Current Investment Environment

Stars Aligning

After losing some steam in the third quarter, the U.S. economy got a few boosts in the final quarter of 2010.  As anticipated, the Fed Open Market Committee launched a second round of quantitative easing – dubbed QE2 – announcing their intentions to purchase upwards of $600 billion in Treasury obligations between November 2010 and June 2011, in addition to maintaining their policy of reinvesting mortgage principal repayments.  A further boost to the economy comes from a White House-Congressional compromise.  The resulting fiscal stimulus deal provides a two-year continuation of the Bush tax cuts, additional payroll tax cuts, incentives for business investment, and an extension of emergency unemployment benefits.

Over all, labor market conditions showed improvement during the quarter.  Initial unemployment insurance claims trended steadily lower over the past few months, and the average workweek extended slightly.  Private sector payrolls posted further modest gains through the quarter, with employment rising predominantly in the temporary help services and health care industries. Nonetheless, the unemployment rate rose to 9.8% in November and will remain elevated while the pace of hiring lingers at current levels.

The rate of growth in the manufacturing economy regained momentum to close out the year.  The Institute for Supply Management (ISM) PMI rose from 54.4% in September to 57.0% for December boosted by accelerating growth in new orders and production.  The December survey of the nation’s supply managers noted that the recovery has been fairly broad based with strength coming from autos, machinery, metals, food, computers and electronics.  Housing-related industries, however, continue to lag.  The ISM Prices Index rose from 70.5% in September to 72.5% for December, suggesting manufacturers are paying higher prices.  This is further supported by the Bureau of Labor Statistics data for the Producer Price Index, which accelerated in the second half of 2010.  So while the manufacturing sector is poised for ongoing growth into 2011, rising prices may erode profit growth unless costs can be passed along to consumers.

Improvement in the economic outlook was reflected in another good quarter for the stock markets.  The Standard & Poor’s 500 Index scored a 10.76% return for the quarter, led by outsized gains in the energy and materials sectors.  The Russell 2000 Index, which represents the U.S. small-cap segment, returned 16.25% for the period.  Foreign stocks lagged domestic, and the EAFE Index gained 6.69% for the quarter.

The firmer economic outlook was certainly discounted in the bond market, and the Barclay’s Capital U.S. Aggregate Bond Index declined 1.30% in the fourth quarter.  Securitized debt fared best within the Index, particularly commercial and residential mortgage-backed securities.  Despite the implications of QE2, intermediate and longer-term Treasury issues took it on the chin.  The Treasuries sector lagged the broader Index as the steepening curve saw yields rise by more than 70 basis points in the five-to-ten year maturities.  While expectations for inflation remain restrained, yields may continue to rise as the domestic recovery strengthens. 

We anticipate that the Fed will stay their course and maintain the current target federal funds rate range of 0% to 0.25% throughout 2011. The combination of monetary and fiscal policy should prove to be a powerful and effective strategy to transition the economy from the current modest recovery toward a moderate expansionary phase.

As of Market close Friday December 31, 2010

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