As April came to a close, economic data reversed its negative trend throughout the month, as represented by the Citigroup Economic Surprise Index.  The index continued to show signs of weakening in April, but then turned positive going into May as economic data began to surprise on the upside.

The ISM Manufacturing and Non-Manufacturing Indices continued their trends down in April.  The ISM Manufacturing Index moved lower from 51.3 in March to 50.7 in April while the ISM Non-Manufacturing Index followed, declining 54.4 to 53.1.  Both still remain in expansionary territory, but continue on a steady downward trend.  This period of the year has been difficult over the course of the past several years and it looks like this year is not going to be an exception. 

• Labor markets continue to show signs of improvement with employers adding 165,000 workers to nonfarm payrolls in April.
  • The unemployment rate continues to decline steadily, dropping from 7.6% in March to 7.5% in April.
  • Professional and business services led the way adding 73,000 jobs followed by leisure and hospitality with 38,000 jobs added.
  • The bright spot in the jobs report came from prior month revisions.
    • March was ratcheted up from 88,000 to 138,000 while February was revised to 332,000 from 268,000.
• After a quick rebound in February to 1.1%, personal incomes fell sharply in the month of March to 0.2%.
  • This negatively impacted consumer spending during the month.  After four months of steady growth, consumer spending dropped from 0.7% in February to 0.2% in March. 
  • Personal incomes and consumer spending may still be finding their normalized levels as the December print was boosted by accelerated dividends and bonuses ahead of the anticipated tax rate change going into 2013.
• Housing data once again come in mixed.  Demand for housing experienced a decline from 44 in March to 42 in April as measured by the Housing Market Index (HMI).  The index continues to tread down throughout 2013.
  • Housing starts, however, continue to increase throughout the year, jumping from 968,000 in February to 1,036,000 in March.
  • Housing prices continue to see modest gains.  The S&P/Case-Shiller Home Price Index continues to trend up.
• Central banks around the world continue to provide increased stimulus to their respective economies.
  • Following the FOMC meeting that occurred on April 30-May1, the US Federal Reserve Bank announced that it will maintain its goal of buying long-term Treasury bonds and housing-related debt worth $85 billion along with targeting a federal funds rate of 0-0.25%.  Monetary policy remains unchanged from their last meeting in March, stating that it may alter the amount of bonds it will be purchasing, contingent on the state of the US jobs market and inflation.
  • The European Central Bank (ECB) announced on May 2^nd that it will cut its main policy rate by 25 bps.  This brings the rate to 0.5% as they continue to provide banks with all the money they need “for as long as necessary.”
  • The yen continues to remain weak relative to the US dollar as the Bank of Japan (BoJ) announced formal plans of aggressive monetary easing on April 4^th.  Following the April 4^th meeting, the yen weakened roughly 7% relative to the US dollar in the matter of days, but has since come down slightly.

EQUITIES

A few weeks ago, Art Cashin of UBS coined the current market advance as the “TINA Rally,” (There Is No Alternative), as aggressive monetary policies globally are pushing investors into equities to achieve acceptable levels of returns in their investment portfolios.  The performance of global equity markets in April certainly appears to confirm this hypothesis, with both Japan and Europe leading the march higher after the BOJ and ECB each reaffirmed their commitment to support their respective economies with quantitative easing.  Although the US markets lagged their global peers, the positive impacts of Fed policy have been clearly visible in the 1.8% advance despite earnings results that have been plagued by disappointing revenue growth and forward guidance.  Emerging markets continued to lag in April as these countries struggle with slowing economic growth, deflationary commodity prices, and stronger currencies relative to their developed counterparts.  While expanding valuation multiples is a positive reflection of improving investor sentiment, with developed markets trading at elevated levels, it will be increasingly important to see these higher valuations confirmed through improvements in company fundamentals and global economic data.

United States:

• Despite lagging most international benchmarks, US markets continued to rise in April, shrugging off disappointing economic data and lackluster earnings results. 
  • Dispersion among the major markets was lower than in previous months with the S&P 500, NASDAQ Composite, and Dow Jones Industrials Average rising 1.8%, 1.9%, and 1.8% respectively.
  • A troubling divergence emerged between industrial and transportation stocks, with the Dow Transportation Average falling 1.2% in April and lagging the Industrial Average by 303 bps, the widest margin since last September.
  • Implied volatility increased modestly, with the VIX rising 6.5% in April to 13.5.  However, overall the VIX remains range-bound at multi-year lows, indicating low levels of fear despite the markets trading at elevated levels.
  • April’s advance was led mainly by large cap equities, with the Russell 1000 Index outperforming the Russell 2000 by a margin of 250 bps.
    • Style leadership varied for market caps, with growth outperforming in large and value outperforming in small. 
      • Both divergences can be largely attributed to the relative outperformance of developed international markets in April, which contributes a larger share of earnings to large cap growth stocks.
      • Conversely, small cap stocks have more exposure to growth in the domestic economy, where data was mostly disappointing during the month.
      • The US dollar, which fell 1.5% in April, also supported the outperformance of large cap growth equities, with a weaker local currency boosting the value of earnings earned overseas.

 International:

• Peripheral Europe, led by Italy (+12.0%) and Spain (+10.5%), appeared to enjoy a relief rally in April, in what can be deemed a “no news is good news” type of environment.
  • Fundamentals remain weak across the continent, as the Eurozone turned in its fifth straight quarter of contraction, and German PPI dropped below 50.
  • The ECB left rates on hold during the month, but announced a cut to 0.5% on May 2^nd. 
  • The UK surprised with 0.3% Q1 GDP growth despite continued contractionary fiscal policy.
• The big news out of Japan (+8.8%) was the BOJ’s announcement that it would be doubling-down on asset purchases which, while not surprising based on recent experience, is still unprecedented from an economy of that size.
• The economy in China (+1.1%) continues to slow.  The country turned in a lower than expected 7.7% Q1 GDP growth number driven by weak consumption, and also suffered a local currency credit downgrade by Fitch.  Export growth pulled back as global demand has slowed.

