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Market Update -- In the Markets

Written by Derrick Wulf, CFA, Portfolio Manager

January 20, 2010

Here's a brief summary of what transpired in the economy and the financial markets during the past three months. We hope you'll find it a handy reference.
 
Growth
GDP rose an estimated 4.5% in the fourth quarter after growing 2.2% in the third quarter. The two consecutive quarters of growth followed one of the longest and deepest recessions on record. Modest improvements in consumption were augmented by strong business spending, most notably due to a restocking of depleted inventories. Strong productivity gains, lean inventories, and rising corporate profits suggest that recent strength will carry into 2010 with additional growth in business spending. Recent surveys show that median forecasts for 2010 GDP growth now fall around 2.75%, with several prominent Wall Street economists predicting growth of 3% or higher.

Inflation
Low base effects owing to sharp price declines in late 2008 helped propel inflation indices higher in the fourth quarter. The Consumer Price Index, the most recognized of the inflation measures, rose 2.7% on a year-over-year basis in December, its highest level in over a year and up from an almost 60-year low of -2.1% in July. Core CPI, however, which excludes food and energy prices, remained subdued at 1.8% in December. The Bureau of Economic Analysis, meanwhile, reported that its Personal Consumption Expenditure Core Price Index rose 1.4% in October and November, just slightly above its recent low of 1.2%. Limited growth in consumer spending and excess capacity have generally kept price pressures from taking hold in the economic recovery, but a weaker dollar, strong growth overseas, and increased risk appetite has helped lift commodity prices. Inflation is generally expected to remain contained in 2010, but longer-term forecasts remain very uncertain. According to the University of Michigan's consumer sentiment survey, 5-year-ahead inflation expectations held relatively steady at 2.7% in December, but inflation expectations implied by Treasury Inflation Protected Securities (TIPS) prices have risen steadily. Five-year TIPS breakevens rose 70 basis points, from 1.25% at the end of the third quarter to 1.95% on December 31, while ten-year TIPS breakevens rose more than 60 basis points to end the year at 2.41%. Moreover, the closely watched five-year forward five-year breakeven inflation rate rose from 2.87% at the end of September to 3.20% at the end of the year.

Jobs
The job markets showed continued improvement in the fourth quarter, with nonfarm payrolls declining at the slowest quarterly pace in two years. In fact, revised figures indicated that payrolls actually expanded slightly in November, the first gain since 2007. Payrolls declined again in December, however, and the unemployment rate, which hit a 26-year high of 10.1% in October, remained stubbornly high at 10.0% at the end of the year. Meanwhile, initial jobless claims, which had peaked at 674,000 during the week of March 27, 2009, hit a 15-month low of 432,000 in the last week of December, while continuing claims fell to just over 4.8 million, a 30% decline from their June 26 peak. The improving trend in employment data indicates that labor markets should begin to expand more meaningfully in coming months. That said, just as steady declines in the labor participation rate kept the unemployment rate from rising even higher in 2009, discouraged workers who reenter the labor force once job growth picks up will keep the unemployment rate elevated for many more months, even as hiring improves.

Income
Personal income benefited from modest wage gains in the fourth quarter as labor markets showed signs of stabilization and average weekly hours began to rise again. Average hourly earnings, as reported by the Bureau of Labor Statistics also rose at a slightly faster pace in the fourth quarter, though they remained below their longer-term averages. On a year-over-year basis, average hourly earnings rose just 2.2% in December, their smallest increase in over 5 years. The high current rate of unemployment suggests that wage and income growth will remain below trend for quite some time.

Manufacturing
The ISM manufacturing index hit its highest reading since April 2006 in December as a restocking of depleted inventories led to material improvement in new orders and production. Durable goods orders also rose on increased business spending and rising exports, with core durable goods orders registering a 2.2% increase in November. The Chicago Purchasing Managers Index, meanwhile, posted its third consecutive increase in December and hit its highest level in over 30 months.

Retail
The holiday shopping season got off to a strong start in 2009 but failed to impress retailers as consumer spending tapered off in December. Retail sales excluding autos rose 1.9% relative to their year-ago level in November, but fell 0.2% in December according to the Census Bureau as soft labor markets and cautious sentiment held consumption in check during the period. Nevertheless, improving economic conditions and an expected return to job growth should support ongoing improvement in the retail sector in 2010.

Housing
Housing markets carried their momentum from a strong summer selling season into the fourth quarter, as low mortgage rates, attractive prices, and first-time homebuyers' tax credits helped push existing home sales above 6.5 million units in November, an increase of 45% from their January low and the highest reading since early 2007. New home sales fell, however, as the pending expiration of tax credits turned away potential buyers. Nonetheless, home prices rose for the fifth consecutive month in October, according to the S&P/Case Shiller Home Price Index, and the National Association of Realtors reported that the inventory of unsold homes fell to 6.5 months' supply in November, down from over 9 months just three months earlier. Although foreclosure rates remain a concern for the housing market, shrinking inventories and high affordability portend further improvement in housing in 2010.

