DOMESTIC EQUITY
The domestic-equity market enjoyed a solid quarter and one of its best six-month periods in the past 15 years, with the S&P 500 returning 25.9%.
There was surprisingly little differentiation by size across the domestic market in the first quarter. The Russell 1000 Value, Midcap Value and 2000 Value indexes were within a 50-basis-point range, from 11.1% to 11.6%.
The growth indexes across the same market capitalization spectrum were a little wider, ranging from 13.3% for the 2000 Growth Index to 14.7% for the 1000 Growth Index, but still a relatively tight spread. Using the Russell 1000 as a proxy, the technology (21.2%), financials (20.5%) and consumer discretionary (16.6%) sectors were the big drivers of returns.
On the flip side, utilities (-1.6%), telecommunications (3.1%) and consumer staples (5.8%) were the worst-performing sectors. The utilities sector also was the only negative sector in the Russell 2000 Index during the quarter.
All the other small-cap sectors had at least a 7% return, led by consumer discretionary (17.9%), health care (15.3%) and materials (13.0%). Despite the run in the market, retail investors continued to shun equity mutual funds, pulling $3.4 billion out of such funds in the first two months of the quarter, after pulling $43.5 billion out in the fourth quarter last year.
According to JPMorgan Chase & Co., the current forward price-earnings ratio on the S&P 500 is just 13, compared with 15.2 at the peak in October of 2007 or 25.6 at the peak in March of 2000.
INTERNATIONAL MARKETS
As with the domestic markets, the international developed markets continued their bull market run in the first quarter. The Russell Developed ex-U.S. Index was up 11% for the quarter.
Of the developed countries, Spain was notable as the only broad country index with a negative return for the quarter in either local (-5.4%) or dollar (-2.9%) terms. Even Greece, much maligned over the past three years, turned in a positive performance (and was well ahead of the S&P 500), up 16.2% (in dollar terms) for the quarter.
U.S. investors generally were rewarded for investing overseas as the dollar weakened against most currencies during the quarter, with the major exception of Japan. The yen return for the Russell Japan Index was 18.3%, but a weaker yen led to a dollar return of just 10.6%.
In general, the major developed countries did slightly worse than the emerging economies, though it definitely was a mixed bag for the quarter.
Major drivers for the quarter (all in dollar terms) were: Turkey (28.2%), Germany (20.6%), Poland (20.1%), Finland (17.3%). Laggards for the quarter included Portugal (2.8%), Netherlands (4.2%), Canada (6.6%) and Australia (6.6%).
We noticed a few trends among the managers we spoke to this quarter in both the developed and emerging markets.
Many of these managers are investing heavily in Asian companies that derive the majority of their revenue from consumers, particularly Chinese consumers. These managers noted that wage growth in China has been running north of 20% annually over the past several years and isn't expected to slow dramatically anytime soon.
On a contrarian note, many also are finding significant value in European companies that sold off substantially during the debt crisis but still derive a disproportionate amount of their revenue from outside Europe. European financials also are beginning to pique the interest of several managers, who noted that after selling off sharply, many are trading at below half of book value.
Standing in the way of a more significant move into this space is uncertainty in Europe. There is less concern about Greece (about 3% of eurozone GDP) and much more about Spain and Italy (30% of eurozone GDP combined).
FIXED INCOME
Over the course of the fourth quarter and the early part of the first quarter, we asked many fixed-income managers: “What makes 2012 different from 2010 and 2011?”
All three years had similar profiles: Entering each year, rates were low, but growth was expected to pick up, and along with it a more active Federal Reserve in pushing rates up off the near-zero floor (though this isn't the case for 2012).
What actually happened in both 2010 and last year, of course, were even lower rates, no Fed action and very positive total returns across the fixed-income spectrum. Most of the managers pointed out that the Fed's “Operation Twist” activities, artificially holding the long end of the curve down, will end during 2012.
Also mentioned were the obvious negative real interest rates through the first seven or eight years of the Treasury yield curve, discouraging the average retail investor. In fact, most of the managers we questioned in the investment-grade space were forecasting a 2012 return in line with the current coupon income, plus or minus 1%.
The first five or six weeks of the year looked to be proving the experts wrong, as rates in the short and intermediate portion of the Treasury curve fell and returns were starkly positive. However, more-positive economic data began to show through, and rates backed up to their beginning-of-the-year levels, hovering there until the final three weeks of the quarter, when rates backed up significantly, taking away most of the gains for the quarter, particularly in the long end of the Treasury curve.
The Barclays Aggregate Index was up just 30 basis points in the first quarter, as returns on Treasuries were negative across all maturities and the mortgage-backed-securities and asset-backed-securities indexes were up less than 1%.
MUNICIPAL BONDS
The municipal market continued to be driven by technical factors during the first quarter, as demand outstripped supply in January, leading to a gain in the Barclays Municipal Index of 2.3% for the month. New issuance began to pick up in February and really gathered steam in March, leading to a flat month for the index in February and a modest loss (65 basis points) in the final month of the quarter.
Like the non-investment-grade market, longer-dated and lower-quality munis outperformed in the quarter.
As was the case in the fourth quarter, most of the managers we spoke to this quarter are favoring the intermediate portion of the yield curve between seven and 15 years. These securities are offering decent coupons and are in the steepest part of the curve, which offers the maximum “roll yield” on a year-over-year basis.
Many of the managers we spoke to in January and February noted significant difficulty in putting new money to work in the market, as new deals have been fairly or overpriced (and oversubscribed, in any case), and the early-quarter rally took most of the value out of the secondary market. The modest backup in yields in March should alleviate some of this concern, but clients should be aware that new accounts may be slower than usual to reach fully invested status.
