Financial Market Update

StrategicPoint of View^®
January 9, 2012

LAST WEEK
The January Effect took hold, for the fourth year in a row. The first five trading days of the year have a history of achieving the highest rate of return in comparison to any other one week period. Over the last ten years, stocks have risen during the first week in January 70% of the time. The rationale (which tends to feed on itself) is that investors who claimed losses in December of 2011 are putting their money to work again, along with pension and retirement plan contributors.

In the US, the big manufacturing and jobs indicators topped expectations. The Institute for Supply Management’s manufacturing index came in at a relatively strong 53.9%. The non-farm payroll number reinforced the positive outlook for the manufacturing and the health sectors as 200,000 jobs were added in December. Unemployment trended down to 8.5%, offering good news for those looking for jobs. Construction spending, factory orders and motor vehicle sales were also strong but same store sales were uninspiring. 

Overseas, the euro zone’s retail sales dropped; its unemployment held steady at 10.3%; its PMI pointed to continued contraction; and consumer prices dipped slightly. The data supports the thesis that the euro zone is already in recession.

S&P 500: 1278 (up 1.67% on the year)
NASDAQ: 2674 (up 2.65% on the year)
Dow: 12,360 (up 1.16% on the year)
US Treasury 10 yr: 1.96% (from 1.87% last week)
Crude Oil (February): $101.93 (from $99.06 last week)
Gold (February): $1,617 (from $1,567 last week) 
USD/Euro: $1.2703 (from $1.2975 last week)

THIS WEEK
Alcoa officially kicks off earnings season on Monday. As of late, a number of corporations have made downward revisions to their profit estimates, setting up lower expectations and concerns over the spillover effects of a recession in Europe.

In the US economic data will be slim, with a focus on Thursday’s retail sales and Friday’s sentiment index. Overseas China reports on economic output, industrial production and retail sales. In Europe, the focus will be on bond auctions in Italy and Spain. 

COMMENTARY
2012 Bond Outlook
Consensus has it that bonds really will be boring this year, living up to their reputation. After all, Federal Reserve Chairman Ben Bernanke has announced that the Fed has little intention of raising interest rates until at least mid-2013. And this past week the December Federal Open Market Committee meeting minutes were released, revealing that senior officials had voted to shift its communication strategy.  In the near future, the Fed will publish its predictions regarding target interest rates for the next few years.

Target rates would provide more transparency and potentially dampen the rumor mill regarding the raising of interest rates. Critics say that such a statement could bind the Federal Reserve to holding rates low for too long. Supporters say that transparency could help keep volatility in check.  The inaugural forecast will be released January 25th.

Regardless of any change in communication policy, the fed funds rate is likely to remain at 0%-0.25% for the coming year. That is good news in the short term for bonds, as any increase in interest rates could result in a fall in bond prices, making existing bonds and bond portfolios less valuable. This would be especially true for government bonds, including treasuries, agency bonds and treasury inflation protection securities.

There is, however, a good chance that the 2012 bond market won’t be boring after all. Just look at what happened to municipal bonds in late 2010. Muni bond rates jumped on the (subsequently proved untrue) declaration that state and local default rates were going to soar. The muni bond market recovered but not before many investors lost money and bailed on their holdings. 

Then there was the prediction that treasury interest rates were going to rise on the debt downgrade that the US received last summer. Exactly the opposite happened as treasury yields tanked, catching bond gurus like Bill Gross of PIMCO with the wrong bet on the direction of interest rates.

High yield bonds also took a beating in the late summer and early fall when the stock market swooned. High yield bonds are tied more to equities than interest rates, although they are labeled as fixed income.

And we can’t forget the global bond market, which suffered at the hands of a rising dollar this fall. Global bonds or bond funds that are not hedged against currency moves, found their prices gouged when local currencies fell relative to the dollar.

However, overall, bonds performed very well in 2011, much better than the stock markets. But their performance at times was choppy and each sector was subject to various pressures at different times of the year.

Working in favor of bonds for 2012 is a global commitment by central banks to keep interest rates low, risk aversion amongst investors who continue to pile into bond funds, and consumer/business deleveraging which has kept yields low. In addition, if there were to be a substantial economic scare, interest rates could fall further, boosting returns.

But, as noted above, not all bond sectors are created equal. Bond performance could vary, depending on the sector and the timing.   At the start of the year, corporate (high yield and investment grade) non-agency mortgage securities and municipal bonds are the most attractive fixed income spaces. 

Historically, corporate bonds perform well in a modest growth environment where bankruptcies are kept from erupting. In addition, many large corporations are flush with cash available to service bonds. There is still room for spreads to tighten, which is positive for prices. Non-agency mortgage bonds usually perform well in stable interest rate environments as yields are relatively steady and the risk of mortgage prepayments is reduced. In the short term, valuations of municipal bonds make them attractive. However, it is a sector to be watched as states and municipalities continue to grapple with budget gaps and underfunded pensions.

Overall, bonds remain a respectable alternative to volatile equities. However, with interest rates at historic lows, it is hard to get overly excited about their potential return. With bonds, it is best to be diversified but flexible as they need to watched, just like their counterparts in the stock market. 

*Past performance is not indicative of future results. Indices are unmanaged and you cannot directly invest in them. The Nasdaq Composite Index measures all NASDAQ U.S. and non-U.S. based common stocks listed on the Nasdaq Stock Market. The S&P 500 index is based on the average performance of 500 industrial stocks monitored by Standard and Poor’s. The data referred to above was taken from sources believed to be reliable. StrategicPoint Investment Advisors has not verified such data and no representation or warranty, expressed or implied, is made by StrategicPoint Investment Advisors.

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