The U.S. Economy
With the end of first quarter 2012 fast approaching, it is becoming more evident that the U.S. economy has gained traction and organic growth is putting down roots. Domestic labor markets took another encouraging step forward in January. Nonfarm payrolls grew by a net 243,000 after backing out 14,000 government positions that were eliminated in the month. Gains were widespread across employment sectors, and the unemployment rate shrank to 8.3%. Relative to investors' expectations, these latest employment figures were good. That being said, the sustainability of improvements in the labor markets and the broader economy remain a concern. Last year, a series of exogenous shocks undermined investors’ confidence and threatened to derail the nascent domestic economic expansion. The U.S. is not immune to these types of shocks today, but the economy appears to be strengthening within the overall slow growth backdrop.
Rising tension in the Middle East is once again being reflected in higher global oil prices and higher domestic gasoline prices. In fact, gasoline prices in the U.S. recently touched their highest level ever for this time of year. As we discussed last year when commodity prices were rising, higher prices at the pump act like a tax on consumption. They also negatively influence consumer sentiment. While it may be true that the U.S. economy is on firmer footing today than at any point since the last recession, certain aspects of the economy remain far from robust and domestic growth is still susceptible to shocks. Consumers have certainly made progress toward paying down debts and repairing their balance sheets, yet they still lack the wherewithal and broad-based confidence to become a more meaningful economic growth contributor. To the extent that tensions in the Middle East remain elevated and continue to drive gasoline prices higher, wage gains created by improving labor market fundamentals may get eroded. Ultimately, higher gas prices could be an additional burden on the still fragile U.S. consumer – an example of a potential headwind facing the U.S. economy.
So far this year, progress in the domestic economy has largely exceeded investors' expectations, but January’s retail sales report was one exception. Retail sales grew a lower than anticipated 0.4% in January, and the monthly gain for December was revised down slightly. While still generally good, these retail sales figures serve as a subtle reminder that there are a number of forces present today that are restraining growth, and some may become more problematic than others in the short-run (i.e., gasoline prices). With this in mind, we continue to expect slow growth going forward.
The Global Economy
European developments remained front page news in February. Last month, Moody’s lowered the credit ratings it ascribes to six countries including Italy, Spain, and Portugal. Fitch ratings also reduced Greece’s sovereign credit rating to a lower junk status, as the nation continued to struggle to secure a much needed installment of bail-out funds. Interestingly, the recent wave of ratings downgrades has done little to deter investors’ renewed appetite for government bonds from some of the larger peripheral nations. In fact, yield spreads over German bunds (i.e., the German U.S. Treasury bond equivalent) in Italy and Spain have stabilized since late November. It appears that recent substantial expansion in the European Central Bank’s balance sheet has made noteworthy strides in calming market fears by reducing the potential for worst case outcomes. Economic growth across the Eurozone remains under pressure as the more fiscally stretched regimes implement austerity measures, but recent indications from some of the stronger nations could help support activity in the region more broadly. France’s economy expanded in the fourth quarter of 2011 (albeit modestly), while other European nations suffered contraction. Germany’s economy has also served as a bellwether of strength in the Eurozone amid the ongoing sovereign debt crisis.
Over the past six months, we’ve seen a flurry of policy-easing maneuvers take shape around the globe. In February, China’s central bank announced a cut to the amount of money it requires banks to hold as reserves for loan losses. The move will reduce the Reserve Requirement Ratio (RRR) in China by 50 bps to 20.5% and is expected to free-up money for new lending to help keep China’s economy growing at a healthy rate.
Current trends in the U.S. consumer price index (CPI) continued into the new year. The annual CPI measure decelerated in January to 2.9% from 3.0% in December. Meanwhile, excluding food and energy components, core consumer prices accelerated slightly to 2.3% year-over-year through January. Core prices had risen at a 2.2% pace in the twelve months through December. While January’s core inflation reading is slightly above the Federal Reserve’s 2% target, we do not believe a monetary policy response is likely in the near term. The Fed’s 2% inflationary target is a long-term goal, and recent commentary from the central bank shows that policymakers are more focused on promoting growth and improving the employment picture in the current environment.
Inflationary pressures outside the U.S. continue to abate as well. Headline inflation in the United Kingdom decelerated to 3.6% in the year to January from 4.2% the prior month. The pace of price increases has been running above the Bank of England’s (BOE) 2% target since December 2009, but there too rate-setters have kept borrowing costs at record low levels and recently approved another monetary stimulus in response to weakening growth. Recent figures showed the U.K. economy contracted 0.2% in the last three months of 2011.
Through the first two months of 2012, changes to the economic, valuation, and sentiment indicators we monitor have been relatively muted. U.S. economic news has been positive and consistent with our slow growth outlook. Valuations also remain generally attractive despite the year-to-date rally in equity markets. In terms of sentiment, pessimism continues to abate, but we are not yet concerned that investors have become overly bullish. Investors have continued to stay on the sidelines as illustrated by equity mutual fund outflows in all but several slightly positive weeks in 2012. Overall, we continue to overweight equities relative to bonds in the current environment. On the equity side, our focus is on companies that are growing faster than the broader economy as well as on businesses that are generating their own organic growth.
Markets have largely been in a ‘risk-on’ mode so far this year, and in the fixed income space this has helped ‘spread product’ (i.e., securities that trade at a yield spread above U.S. Treasuries) outperform other sectors. Municipal and corporate bonds in particular have done well this year. Despite the recent rally, our preference remains tilted toward investment opportunities we are finding in both investment grade and below investment-grade areas of the corporate bond market. With regard to Treasuries, we continue to prefer U.S. Agency (i.e., Fannie Mae, Freddie Mac, Ginnie Mae) mortgage-backed securities over Treasuries.