FIXED INCOME

First quarter fears of immanent rising interest rates melted away with a disappointing domestic jobs report and weak growth numbers from around the world, especially China.  Treasury yields fell across the curve in a bull flattening which was supportive of gains for most US fixed income markets during the month of April.

• The yield on the ten year, which had threatened to break above 2.0% in the first quarter, ended the month at 1.7%. 
• The BC Aggregate Index gained 1.0% in April with returns predominantly driven by falling Treasury yields. 
• TIPS gained 0.8% during April slightly lagging the performance of duration equivalent Treasuries.  Absolute performance was driven by falling real yields.  TIPS yields did not fall as much as their nominal counterparts, however, as inflation expectations declined.
• Agency MBS gained 0.5% with positive price returns partially offset by stubbornly high prepayments.  In a reversal from Q1 2013, lower coupon securities significantly outperformed their higher coupon peers.  These securities, which are targeted by the Fed in their purchasing programs, are becoming very sensitive to macroeconomic indicators.  A weaker outlook in April gave confidence to investors that the Fed was less likely to curtail QE in 2013.
• Investment grade bonds gained 1.5% during the month.  Spreads were static and gains were due to falling Treasury rates.  Thus far in 2013, returns for the sector have been driven by Treasury moves.  Spreads did not compress during the robust markets of Q1 2013 nor did they rise as Treasury yields fell back in April.
• Intermediate Municipals, as represented by the BC 1-10 Year Blend Index, gained 0.7%.  Yields feel across the curve in similar fashion to the US Treasuries resulting in some performance benefit to holding long maturity munis.  The muni credit story was more mixed in April with high yield munis giving up their long held performance leadership. Within investment grade munis, the performance differential amongst credit tiers was relatively narrow and no clear quality hierarchy was established.
  • Municipal mutual fund flows ended the month on a seven week long losing streak.  Long term and high yield funds are exhibiting the most weakness while intermediate strategies were relatively insulated.  Valuations for munis have held steady despite the outflows.
• With the notable exception of the Japanese yen, the dollar was broadly weaker against both major developed and EM currencies.  EM bonds benefitted from falling yields in developed countries with the EU and Japan becoming increasingly accommodative.

ALTERNATIVES

Hedge Funds:

Alternative investments generated modest returns in April, in what was a mixed month for equity markets.  The overall dispersion of strategy performance was fairly compressed, as both directional and more hedged strategies posted positive results.  The lone category that lost money during the period was systematic diversified strategies, although the HFRX index appears to be out of synch with the performance of most big players in the space.

• Equity strategies had mediocre performance in April.  Despite increasing bullishness among hedge equity managers, collectively those Funds were only able to capture a third of the S&P 500’s monthly performance. 
• Event driven managers continued to perform well in April, led by distressed Funds as well as unhedged activist products.  Merger arbitrage managers generated respectable returns during the month amid an apparent uptick in activity.

Liquid Alternatives:

• Managed futures were the best performing category in April, reversing several quarters of disappointing performance.  Managed futures mutual funds outperformed comparable hedge funds largely due to the higher allocation towards traditional trend based models.  There was a wide dispersion among managers, but relatively few posted negative performance.  Positioning tended to favor a long equity posture, along with long US Dollar and long government bond.
• Long/short equity mutual funds performed nearly identical to their hedge fund peers, gaining 0.5%.  Performance was mixed across the board due to divergent performance at the sector level, as mentioned previously. 

 Liquid Real Assets:

• Crude oil fell on global economic growth concerns.  The International Energy Agency cut its 2013 global oil demand forecast for a third consecutive month in April to 795,000 barrels per day (5% lower than the previous figure).  Natural gas (+6.9%) was again a bright spot, aided by cooler weather and falling rig counts.
• Mid-month, gold experienced a two-day sell-off not seen in more than 30 years, spurring a wave of precious metals declines.  On Friday, April 12 and the following Monday, more than 1 million gold futures contracts (equivalent to more than 1 year of global mine production) were traded on the COMEX.  The metal fell below $1,500/oz and subsequently burnt through several technical support levels to fall below $1,350/oz on April 15.  The action in futures trading was unique since normally 90% of gold volume comes via the spot market.  Hence, several reports surfaced blaming “orchestrated” naked short selling for the decline.  The metal rebounded above $1,450/oz at month–end, but remained below the $1,561 April 11^th close.
• A record Q1 for MLPs was followed by a flat April, as the earnings and distributions announcement season began to wind down.  As a reminder, MLPs tend to catch a tailwind during distribution season (January, April, July, and October) because most distributions are 80-90% return of capital, and therefore tax-deferred.

Key points of the conversation included:

• Global central banks determined to keep rates extremely low
  • Federal Reserve likely to continue QE into 2014
  • Bank of Japan embarking on huge stimulus plan
  • Investors view stocks as "the only alternative"
• U.S. stocks at all-time highs; major issues below the surface
  • Gold plunged 15% in 48 hours
  • Japan Yen down 25% vs. U.S. Dollar in six months
  • Commodity bull run is fading
• Risk appetites to be challenged by weaker data
  • Consolidation of strong Q1 advance
  • Effects of tax increases, lower government spending
  • Q1 rally not tied to improved global growth prospects
• Correction in stocks will create a buying opportunity
  • Stocks are cheaper than at previous peaks (2000/2007)
  • Companies are in better shape fundamentally
  • Difficult to find enthusiastic stocks bulls

Watch a recording of the webinar by clicking here.

