All eyes continued to be on Europe in the first quarter, but right here at home there were equal reasons for smiles and frowns in the first three months of 2012. The European Central Bank and European Union leaders took a page from the US playbook (money printing) and quashed short-term fears in the Eurozone through the implementation of additional Long Term Refinancing Operations (LTRO). This facility provided a liquidity injection to the markets and helped to spur the first quarter rally around the globe. However, longer term debt and growth projections in many global economies still lingered, and, as the quarter came to an end, the markets saw increased volatility and daily contractions as investors and traders were confronted with the simple fact that the liquidity from LTRO was not a permanent solution for the problems abroad as Spain and Italy replaced Greece in the headlines as the next problems to be dealt with by the ECB. Additionally, several key economic indicators on the homefront (namely jobs and housing) negatively missed expectations and caused more frequent daily hiccups in the S&P, which actually posted declines on 12 of 22 trading days in March, as it was en route to its third positive month in a row to start 2012. Meanwhile, China continues to be the subject of fervent debates regarding a “hard” or “soft” landing and the deceleration in its GDP growth clearly had a tangible effect on worldwide markets. This slow-down, when coupled with China’s housing bubble, make it an area of concern and the markets responded in due fashion to close the first quarter.
In light of the more volatile end to the first quarter described above, the key question going forward is clear: how will markets sustain themselves without the “respirator” effect of aggressive monetary policies in the US and around the globe? We are watching to see whether the trillions of additional liquidity translates into growth or inflation, and pundits on both sides of this issue can make a convincing argument.
The positive sentiments and market rally that began in worldwide equity markets in the fourth quarter of 2011 continued into 2012. While many different asset classes posted gains in the early months of the year, the rally was seen most prominently in equity markets: after declining 17% in Q3 2011, the MSCI World Index rose 7% in Q4 2011 and continued climbing upward in Q1 2012, posting a further gain of almost 11% for that time period.
The following chart summarizes various equity market indices in the first quarter:
In the US, promising earnings and revenue reports coming off of US balance sheets and improving consumer data helped to drive domestic markets upward. Earnings reports were positive and corporations were also reporting continued revenue increases, each of which helped fan some of the bullish flames in Q1. In the US, unemployment finally dipped to 8.3% creating further short-term momentum in the equity markets in the US.
As discussed, European stocks benefited from headline positives and reactions to LTRO policies. Emerging markets saw inflows after posting sharp declines in 2011 as investors mindset shifted into a more “risk on” mentality.
As the concluding weeks of March made clear, it seems that the markets are very dependent on the actions of central banks and require ample liquidity in order for investors to feel confident putting money to work. We are wary of the effect that a sudden decrease in central bank activity could have on the markets, especially in more volatile geographic regions and more economically sensitive companies.
Bottom Line: We have a bias toward larger cap, higher dividend paying positions which tend to travel with the most safety through uncertain waters. We will use dips to add to managers with equity exposures where appropriate as we like equities in the long term. We still selectively allocate to managers that invest in emerging and developed market names outside of the US as well, but have a greater weighting to US names given the current macroeconomic uncertainty.
Fixed Income Markets
Most worldwide fixed income indices posted positive results in the first quarter; however, returns were muted compared to their equity counterparts. The following chart summarizes various fixed income index returns in Q1:
Fixed income returns hinge on two fulcrums: interest rates and inflation. For a long time now, many (including our own Fed Chairman) have been making predictions about both, and so far no one has got the timing down to a science. That being said, we still feel the inevitability (short or long term) of higher rates and inflation makes longer duration instruments less attractive than shorter and intermediate duration paper.
Bottom Line: We remain overweight to strategies focused on short duration fixed income with a slight bias towards domestic issuers as opposed to foreign credits. When allocating to managers that invest in global fixed income markets, we are focusing on those with dedicated risk management processes as well as teams that actively engage in currency hedging. Given our overall concern about the long-term return potential for traditional fixed income, we are looking also at managers with allocations to mortgages with risk-adjusted exposures to good paper and smart pricing.
While alternative managers participated in the market rally, they generally lagged behind long only exposure for the quarter. The following chart summarizes various alternative and hedge fund indices in the first quarter:
The first quarter continued to be a difficult short-term environment for hedge funds across all strategies due to an aggressive “risk on” mentality. Many of our managers de-risked their portfolios in the later months of 2011, which left them underexposed. This reduced exposure (and hence reduced upside relative to indexes and other long-only strategies) was in fact entirely in line with what we seek from alternative managers, namely, a focus on risk reduction as opposed to mere performance chasing. We want alternative managers to avoid severe drawdowns rather than simply capture every rally. This risk management is what hedge funds offer and thus illustrates why they are an essential component of any portfolio allocation. We feel this role makes them all the more important as we head into expected and unexpected macro headwinds.
Bottom Line: We continue to view alternative allocations as an integral part of any portfolio. We are focused on allocating towards multi-strategy managers as we believe their nimble, opportunistic, multi-asset approach makes them particularly well-suited to navigate any forthcoming volatility. We continue to seek active management in niche, uncorrelated strategies that can deliver alpha.
Conclusion and Outlook
Macro winds predominate. Many of the Euro-based fears from the summer of 2011 seemed momentarily forgotten in the wake of a massive Q4 2011 rally that continued into the first quarter of 2012. Despite many positive indicators on balance sheets and consumer minds, ongoing concerns regarding overly aggressive monetary policies around the world are reason for concern. Though no central bank is the same, there is a global trend toward liquidity, and this poses both risks and rewards. To the extent that economies are “doping” through QE and other policies, there is concern that even the best corporate earnings reports cannot stave off macro currents. In short, reasonable exposures are needed, but risk management across asset classes and strategies in addition to effective asset allocation continues to be our priority.
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