skip navigation

1st Quarter 2011

Quarterly Market Outlook

Economic Overview and Outlook

The global economic recovery continued to march forward in the first quarter of 2011 but faces new challenges in the months and quarters ahead. Markets were dominated by two major global macro events during the quarter, the increased geopolitical turmoil in North Africa and the Middle East, and the tragic 9.0 magnitude earthquake and subsequent tsunami in Japan. Global economies also had to deal with a surge in commodity prices that had some pundits whispering of a return of higher inflation or slowdown in economic growth, or both. However, in early April the International Monetary Fund (IMF) announced that despite the recent macro events, the world economy is still expected to grow at 4.4% in 2011, down just slightly from the 5.0% rate in 2010, and furthermore, that the recovery is set to continue over the next two years and will not be derailed by the earthquake in Japan nor the spike in commodity prices. Additionally, growth in the U.S. is expected to come in at a more modest but respectable 2.8% this year before increasing to 2.9% in 2012. The IMF concluded that fears that higher commodity prices will lead to 1970s-style stagflation are way overblown.

U.S. inflation expectations remain muted but have been inching upwards so far in 2011. The most recent read on core inflation, which excludes the volatile (and rising) food and energy components, came in at a modest 1.1%. But headline inflation, which includes the food and energy components (and together makes up approximately 23% of the overall inflation measure), came in a full percentage point higher at 2.1%. The 2.1% headline inflation number is still well below its long term average of 3-4%, and it continues to appear that inflation does not pose an issue for the U.S. economy over the near term. Unemployment, though still elevated, continues to improve in 2011. The latest unemployment rate came in at 8.8%, its lowest level in nearly two years, and the economy has been on average adding ~200K new jobs per month during the recovery. And although unemployment continues to slowly improve, economists generally agree that GDP growth rate needs to be well in excess of 3% before the unemployment rate will start to significantly decline and it may take up to three years before the unemployment rate reaches a level to which most economists would consider full employment.

Most signs point to the U.S. economic recovery continuing despite the recent challenges witnessed overseas. The primary drivers pushing the economy forward include increased business investment and productivity improvements from U.S. companies and higher demand for U.S. goods from the rapidly growing emerging market economies. However, economic growth will likely continue to be somewhat constrained by relatively tight retail credit conditions in some markets and the modestly negative effects of higher energy and food prices.

Equity Markets Review

2011 started off on a positive note as capital markets around the globe once again posted fairly healthy positive returns in the first quarter, but the strong performance was accompanied by higher volatility. Equity markets were impacted by the increased geopolitical turmoil in the Middle East and the devastating Japan earthquake, which hastened a spike in global capital market volatility. The sudden onset of uncertainty in the markets drove many investors into de-risking mode. However, as is usually the case, the patient investor was rewarded as equity markets quickly stabilized and ended the quarter on a high note, despite the uncertainty remaining in the two troubled regions.

In the U.S. the broad market S&P 500 Index rebounded nicely from quarter lows reached in mid-March and finished the quarter firmly in positive territory, returning a strong +5.9%, its best first quarter return since 1998. The Energy sector led the market higher courtesy of oil prices rising to 2½-year highs, but equity markets broadly saw healthy positive gains as strong corporate earnings announcements continued to gain momentum and on balance exceeded expectations. The more defensively oriented Utilities and Health Care sectors were also amongst the leaders

for the quarter, and small cap stocks, more insulated from global macro factors, once again outperformed their large cap counterparts with the small cap benchmark Russell 2000 Index posting a very strong +7.9% return.