As the first quarter came to a close, economic data turned slightly negative, as represented by the Citigroup Economic Surprise Index.  The index trended up throughout February, but then turned negative over the course of March as economic data began to surprise to the downside.  The ISM Manufacturing and Non-Manufacturing indices contributed to this decline, as both softened in March.  However, despite the moderation, both remained solidly in expansion territory.

•  Labor markets grew 236,000 in February following a 119,000 gain in January.
  • The unemployment rate dropped from 7.9% to 7.7%.
  • February marked the best month of construction-related job growth since March 2007, supporting the notion that housing is finally breaking out of its longstanding downtrend.
• Personal income grew 1.1% in February, well above the expected 0.9% rate. 
  • Consumer spending also surpassed expectations, expanding by 0.7% in the month.
  • Income rebounded from a sharp period of volatility in December-January.  In December, incomes spiked due to employers accelerating dividends and bonuses ahead of an anticipated tax rate change in 2013.  This pulled forward much of the seasonal activity in January, causing a deep month-over-month plunge in incomes.
  • February’s 1.1% increase may indicate a normalization of the data.
• Housing data came in mixed.  Demand for housing tapered off throughout the quarter.  However, housing starts increased after dropping off from a sharp spike in December.
  • Housing prices continued to see modest gains throughout the quarter as measured by the Case-Shiller Home Price Index.  This is positive for the housing market as the 20-city index is up over 9% since March 2012.
  • Existing home sales also improved by 0.8% in February to a rate of 4.98 million sales.  This was 10.2% over year-ago levels, and the highest since February 2009, a period boosted by the government’s tax credit stimulus.
• The easing campaign of the US Federal Reserve Bank continued in March.
  • The FOMC remained committed to its previous policy stance following its meeting in March.  This included $85 billion in asset purchases per month, the reinvestment principle from maturing securities, and maintaining rates near zero as long as unemployment stays above 6.5% and inflation does not exceed 2.5%.
  • Many Fed officials have indicated that the Fed is in no hurry to reduce its record bond buying with inflation less than 2.0%.

 EQUITIES

A clear trend has emerged to start off 2013, namely the relative strength of developed markets compared to those of the developing world.  Markets in the US have rallied thanks to renewed optimism and improved economic results, and the Japanese market continues to ride the wave of monetary easing and currency depreciation.  Emerging Markets however are facing significant headwinds for a number of reasons.  One of the most obvious is the ongoing “currency war”, not only for economies in East Asia in the face of a depreciating yen, but also in Latin American where policy makers are establishing curbs against appreciation of their currencies if not outright competitively devaluating.  These actions are in many ways a zero-sum game, and the impacts are felt globally as economics are more interconnected.  Another reason for emerging market weakness is due to the general weakness in commodities, particularly industrial and precious metals.  A third major contributor to the weakness in the developing world is the overall capital shift to the advanced economies.  As the rally in emerging markets has been largely fueled by excess liquidity, it appears that much of the liquidity is finding its way back home in search of better returns as sentiment improves, while macroeconomic conditions in many of the larger emerging market countries have been worsening.  Whatever the reason, it is clear that investment tides have shifted in favor of the larger industrialized economies.

 United States:

• During the quarter, US equities continued the rally that began in November 2012 and outperformed most global peers as investors flocked to the relative stability and improving momentum offered by the US economy.
  • All major US equity indices rallied to new all-time highs, except for the NASDAQ, which underperformed its domestic peers to hit its highest level since March 2000 tech-bubble highs.
  • While the Dow Industrial Average enjoyed its best Q1 since 1998, the most impressive performer was the Dow Transportation Average, which rallied 19% for its strongest single quarter since Q2 of 2009.
  • The rally coincided with a sharp drop in volatility, with the VIX falling 29.5% in the quarter to its lowest levels since February 2007.
  • The market rally in Q1 was fairly broad-based, with leadership varying across different asset classes.
    • When looking at market capitalization the rally appeared to be driven by growth-sensitive areas, with microcap and small cap indices outperforming large cap.
    • Style leadership varied within asset classes, with growth leading in small caps and value outperforming in large caps.
    • Despite mixed signals, in general the rally was driven by increasing investor risk-tolerance, evident through rising valuations and consistent EPS growth (7.3%) across all asset classes.  This is evident through strong equity fund flows in Q1, which can mainly be attributed to the continued monetary support from the Fed and improving clarity on fiscal and regulatory policy from Washington following the resolution of sequestration and the fiscal cliff.
• Despite an increasing appetite for domestic equities, investors continued to show a strong preference for defensive characteristics and high dividend yields.
  • The top three performing sectors in the Russell 1000 during Q1 were health care, consumer staples, and utilities.
    • Health care was the best performing sector in the quarter, rallying 15.8% on continued benefits from demographic tailwinds in US.
    • Consumer staples rose 14.7% in Q1, benefitting from the announced acquisition of Heinz (+25.3%), as well as the strong rebounds of recent laggards like Safeway (+45.7%), Campbell Soup (+30.0%), and Archer Daniels Midland (+23.2%). 
    • The 13.6% rally in utilities was mainly driven by continuing demand for yield in a low interest rate environment.

