Investment Commentary: First Quarter 2011
April 01, 2011
Thoughts on the Investment Markets
U.S. stocks started the year off well with the S&P 500 up 5.9% for the first quarter. International stocks as measured by the MSCI EAFE were up 3.4% for the quarter. Despite widespread political unrest in the Middle East, the tragic earthquake off the coast of Japan and continued concerns over sovereign debt issues in Europe, the market continued to climb the proverbial wall of worry. The earthquake and subsequent nuclear crisis in Japan created a lot of volatility in Japanese stocks. Our international managers have been substantially underweighted to Japanese stocks, which was an advantage to our portfolios this quarter.
Taxable bonds were up modestly for the first quarter with the Barclays Capital U.S. Aggregate Bond Index gaining 0.4%. Municipal bonds also increased, overcoming investor concerns about the fiscal health of many state and local governments. Intermediate and long-term Treasury yields moved slightly higher as the Fed continued to purchase Treasury bonds as part of its quantitative easing program. QE2, as it is commonly referred to, is scheduled to conclude at the end of June. Once the Fed stops buying a considerable portion of the Treasuries that are issued, we expect interest rates in the U.S. will likely rise further.
The U.S. economy continued to recover with GDP growth revised upward to a better than expected 3.1% for the fourth quarter of 2010. Additionally, the unemployment rate improved during the first three months of the year. Corporate profitability is near all time highs, as companies are operating very efficiently. Technology is a sector we expect to continue to perform well, and we repositioned client portfolios earlier this year to take advantage of the opportunities there.
The first quarter was a solid start to the year, and there are a number of positives in the markets and economy. However, rising energy and commodity prices coupled with the potential impact of recent and unfolding global events could create higher than normal volatility over the short to intermediate time frame. We think our client portfolios are well positioned to navigate future potential volatility and to capture the growth opportunities both within the U.S. and around the globe.
The Fed –Walking the Inflation/Deflation Tightrope
Inflation has picked up in recent months as food and energy prices have soared around the globe. Two of the major causes of the unrest in many North African and Middle Eastern countries were economic challenges of the unemployed and the soaring cost of food. Overall and core inflation in the U.S. (excluding food and energy prices) have remained low over the past twelve months, but both are likely headed higher as low inflation months from last year roll off and new months are added (see chart below).
Although inflation in the U.S. appears to be headed higher in coming months, a number of factors should keep it under control this year. First, high unemployment, downsizing state and local governments, less wage and benefits cost pressure and globalization should keep wage inflation in check for a long time. Since wages are a significant part of corporate costs, this should help suppress overall inflation.
Second, overall economic growth faces continued headwinds from high unemployment, a weak housing market and a deleveraging private sector. Inflation can occur even when overall demand is not surging (stagflation), but that’s not typical. Slack in industrial capacity should also dampen inflation. A continued weak housing market should curtail increases in rental prices that make up over 40% of the Consumer Price Index (CPI). And consumer spending should only grow modestly as consumers continue to reduce debt. All of these factors are likely to keep demand in check, thus reducing inflationary pressures.
Sharply higher energy prices have contributed to rising inflation in recent months as unrest in the Middle East has raised the risk of supply disruptions. Events in the Middle East are unpredictable and oil prices may go higher, but in recent years higher energy prices haven’t flowed through to higher prices elsewhere. Consumers feel higher oil prices primarily at the gas pump, as the price of a gallon of gas may be the best known price of any product in the country. High gas prices can tend to have a disproportionate impact on consumer psychology resulting in consumers spending less money on other items. Less demand creates downward pressure on prices for other goods and services. Paradoxically, high energy prices may actually be deflationary over the intermediate term when measured across all goods and services. While oil prices could spike even higher in the short term, sustaining sharply higher oil prices over an extended period is unlikely because of the self-correcting pricing mechanism commodities tend to have over the intermediate term.
How Will the Fed Respond to Higher Food and Energy Prices?
The Fed’s dual mandate of price stability and full employment puts the Fed in a difficult position since unemployment remains very high. Based on the Fed’s most recent statements, for now they seem less concerned with inflation and believe high food and energy prices are transitory and unlikely to lead to higher core inflation. The Fed plans to continue QE2 through the end of June in an effort to reduce unemployment although they could adjust this if inflation expectations rise significantly. One of the big questions is what will happen when QE2 ends in June?
Last summer when QE1 ended there were signs that economic growth was sputtering and the stock market fell. If that happens again, this time the Fed could hold monetary policy steady to not add to inflation, but that could risk the still fragile economic recovery. Or the Fed could step in again with QE3, risking higher inflation in an effort to keep the economic recovery from slipping back into recession. Another possibility is that the economy will have reached a self-sustaining level and do just fine when QE2 ends and the Fed won’t have to make a tough decision. If things are unclear, this could present a dilemma where the Fed has to decide between fighting inflation and slowing growth, or continuing to spur growth at the risk of higher inflation in the future.
