Monthly Market Wrap-Ups

February 2010

U.S. stocks have been trading in a tight range since the middle of January. Major U.S. stock indexes rose in February but ended the month below their highs for the year as they struggled with some disappointing economic data. Concerns persisted about the fiscal health of Greece and other European countries, as well as Chinese actions to curtail aggressive lending activities.

Mid- and small-cap shares outpaced their large-cap peers. As measured by various Russell indexes, growth and value stocks were fairly evenly matched across all market capitalizations. Since reaching their lows in March 2009, most major U.S. stock indexes have jumped 60% to 85% through the end of February 2010, although they remain below the levels reached in 2007. Most sectors in the S&P 500 Index produced positive returns. Several economically sensitive sectors—information technology, consumer discretionary, industrials and business services, and materials—were particularly strong. Consumer staples, financials, and energy stocks did reasonably well. Health care stocks were flat as the government continued to consider legislative reforms, while utilities and telecommunication services declined for the month.

Consumer confidence took a surprising tumble in February, reflecting investors’ concerns about the strength of the economic recovery. The Conference Board reported that its widely watched consumer confidence index fell more than 10 points, to 46.0 from 56.5 the month before. Analysts had been expecting a small drop to 55. A reading above 90 signals that the economy is on solid ground, so the sharp decline indicates that we have a long way to go before we put the recession safely behind us. Consumer confidence is particularly important since consumer demand has been generating more than two-thirds of total economic activity.

Federal Reserve Chairman Ben Bernanke told Congress that continuing low interest rates are necessary to support the economy. He was optimistic about the long-term prospects for a recovery, but he maintained that low-cost borrowing over an “extended period” will be required to stimulate growth. Indeed, the economy grew at an annualized rate of 5.9% in the fourth quarter of 2009, according to the latest reading, but that brisk pace is not expected to continue. Bernanke also expressed concerns about the mounting federal budget deficit. During the month, President Obama signed an executive order creating a bipartisan commission tasked with finding solutions for the deficit, which has been a growing worry for U.S. investors.

The brisk rally that took place over the last nine months of 2009 was largely fueled by the Fed’s aggressive monetary policy and the government’s fiscal stimulus programs. Companies exposed to the greatest risk recovered the fastest. Mid-cap shares led the upturn in 2009, but at the beginning of this year, valuations appeared to favor large-cap stocks. Cautious consumers remain the biggest deterrent to a strong, sustained economic rebound. Companies have begun to benefit from extensive cost-cutting, but continuing gains for stocks in 2010 will depend to a great extent on a steady resumption of growth. The U.S. economy is still one of the world’s most resilient, but equity gains this year could be more restrained than they were following the March 2009 bottom.

February 2010

Bond returns were modestly positive in February, thanks mainly to income gains rather than price appreciation. Although all major domestic sectors moved higher, high yield issues trailed as investors withdrew money from the asset class early in the month. Long-term government bonds also lagged as yields spiked at mid-month before falling back at the end of the period. Municipal bonds led returns among domestic segments as low issuance kept supply muted. While dollar-denominated emerging markets bonds posted good gains, bonds from developed markets outside the U.S. were hampered by a sharp rise in the dollar relative to major European currencies.

Developments in European credit markets dominated bond headlines during the month. Disturbing echoes of the 2008 financial crisis appeared in the form of growing concerns about spiraling deficits in Portugal, Spain, and in particular, Greece. Although most observers agreed that outright defaults on sovereign debt were highly unlikely, some worried that a new contagion might spread to other European markets—or that at least the continent’s growth would slow as interest rates in peripheral European Union nations climbed and as Germany and other large economies diverted resources to help Greece deal with its debt issues. As a result, investors once again rushed to the safe haven of the U.S. Treasury market, boosting the value of the dollar and temporarily driving down yields.

In a sign that the Federal Reserve was confident U.S. credit markets were faring better, the central bank took its first step in tightening monetary policy in nearly four years. On February 18, the Fed announced that it was raising the discount rate it charges member banks for emergency loans by a quarter of a percentage point, to 0.75%. The Fed took pains to assure investors, however, that the more influential federal funds rate—which directly affects consumer and business lending rates—would remain unchanged for the near future. If anything, the inflation threat appeared to diminish during the month. The Labor Department announced that core inflation, which excludes volatile food and energy prices, had fallen during January for the first time in nearly 30 years. The month’s economic data was mixed, with good news in manufacturing offset by a sharp drop in consumer confidence and conflicting signals on the housing recovery.

The recent rise in the discount rate alarmed some investors and led to a brief rise in bond yields. The Federal Reserve appears unlikely to raise the more consequential federal funds rate, however, until employers begin adding workers and set the stage for a gradual decline in the unemployment rate. We do not believe the labor market will improve until the spring, implying that official short-term interest rates will remain low until at least the summer.