International:

•   The Cyrus bailout dominated headlines in March, as markets across Europe reacted to an unprecedented plan to hold depositors responsible for saving the small nation’s banking sector.
  • Fears of bank runs in the peripheral economies unsurprising spooked markets, as Spain (-5.9% March, -5.4% Q1) and Italy (-5.2% March, -9.8% Q1) led the declines in Europe for the month.
  • The Eurozone hit an unfortunate milestone as unemployment reached 12%, the highest level in the history of the common currency
  • In the UK, falling industrial production and manufacturing have further stoked fears of a triple-dip recession.
• Japan (+5.0% March, +11.7% Q1) led the major market indices in March, boosted by improving sentiment and domestic demand, in addition to continued aggressive policy actions.
  • The market has become extremely sensitive to central bank news; on March 22^nd the Nikkei dropped 2.3% when Bank of Japan Governor Kuroda gave an announcement  which did not explicitly state a concrete plan for additional stimulus, even though it is widely understood that that will be the ongoing order.
• China (-4.6% March, -4.5% Q1) has lagged for a number of reasons, chief among them being the curbing of investment in the property market.
• South Korean (-4.3% March, -3.2% Q1) returned to weakness after a strong February, as exports fell 8.6% YoY.  Officials are considering introducing taxes on financial transactions to help curb excessive capital inflows and stabilize the currency in the face of the strong won vs. the yen.
• India (0.1% March, -2.6% Q1) continues to lag due to poor economic conditions, particularly a higher than expected February inflation number.
• Russia (-3.5% March, -3.7% Q1) suffered a significant hit from the Cyprus news, as the island’s banks serve as an offshore tax haven for Russian depositors.
• Mexico (+3.7% March, +6.1% Q1) remains the lone bright spot in the larger emerging markets.  The market has attracted a lot of attention thanks to President Pena Nieto taking actions to establish his credibility as a reformer, including introducing competition to the telecom and broadcast industries, and potentially opening up the oil and gas sector.

FIXED INCOME

With rates showing life from historically depressed levels, investors are increasingly anxious about the potential damage of further increases or even a “rate shock” (a swift and dramatic increase in rates).  The theme de jour is a “Great Rotation”, or mass reallocation away from bonds and into other risks, be it equities or credit.  The strong sentiment against taking on interest rate risk is manifesting all across fixed income. 

• Long duration corporate bonds severely underperformed their intermediate counterparts even as spreads were constant; retail flows are pivoting away.
• Emerging market investors are allocating away from hard currency bonds, which are US interest rate sensitive.  Flows have favored local currency paper, with exposure to more normalized local rates.
• TIPS lost 0.4% during the quarter to post returns that were largely in line with US Treasuries which lost 0.2%.  Both were hurt by an increase in real rates and the slight performance differential is primarily accounted for by the longer duration of the TIPS Index.
• Agency MBS was flat in Q1 2013.  Within agency MBS, there was a notable performance differential across the coupon stack.  Low coupon MBS were substantial underperformers as investors begin to anticipate the end of the Fed sponsorship, and due to extension concerns.    High coupon agency MBS and non agency both posted solid performance.
• Investment grade corporate bonds lost 0.1% during the quarter falling in line with Treasuries.  Income for the quarter was offset by rising yields as spreads did not contract when US rates increased.
• High yield bonds gained 2.4% during the quarter.  Performance remained strong with investor demand for excess yield.
• Leveraged loans rose 2.2% in Q1 2013.  Average price in the space stands at $98 – BB/B loans are already pricing at slight premiums which are their theoretical maximums.  The sector is on a 40 week inflow streak with $14B allocated YTD.  In contrast, bonds have seen $1B.
• Intermediate municpals, as represented by the BC 1-10 Year Blend Index, gained 0.5% for the quarter as AAA municipal yield curve twisted with a pivot on the 5 year rate.  Lower credit quality still outperformed with high yield munis the performance leader. 
  • Flows into munis are traditionally weak during Q1, especially in March as investors exit positions to meet tax obligations.  The first quarter is shaping up to the norm as retail flows were flat to slightly negative.
• Emerging market bond performance was week in Q1 2013 losing 0.1% as global markets deviated from established trends.  The US dollar strengthened as investors rotated towards US capital markets.

ALTERNATIVES

Hedge Funds:  Hedge Funds performed reasonably well in the first quarter, although they failed to keep pace with the rapid move in the equity markets.  Not surprisingly, directional strategies performed best, as the equity sensitivity led to more robust returns.

• Equity strategies had mixed results in the quarter.  While market neutral funds saw headwinds from a general low quality rally in the quarter, long-biased managers generated better results.  Falling cross-correlations among equities and rising single stock dispersion is providing to be a tailwind for fundamental strategies.
• Event driven managers performed strongly in the first quarter, leading all other hedge fund categories.  Activist and special situation managers continue to lead the way, while distressed and merger arbitrage is lagging.

Other Areas:

• Fundamentally, there was little change in the oil markets as sideways trading continued for what is now more than two years.  Rising supply from the US, Angola and Nigeria offset falling output from several OPEC members and increased demand from Asia.
• Gold (-5.0%) was among the weakest performers primarily due to investor outflows.  More than 150 tonnes (nearly $8 million USD) worth of gold was sold in Q1, the largest such outflow in recent history.
• MLPs enjoyed its strongest quarter ever, rising nearly 20% in the wake of a relatively weak 2012.  In part, this was catch-up from last year, but the scale of the rebound surprised many market participants.  The rise was indiscriminate, lifting up-, mid-, and downstream MLPs between 15% and 25%.  Distribution growth is expected to be in the mid single digits in 2013.

Drew explained that investors should not focus on the level of the indexes, but rather the health of the companies, which he believes are in better shape fundamentally now than in 2000 and 2007.

 Watch the segment

The pace of positive economic data improved in February.  A stunning personal income report along with improved ISM manufacturing figures and a steep drop in the trade deficit gave the economy a lift.

• Personal incomes jumped considerably in December, rising 2.6%. This was the biggest gain in eight years.
  • The increase was attributable to accelerated bonuses and special dividends, as companies sought to distribute capital ahead of potential tax hikes in 2013.
  • Spending was also positive, although slightly below expectations with a 0.2% increase. Negative spending growth for nondurables, specifically gasoline, weighed down the headline level.
• On the manufacturing front, the Institute of Supply Management (ISM) reported in February that its manufacturing index accelerated to 53.1 in January. This was a jump of nearly three points, and ended a string of reports that hovered around the 50-line (which demarcates expansion/contraction in the sector).
  • New orders improved by 3.6 points, returning to expansionary territory and boosting the headline index.
  • Later in the month the composite index continued its recent strength, increasing to 54.2. Most of the gain came from the new orders and production side, which generally bodes well for future readings.

