U.S. equities started 2012 with the best returns since 1998. Evidence of a sustained economic recovery in the United States encouraged investors to return to riskier assets, including stocks and lower‐quality bonds. The bellwether S&P 500 Index rose over 12% during the quarter. A closer look at the components of the S&P 500 provides interesting insights into the first quarter’s gains. Financial stocks rose more than any other sector, increasing 22% after declining ‐17.1% during 2011. Remarkably, this sector is still 51% below its peak valuation reached in October 2007, before the financial crisis ensued (J.P. Morgan data). Technology stocks within the S&P 500 Index, another strong contributor to returns in the first quarter, rose 21.5% and are now 22% above their October 2007 prices. Other cyclical investments in the index including industrial and consumer discretionary stocks posted double‐digit returns as investors gained confidence in the U.S. economic outlook.
Patterns of historical returns show that small and value stocks tend to earn higher returns when investors are enthusiastic about owning stocks, as we experienced in the first quarter. In a diversion from this expectation, growth did a bit better than value stocks and large company performed somewhat better than small company stocks during the quarter. Much of the large and growth outperformance during the quarter can be attributed to the stock of one company – Apple. Apple’s stock price rose 48% in the first three months of the year. This one stock makes up nearly 19% of the Nasdaq 100 and 4% of the S&P 500 Index, so its performance is an important contributor to overall returns in the first quarter of 2012.
Developed‐economy foreign stocks, represented by the MSCI EAFE Index, rose nearly 11% during the quarter. The European Central Bank (ECB) encouraged investors by executing a quantitative easing program called the Long‐Term Refinance Operation (LTRO). The ECB loaned a total of $1.3 trillion to 800 European banks in two transactions, effectively empowering the banks to purchase sovereign bonds of their home countries. This activity stabilized investors’ perceptions of the euro‐zone sovereign debt crisis—at least for now—and is believed to be one of the primary reasons for the broad‐based rally in stocks in the first quarter.
Interest rates rose modestly during the quarter and bond returns were muted as a result. Investors left the safety of high‐quality bonds in hopes of better returns in riskier assets. The major bond indexes showed slightly positive returns. Municipal bonds fared a bit better than U.S. Treasury bonds as demand for municipal bonds remained strong despite the low interest rate environment.
Reflections on LTRO
Over the past few months, the ECB engaged in a program called the Long Term Refinancing Operation (LTRO). The LTRO is a bank lending program intended to stabilize the euro‐zone’s sovereign debt crisis and restore investor confidence in the European financial system, ambitious goals indeed. Lending money to banks has become a common practice for the ECB; however, this recent round of financing offered a three‐year term instead of the typical three‐month facility. The borrowing rate for participating banks is a paltry 1% per year.
Why was this financing necessary? As the euro‐zone sovereign debt crisis played out over the past few years, investors became increasingly concerned about the abilities of weaker European nations to repay debts. These nations have debt rolling over each year so, at the very least, they need to find buyers for newly‐issued bonds to refinance maturing debt. For a near‐insolvent sovereign nation to attract investors, it is forced to pay high interest rates on new bonds, making its debt even more burdensome. In turn, investors become increasingly concerned and demand even higher rates, or shun the investments all together, creating a liquidity crisis and almost certain default for the borrower.
With poor liquidity among the banks and sovereign nations struggling to refinance maturing debt, the ECB needed to find a way to break this vicious cycle. Based on its charter, the ECB is not allowed to lend directly to countries. In providing inexpensive financing to European banks through the LTRO, the ECB created buyers for the most maligned sovereign debt. By extending the term to three years, the ECB is hopeful that troubled euro‐zone members will have enough time to get their fiscal houses in order.
What’s in it for the banks? The banks must pay the ECB 1% on the three year loans but during that time are able to earn much higher rates of return by owning sovereign debt. This interest rate spread could be an important source of earnings for the banks, contributing to the stabilization of their operations. Like any other investment, the promise of higher returns comes with the assumption of greater risk. The downside is that European banks are now even more exposed to the fortunes of these sovereign borrowers. A default by a sovereign borrower could be detrimental to the capital position of the European banks participating in the LTRO program.
Unfortunately, the ECB and the LTRO cannot solve the underlying problems of the euro‐zone sovereign debt crisis. Many years of lax policy and overspending created the problems and the solutions must be devised by the elected officials of the troubled nations. The LTRO gives these governments time to develop and implement the difficult policy changes that will be necessary to achieve fiscal independence. Investors will be watching this process carefully. Perceptions of the likelihood of success or failure along the way will likely result in periods of increased volatility, particularly for stocks.
No one knows how and when the problems in the eurozone will be resolved; however, the European authorities have shown great cooperation and creativity in devising short‐term solutions. This process is a little like tackling a 1,000 piece jigsaw puzzle with your family on a rainy day. With a little luck, the actions taken by the ECB so far are like constructing the outer frame of that puzzle. Having that completed is very encouraging, but another 900 pieces remain and there will likely be many failed attempts to put the pieces together before the puzzle is finally complete.
In any event, investors may have finally accepted that there is no single or immediate solution to the complex problems the eurozone faces. Resolution is likely to come in small steps over a long period of time. Despite all of this uncertainty, we advocate continued exposure to foreign stocks, including companies in Europe. The LTRO gives the weakest European nations three years to reduce public spending on entitlements, fight tax evasion and balance their fiscal budgets. Investors already know that Rome can’t be built in a day, but perhaps three years is a possibility.
|Index||Market||Year-to-Date Return as of 3/31/2012(%)|
|Standard & Poor’s 500||Large Co. U.S. Stocks||12.58|
|Russell 1000 Value||Large Co. Value U.S. Stocks||11.12|
|Russell 2000||Small Co. U.S. Stocks||12.44|
|Russell 2000 Value||Small Co. Value U.S. Stocks||11.59|
|FTSE NAREIT Equity REIT||Real Estate Investment||10.80|
|NASDAQ 100||Technology Stocks||20.96|
|MSCI EAFE*||Foreign Stocks||10.98|
|Barclays Capital Aggregate||U.S. Dollar Bonds||0.30|
|Barclays Capital Municipal||Municipal Bonds||1.75|
|Merrill Global Gov’t Bond||Global Bonds||0.33|
Source: Thomson Financial’s Investment View; www.REIT.com; MSCI (1)
Key Economic Indicators Compiled by Barbara A. Ziontz, CFP; [email protected]
Data Sources: The Wall Street Journal; US Dept. of Commerce ‐ Bureau of Economic Analysis; US Dept. of Labor; Bloomberg.com; Live.Lehman.com; MSCI.com; REIT.com; NYTimes.com; StandardandPoors.com; Vanguard.com.; Dimensional Fund Advisors
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