The final quarter of 2010 provided robust returns for equity owners, but was disappointing for most fixed income investors. All equity styles and capitalizations posted strong positive returns with domestic equities faring better than foreign equities. Small caps outperformed large and mid caps and growth-oriented equities outperformed their value-oriented counterparts during the quarter. Fixed income securities represented a big letdown for investors during Q4 2010. Almost all fixed income asset classes (the only exception being high yield bonds) posted negative returns during the quarter. Longer term maturities posted larger losses than shorter maturities and government debt lost more than corporate issues with similar maturities.
Respectable results in the equity markets being partially offset by recent negative returns in the fixed-income arena is not the most promising way to end one year and start another. An enhanced outlook can be rendered by considering our general economic conditions. Instead of stumbling into a double-dip recession, our economy appears to be inching forward in a slow-growth environment.
The recovery in general business activity that began in the third quarter of 2009 is now on the verge of becoming a net expansion in the economy. Real GDP is expected to increase for the sixth consecutive quarter when fourth quarter results are reported later this month. This expected increase may prove to be enough to push RGDP past the level it was when the economy entered the last recession.
In the household sector, disposable income continued to increase. Personal consumption expenditures, in particular, spending on nondurable goods continues to increase. Fourth quarter measures of saving and debt will show whether or not households are continuing to pay down debt loads.
The business sector presents a mixed picture that seems to be improving over time. Although inventories have risen over the past quarter, so have sales. The Inventories to Sales ratio remains very low, suggesting that balanced growth is occurring in the retail and manufacturing industries. Modest increases in Private Domestic Investment Spending and capacity utilization are encouraging, as is the recent drop in the national unemployment rate from 9.8% to 9.4%. Along with that, some data provide an early indication that the overall housing market is picking up with new construction starts.
The government sector continues to engage in stimulative measures that continue to widen the budget deficit and add to the national debt, which is approaching 90% of GDP. A policy of quantitative easing, designed to maintain low short-term interest rates and lower long-term rates, continues for the time being. The goal of quantitative easing is to expand economic activity at a much more rapid pace, putting people back to work and generating more output and income. When such success is achieved, interest rates can be expected to rise due the increased demand for goods, services, and inputs. These demands result in higher money and loanable funds demands, which all other things equal could result in higher interest rates. Additionally, when economic activity expands in earnest, we can expect the same increased demands for goods, services, and inputs to push up price levels, all other factors being the same.
At this juncture, the overall yield curve does remain somewhat flat for the longer terms to maturity, indicating that optimism for accelerated expansion does not yet abound.
One thing is sure: if economic growth rebounds in a big way, it will call for great skill on the part of our governmental and Federal Reserve policymakers to manage the inflationary environment it will surely bring with it.
We continue to find compelling arguments for the advancement of equities. Equity valuations remain attractive, corporate balance sheets remain strong, macro economic conditions are promoting growth and consumer sentiment has increased rapidly. Arguments to be bullish on fixed income remain more elusive.
Earnings multiples for the overall market remain low. Although equities appreciated significantly in Q4 2010, so did future earnings estimates. As a result, forward P/Es remain well below historical norms. Future earnings estimates of the S&P 500 companies for Q3 2011 are now expected to be at their greatest quarterly levels ever surpassing the previous high set in Q2 2007.
Corporations continue to possess solid balance sheets. During Q4 cash accounted for 7.4% of the companies’ total assets, the highest percentage since 1959 according to the Wall Street Journal. While significant cash on balance sheets may be viewed as a negative in terms of economic growth, we are beginning to see companies put that capital to use in productive ways. There were numerous mergers and acquisitions announced during the past quarter, and 222 of the S&P 500 companies increased their dividends while another 13 companies initiated dividends.
We see some additional strength in economic activity that could lead us to full recovery from the last recession and into net expansion this year, in terms of Real GDP.
Not only do we expect further increases in our Real GDP but also for the Real GDP of our major trading partners to expand as well. Recently, unemployment has improved (but remains high) and interest rates remain low. The specter of deflation is not to be found; and for time being, we continue to enjoy a low interest rate environment for fostering economic growth.
During the fourth quarter of 2010, consumers began expressing more confidence in the wellness of the economy through increased expenditures. It is our opinion that with consumer confidence that continues to build, higher and more consistent demands for goods and services will provide a firmer foundation for desirable equity performance.
While we find many reasons to be optimistic regarding equities, we find it more difficult to remain optimistic regarding fixed income. In the Q3 2010 Economic Roundtable, we stated we had “elevated concerns” regarding rising interest rates. We continue to bear these concerns, and believe interest rates will continue to rise. Many believe an argument can be made that interest rates cannot (meaningfully) go lower. The Federal Funds Rate has spent all of 2009 and 2010 below 0.21%, a very low interest rate figure.
Second, even as the U.S. Federal Reserve buys more U.S. Treasury Bonds, those bond prices, more recently, are going down, not up; indicating that other factors are impacting bond demand. These factors include a growing uneasiness about the safety of the sovereign debt of nearly all countries. The European experience over the summer and fall of 2010 continues to create doubts among investors regarding the credit-worthiness of countries such as Portugal, Italy, Ireland, Greece, and Spain. Due to the size and timing of the U.S. debt issues, some of this doubt is impacting our markets. In particular, municipal bond market debt in the United States is under close scrutiny for signs of distress and possible default. Finally, signs of inflation, world-wide, are beginning to crop up in commodity and other resource prices. Generally, higher input prices translate similarly into higher final goods and services prices. Inflation, or even the expectation of inflation, can curb both lending and the demand for bonds because the return will be worth less through the effects of inflation.
Many investors are aware that the U.S. government is the world’s largest net borrower. As such, the U.S. government faces a dilemma when incurring large amounts of debt as it has in the past few years. One option is to pursue economic policies that promote stable and relatively low prices, thus helping all participants in the U.S. economy to pursue growth in an environment of enhanced price level certainty. This real growth can help generate additional income by which to slowly pay down the national debt. Another option is to allow significant inflation to occur, despite knowing it is the “pick-pocket of prosperity” over time, in order to pay down the national debt quicker, with dollars that are now worth less. In the classic inflationary scenario, as consumers purchase goods and services at higher prices, they become more aggressive in their wage demands. In growing industries that can afford it, incomes rise to offset inflation. In the end, higher nominal incomes lead to higher nominal tax receipts and the ability to pay back a fixed amount of debt, at a fixed interest rate, with dollars that are worth less than before.
From the highlights presented, it should be easy to understand why we bear concerns about the fixed-income sector due to rising interest rate and inflation concerns. We continue to operate in a slow growth environment. Much of the pain associated with the most recent recession is still with us, primarily identified by the high duration of unemployment metric and austerity measures put into place by many state and local governments.
Despite this, the overall economy is gaining strength. Real GDP is expanding both domestically and abroad, retail sales are expanding, and the unemployment rate has recently declined. Where certain disadvantages exist in our financial markets, elsewhere opportunity presents itself. Among a short list of opportunity catalysts are attractive equity valuations, resilient corporate earnings, and significant cash reserves held by corporate America.
Pension Consultants, Inc. is a Registered Investment Advisor. Securities offered through Securities Service Network, Inc. Member FINRA/SIPC.