• Housing data remained fairly positive in February, particularly housing prices.
  • The Case-Shiller Home Price Index was up 0.9% in December; in the past year, the 20-city index is up nearly 7%. Housing starts softened slightly during the month following robust January figures, but remain nearly 24% higher on a year-over-year basis.
  • Meanwhile, both existing and new home sales improved. New home sales, in particular, surged 15.6% in the month.
  • The housing market is generally being supported by some of the lowest inventory levels in years and record low mortgage rates.
• In late January, the first estimate of fourth quarter 2012 GDP suggested the US economy contracted by 0.1%. In late February, that number was revised up to 0.1%; while an improvement, economists were disappointed by the meager pace of growth to end last year. Weakness in inventories and government spending was generally offset by consumer spending and business investment. 
• The FOMC did not meet in February, however minutes from the January FOMC meeting were released indicating committee members’ increased concerns about the impact of ongoing asset purchases surprised market participants.
  • Specifically, “several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability.”
  • The committee members’ concerns have sparked fears that the Fed could end its easing program earlier than expected. It remains uncertain whether investors see enough organic strength in the economy and in the corporate sector to stay committed to risk assets if this measure of support is withdrawn.

 EQUITIES

Global equities were mixed following January advances due to a number of macroeconomic factors. The All Cap World Index was flat for the month of February reflecting a balance between relative strength in developed Asia and the US, and weakness in emerging markets and Europe.

• February proved to be another strong month for US equity markets, as stable corporate fundamentals, improving economic data, high levels of corporate M&A activity, and strong fund flows drove the US markets to new recovery highs, the Dow Jones Industrial Average, S&P 500, and NASDAQ higher by 1.4%, 1.1%, and 0.6%, respectively.
  • February experienced more volatility than prior months, with the VIX rising 8.8% to 15.5 on fears about the outcome of the Italian election and concerns that the Federal Reserve may scale down monetary stimulus sooner than expected.
  • Increased investor caution was evident through sector leadership, with three of the top four performing sectors in the month being defensively-oriented.
• The Japanese market (+2.7%) continued to benefit from export growth due to the depreciating yen. The currency has now dropped 17% vs. the US dollar since the beginning of November, prompting concern from some members of the G7 of a potential currency war.
•  News from Europe was broadly negative for the month, and this was reflected in market performance. Q4 GDP for the Eurozone contracted 0.6%, the worst quarterly decline since Q1 2009. The economies of Germany, France, and Italy all shrank more than expected. The forward-looking expectations are not much better, with the ECB predicting zero growth for 2013.
  • Moody’s downgraded the UK’s credit rating, driving the pound to a two-year low against the dollar.  The Bank of England is predicting a higher inflation outlook due to the weak pound and higher energy costs.
  • The biggest story out of Europe was the Italian elections, which had a profoundly negative impact both across the continent and globally. The Italian market (-12.6%) was the worst performer among the major economies during the month.
• The emerging markets index continued to show weakness (-1.2%), erasing minimal January gains. The fear that the Fed will bring an earlier end to stimulus measures affected investor sentiment as the rally in emerging markets has largely been fueled by excess liquidity.

 FIXED INCOME

Bernanke boosted credit markets during his semiannual address to Congress. The chairman took a dovish tone by highlighting the benefits of the Fed’s unconventional purchase programs and downplaying potential costs. In particular, Bernanke assuaged market fears about the early termination of its QE programs. High quality fixed income, as represented by the BC Aggregate Index, returned 0.5% in February.

• Investment grade corporate bonds gained 0.8% during the month as price movements are primarily driven by Treasury rates thus far in 2013. 
• Intermediate municipals, gained 0.3% during the month. Muni yields generally lag Treasury moves so the market underperformed on a relative basis.  Investors may be rotating into higher quality intermediate products to position more conservatively in terms of credit and duration. 
• Leveraged loans gained 0.2% in February. Retail flows into loans continue to accelerate to historically strong proportions. The month saw weekly inflows of $1.4B, $1.3B, and $1.2B, which represent the top three heaviest flows ever for the sector. However, loan yields are poised to scale down with record re-pricing activity.
• US TIPS underperformed nominal Treasuries with a 0.0% return. Lower inflation expectations cancelled out gains from decreases in the real yield. Higher gasoline prices, which were pressuring inflation prints at the start of the year, eased in February.
• Agency MBS gained 0.3% during the month. Total returns for the sector continues face the headwind of mortgage pre-payments.

ALTERNATIVES

In an environment rewarding fundamentals, hedge funds and alternative investments are returning to more favorable status. Directional strategies did well in the month with modest market exposures.  Systematic trading (Managed Futures) strategies continue to be the laggard, posting a modest loss in the month due to a handful of trend reversals.

• Equity Hedge and Market Directional Indices posted gains of 1.2% and 0.6% in the month. Current consensus that equities are one of the more attractive asset classes can be seen in managers willingness to increase equity exposures. According to prime brokerage reports, net market exposure in the equity hedge universe has risen quickly since the start of the year.
• Event driven managers also posted positive returns in February to continue the more favorable backdrop for that strategy.  The index was up 0.5% in February and 3.8% YTD. Activist and special situations managers are leading the way, while distressed and merger arbitrage lag.  This year has been notable for the event driven space as many of the recent deal announcements are the largest seen since the financial crisis.  It appears we are still in the early phases of the cycle based on corporate leverage ratios, cash on balance sheets and overall activity levels. 
• Yield-heavy liquid real assets generated range bound returns in February.  Commodities were the relative laggard, led lower by sequestration concerns in the US, Italian Parliamentary elections, and less than stellar import and PMI data out of China. 
• Gold fell 5.0% in February owing to investor skittishness.  According to Barclays, gold investments closed the month at their lowest level since 2008 and new shorts at the highest level since 1999. Flow data shows that February was one of the worst months on record, with GLD suffering nearly $4 billion in outflows.  New access points to gold have allowed investor interest to grow and even outpace jewelry demand.  This has resulted in a fickle pricing environment prone to bouts of volatility. 
• Energy prices were unsupportive of commodity exposed MLPs in February. An uptick in natural gas futures ate at the margins of gatherer and processor operators, while falling oil prices hurt upstream operators. Neither of the above had a material impact on midstream operators. MLPs finished the month yielding 6.0%, although at certain points the number fell into the fives. The last time that happened was a year ago when the US 10-year was also yielding near 2.0%. The historical spread between the two is close to 300 bps.

