October, 2010 Global Financial Market Perspective
By Andrew Mehalko, CFA, Chief Investment Officer

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Third Quarter Highlights

• Fears of a double dip recession subsided
• Risk assets had a tremendous quarter
• Fear gauge remained high as Treasury bonds and gold continued to move higher
• Emerging markets led the advance in equities

Third Quarter in Review: Markets Rallied Worldwide

The third quarter was marked by wide swings in the equity markets, concluding with a considerable gain for stocks, bonds, and commodities. Both the S & P 500 and the equity markets rallied, weakened, and rebounded. Domestic equities market exhibited peculiar behavior in September with low volatility, volume, and flows out of the asset class, yet the gain was strong for the month. Internationally, equity markets surged ahead, with emerging markets leading the charge. Improved confidence in business conditions (as evidenced by decent second-quarter earnings) and the likelihood of further quantitative easing by the Fed led investors to begin taking more risks.

Governments in developed economies have used multiple methods to bolster economic growth: stimulus money, near-zero interest rates, and quantitative easing. Given this support, it is difficult to tell how much of the current growth in corporate earnings is true organic growth driven by solid end-demand. We remain acutely aware that the foundation for a sustainable bull market in equities is fragile.

In the bond markets, high yield bonds outperformed municipal bonds and investment grade corporates, but all three posted respectable returns for the quarter. Hedge funds posted lackluster quarterly returns in comparison to the equity markets. Overall, however, hedge funds posted gains each month of the quarter. Hedge fund returns were slightly higher than the overall bond indices and volatility was comparable.

Investment Return Expectations: What is Reasonable Going Forward?

The amplified swings in the markets indicate that investors continue to be uncertain about the range of outcomes for the global economy. With equity markets advancing as of late, investors seem to be gaining confidence in decent future growth prospects. However, the familiar concerns of high unemployment, weak housing markets, weak lending activity, and rising government debt and deficits linger, and rightfully so. Developed economies seem to be at an inflection point: are we stuck in a quagmire of sluggish growth, augmented by government intervention, or can we work through some of these structural problems and start to generate sustainable, real growth? If it is the latter, it will still take time to work through the problems; thus, for the foreseeable future, a low-growth, low-inflation, low-interest rate environment is the likely scenario. A future of constrained growth will likely lead to lower absolute returns for both stocks and bonds over the next three to five years.

How Will Equity and Bond Markets Fare in a Low-Growth Environment?

While we are seeing positive signs of economic growth in corporate America, the reality is that companies have had to cut many costs to weather the economic crisis and they are at a dead-end on further cost-cutting. There is concern about whether businesses will be able to organically maintain their upward revenue trends in a sluggish economic environment. Thus, as companies look to boost their growth, we expect to see continued acceleration in mergers and acquisitions. If they are unable to find good assets to acquire, they will likely return cash to shareholders in the form of dividends or share repurchases. We expect dividends will be an important source of return for equity investors over the next few years.

A very positive sign for economic growth will be a sustained upward trend in capital expenditures. At some point, companies will have to invest money in hiring, technology, and other overhead costs. Once this trend materializes, we should see some job creation so long as regulation and tax policy are not too uncertain or restrictive.

Our recommendations for portfolio positioning this quarter remain nearly unchanged from the first quarter.

Politics and Taxes Cloud the Picture

The potential for a power shift in the November elections in the United States adds a layer of uncertainty in terms of how markets will perform. It is likely that the Republicans will take a majority control of the House of Representatives and the Democrats will maintain their hold in the Senate. While the net effect is greater balance, policy decisions will be harder to achieve, and true, positive change will become even more of a challenge.

Tax changes scheduled to occur in 2011 may also alter the domestic picture. Tax cuts implemented in 2001 are scheduled to expire; income tax and dividend tax rates for high earners will climb; capital gains taxes will increase; and various income tax deductions will be reduced. In addition, the estate tax will return, and after 2012, a new Medicare contribution tax will be imposed on investment income as part of the health care reform bill.