As the quarter opened, investors were worried about the impact of the “fiscal cliff” on both the markets and the U.S. economy. On New Year’s Day, Congress settled much of the uncertainty over taxes but also left much undone. The postponement of sequestration until March, the prospect of another debt ceiling debate, and the expiration of budget resolutions, made prospects for first quarter returns very uncertain. At the end of the quarter we were celebrating record highs for both the Dow Jones and S&P 500 averages. In summary, the S&P 500 rose by 10.6% on a total return basis. Similarly, the Russell 2000 (small cap) rose by 12.4% and the Russell Mid cap by 13.0%. Foreign markets were not nearly so strong with the MSCI EAFE (developed markets) up by 5.1%. Emerging markets, also measured using an MSCI index, actually fell by 1.6%. Fixed income was also weak during the quarter as yields rose. Treasuries were generally the weakest part of the bond market with credit, including mortgages, and high yield generally out-performing.
During the 1992 Presidential election, James Carville, campaign strategist to candidate Bill Clinton, reminded all that it was the economy that mattered and, in the first quarter, it was the economy that mattered most as well. For a good part of the period of recovery since the financial collapse in 2008, markets have been driven by “macro” forces: central bank policy, geopolitical events, European financial stress, among others. Markets tended to move en masse, or, as quantitative strategists would say, with very high correlations among stocks. This is certainly still a characteristic of today’s markets as the crisis in Cyprus reminded us, and we still do not wish to fight the Fed or any of the other major central banks when they are aggressively easing, but gradual improvement in the economy is beginning to create a more normal feel, to the U.S. market at least. The correlation between stocks reached its lowest level since 2008 in the quarter. The labor situation has improved, housing is recovering and companies are beginning to contemplate capital spending. With this improvement, the market is now more often distinguishing between stocks based on earnings and dividends and returns on capital. This is a relative judgment, global factors will still impact the market generally, but it does suggest that even at new highs the market can advance on continuing economic and profit improvement.
When the Federal Reserve announced the most recent version of quantitative easing, it changed the criteria for ending the program from a date to economic targets, including ones for unemployment and inflation. The next point of sustained risk for the market is likely to come when the improving economy takes us closer to these economic targets. The suggestion of a debate about the continuing need for quantitative easing among the Federal Reserve members in February took the market down by 3%. While we do not see this as a problem over the next several quarters, the better the economy does, the more likely it is that the market will begin to anticipate an end to Federal Reserve easing.
In the fourth quarter of 2012, the market took its cue from Washington. In the first quarter of 2013, it was economic statistics that influenced the market. We expect the second quarter to be similar to the first. As the economy moves so will the equity market.
by Willard N. Woolbert
Mr. Woolbert is Senior Vice President and Chief Investment Officer at Pennsylvania Trust.