Kanaly explained that investors might want to begin easing into the market as momentum continues to pick up.  He's also paying close attention to the end of the earnings season and performance in emerging markets.

Watch the Segment.

The pace of positive economic data weakened in January. While some reports have been relatively healthy, negative surprises such as home sales and Q4 GDP weighed on the economy.

• The first estimate of fourth quarter GDP revealed that the US economy contracted 0.1% during the period. This was the first contraction in more than three years and was well below even the most pessimistic estimate.
  • Declines were concentrated in inventory investment and government spending, specifically defense spending. The 22% drop in defense spending was the biggest decline since 1972 and illustrative of the belt tightening that has occurred in anticipation of Congress’ looming sequestration.
  • Below the headline were some encouraging signs. Consumption increased 2.2% and nonresidential and residential investment also showed strength. These are all pillars of sustainable growth and suggest the country is on stable footing.

• Nonfarm payrolls expanded by 157,000 and private payrolls grew 166,000. Consistent with the post recession environment, the strongest growth occurred in the retail, business services, education and health & leisure sectors.
  • Less encouraging was the unemployment rate, which moved higher to 7.9%. The household survey showed a modest rise in labor force participation. At the same time however the share of the population currently employed remains historically low at 58.6%.
• Institute of Supply Management (ISM) reported that its manufacturing index accelerated to 53.1 in January. This was a jump of nearly three points and ends a string of reports that hovered around the 50 level.
  • New orders improved by 3.6 points, returning to expansionary territory and boosting the headline index. At 53.3, new orders are solidly in positive territory and foreshadow sustained growth moving forward.
• The easing campaign of global central banks continued in January as nine banks cut rates during the month, mostly from emerging and frontier markets. Only two banks raised rates.
  • The FOMC meeting in January resulted in little new guidance as the Fed maintained its current policy stance of zero interest rates and its purchases of $85 billion per month of Treasuries and mortgages.

 EQUITIES

Global equities continued their upward trajectory in January, rising 5.1% as investors became more confident with the macro environment and cycled capital into equities. Developed markets led the rally, as improved clarity in Europe (+5.9%) and the US (+5.4%) drove higher valuations and lower volatility in the absence of significant earnings growth. Contrasting from recent months, emerging markets (+1.4%) lagged their developed counterparts as investors gauged local Asian currencies to be less competitive after Japan aggressively depreciated the yen.

After a strong January equity markets may see a pause as the Q4 earnings season concludes and investors look to US budget cuts scheduled to occur on March 1. While a compromise was ultimately reached to delay the debt ceiling and avoid the fiscal cliff, early signs indicate that Republicans are prepared to let sequestration occur if Democrats are unwilling to make cuts to entitlement spending. Furthermore, Q4 earnings remain mixed and investor sentiment surveys have reached levels of excessive bullishness. The majority of firms in the S&P 500 have reported results in-line with consensus but lowered forward guidance. Analysts have responded by trimming 2013 EPS estimates by 1% since earnings season started.

•  After lagging in Q4 on election and fiscal cliff uncertainty, January was a strong month for US equity markets as strong capital flows into equities pushed the market to new recovery highs. While the rotation into equities was a “tide that lifted all boats,” value generally outperformed growth as expanding price-to-earnings multiples drove the majority of outperformance. Conversely small and midcap stocks outperformed their large cap peers as disappointing earnings results from several large cap growth stocks constrained overall performance.
  • The relief-driven rally was also evident by the significant decline in implied volatility, with the S&P 500 VIX index falling 20.8% in January to multi year lows. Stock correlations also dropped significantly.
  • Energy was the top performing sector in January after lagging most of 2012, rallying 7.6% due to stronger commodity prices and positive earnings results.
• Europe continued to show improvement in January as investors gauged stabilization efforts as a buy signal. Non-eurozone countries also had significant gains.
  • The UK continues to struggle in the face of a potential triple-dip recession.  GDP contracted again in Q4.
  • Japan (+3.7%) slowed from its December advance as investors took profits. The Bank of Japan continued efforts to fight deflation, setting the inflation target at 2% and committing to continued open ended monetary easing. The effects have been positive on corporate sentiment as expectations surveys have improved markedly.

FIXED INCOME

The BC Aggregate Index, a proxy for high quality fixed income, lost 0.7% during January. Treasury rate movements were the main impediment to returns. Spreads for corporates and agency MBS were essentially stagnant and thereby yields rose in sympathy with Treasuries.

