The following is a comprehensive overview of market activity and economic analysis for Q4 2011 provided by Personal Capital Advisors Investment Committee. This report including a look back at Q4, a look ahead at market conditions heading in to Q1 and further analysis on economic conditions, such as the state of the US economy and the construction and housing markets in specific, as well as a look at how current events in Iran could affect the economy.
Fourth Quarter Market Recap
It may not have felt like it, but the fourth quarter was a great one for stocks. The S&P 500 index rallied 11.1% in the final three months of 2011, only to finish dead flat for the year (up 2% counting dividends). The surge was largely a bounce-back from a late summer panic over European debt contagion, but there were meaningful positive developments as well.
Like Desperate Housewives, the European debt crisis provided new plot twists and drama on a weekly basis. Two main characters were ousted from the show – Italy’s Berlusconi and Greece’s Papandreou. Italian and Spanish bond yields ceremoniously spiked above the “unsustainable” 7% threshold, only to decline modestly by quarter end. A highly anticipated December summit produced agreements for increased fiscal unity and discipline, but disappointed those who were looking for direct assurance the ECB (European Central Bank) would buy unlimited amounts of troubled sovereign debt. Even so, behind the scenes, the ECB and EFSF (European Financial Stability Facility) were the major buyers of newly issued Italian and Spanish debt. The ECB also lent a whopping 489 billion Euros to banks for a three year period to quell liquidity concerns and provide more backdoor demand for sovereign debt. On balance, these actions were enough to please the market, which had feared governments and the ECB would sit idly by while the Euro disintegrated.
Meanwhile, in the US, most economic news was good. Unemployment ticked down and new housing starts increased. This confounded the large number of market participants who assumed a double-dip US recession was inevitable.
For the quarter, foreign stocks lagged domestic, as the Euro declined and fears of a hard landing in China pressured Asian shares. US Treasuries increased, pushing yields near record lows. Gold lost some of its luster, retreating about 4% for the quarter even while finishing positive for an 11th straight year.
Had you spent 2011 reading the financial media without actually checking stock prices, you might have guessed the S&P 500 was down 30% instead of flat. A tremendous amount of fear and pessimism pervades the market, primarily related to Europe’s debt crisis. This is bullish looking forward because anything but a disastrous outcome allows room for the market to rise.
For the first part of 2012, we believe the market will continue to trade on evolving perception of the situation in Europe. The primary bearish case for the market is a spiral into default by Spain or Italy, or some other rupture that breaks the Euro apart. We view this type of nightmarish outcome as highly unlikely. Greece exiting alone is more likely, and would be painful but manageable. If the ECB prints Euros to buy Spanish and Italian debt, it could cause highly problematic inflationary pressure down the road, but markets would love it in the short term. So far, Germany and the ECB have been very public that the ECB will not play this role, but at the end of the day it would be preferable by all stakeholders, if necessary, compared to a default by a major country. Therefore, we do not envision a major breakup of the Euro in 2012 or 2013, or an associated market collapse.
The following chart shows the relative size of selected European economies and their current debt levels.
Inefficient, corrupt government spending has played too large a role in Europe’s economy, and for too long. Austerity measures will likely lead to short term recession, but could pave the road for a more productive Europe to emerge. We are not counting on this, but it would be massively bullish longer term, and mostly unexpected.
Domestically, economic momentum should continue to build. The Fed will almost surely remain highly accommodative through the elections, and a stabilizing housing market should provide a nice tailwind for continued growth.
On balance we believe investors should maintain their full strategic allocation to global equities. Bonds continue to play a meaningful role in most portfolios, but concern us more than stocks for 2012. Record low yields mean bond holders need to measure potential risk versus expected return. We advise against owning longer duration bonds. The following is an outline of the bullish and bearish case for equities in bullet point form:
The Bullish Case
- Stocks are very cheap globally. The S&P 500 is trading at just over 12 times expected 2012 earnings, well below the historical average. The Stoxx Europe 600 Index is trading at just 10 times expected earnings.
- Interest rates are extremely low. Historically, valuations of stocks are inversely correlated with interest rates, implying stocks should move higher. The earnings yield on stocks is around 9%, compared to just 2% in ten year Treasuries. This is unprecedented and massively bullish if you believe earnings will continue growing.
- Almost no one is bullish, but fear is rampant – this is usually a good sign.
- Important European leaders demonstrated in the quarter that they “get it”, and indicated they will do whatever is necessary to keep the Euro from disintegrating.
- So far, European economies have mostly been resilient.
- The Fed is acting in an extremely accommodative manner, promising to keep interest rates low through 2013 and essentially printing hundreds of billions of dollars to buy bonds and inject money into the system.
- Corporate earnings are still growing, and corporate balance sheets are strong.
- The fourth year of a President’s term has historically been good for stocks.
- The US economy is growing. Unemployment dropped by 0.5% in the quarter, manufacturing was higher, and new construction starts exceeded expectations.
- The housing market is showing signs of stabilization.
The Bearish Case
- Austerity measures in Europe will likely lead to recession.
- Political gridlock could lead to a collapse of the Euro.
- Falling commodity prices indicate a higher likelihood of pending recession.
- Risk of geopolitical tension stemming from Iran and/or North Korea has increased.
- Analyst estimates for Q4 continue to be revised downward.
- Populist movements may lead to over-regulation.
- Major financial institutions such as Bank of America are still at risk of crippling losses from the sub-prime crisis and a large inventory of distressed properties.
