• CIO Outlook
• July, 2012

The first half of 2012 produced a few surprises. Notably on the positive side, U.S. equity markets broadly outperformed international markets and U.S. bond markets continued to provide positive returns. But there was a catch: the positive bond returns came on the heels of substantial bond price volatility and on growing fears the European debt situation is spinning out of control. Indeed, U.S. Treasuries and German Bunds continue to be the preferred fixed income hiding place of choice for many investors. More disappointing during the first half was the performance from hedge funds. These strategies were especially hurt by the fact that correlations among asset classes, and specifically stocks, remained elevated, effectively limiting the opportunity for beating the markets.

Outside the U.S., the picture in the first half was more challenging. Like U.S. markets, Europe markets had a very strong first quarter. However, they completely crumbled in the second, as the numerous summits called to resolve the European debt crises essentially produced... nada... rien... nichts. The euro weakened (making returns from European investments for U.S. investors look even weaker), and crisis fatigue set in on the persistent warnings of peripheral Europe's default, the Eurozone banking systems' insolvency and countries' imminent exits. Asia, too, had a good Q1, followed by a less good Q2. The biggest factor there continues to be the effect of China's slowing economy — on the region, on overall global growth (and therefore indirectly on the region), and perhaps most importantly on the response from Chinese policymakers. (They already cut interest rates once in May, and we expect additional measures throughout the year.)

Still, beyond these larger patterns, a number of markets performed exceedingly well in the first half. Of particular note, the Turkish, Egyptian, Philippine and Vietnamese stock markets all logged U.S. dollar returns of more than 20%.

As it turns out, the Turkish, Egyptian, Philippine and Vietnamese stock markets all logged U.S. dollar returns of more than 20%.

In fixed income markets, the story was more consistent: positive returns across much of the board, as the "trifecta of fear" (China hard landing, U.S. fiscal cliff and Eurozone debt crisis) prompted investors to buy more bonds. That said, with yields already starting at low levels, the total return on many bond indexes through the first half was lower than that for equities (2-3% vs. 7-9%).

More relatively speaking, U.S. bonds were strong and European were weaker, with bright spots including European high-yield, U.S. municipals and local Emerging Market debt indexes. Currency volatility was another bright spot, with the Canadian dollar, the Brazilian real, the euro and the Aussie dollar all making strong moves.

In the end, the main story for the first half of 2012 has been an amalgamation of investor fears, fading global economic growth, the urgent need for debt restructuring in Europe's periphery, and hopes for central bank intervention. The product of this Frankensteinian mash-up has been a market in churn mode: rallies on hope of central bank action, hopes dashed on central bank inaction, confidence that falls with the latest growth reports, hopes that rise in anticipation of central bank action... lather rinse repeat.

Looking ahead to the second half of 2012, the good news is we think we'll begin to see more clarity. The bad news is global economic growth numbers are likely to be even more anemic than they were in the first.

The irony is even higher taxes may raise business and consumer spirits, so long as there's clarity.

One of the key issues plaguing markets in our view has been the lack of clarity on the direction of fiscal policy in the U.S. and Europe. Time and again, policymakers in the U.S. have failed to reach an accord on how to stimulate growth and reign in excessive spending. In Europe, summit after summit on the European debt crisis has produced little in the way of concrete solutions, let alone a framework that member nations can agree on for addressing the Eurozone's structural problems.

Unfortunately, we expect things to get worse before they get better. For the balance of the summer, we expect just more political posturing and no earnest discussion in Washington to address the core issues of debt, jobs and growth. As a result, we expect markets to continue their first half pattern of bungee-cord-like moves, and a list of outperformers (chiefly dividend stocks and high-quality investments in general) that is virtually indistinguishable from the list for the first six months of the year.

Starting sometime later in the fall, however, we expect the fog to begin to lift, for a simple reason: the global election cycle starts winding down. This should create greater clarity on tax policy, which in turn should boost investor and business confidence. The irony is even higher taxes may raise business and consumer spirits, so long as there's clarity.

Overall, we continue to see opportunities for defensively positioned investors to selectively add risk assets to their portfolios in a few areas. In Emerging Markets, valuations are now at relatively attractive levels and in our view reflect a greater deal of pessimism about global economic growth than is warranted. Active strategies in U.S. small cap stocks are also attractive. As Steve DeSanctis, the BofA Merrill Lynch Global Research small cap strategist, noted in his July 5 report, more than 20% of the Russell 2000 index is trading below 10x next year's earnings. Those are levels last observed in 2008. In our view, this suggests there are opportunities for active and more value-oriented strategies in the small cap space. Lastly, we think the spike in currency volatility seen earlier this summer was not just a passing phenomenon. Given the role that currencies play for many global macro hedge funds, we thus see an opportunity to add to global macro strategies as another way of putting volatility to work for you.