• US TIPS marginally outperformed nominal Treasuries in January with a (0.7%) return. Inflation expectations increased as equity markets rallied and commodity prices rose. Increases in inflation expectations were not enough to offset the price depreciation caused by increases in real rates.
• Investment grade corporate bonds lost 0.9% during the quarter. Negative returns were almost entirely driven by a back up in Treasury yields.
  • Within the sector, financials were a strong outperformer compared to industrials and utilities. The sub sector has a shorter duration which insulated it form the Treasury sell-off.
  • Investor sentiment also continues to improve with strong earnings reports and less macro economic uncertainty. Corporations continue to take advantage of low rates with over $100 Billion of issuance during the month.
• Intermediate municipals returned 0.2% during the month, outperforming Treasuries as muni rates did not follow the same hike as Treasuries. Higher yielding and longer duration munis continued to outperform as investors reached for yield.
  • Long maturity muni performance may also be impacted by the dearth of long dated issuance recently. Municipalities are refinancing paper in intermediate maturities and wary of taking on new debt and issuing long maturities. The supply and demand mismatch has seen the muni curve remain flat for the better part of a year.
  • Illinois and California, two of the largest state muni issuers, made headlines for very different reasons. S&P downgraded Illinois to A-, making it the lowest rated state. The rating agency expressed concern about the state’s massive amount of unfunded pension liabilities. On the bright side, S&P upgraded California to A. The state’s budget is stabilizing with a brighter economic outlook and higher taxes. Taken together, the two issuers provide a good dichotomy of broad dynamics in the muni markets - municipalities are generally taking in more revenue but pension liabilities represent a very real threat to the muni credit landscape.

ALTERNATIVES

Hedge funds started the year with positive performance in most styles. Directional managers were the beneficiary of the rally in risk assets, while diversifying strategies were mostly positive in the first month of 2013.

• Equity managers gained 2.3% in the month as measured by the HFRX Equity Hedge Index. Fundamentally based strategies posted solid performance across growth and value strategies. In aggregate, the equity hedge index captured 44% of the S&P 500’s performance, slightly better than anticipated given the index’s 0.25 beta.
•  Event driven was the top performing category for the month, gaining 3.3%. Activists made news over the month, including the much publicized Herbalife situation. M&A activity was notable throughout the month with deals such as Clearwire and Avis/Zipcar contributing to returns.
•  MLPs started the New Year off with a bang, more than doubling the returns of their real asset peers. The quarterly earnings season brought the latest round of distribution growth with data thus far mostly positive (only two coal MLPs cut or suspended distributions).
  • The distribution season also brought structural tailwinds. January, April, July, and October are the distribution months for most MLPs. Unlike traditional dividend stocks where investors may want to sell prior to the ex-date to avoid taxed income, MLP investors tend to do the opposite. That is they buy in advance because most distributions are 80 to 90% return of capital and therefore tax deferred.
•  Correlations continued to fall during the month, extending the trend that started in 2011.
  • Natural gas traded down on reports of a lesser than expected inventory withdrawal in the last week of January. A warm winter continues to be a major headwind for natural gas as well as other heating commodities such as propane and coal.
  • Crude oil on the other hand rebounded as global risk reappeared via escalating tensions between Israel and Syria.
  • Gold (-1.0%) lagged other metals in January, as silver (+3.7%), palladium (+6.0%), and platinum (+8.6%) rebounded on investor interest and strong demand. 
    • Despite the decline in gold, several tailwinds remain, particularly Chinese buying and a strengthening Rupee. India’s financial minister mentioned no immediate plan for additional import taxes on the metal, a prospect that had concerned many in the marketplace.

Key Points of the conversation included:

• Major global event risks have faded
• Majority of global equity markets in a bullish trend
• Economic recession risk is low
• 2013:  Transition to new secular bull market?

Watch a recording of the webinar by clicking here.

Kanaly explained that technically speaking the market should be due for a correction unless fundamentals continue to remain strong.  Kanaly Trust suggests investing in global equities such as emerging markets and to avoid long maturity fixed-income.

Watch the Segment.

The pace of positive economic data remained strong but fluid in the fourth quarter. Volatility was partially the result of Hurricane Sandy, as the storm wreaked havoc on a number of economic data series and normal business activity was severely disrupted.

• One such indicator was retail sales, which bounced back in November posting a 0.3% gain. A similar pattern occurred in the personal spending data, where Outlays increased by 0.4% in November.
  •  Overall, however, it appears the consumer entered the holiday shopping season in apprehensive fashion, with the uncertainty of the fiscal cliff negotiations looming. Retailers reported meager November holiday sales results before a jump in December.

• Manufacturing was also impacted by the storm with several important series indicating contraction in November. The all-important ISM Manufacturing index fell from 51.7 in October to 49.5 in November. Regional surveys including the Empire State and Philadelphia Fed Manufacturing Surveys reported significant business disruptions, underscoring the Sandy’s effects. Some sense of normalcy returned in December with the ISM report re-entering expansionary territory at 50.7.
• The jobs picture was relatively stable in the fourth quarter, with nonfarm payrolls averaging 151,000 jobs per month, including a 155,000 gain in December. The unemployment rate remained steady at 7.8% in November and December.
  • The labor force participation rate was unchanged for the quarter, a closely watched factor that has had sizeable impact on the jobless rate. 
  • Encouragingly, the “underemployment” rate, which adds discouraged workers and temporary workers who prefer to be full time to the traditional measure, declined from 14.7% to 14.4%. The labor market is exhibiting slow but steady progress. 
• The clear pocket of strength in the quarter was housing. Housing starts surged, climbing from 750,000 in August to 843,000 in September. That robust figure was backed up by readings of 888,000 and 861,000 in October and November, respectively, the highest levels since 2008.
  • Sales and home prices also improved. Existing home sales increased to an annualized rate of 5.04 million in November, 14.5% above a year ago and the highest level in more than five years. 
  • New home sales were similarly strong, rising to 377,000, a 30 month high. Meanwhile, home prices continued to climb. The S&P Case-Shiller Home Price Index and FHFA Home Price Index hit multi-year highs during the quarter. 
• The easing campaign of global central banks continued in the fourth quarter, as thirteen banks cut rates during December and three raised rates. For the year, central banks cut rates 127 times and raised rates 31 times. 
  • The Federal Reserve announced it would replace Operation Twist with an outright purchasing program. While the former funded the purchase of $45 billion per month in longer dated Treasuries with the sale of shorter dated ones, the new program will simply purchase $45 billion without conducting actions on the sell side. This will increase the Fed’s balance sheet, and is in addition to the $40 billion in mortgages the bank is also purchasing.
  • The FOMC surprised many by also announcing it was tying interest rate policy to the unemployment rate. The committee will maintain its zero interest rate policy until the unemployment rate falls below 6.5%, so long as core inflation remains below 2.5%. This raises the possibility that the Fed could end its low rate stance earlier than its previously announced 2015 target date.