- China’s property market could be a bubble about to burst, unleashing a wave of bad debt issues and slowing global growth.
Economy and Construction and Housing Outlook
“Remember, my son, that any man who is a bear on the future of this country will go broke.” -J.P. Morgan
Indeed, the US economy continues to prove itself to be surprisingly resilient. With unemployment still at 8.5% it is hard to get too excited, but it was a good quarter for the US economy. Just months ago, consensus opinion among economists was for a double-dip recession. The naysayers were proven wrong. With monetary policy still highly accommodative and unlikely to change before the election, it seems almost safe to say the US will avoid double-dip recession in 2012.
Here is a quick summary of the major economic data points from the quarter:
- US Q3 GDP originally announced at 2.5%, but later revised down to 1.8%, still above most expectations from the summer
- ISM manufacturing index increased to 52.7 in November, exceeding expectations
- Private sector jobs in November rose by 206,000, exceeding expectations
- University of Michigan US consumer confidence hit a six month high
- Retail sales were considered strong for the holidays, but rose just 0.2% in November
Construction and Housing: Turning the Corner?
Declining residential and commercial construction has been a huge drag on US GDP growth in recent years. Combined, this portion of the market represented approximately 10% of GDP in the 2010 (full year 2011 numbers still pending), down from 17% in 2006. If construction spending simply stops falling, it would be a huge boost to the economy. It would be difficult to overstate the positive impact a return to growth could have. Many signs indicate the tide has already started to turn.
The Census Bureau reported that US housing starts rose 9.3% sequentially in November and were up 24.3% year over year. This was well ahead of expectations and the highest level in almost two years. Building permits also increased 5.7% from October and were up 20.7% over the same period a year ago. But progress wasn’t limited to housing—non-residential construction improved sequentially and was roughly flat, compared with a year ago. The national office vacancy rate fell slightly in the fourth quarter. Clearly it’s too early to claim a full recovery is underway, but if US economic data continues to improve we would expect further support to these trends.
Home prices have begun to level off. Most experts are predicting an L shaped bottom because a large supply of distressed properties will continue to act as a weight on values. But in our mind, improving employment, high rental rates, historic low mortgage rates, and political desire to help homeowners combine to form a strong case for rising home prices sooner than most expect. As for the data, the Case-Shiller indices continue to show year over year declines, but the pace is slowing. A return to even modest growth would reduce pressure on banks and create all sorts of new economic activity.
Something to Watch: Iran
We strive to keep our eye on topics with the potential to move markets, but aren’t yet a media focus. Iran is one such area. In recent days and weeks there have been some noteworthy developments. First, the US signed into law a bill that would punish foreign financial institutions for doing business with Iran’s central bank. In other words, if they don’t cease operations with Iran they may be forced to cease operations in the US. The goal is to choke off revenue, as Iran clears most oil transactions through its central bank. But perhaps more important, Europe appears to be taking a stronger stance. Officials are currently in talks to implement a complete embargo on Iranian oil. Europe is Iran’s second largest consumer.
These actions represent the toughest and most tangible sanctions brought against Iran over their nuclear program to date. And Iran is clearly rattled. As multiple reports have detailed, the country has threatened to close the Strait of Hormuz—a stretch of ocean south of Iran and north of the UAE where, according to the EIA, one-fifth of global oil exports pass.
But we do not believe Iran will close the Strait of Hormuz, at least not for an extended period of time. Doing so would likely result in naval warfare between Iran and the US, not to mention choke off Iran’s primary source of income. That’s a poison pill any rational nation would avoid. And it seems hard to believe Iran’s naval fleet could match that of the US. In other words, recent spikes in oil prices (based on Iran’s threats) are likely temporary.
The sanctions, however, may have a longer-term impact. While the US bill and proposed European embargo are set to phase in gradually, both could drive up oil prices over time. To prevent shocks to the system, officials are already meeting with other oil producing nations to discuss increasing production and ensure greater shipments to Europe. After all, a European recession is very likely at this point. Higher oil prices are the last thing the region needs.
The impact on China might actually be positive. If Europe, along with other nations, stop purchasing Iranian oil, Iran is going to be short revenue and sitting on a stockpile of oil. As Iran’s largest consumer, China would gain a significant amount of bargaining power—the country could buy up oil at fire sale prices. China currently faces a significant real estate slowdown. Whether it’s a hard or soft landing remains to be seen, but cheaper energy costs would be an added tailwind that could help bolster economic growth.
With respect to Iran itself, the country has thus far spurned any and all efforts from the international community to halt uranium enrichment. But the international community also never produced a credible threat. These new sanctions do just that: they have the ability to materially impact Iran’s economy. One would hope they represent the final steps in getting Iran’s nuclear program in order, but this is wishful thinking at best.
A military strike against nuclear facilities, either by the Israel or the US, cannot be ruled out if Iran remains unresponsive. This type of action could come sooner than many expect. No one really knows how close Iran is to successfully producing a nuclear weapon, but it’ll likely happen in the next one to three years if nothing is done to prevent it. This means a military solution would have to be conducted soon. We don’t have any special insight into how the situation may play out, but Iran could be a bigger story than anyone would like this year. If so, it would have a meaningful impact on how capital markets behave, potentially delaying or muting a “recovery rally” and boosting oil and gold prices.
Thank you for your interest.
Bill Harris, Craig Birk, Rob Foregger and Kyle Ryan, The Personal Capital Advisors Investment Committee
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