Confidence
The Conference Board's index of consumer confidence fell slightly in the fourth quarter as jobs remained scarce. Though still well above its February lows, the index has yet to show any real optimism about current conditions or future economic prospects. To wit, the November index reading of 52.9 remains lower than at any other time in the fifteen years preceding this most recent recession. The University of Michigan Survey of Consumer Confidence tells a similar story, having bounced from its recent lows but still registering readings below levels seen even during the last recession. While the broader trend remains positive, it is unlikely that consumer confidence will see any meaningful improvement until labor markets return to growth in 2010.

The Fed
The FOMC met twice during the fourth quarter, and while policy makers had plenty to talk about, rate hikes were not on the agenda. As expected, at both meetings FOMC members voted unanimously to hold the target fed funds rate at its effective floor, and reiterated their position to keep "exceptionally low levels of the federal funds rate for an extended period." They did, however, focus more attention on some of their unconventional policy initiatives. First, though no specific reference was made to it in subsequent policy statements, the Fed completed its $300 billion Treasury purchase program early in the fourth quarter. Then, at the November 4 FOMC meeting, policy makers agreed to reduce the size of the agency debt purchase program by $25 billion to $175 billion, citing "limited availability of agency debt." They did, however, maintain their commitment to purchase $1.25 trillion in agency mortgage-backed securities, and by the end of the year had completed over $1.1 trillion in purchases.

In 2010, the Fed will focus on gradual removal of monetary stimulus, beginning with the expiration of its special liquidity facilities on February 1 and the completion of its large scale asset purchase programs by the end of the first quarter. The Fed is also scheduled to allow its Term Asset-Backed Securities Loan Facility, or TALF, to expire in the first half of the year. And, barring an unforeseen decline in economic growth, the Fed is expected to gradually introduce measures to drain excess reserves from the financial system and eventually move to tighten official policy, perhaps as early as the second quarter. According to fed funds futures pricing as of December 31, investors were betting on a possible rate hike as early as June, with more rate hikes to follow. With a closing price of 98.905 at year-end, the December 2010 fed funds futures contract implied a rate of at least 1% by this time next year.

Treasuries
Steadily improving economic conditions and heavy new issuance put upward pressure on Treasury yields during the fourth quarter, leading to a loss of 1.3% in the Treasury component of the Barclays Capital Aggregate Index. The yield curve also steepened as the Fed reiterated its commitment to holding the target overnight lending rate at the zero-bound for an "extended period" while Congress continued on a path of seemingly unrestrained federal spending. Net of maturities, the Treasury issued over $250 billion in new securities and increased its total debt outstanding by more than $400 billion in the fourth quarter to finish the year with over $12.3 trillion worth of IOUs. Yields on 2- and 10-year notes rose 19 and 53 basis points, respectively, while the yield on 30-year bonds rose almost 60 basis points, closing at 4.64%, just shy of their highest level of the year.

Meanwhile, with more than $1 trillion of excess reserves sloshing around on the Fed's balance sheet, some investors also began to grow increasingly concerned about the risk of an eventual buildup of inflationary pressures. This view was manifested in a continued widening of TIPS inflation breakevens, which increased from an implied 10-year rate of inflation of 1.75% at the beginning of the period to over 2.4% by the end of December. Moreover, 5-year forward 5-year inflation breakevens, a closely watched gauge of long-term inflation expectations, rose over 30 basis points in the fourth quarter to end the year above 3%.

Bond Markets
Despite a sharp sell-off in Treasuries, broad market bond indices posted positive returns in the fourth quarter, aided by continued spread tightening among non-Treasury securities. With economic indicators showing ongoing improvement, credit spreads tightened to their narrowest levels of the year. In the investment-grade universe, the best performers were commercial mortgage-backed securities (CMBS), which benefited from attractive yields, declining available supply, and increased risk appetite among investors despite a worsening of fundamentals. The sector outperformed duration-matched Treasuries by some 374 basis points with spreads tightening by more than 60 basis points. Corporate bonds were the next best performer as improved earnings and low issuance compelled investors to drive spreads almost 50 basis points tighter, leading to over 300 basis points of excess returns for the sector. Agency debt and mortgage-backed securities (MBS) also outperformed Treasuries but lagged competing sectors because of their already rich valuations. Ongoing support from the Fed through its large-scale asset purchase programs helped drive spreads tighter in those sectors as well, with mortgages ending the year near their richest valuations ever.

Outside the domain of domestic taxable investment-grade bonds, high yield debt outperformed once again, returning over 6% to investors and lifting its full-year performance up to a staggering 58%. Many of the same factors that drove performance in investment-grade corporates similarly impacted the high yield sector, driving spreads tighter by almost 150 basis points. International non-dollar modestly outperformed Treasuries as well, buoyed by improving credit and financial market conditions worldwide, but suffered bouts of sovereign debt fears as both Dubai and Greece made negative headlines during the period. Municipal bonds, meanwhile, also enjoyed modest outperformance relative to U.S. Treasuries but were hurt by rising Treasury yields and lingering concerns about state and local municipal finances.

Some additional data about the U.S. bond markets are shown in the charts below.