4Q Commentary by Nathan Behan
After a truly dismal third quarter, the domestic equity markets bounced back strongly in October. Then, although daily volatility was high, these markets held mostly steady during the final two months of the year.
Small-caps generally outperformed larger-caps, with the Russell 2000 Index up 15.4% and the Russell 1000 Index up 11.8%. Despite the outperformance in the final quarter, the Russell small-cap indexes all posted negative returns for the year (as did the midcap indexes), while the large-cap indexes had marginally positive gains for 2011.
The value style indexes outperformed the growth indexes for the quarter, with a strong showing in the final month. This was a result of strong performances in December in the health care and financials sectors in the Russell 1000 Index, and a strong showing in financials and utilities in the Russell 2000 Index.
In both large- and small-caps, energy and materials were down significantly in the final month. Despite the rebound in the markets, investors continued to move away from domestic (and international) equities in favor of higher fixed-income allocations. For the first two months of the quarter, Morningstar Inc. data show nearly $29 billion in outflows from domestic stock funds and $7 billion from international equity funds.
As we noted last quarter, many of our managers have been emphasizing stocks with higher dividend payouts as a cushion against higher volatility. This continues to be the case as we move into 2012, with a lot of support for financials, staples and utilities, the quarter's best performers.
There is also a bias among our managers (that have some flexibility) toward large-cap names, based on current fundamentals and long-term exposure to emerging-markets economies. In the five-year period through 2011, the average annual returns on the Russell 1000 and Russell 2000 were both near zero: minus 2 basis points for large-caps and plus 15 basis points for small-caps. This has left the larger-cap names, even after outperforming in 2011, cheaper on a price-to-earnings basis.
As with the domestic markets, the international and developed markets rebounded from the significant losses in the third quarter. However, for most of the regions, the rebound was decidedly less enthusiastic than here in the U.S. Combined with larger losses than the U.S. in the third quarter, it placed most of the regional returns in negative territory, well behind the U.S for the year.
The Russell Developed ex-North America Large Cap Index was up just 3.31% in dollar terms during the fourth quarter and was down 12.4% for the year. In dollar terms, only Ireland (represented by the Russell Ireland Index) outperformed the U.S., up just over 22% for the final quarter and up nearly 14% for the year. In fact, despite all of the headlines around the European debt crisis, the European markets held up very well during the quarter (in dollar terms), with Norway (up 9%), the U.K. (9%) and Denmark (8%) leading the way. As has been the case for more than a year, the countries at the center of the debt crisis were some of the worst performers, with Greece down another 27% in the quarter and Portugal down more than 9%. The Asian markets were broadly mixed, with strong returns from Malaysia and Thailand offset by weakness in Japan and New Zealand. Among the emerging economies, Latin America did the best, with Peru (up 12%), Mexico (9%) and Brazil (nearly 9%) leading the way for the quarter. Of the significant emerging economies, only Indonesia had a positive return for the year.
The managers we spoke to this quarter continue to believe the emerging-markets space has the best long-term potential, but one that also has some hurdles to overcome after a disastrous year.
Questions remain about the extent to which continued slow growth in the global economy (or even a contraction in Europe) will soften demand for exports, and to what extent that demand can be made up by local market participants. Several managers are focusing on domestic consumer-oriented companies, whose products are sought after by the growing middle class and affluent consumers.
What appears on paper to be a relatively boring quarter, with the Barclays Aggregate Index up 1.1%, was actually anything but. Although the Treasury curve ended the quarter with only small changes from the previous quarter, the changes during the quarter were relatively substantial.
After the dramatic flight to quality and sharp drop in the long end during the third quarter, the “risk on” trade came back into favor in October, and the spread sectors rallied while the Treasury market slumped. Yields on the 10-year Treasury jumped more than 50 basis points before the end of October.
This move quickly reversed itself in November, as continued uncertainty in Europe swamped relatively positive news domestically. Treasuries rallied and the Barclays Corporate Index gave back all of its October gains before the end of November. December was much quieter, and a combination of demand for Treasuries and cautious economic optimism allowed all the major sectors to record positive returns for the month.
Going into 2012, there again is a consensus for nominal improving GDP growth, though no thought of a rate increase from the Fed. And while the majority of the managers we spoke to remain more conservatively positioned (shorter durations, higher quality), there is an increasing minority calling for longer-duration positioning. This minority concludes that rates are likely to be range-bound over the short to intermediate term, making the increased income available with longer-maturity instruments worth the interest rate risk.
Similar to the investment-grade sector, the domestic high-yield sectors saw significant swings in the first two months of the quarter before settling down in December. Unlike the taxable market, the losses in November were significantly smaller than the gains in October, allowing the Barclay's High Yield Index to return nearly 6.5% for the quarter. The High Yield Loans Index was up 3.1%. These gains allowed both indexes to have positive returns for the year, 5% and 1.1%, respectively. Our managers continue to believe this asset class offers an attractive risk/reward profile, even if default rates begin to rise.
The municipal market closed out the year with the best return of the broad investment-grade indexes, with the Barclays Municipal Index up 2.1%, outperforming the Barclays Corporate Index by 20 basis points and more than doubling the return of the Barclays Treasury Index. This capped the year at 10.7% for the index after a weak start in the first quarter. The municipal index has returned more than 10% only twice in the last 15 years: 2000 and 2009, both years following 2% losses in the index.
Despite the substantial returns, many of our managers believe the muni markets offer significant opportunities entering 2012, as the yields on AAA municipals are higher, on a pretax basis, than Treasuries across the curve, with the exception of the 10-year. Add in modestly improving state and local budgets (generally) and expectations that new issuance will be lower than the five-year average, and even our taxable managers are making a case for adding municipals to their portfolios.