Outside the U.S. equity markets also posted positive but more subdued returns for the quarter. Developed non-U.S. equity markets returned a respectable +3.4% return as measured by the MSCI EAFE Index, but the index was held back by lackluster returns in the Asian region, and Japan (-4.9%) in particular, as the region struggled with the economic and human toll brought on by the one-two punch of the devastating earthquake and subsequent tsunami. The tsunami measured over 120-feet in some locations and walloped the coastally situated Fukushima Daiichi nuclear power plant, severely damaging the plant and leaving at least one reactor core as of the end of March still in unstable condition. Given the severity of the Japan tragedy and the extensive rebuilding efforts Japan faces, the Japanese markets (and people) have held up remarkably well. In Europe, the sovereign debt concerns that plagued the region for much of 2010 returned once again at the end of the quarter, with heightened concerns now focused on the fiscal health of Portugal and Ireland, but the concerns were not at a level to cause broader global capital market issues. Emerging market equities also posted positive but more subdued returns during the first quarter, with the MSCI Emerging Markets Index returning +2.1%. However, the majority of the return for the quarter was attributed to the strength of the emerging market currencies versus the U.S. dollar. Emerging markets equities, particularly in the Asian region, were held back due to the repercussions of the Japan crisis, but were also pressured from rising and somewhat high inflation levels in many of the countries in the region.

Fixed Income Markets Review

U.S. bonds were somewhat quiet during the first quarter but managed to generate a modest gain of +0.4% for the period as measured by the Barclays U.S. Aggregate Bond Index. Bondholders began to move modestly out of the asset class during the beginning of the quarter as concerns surrounding the possible future upward movement of interest rates started to escalate, but that brief trend reversed as bond markets became a safe haven during the global turbulence witnessed in March. Interest rates (and bond prices) were also positively affected in March after the Federal Reserve calmed the markets by announcing that it will fully implement the announced $600 billion QE2 Treasury bond buying stimulus program through June, but that no additional stimulus would be needed. Municipal bonds bounced back in the first quarter as the fears that had plagued the sector during the end of 2010 were found to be overblown. The sector, as measured by the Barclays Municipal Bond Index, returned +0.5% for the quarter. High yield bonds continued their torrid pace in the first quarter, benefitting from continued positive economic and corporate earnings data, returning +3.9% as measured by the Barclays U.S. Corporate High Yield Index.

Capital Markets Outlook

As we continue into 2011, equity markets on balance remain fairly valued despite the strong run-up witnessed since the beginning of September of last year. Common market valuation metrics such as price-to-earnings (P/E ratio), price-to-book (P/B ratio), and price-to-cash-flows (P/CF) continue to sit below longer-term historical averages with the exception of small cap equities, which are beginning to look a bit expensive relative to their large cap counterparts. Equity markets are also benefitting from continued strong positive momentum, and look comparatively more attractive versus fixed income.

As we have commented previously, U.S. fixed income markets continue to face headwinds as U.S. interest rates remain near all-time lows. With the prospects of higher interest rates in the future, non-core fixed income asset classes such as floating rate notes, non-U.S. bonds, emerging market debt, Treasury inflation protection securities (TIPS), and where appropriate, short-term bonds appear comparatively more attractive, as do absolute return strategies (e.g. equity long/short, global macro, arbitrage), as these strategies are generally not affected by the general direction of equity or fixed income markets and often possess bond-like risk characteristics.

Prepared by:

Alex Kaye, CFA, Head of Research
Research Department, Cetera Financial Group

The views are those of Alex Kaye, CFA, Head of Research, Research Department, Cetera Financial Group, and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. All economic and performance information is historical and not indicative of future results. Investors cannot invest directly in indices. Please consult your financial advisor for more information.

While diversification may help reduce volatility and risk, it does not guarantee future performance.

Asset backed securities (i.e., hedge funds) often engage in leveraging and other speculative investment practices which may increase the risk of investment loss; are illiquid in nature; do not require periodic reporting to investors; may involve complex tax structures with a resulting delay in distribution of tax information; are not subject to the same regulatory requirements as mutual funds; and may have high fees associated with them.

Securities and insurance products are offered by PrimeVest Financial Services, Inc., a registered broker/dealer. Member FINRA/SIPC. PrimeVest Financial Services is unaffiliated with the financial institution where investment services are offered. Investment products are * Not FDIC/NCUSIF insured *May lose value *Not bank guaranteed *Not a deposit * Not insured by any federal government agency.