulating longterm rates is a departure for the Fed from its typical focus, which has been to adjust short-term rates. It has only been about two months since the Fed released the details of its plan but since then interest rates have moved sharply higher, which does not bode well for mortgage rates. According to Freddie Mac, the rate on the 30-year fixed rate mortgage averaged 4.86% for the week ended December 30, 2010. In November, the 30-year fixed rate mortgage reached a 40-year low of 4.17%. The housing market is already fragile and could suffer if mortgage rates move substantially higher.

Thus far, the Fed’s plan has had unintended consequences for the bond market, with interest rates rising and bond prices falling significantly during the fourth quarter. Going into the last quarter of the year, some investors were already concerned about valuations in the bond market, especially in the higher-quality segments such as Treasuries and agency mortgage backed securities. As it turned out, QE2 provided investors with a reasonable thesis for selling bonds. With interest rates at historic lows, and bond prices with nowhere to go but down, investors had little reason to be excited about the prospects for fixed income securities. Furthermore, some investors also expressed concerns about how QE2 might result in a depreciation of the U.S. Dollar and lead to higher inflation down the road.

We at Managers Investment Group are also concerned about the potential negative side effects of QE2, especially with respect to how it will impact interest rates and bond prices. Over the past few years, investors have directed an unprecedented amount of money into fixed income securities and funds. Since the end of 2007, approximately $612 billion has flowed into fixed income funds, while equity funds have experienced net outflows of $166 billion. There is some evidence to suggest that this trend is slowing and/ or reversing. In November, non-money market fixed income mutual funds saw a small net outflow of $1.4 billion, which represents a significant change from October when this group attracted $22.5 billion of net new money. In contrast, equity mutual funds experienced net inflows of approximately $8 billion dollars compared with a $5 billion inflow in October and a $10 billion outflow in September.

While bond funds, overall, have not experienced large outflows, the potential exists for this type of environment, especially if interest rates continue to rise. We still believe that bonds are an essential part of many portfolios, however, the potentially changing landscape for fixed income securities provides an opportunity for many investors to reevaluate their portfolios to ensure that their asset allocation remains appropriate for their circumstances and goals.

 

¹Data sources: FactSet and Strategic Insight Simfund MF 1 The euro area (EA16) consists of Belgium, Germany, Ireland, Greece, Spain, France, Italy, Cyprus, Luxembourg, Malta, the Netherlands, Austria, Portugal, Slovenia, Slovakia and Finland. The EU27 includes Belgium (BE), Bulgaria (BG), the Czech Republic (CZ), Denmark (DK), Germany (DE), Estonia (EE), Ireland (IE), Greece (EL), Spain (ES), France (FR), Italy (IT), Cyprus (CY), Latvia (LV), Lithuania (LT), Luxembourg (LU), Hungary (HU), Malta (MT), the Netherlands (NL), Austria (AT), Poland (PL), Portugal (PT), Romania (RO), Slovenia (SI), Slovakia (SK), Finland (FI), Sweden (SE) and the United Kingdom (UK).

Any sectors, industries, or securities discussed should not be perceived as investment recommendations. The views expressed represent the opinions of Managers Investment Group LLC and are not intended as a forecast or guarantee of future results. The information and opinions contained herein are current as of Dec 31, 2010 and are subject to change without notice. Information has been obtained from sources believed to be reliable, but its accuracy, completeness, and interpretation are not guaranteed. The Russell 3000® Growth, Russell 3000® Value, and Russell 3000® Indexes are trademarks of Russell Investments. Russell® is a trademark of Russell Investments. All MSCI data is provided ‘as is’. The products described herein are not sponsored or endorsed and have not been reviewed or passed on by MSCI. In no event shall MSCI, its affiliates, or any MSCI data provider have any liability of any kind in connection with the MSCI data or the products described herein. Copying or redistributing the MSCI data is strictly prohibited. An investment cannot be made directly into an Index. Index returns do not reflect any fees, expenses or sales charges.

Investment advisory services are offered by Managers Investment Group LLC.

Funds are distributed by Managers Distributors, Inc., member FINRA.

 

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