Market Monthly October 2012

Market Monthly

An analysis of the economy and
the markets

October 2012

The Economy
As we have reported over the past several months, the many leading and coincident indicators we follow, including ISM Manufacturing and The Federal Reserve Board of Philadelphia’s Leading Index of the United States, suggest that a recession in the U.S. appears likely. Indeed, much of the globe is either in or near recession. Economic indicators are generally coming in below expectations with negative revisions to prior periods. Business investment is declining and industrial production is contracting. Even lagging indicators such as GDP show steep deterioration from the end of last year. While recent ECB measures in Europe to reduce peripheral countries’ interest costs are a significant step in the right direction, the continent will remain mired in recessionary territory for the foreseeable future as structural issues and austerity measures continue to bite. However, the worst of the liquidity crisis appears to be past. The Fed just announced additional quantitative easing measures (QE3) that it hopes will improve employment and boost core inflation expectations (from current deflation concerns), but the economic impact has largely already played out. Fiscal policy remains the primary concern. The U.S. continues to remain vulnerable to adverse shocks, whether from the fiscal cliff, Europe, the Middle East, or elsewhere. Corporate America has taken advantage of record low interest rates to lever up from a low base, leaving it more vulnerable as earnings (and revenue) pressures continue to mount. Companies remain largely unwilling to add workers given the uncertain economic and policy environment in Washington. Consumer real incomes remain quite weak and consumer savings remain low. Meaningful economic improvement, however, hinges on global policy makers shifting to a pro-growth stance, staunching the European crisis, and the global economic downturn running its course. Housing remains a bright spot as it continues to show progress, but it’s from a very low base and will likely not be enough to avert a recession. However, this has positive long-term implications for the U.S. economy.

Equity Outlook
U.S. economic data has generally been below consensus with negative revisions. Recession is likely, and profit margins and earnings should continue to weaken accordingly. The U.S. is very vulnerable to shocks such as the European crisis or Mideast tensions. We therefore favor a more diversified portfolio that offers greater growth and defensive exposure with strong financial strength and attractive valuations. We believe these companies should outperform in this environment. While equity valuations in general remain attractive on a long-term basis, stocks are vulnerable in the near-term due to economic weakness and external shocks. While Fed quantitative easing should help financial assets temporarily and weaken the dollar, the underlying economic and company fundamentals will remain challenged.

Strengths:

  • Higher quality companies reasonably valued on a long-term basis
  • Dividend yield for many equities relatively attractive in current low interest rate environment. Prospective dividend growth increases return potential
  • Federal Reserve is accommodative; QE3 just announced
  • Housing improving

Concerns:

  • Likely recession, earnings at risk
  • Weak consumer income and savings bode ill for consumption
  • Exports declining
  • Cyclical companies at higher risk

Fixed Income Outlook
Treasury securities offer negative real yields at several tenors along the term structure. Therefore, in order to outperform inflation investors need an allocation to spread products. Corporate balance sheets remain reasonably healthy despite growing revenue and earnings pressures, and property prices have stabilized, which is supportive for corporate bonds and securitized products.

Our short-term portfolios will be managed long relative to benchmark duration, as we believe the front-end of the yield curve will be anchored by an accommodative monetary policy. However, intermediate- and long-term portfolios will be managed neutral to benchmark duration, due to the potential for headline risks in Europe, the fiscal cliff and political uncertainty. Our portfolio positions will be underweight Treasury exposure versus corporate bond and securitized products; underweight government-related securities in favor of municipal bonds; and overweight select commercial and residential mortgage-backed securities. Our municipal portfolios will be managed long across all mandates as the municipal sector remains extremely attractive.

Strengths: 

  • Fed on hold through 2015
  • Corporate fundamentals remain satisfactory
  • Growing pressure to reduce government debt/spending
  • Continued low inflationary pressures

Concerns:

  • European economic woes
  • Fiscal cliff
  • China slowing
  • Large budget deficit
  • Weaker dollar

Our Investment Strategy
We are maintaining our strategic allocation to equities, fixed income, and diversifying assets. Within equity, we continue to have a strategic weighting to international developed equities and an equal weighting to both growth and value stocks. Emerging markets also remain at their strategic weighting. Within fixed income, we are maintaining our overweight to U.S. aggregate fixed income versus international bonds. We believe our asset allocation should outperform in either a recessionary or sluggish growth environment, but lag if economic conditions accelerate meaningfully or the stock market is up strongly.

The opinions expressed herein are those of Jeffrey J. Schappe, CFA, Chief Market Strategist of Sterling Capital Management, and the Sterling Advisory Solutions Team, and not those of BB&T Corporation or its executives. The stated opinions are for general information only and are not meant to be predictions or an offer of individual or personalized investment advice. They also are not intended as an offer or solicitation with respect to the purchase or sale of any security. This information and these opinions are subject to change without notice. Any type of investing involves risk and there are no guarantees. Sterling Capital Management LLC does not assume liability for any loss which may result from the reliance by any person upon any such information or opinions.

Investment advisory services are available through Sterling Capital Management LLC, a separate subsidiary of BB&T Corporation. Sterling Capital Management LLC manages customized investment portfolios provides asset allocation analysis and offers other investment-related services to affluent individuals and businesses. Securities and other investments held in investment management or investment advisory accounts at Sterling Capital Management LLC are not deposits or other obligations of BB&T Corporation, Branch Banking and Trust Company or any affiliate, are not guaranteed by Branch Banking and Trust Company or any other bank, are not insured by the FDIC or any other government agency, and are subject to investment risk, including possible loss of principal invested.

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