Mainspring Connection

Spring 2012

Market Commentary

By Julie Grandstaff, VP & Managing Director, StanCorp Investment Advisers, Inc.

The first quarter closed with what may have been the hottest March on record in the U.S. More than 7,700 high-temperature marks were tied or broken throughout the country during the month. Temperatures were approximately 18 degrees warmer than usual in about two-thirds of the country, according to data from the National Oceanic and Atmospheric Administration.

Perhaps taking a cue from the weather, equity markets were "hot" as well. Investors grew emboldened due to encouraging economic news coming out of the U.S., coupled with signs of an easing to Europe's debt troubles. These developments fed a renewed appetite for equities throughout the world. Risk assets rallied for most of the quarter, with some of the biggest gains made right here in the U.S.

These market gains have come despite a significant amount of skepticism. Continuing the trend from 2011, U.S. investors pulled $15.6 billion from U.S. equity mutual funds so far this year, according to the Investment Company Institute. This is remarkable, given that a rising market usually results in fund inflows. Daily trading volumes have also been light. An average of 3.82 billion shares changed hands daily in New York Stock Exchange trading in the first quarter. That figure is 15 percent less than the same period last year and is the worst quarter for trading volumes since 2007. The world economy has shown some signs of improvement, but apparently not enough to regain the trust of the retail investor as of yet.

U.S. Economy

U.S. employment continues to make positive strides, though the March data was disappointing. There were only 120,000 new jobs created in March, which was well below expectations of 205,000 and half the February figure of 240,000. The unemployment rate dropped to 8.2 percent primarily on lower participation in the job market. Nevertheless, in the last six months the economy has added well over 1 million jobs, indicating that companies have become more confident in the economic outlook.

This pickup in hiring has boosted consumer confidence to a four-year high, giving hope that the recent gains in household spending, which account for 70 percent of the economy, can be sustained. Household spending was up a surprising 0.8 percent in February after a respectable 0.4 percent in January.

In any case, the recent spending will have likely led to another positive quarter of economic growth for the U.S. once the first quarter Gross Domestic Product (GDP) calculation is finalized. Overall, the U.S. economy, as measured by GDP growth, grew at an annualized level of 3 percent in the fourth quarter of 2011. It is expected to come in at roughly 2 percent for the first quarter of 2012. While positive, this growth is not very good considering that we are coming out of a recession. Post-recession GDP growth is usually stronger than average. By comparison, our average GDP growth from 1948 through 2011 was 3.25 percent.

But weak growth is preferable to no growth. It is uncertain, however, just how long even the relatively weak growth can continue. While consumer spending was up significantly in the first two months of the year, it was not funded by rising incomes. In contrast, incomes have remained stagnant, failing to keep up with inflation so far in 2012, despite the increases in overall employment. In effect, we do not yet appear to be creating high-income jobs. Consumption has recently increased, but consumers have been funding it by saving less in order to supplement their low income.

However, savings rates are already very low in the U.S., both historically and as compared to other countries. Taxes must inevitably increase at some point as well. Both will put a strain on consumer spending. Consequently, we cannot expect to sustain spending growth in excess of income growth for very long. Ultimately, we need to see real income growth before we have a sustainable economic recovery.

Europe

Greece is saved! The euphoria did not last long though. Weeks after Greece secured a second package of rescue funds, the Greek prime minister Lucas Papademos began talking about a potential third bailout for the crisis-plagued country. Athens has already received the biggest combined bailout in history at €240 billion total since the beginning of the crisis. The bailout thus far is expected to cover Greek deficits until 2015 when they will have to attempt to re-access capital markets on their own. They will need to have figured out how to create a sustainable economy by that time. If not, a third bailout will likely take place. In addition to the direct monetary aid received, Greece was also able to complete a voluntary bond swap last month which sliced about €95 billion from the country's €360 billion debt, an attempt to create a little more breathing room to get their finances under control.

Once again, the bailout money comes with strings attached. Greece must continue to enact spending reforms subject to periodic inspection. The next inspection is scheduled for June, which could be complicated by their new government elections. Even if Greece stays out of the headlines in April, you can expect to hear about the country again in May, when elections are tentatively scheduled to take place.

Aside from Greece, there are still worries about the rest of Europe. In a European Credit Risk Survey conducted earlier this year by FICO, 79 percent of European credit risk management professionals forecast a new European recession during 2012. Recession would put pressure on the peripheral countries, notably Portugal and Spain. The big concern is that Greece is just the tip of the iceberg and not simply an isolated case.

Fixed Income

The renewed appetite for risk seen in the equity markets also manifested itself in bond markets. U.S. Treasuries suffered the worst quarter since 2010 as investors moved out of safer assets. But where did the money go if it did not go into equities? At least some of it went to high-yield fixed income. Junk rated companies sold $75.7 billion in bonds during the quarter, a record that stretches back at least to 1980, according to Thomson Reuters.

Equity markets rallied sharply in the first quarter as the U.S. reported improved economic data and in the absence of negative news out of Europe. U.S. large companies gained across the board. Their representative indexes, as measured by the Dow Jones Industrial Average and the S&P 500^®, were up 8.84 percent and 12.59 percent respectively for the month. The performance difference can be mostly explained by Apple Inc., which is not in the Dow Jones Industrial Average, but is the largest component of the S&P 500 at 4 percent. Apple stock soared 48 percent during the quarter.

U.S. small companies, as measured by the Russell 2000^®, also recorded significant gains of 12.44 percent during the first three months of 2012. International equities, as measured by the MSCI EAFE Index, rebounded after a poor 2011, increasing 10.86 percent for the quarter. Fixed income markets were flat. The Barclays Capital Aggregate Bond Index, which represents the U.S. corporate bond universe, increased by 0.3 percent for the month.

Outlook

Despite the terrific gains of the first quarter, we remain cautious for the near-term future. While not inevitable, recession remains highly likely in Europe. The U.S. looks a little better. In the U.S., we expect the economy to continue to grow slowly but remain fragile, subject to periodic shocks. If that is the case, we will cycle through periods in which risk assets perform well, followed by shock periods where risk assets underperform. As a result, trends may be short-lived and subject to reversal at any time. Proper diversification will likely be important for future quarters as well as for the long term.