The pace of positive economic data remained strong but fluid in the fourth quarter. Volatility was partially the result of Hurricane Sandy, as the storm wreaked havoc on a number of economic data series and normal business activity was severely disrupted.

  • One such indicator was retail sales, which bounced back in November posting a 0.3% gain. A similar pattern occurred in the personal spending data, where Outlays increased by 0.4% in November.
    •  Overall, however, it appears the consumer entered the holiday shopping season in apprehensive fashion, with the uncertainty of the fiscal cliff negotiations looming. Retailers reported meager November holiday sales results before a jump in December.
  • Manufacturing was also impacted by the storm with several important series indicating contraction in November. The all-important ISM Manufacturing index fell from 51.7 in October to 49.5 in November. Regional surveys including the Empire State and Philadelphia Fed Manufacturing Surveys reported significant business disruptions, underscoring the Sandy’s effects. Some sense of normalcy returned in December with the ISM report re-entering expansionary territory at 50.7.
  • The jobs picture was relatively stable in the fourth quarter, with nonfarm payrolls averaging 151,000 jobs per month, including a 155,000 gain in December. The unemployment rate remained steady at 7.8% in November and December.
    • The labor force participation rate was unchanged for the quarter, a closely watched factor that has had sizeable impact on the jobless rate.
    • Encouragingly, the “underemployment” rate, which adds discouraged workers and temporary workers who prefer to be full time to the traditional measure, declined from 14.7% to 14.4%. The labor market is exhibiting slow but steady progress.
  • The clear pocket of strength in the quarter was housing. Housing starts surged, climbing from 750,000 in August to 843,000 in September. That robust figure was backed up by readings of 888,000 and 861,000 in October and November, respectively, the highest levels since 2008.
    • Sales and home prices also improved. Existing home sales increased to an annualized rate of 5.04 million in November, 14.5% above a year ago and the highest level in more than five years.
    • New home sales were similarly strong, rising to 377,000, a 30 month high. Meanwhile, home prices continued to climb. The S&P Case-Shiller Home Price Index and FHFA Home Price Index hit multi-year highs during the quarter.
  • The easing campaign of global central banks continued in the fourth quarter, as thirteen banks cut rates during December and three raised rates. For the year, central banks cut rates 127 times and raised rates 31 times.
    • The Federal Reserve announced it would replace Operation Twist with an outright purchasing program. While the former funded the purchase of $45 billion per month in longer dated Treasuries with the sale of shorter dated ones, the new program will simply purchase $45 billion without conducting actions on the sell side. This will increase the Fed’s balance sheet, and is in addition to the $40 billion in mortgages the bank is also purchasing.
    • The FOMC surprised many by also announcing it was tying interest rate policy to the unemployment rate. The committee will maintain its zero interest rate policy until the unemployment rate falls below 6.5%, so long as core inflation remains below 2.5%. This raises the possibility that the Fed could end its low rate stance earlier than its previously announced 2015 target date.


Global equities continued their rally, rising 4% in the fourth quarter, ending 2012 with a fairly strong 16.8% return for the full year. Europe (+7.1%) and Asia ex-Japan (+6.0%) continued to rebound in Q4 as equity leadership clearly was focused outside of the US. Unfortunately, fiscal cliff uncertainty became a large overhang for US markets, which rose only 0.1%. In Q4, the best performing primary equity category was International (MSCI EAFE +6.6%), while the worst performing was US Large Cap (+0.1%).

  • In the US, style-box index performance was fairly mixed in Q4, with small cap value outperforming large-cap growth by 4.5%. Generally, value outperformed growth and small cap outperformed large cap.
    • Corporate executives stressed the importance of receiving clarity from Washington in order to effectively manage their businesses going forward, and continued delays on a fiscal deal impacted capital allocation decisions during the quarter. Congress came to an agreement (just past the December 31st deadline) on the tax portion of the deal, however as the decision on spending cuts has been postponed the overall fiscal picture remains somewhat clouded.
  • Europe led performance in Q4, driven by strong results in France (+10.9%), Spain (+9.9%), Italy (+9.3%), and Germany (+8.5%). The ESM backstop and plans for a banking union has reduced the overall regional risk profile. 10 year government yields in both Spain and Italy have settled well below 6%. It should be noted that the situation in Europe can only be described as stabilizing, as an extended recession is still quite possible.

