QUARTERLY MARKET UPDATE as of January 2012
A strong fourth quarter brought some relief to a volatile year with the stock market gaining back most of the losses from the third quarter. Safe haven investing allowed the U.S. bond market to sustain the low interest rate environment. Yields on longer term bonds which started increasing at the beginning of the quarter went back down within historically low ranges. The thirty-year U.S. Treasury Bond finished the year below 3%.

All sectors of the stock market were up during the quarter led by energy, industrials, and materials. Over the year, a combination of ultra-low interest rates and the volatile and uncertain economic and geopolitical environment made investors seek out both income and protection within the stock market. For the year, the higher yielding utilities sector, and defensive consumer staples and healthcare sectors performed much better than the other sectors.

Often a new year sees rotation out of the best performing sectors and into the prior year’s lower performers. Rich valuations support a movement out of utilities and staples this year which ironically increases the risk profile of these traditionally defensive sectors.

Economic growth picked up in the final quarter of the year. GDP estimates for the fourth quarter are expected to increase more than 3%, a healthy growth rate. This is a welcome contrast to the pessimism back in the summer and concern that our economy was moving back towards a no growth recessionary environment

Consumer spending picked up, especially during the holiday shopping season which helped drive growth. Modest income gains and a lower unemployment rate also helped the economy. Meanwhile, the housing market continues to languish. The backlog of foreclosures has been improving, but the level is still high and should keep prices down for the near future.

Most forecasts show a 2% GDP growth rate in the U.S. in 2012, just a bit higher than 2011. There is no surprise that a recession will take hold in the EU where growth is expected to decline slightly this upcoming year, while Asian growth will remain much higher than the rest of the world. Japan is expected to rebound and grow 2% after last year’s recession, and both India and Australia should see incremental improvements in GDP. Forecasts show China slowing to an 8.2% growth rate from 9.2% in 2011, still very strong and increasingly important to worldwide economic growth. In November, China lowered bank reserve requirements which could provide an upside surprise to this year’s growth forecast or at least keep their economy from slowing further.

European debt problems are still holding worldwide markets captive. Large sums of sovereign debt come due this quarter in Italy, France, and Spain with uncertainty on how it will be assimilated. Longer term Italian bond rates are near 7%, a rate that is considered economically unsupportable. Resolving the crisis will likely depend on progress towards fiscal unity, which seems far from certain. In the meantime, central banks have increased liquidity to avert a credit squeeze and put off the problem.

In March, EU leaders expect (or hope) to finalize a new intergovernmental treaty that will create fiscal unity and allow the EU to stand behind its members. If passed, this agreement will replace the temporary European Financial Stability Facility with a permanent bailout fund. The purpose of the permanent fund is to back the debt of its members and lower the risk of default. A new form of financing, the Eurobond, will become available to help with liquidity. Requirements for this to be successful depend on the ability of larger EU countries like Italy to actually pass austerity measures, and for bond investors to not lose confidence. These are two big ifs that investors will be focusing on this quarter and will have a large impact on the markets.

Uncertainty on how the EU credit crisis will play out makes forecasting the markets tenuous. However, the latest domestic inflation reports only show small increases, and current stock market valuations are reasonable, while interest rates are low. The combination of low inflation with slow but steady economic growth forecasts is usually a good recipe for more normalized stock market returns.