The fourth quarter of 2012 capped an already volatile year with additional economic, political, and market related volatility. The Northeast witnessed one of the most devastating and costly natural disasters ever as Hurricane Sandy crashed against the eastern seaboard knocking out power for millions of residents and crippling businesses in its wake. President Obama was re-elected by a wide margin after the political “experts” contemplated a potential election tie scenario just days before the election results were finalized. Media outlets were literally counting down the seconds to the fiscal cliff deadline as uncertainty created widespread worry. Our political leadership reached a deal on the revenue side just hours before markets opened for the New Year. Europe continued to be a source of concern while both Japan and China welcomed new leadership during the quarter.
Generally speaking, the economic data out of the US was positive for the quarter. Housing and auto figures were relatively strong. While the unemployment picture wasn’t showing much in the way of improvement, it wasn’t getting worse either. Corporations were reluctant to put capital to work via capital improvements or by making new hires. The Federal Open Market Committee (FOMC) met in mid-December and agreed not only to continue purchasing longer-term Treasury securities at a pace of $45 billion per month but to also continue purchasing $40 billion of mortgage backed securities. The big surprise was the Fed’s announcement that they would continue to do so until unemployment approached 6.5% or inflation expectations were below 2.5%. While this slightly modified the terms of QE3 (announced in September) to include official targets on integral economic indicators, the news was positive enough to keep risk assets moving higher. At the very least, the December announcement provided additional clarity around when the liquidity injections might come to an end.
The financial crisis in Europe continued to dominate worry lists across the globe as Spain was downgraded and questions around Greece’s austerity measures loomed. Fortunately, the European Central Bank’s commitment to do “whatever it takes” in the previous quarter kept most concerns at bay.
After Japan’s current account balance fell into a deficit for the first time in thirty years, the Liberal Democratic Party (LDP) regained control as Shinzo Abe was elected Prime Minister. Since both Abe and the LDP are in favor of government spending and central bank stimulus as methods of increasing economic growth, the yen fell to a twenty month low.
There was clarity on the political landscape in China as Ma Ying-jeuo was elected. Trade data came in much stronger than expected and manufacturing rose to a seven month high during the quarter.
International equity markets posted a very strong quarter after lagging domestic markets for most of the year. While the S&P 500 finished down 0.38% for the quarter, the MSCI EAFE finished up over 6% but both the Shanghai 300 (up 10%) and the Topix (up 16%) were the real winners as clarity around political leadership and monetary policy lifted equity prices in Chinese and Japanese markets. US markets were volatile for the quarter to say the least. After an initial rally on hopes that a pro-business administration would unseat the incumbent, markets experienced their largest single day selloff of the year the day after Obama won re-election. The S&P 500 was down over 2.3%, the Russell 2500 was down 1.9%, and the NASDAQ was down nearly 2.5%. Politicians and markets quickly focused on the impending fiscal cliff. To make matters worse, third quarter earnings announcements were underwhelming and most included revised downward outlooks due to uncertainty around the fiscal cliff. In fact, both the Russell and NASDAQ entered correction territory during the quarter (-10%). The one bright spot to the fiscal cliff was that a large percentage of public companies initiated special dividends in an effort to distribute cash to investors at preferred 2012 tax rates. Additionally, the announcement of the postponement of Basel III capital requirements for US financial institutions lifted financial stocks with the S&P Financials index up 5.3% for the quarter.
The following chart summarizes various equity market indices in the fourth quarter:
Bottom Line: Corporate America is in good shape. Balance sheets have very high cash levels. Interest expenses, inventories and head counts are low. Revenue growth will pick up, albeit slowly, as the fed maintains a low unemployment mandate which will lead to a stronger consumer base. Slow but steady GDP growth has historically been very good for equities. We have begun to overweight growth strategies relative to value as we think markets will appreciate as economic conditions steadily improve.
Fixed Income Markets
The higher yielding fixed income strategies continued to perform well during the quarter as high yield was up 3% and emerging market debt was up 2%. The big story for the quarter was the sell-off in municipal bonds in December as word spread that the interest on municipal bonds may no longer be tax free as a means of generating additional revenue amidst the fiscal cliff negotiations. Below is a table of municipal bond returns for the quarter.
BarCap Muni Index
7 Year GO
3 Year GO
Managed Money Intermediate
Managed Money Short
Bond - Taxable
Inter - Short (1-10Y)
The price movement for the month of December is substantially negative in comparison to the average monthly movement for the market. While we view a drastic change to municipals’ tax exempt status as unlikely, it is clear that the administration is leaving no stone unturned for potential revenue increasing opportunities.
The following chart summarizes performance for various fixed income indices in the second quarter:
Bottom Line: Unprecedented central bank activity has created historically tight spreads across all fixed income instruments. Investors have been hungry for yield during an extremely low interest rate environment. When GDP growth picks up and inflation becomes a real concern, rising interest rates will negatively impact fixed income investors. The downside risk is much greater than the potential for return. Limit fixed income allocations to the low end of policy ranges.
The absence of unexpected central bank activity and macro driven market movement created a lower cross correlation environment for hedge fund managers to demonstrate the benefits of fundamental analysis. Most strategies generated positive returns for the quarter with the fundamentally driven funds generating the largest outperformance as both short and long investments delivered returns. The following chart summarizes performance for various hedge fund indices in the fourth quarter:
Bottom Line: Hedge Funds will generate returns more in line with historical averages as the slowdown of macro/central bank driven activity will reduce correlations and reward those that can distinguish between the good, the bad, and the ugly. We are optimistic that long and short trades will start to work again. Portfolios should maintain a diversified hedge fund allocation to reduce volatility. Investors are being rewarded for illiquidity once again as certain investment opportunities offer attractive uncorrelated return potential in return for locking capital. This reemergence of the illiquidity premium stems from traditional sources of capital, namely financial institutions, no longer being big participants in some markets. Middle market lenders, direct private equity, distressed, real estate, and secondary private equity are worthwhile allocations for investors with long term horizons.
Conclusion and Outlook
On the eve of January 1st, the administration agreed to a deal to avert the fiscal cliff. The major terms of the deal are listed below:
- Individuals earning more than $400,000 and couples earning more than $450,000 would be subject to a higher 39.6% top marginal rate
- This group would also see an increase in capital gains and dividends tax rates to 20%
- Individuals earning more than $250,000 and couples earning more than $300,000 would be required to reduce and eventually eliminate personal exemptions and deductions
- The tax rate on inheritances over $5 million for individuals and over $10 million for couples would increase from 35% to 40%.
While the above terms represent progress, the end is by no means in sight. The deficit discussion will clearly dominate headlines and investor psyches for the next few months. With that being said, the “three risks” of 2012 are largely being addressed, albeit slowly. Patient investors can position portfolios for the longer term while allowing active managers to take advantage of near term volatility and capitalize on asymmetric risk reward opportunities. Asset allocation remains paramount in our overall investment strategy. A disciplined approach with periodic rebalancing will reward investors over time.
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