Fixed Income

Core taxable bonds, as represented by the BarCap Aggregate, returned 0.2% during the quarter to take 2012 returns to 4.2%. A small increase in Treasury yields and a weakening of agency MBS offset a portion of income. The most significant event in the quarter was the Fed’s December announcement of a successor to Operation Twist.

  • US TIPS posted good relative performance to their nominal peers with a quarterly gain of 0.7%, primarily due to increasing inflation expectations driven by a brighter economic outlook and aggressive intervention by global central banks.
  • Investment grade corporate bonds were up 1.1% during the quarter. The income produced was slightly impaired by rising rates and resulting price losses. Investor demand for high quality corporate credit remained overwhelming even as yields bounced around historic lows.
  • Agency MBS lost (0.2%) to drop 2012 returns to 2.6%. Returns were driven by faster prepayments, which push premium priced agency MBS back towards par. In contrast, non-agency MBS held strong with solid gains during the quarter. The year saw a marked difference in performance between agency and non-agency MBS as elevated prepayments weighed on agency valuations while the search for yield continued to drive non-agency valuations.
  • Intermediate municipals gained 0.3% for the quarter to tally a 2012 return of 3.6%. Longer and lower quality municipals tended to outperform. The municipal yield curve flattened (long rates generally fell while short rates rose a bit) forcing valuations on long term bonds a bit higher. This activity along with investor demand for yield pushed lower quality bond valuations higher as well.
    • Lawmakers and tax policy played a major role in muni performance during the quarter. The muni markets rallied strongly after Obama’s reelection with the expectation that tax rates were increasing. However, apprehension eventually spread in the markets as lawmakers appeared willing to cap the tax exemption of munis to raise revenue. These fears led to an investor pull back and the first sustained outflows from munis in 2012 during the waning weeks of the year. Yields rose with longer maturities hit the worst.
    • Congress passed the first tax hikes in over 20 years and more look to be potentially forthcoming making the tax exemption of muni bonds more valuable. Unfortunately, lawmakers are also debating whether to cap the tax exemption for muni bonds, and/or to limit the number of issuers eligible to issue tax exempt bonds. These dynamics have contradicting effects on muni valuations and investors may be in for volatility as the market prices in the potential scenarios.


Hedge funds finished out the year with one of their better quarters in recent memory. Lower correlations and greater security dispersion allowed managers to create value through security selection and fundamental analysis. Directional strategies did well in the quarter as did diversifiers such as convertible arbitrage and event driven.

Alternative strategies finished the year with relatively meager performance. The environment was difficult to navigate for many managers and led to underwhelming performance. While index level data shows another disappointing effort for the hedge fund universe this year, there was a very high level of dispersion among alternative investments, with some managers easily beating the market and others offering a return profile commensurate with their hedged nature. An improved economic backdrop in 2013, along with lower correlations and greater security dispersion, should provide the necessary environment for managers to generate alpha.

MLPs limped to the finish line, held back by volatile and ultimately negative energy prices. They still however posted another solid year. Commodities, which were positive through QE3, sold off in Q4, dragging YTD returns into the red. With the exception of a few smaller index constituents, commodities were down across the board in Q4, with investors overlooking improving economic data from China and instead, focusing attention on election and fiscal cliff questions in the US.

Gold (-5.7%) and silver (-12.8%) were weak during the quarter despite new QE measures in the US, Japan, and Europe. Nothing in particular stood out as a catalyst for the gold sell-off, with the exception of temporary bouts of dollar strength. Looking ahead, fundamentals appear to be in the metal’s corner, as interest rates remain low, central banks are buying on dips, and a portion of mining output is in question due to continued strikes in South Africa. The main risk to the metal is investor interest, as speculative buyers now make up a larger portion of incremental demand than traditional sources ( and industry).


This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.

There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.