Market Commentary · May 2011

OUTLOOK

Investor risk appetite was tested last month by the March 11 East Japan earthquake and tsunami. As the economic impact was analyzed and the scale of the nuclear disaster assessed, most equity markets outside of Japan rebounded by the end of the month to their pre-earthquake levels. At the same time, early signs of potential slowing U.S. economic growth have surfaced. The negative economic effect of the Japanese disaster will likely prove temporary, and the rebuilding efforts may provide a boost to future Japanese and global output. But continuing high oil prices are a risk to both near- and long-term global economic growth. Additionally, the scheduled June completion of the Federal Reserve's program of Treasury security purchases (dubbed QE2) raises the specter of less-accommodative monetary policy and therefore lower prospective growth.

While we think the primary driver of oil prices is global economic growth, the current turmoil in the Middle East and North Africa has added a risk premium. We don't see a clear path to eliminating this premium over the near term, as political progress in the most tumultuous countries is slow. Central banks are also powerless to address a price hike caused by a supply shock such as the current situation in Libya. However, the European Central Bank (ECB) has recently joined many emerging-market central banks in raising interest rates in response to rising inflation concerns.

We don't see the Fed joining this party until the first quarter of 2012 at the earliest. We believe the Fed will embark on “QE2.5” this summer, by reinvesting portfolio proceeds, to keep its balance sheet from contracting and tightening monetary conditions. In the face of potential fiscal drag from spending cuts, and a growth headwind from high oil prices, this would mitigate another drag to growth. While we see it as unlikely, we don't completely rule out the prospects for QE3 should U.S. economic growth begin to falter.

U.S. EQUITY

We have previously discussed equity market valuations by analyzing the implied risk premium for holding equities as compared to the risk-free rate (U.S. Treasuries). Another measure to assess is the cash-flow yield, or the income generated by a business after normal operating expenses, including capital spending, but before noncash expenditures. Even after recent highs, the cash flows of equities compared to the yields on investment-grade fixed income are at historically attractive levels. A benefit of this approach is that both measures include the credit risk involved in private enterprises. We continue to favor U.S. equities, even in the face of a potential economic slowdown, given their valuation and our expectation of continued supportive monetary policy.

EAFE & EMERGING MARKETS

Having entered the global financial crisis in relatively strong economic and fiscal positions, most emerging-market economies now find themselves with little slack and building inflationary problems. Additionally, the significantly greater percentage of consumer spending focused on food and energy has exacerbated their inflationary pains. This has led to tightening monetary policy actions in leading economies such as Brazil, China and India.The ECB has recently joined this bandwagon, though we expect the magnitude of its actions to be relatively muted. While the ECB's sole mandate toward inflation would argue for a one-sided approach, the fragility of key European real estate markets should give policy-makers some pause. Global European companies should continue to prosper, while domestically focused companies may see more headwinds to growth.

FIXED INCOME

Financial company yield spreads were typically lower than those of industrial companies until 2007, when the U.S. subprime mortgage market began to collapse. During the next two years, financial institutions took hundreds of billions of dollars of losses, significantly weakening their capital positions. With strong earnings and equity issuances since then, investor and regulator confidence in the creditworthiness of financial institutions has significantly improved. Last month, the Fed cleared some of the 19 largest U.S. banks to increase dividends, buy back shares or repay government aid, and financial institution credit spreads are at their lowest level relative to industrial companies since 2008. While we don't see robust demand for credit currently, this should provide some support to future economic growth.

GLOBAL REAL ESTATE

After three months of positive performance, global REITs posted a –0.5% return in March. North America and the Asia/Pacific region sold off in the quarter, dragging down performance for the benchmark. In the United States, REITs underperformed the broader equity market. Lodging and retail were the worst performers, while apartments and storage outperformed the FTSE NAREIT Equity REIT Index. Apartments also are the best-performing property type for the previous 12-month period. The pause in upward momentum for REITs can be partly explained by valuations, which appear stretched. Although REITs currently trade below peak valuations on price/cash flow, they're well above the average historical multiple of 13.2x. This supports our current tactical underweight to the asset class.

COMMODITIES

The commodity complex currently is being pressured by strong emerging-market growth, erratic weather and the weak U.S. dollar. In the case of the global oil markets, while we think global growth is the key longer-term driver of oil prices (especially in the wake of tightening supplies), the shorter-term driver is clearly the unrest in the Middle East and North Africa. We believe some commodities, such as copper, are trading at price levels unjustified by industry fundamentals. Recent data on agricultural markets has turned modestly positive, and we continue to believe recent spikes in agricultural prices have been driven mostly by short-term weather patterns. As such, we would expect prices to return to more normal levels during the next year barring another year of unusual weather patterns.

CONCLUSION

The first quarter of 2011 was an excellent one for risk assets, with the S&P 500 returning nearly 6%, large European stocks up 4.5% and Chinese shares gaining 4.3%. The strength of the global economic recovery was enough to offset the exogenous risks of the East Japan earthquake, rising oil prices and the European debt crisis. But early in the second quarter, some concerns have started to surface about the recovery's pace.

We made no changes in our tactical asset allocation views this month. Our current view is that a slowing in economic growth will not lead to a recession, and in that environment we think we can experience positive returns from both stock and bond markets. We expect equities to outperform investment-grade bonds and continue to favor U.S. equities over European and Japanese shares. Our tactical overweight to gold remains in place, as a hedge against a monetary policy mistake and a buffer toward geopolitical and sovereign credit risk.

Commentary provided by Jim McDonald