February 2010

Non-U.S. stock markets were flat for the month, reflecting the generally discouraging financial and economic news. Investor fears about the possibility of sovereign defaults in Greece and other peripheral European Union nations, Chinese monetary tightening, and disappointing global economic data pushed markets lower for the first half of the month. After falling just short of a 10% correction in the middle of February, markets recovered. Most developed markets closed lower this month, with the exception of Japan and several Pacific Rim markets. Emerging markets were barely positive.

Growth and value stocks gained, but growth handily outperformed value. Small-cap stocks advanced and outperformed large-caps. Within the MSCI EAFE Index of developed non-U.S. markets, materials and consumer staples were the only sectors able to register gains. Energy and consumer discretionary were the month’s weakest-performing sectors. The dollar strengthened against major European currencies, but it declined against the yen.

Despite a season of generally upbeat earnings reports and projections, the difficulties in Europe and the weak global economic recovery clearly dampened investors’ hopes for the remainder of the year. Most major developed countries reported that their economies had expanded, but their recoveries have failed to build any momentum. Concern about the sustainability of the recovery strengthened expectations that major central banks—the Federal Reserve, European Central Bank, and Bank of England—will keep their interest rates historically low for much of the year. With credit availability remaining weak and the expectation that public and private sectors will need to retrench, central banks are in no rush to begin the process of raising interest rates.

The Greek fiscal crisis framed investors’ perceptions for most of the month. The lack of a resolution to the country’s budgetary crisis ignited concerns over the value of the euro and the strength of the European Union. Skittish investors continued to unload Greek holdings, but they also sold off the region’s other financially vulnerable markets, such as Spain and Portugal. Bank of England Governor Mervyn King said that the weaker-than-expected recovery in the euro zone, Britain’s main trading partner, may force the bank to rethink its policy of ending quantitative easing. He said the fall off in euro zone exports is taking place when domestic demand in the U.K. remains quite weak.

Japan’s stock market rallied for the second month, generating the world’s best year-to-date returns. Strong demand from China and other Far Eastern economies boosted the country’s export-oriented stocks. Other Asian stock markets also advanced. Asian manufacturers reported that they are increasing production to meet stronger demand. China reported record industrial activity for the month, and the purchasing managers’ indexes in India, South Korea, and Taiwan also climbed.

Concerns about the solvency of Greece and—increasingly, Spain and Portugal—along with disappointing economic data have created doubts about the strength and durability of the global recovery. The worldwide economy may be expanding, but the fastest rates of growth are in emerging markets. In this environment, the most attractive opportunities are companies that have exposure to the rapid growth occurring in emerging markets. Companies that have strong balance sheets and can finance growing sales at the expense of their competitors should do well. Strong fundamental research and stock picking will be critical to investment success.

February 2010

Emerging markets stocks posted modest gains in February but remain significantly underwater so far this year. Emerging markets were buoyed by the strong performance of stocks in Latin America but were dogged by losses in the Europe, Middle East, and Africa (EMEA) region. Investors’ previously insatiable appetite for developing market equities has waned as expectations for global economic growth have diminished. Concerns about tighter monetary policy in the U.S. and in China, and a weak U.S. economic recovery, also weighed on investors. Across the emerging markets universe, sector performance was mixed. The best-performing sectors were health care and materials, while the information technology and utilities sectors declined the most.

Stocks in the Latin America region were among the strongest. Brazil and Mexico, the region’s two largest markets, and Peru, a relatively small market, posted solid gains. Brazilian equities are ahead nearly 110% for the past 12 months due to the favorable economic environment and strong commodity prices. Mexico, the region’s second-largest economy, is also up triple-digits in the past year, but, like Brazil, is in the red this year. We remain confident that the region is positioned to benefit from greater political stability, resilient domestic-driven economic growth, sensible fiscal management, and sound economic fundamentals.

The largest EMEA markets—South Africa and Russia—posted losses for the month. South Africa’s market is down more than 5% this year, and Russia’s market is off about 3% after losing 5% in February. Nevertheless, Russia remains the most attractive investment opportunity in the region, and we continue to favor a mixture of domestic retailers and energy companies that can benefit from solid production growth.

Among major emerging Asian markets, Indonesia and Taiwan were the worst performers for the month, and only Pakistan is ahead for the year to date. In general, we believe Taiwan—the region’s third-largest market—offers fewer growth opportunities than China or India (both posted modest gains in February). We think China and India remain the most attractive economies in Asia. We believe a focus on these two markets will be rewarded over time due to the rising levels of urbanization, industrialization, and domestic consumption.

We remain confident in the longer-term prospects for emerging markets, primarily because the fundamentals appear stronger than they do in most of the developed world. Emerging markets economies are growing faster than developed markets, and at a corporate level, earnings proved more robust during the downturn. Profitability also has remained higher. Finally, we believe valuations, which have risen markedly during the past year, are still reasonable. They are trading slightly above the long-term averages but still at a slight discount to developed markets.