EQUITY

Global equities continued their rally, rising 4% in the fourth quarter, ending 2012 with a fairly strong 16.8% return for the full year. Europe (+7.1%) and Asia ex-Japan (+6.0%) continued to rebound in Q4 as equity leadership clearly was focused outside of the US. Unfortunately, fiscal cliff uncertainty became a large overhang for US markets, which rose only 0.1%. In Q4, the best performing primary equity category was International (MSCI EAFE +6.6%), while the worst performing was US Large Cap (+0.1%).

• In the US, style-box index performance was fairly mixed in Q4, with small cap value outperforming large-cap growth by 4.5%. Generally, value outperformed growth and small cap outperformed large cap.
  • Corporate executives stressed the importance of receiving clarity from Washington in order to effectively manage their businesses going forward, and continued delays on a fiscal deal impacted capital allocation decisions during the quarter. Congress came to an agreement (just past the December 31st deadline) on the tax portion of the deal, however as the decision on spending cuts has been postponed the overall fiscal picture remains somewhat clouded. 
• Europe led performance in Q4, driven by strong results in France (+10.9%), Spain (+9.9%), Italy (+9.3%), and Germany (+8.5%). The ESM backstop and plans for a banking union has reduced the overall regional risk profile. 10 year government yields in both Spain and Italy have settled well below 6%. It should be noted that the situation in Europe can only be described as stabilizing, as an extended recession is still quite possible.

FIXED INCOME

Core taxable bonds, as represented by the BarCap Aggregate, returned 0.2% during the quarter to take 2012 returns to 4.2%. A small increase in Treasury yields and a weakening of agency MBS offset a portion of income. The most significant event in the quarter was the Fed’s December announcement of a successor to Operation Twist. 

• US TIPS posted good relative performance to their nominal peers with a quarterly gain of 0.7%, primarily due to increasing inflation expectations driven by a brighter economic outlook and aggressive intervention by global central banks. 
• Investment grade corporate bonds were up 1.1% during the quarter. The income produced was slightly impaired by rising rates and resulting price losses. Investor demand for high quality corporate credit remained overwhelming even as yields bounced around historic lows. 
• Agency MBS lost (0.2%) to drop 2012 returns to 2.6%. Returns were driven by faster prepayments, which push premium priced agency MBS back towards par. In contrast, non-agency MBS held strong with solid gains during the quarter. The year saw a marked difference in performance between agency and non-agency MBS as elevated prepayments weighed on agency valuations while the search for yield continued to drive non-agency valuations. 
• Intermediate municipals gained 0.3% for the quarter to tally a 2012 return of 3.6%. Longer and lower quality municipals tended to outperform. The municipal yield curve flattened (long rates generally fell while short rates rose a bit) forcing valuations on long term bonds a bit higher. This activity along with investor demand for yield pushed lower quality bond valuations higher as well. 
  • Lawmakers and tax policy played a major role in muni performance during the quarter. The muni markets rallied strongly after Obama’s reelection with the expectation that tax rates were increasing. However, apprehension eventually spread in the markets as lawmakers appeared willing to cap the tax exemption of munis to raise revenue. These fears led to an investor pull back and the first sustained outflows from munis in 2012 during the waning weeks of the year. Yields rose with longer maturities hit the worst. 
  • Congress passed the first tax hikes in over 20 years and more look to be potentially forthcoming making the tax exemption of muni bonds more valuable. Unfortunately, lawmakers are also debating whether to cap the tax exemption for muni bonds, and/or to limit the number of issuers eligible to issue tax exempt bonds. These dynamics have contradicting effects on muni valuations and investors may be in for volatility as the market prices in the potential scenarios.

ALTERNATIVES

Hedge funds finished out the year with one of their better quarters in recent memory. Lower correlations and greater security dispersion allowed managers to create value through security selection and fundamental analysis. Directional strategies did well in the quarter as did diversifiers such as convertible arbitrage and event driven.

Alternative strategies finished the year with relatively meager performance. The environment was difficult to navigate for many managers and led to underwhelming performance. While index level data shows another disappointing effort for the hedge fund universe this year, there was a very high level of dispersion among alternative investments, with some managers easily beating the market and others offering a return profile commensurate with their hedged nature. An improved economic backdrop in 2013, along with lower correlations and greater security dispersion, should provide the necessary environment for managers to generate alpha.

MLPs limped to the finish line, held back by volatile and ultimately negative energy prices. They still however posted another solid year. Commodities, which were positive through QE3, sold off in Q4, dragging YTD returns into the red. With the exception of a few smaller index constituents, commodities were down across the board in Q4, with investors overlooking improving economic data from China and instead, focusing attention on election and fiscal cliff questions in the US.

Gold (-5.7%) and silver (-12.8%) were weak during the quarter despite new QE measures in the US, Japan, and Europe. Nothing in particular stood out as a catalyst for the gold sell-off, with the exception of temporary bouts of dollar strength. Looking ahead, fundamentals appear to be in the metal’s corner, as interest rates remain low, central banks are buying on dips, and a portion of mining output is in question due to continued strikes in South Africa. The main risk to the metal is investor interest, as speculative buyers now make up a larger portion of incremental demand than traditional sources (i.e.jewelry and industry).