Conundrum Redux

Cash was king last year. Despite yields well south of 1%, cash and cash equivalents held their own in an environment wherein inflation was conspicuous by its absence. No such claim can be made for any other class of investments (no, we don’t accept contemporary art as an investment class).

Although things could have gone either way with the stock market, selling late in the year eliminated any chance of price gains for the Dow and the broader indices. The Dow Industrials fell 2.23% (before dividend reinvestment) while the S&P 500 edged lower by 0.73%.

This occurred following a fairly spirited rally from the August lows at 15,355 that saw the Dow make several valiant efforts to break back above the 18,000 level. Alas, each subsequent attempt failed at a lower high and lack of breadth helped pull prices lower as the year came to a close.

Despite much wailing and gnashing of teeth about potential Fed tightening during the year, as well as the actual event on December 16th, Treasury bonds and notes fared reasonably well with only modest price declines. Corporate bonds, however, suffered from spread widening and the high yield sector, especially extractive industries such as mining and petroleum, was hit hard by fears of a repeat of the debacle in 2008.

The Commodity Research Bureau’s Index, moreover, fell 23.4% in what was largely an across the board rout of all things taken from the earth. Gold fell 11.6% but the biggest loser was crude oil, which tumbled 32.3%.

The economy continued to limp along at a relatively slow pace during the final months of the year. Housing starts showed some oomph in November, but retail sales were up a disappointing 0.1% and 0.2% in October and November, respectively. There appears to have been some improvement in December as Christmas sales were relatively strong and auto sales, led by SUV’s, moved higher as the price for gasoline continued to drop.

Employment increases were impressive during the fall months, but wage gains were muted and the unemployment rate remained stuck at 5%. Unemployment claims ticked up a bit, but we wouldn’t read much into that as they are often volatile during the holidays.

There were notable signs of distress emanating from the manufacturing sector. The effects of a stronger dollar were felt as industrial production dropped in every month from August through November in large part due to a slump in exports. The ISM Index dropped below the key 50% level that demarcates growth from decline.

In the sporting news, the Cubs, after a storybook season during which they achieved the third best record in baseball while playing in the most competitive division, managed to lose the pennant in typical Cubbie fashion by dropping the NLCS to a team against whom they went 7-0 during the regular season. Oh well, there’s always next year.

At the end of the college football season, the Vanderbilt squad had exactly the same number of wins (four) as they have uniforms. At least one member of the Commodore Nation would be happier with more of the former and fewer of the latter. After all, one helmet, one pair of pants and two jerseys is all that Alabama requires.

Before penning this epistle, we reviewed our letter from this time last year and were sorely tempted to reprint most of it as little has changed in the intervening months as far as the economic and market outlooks are concerned. A year ago we discussed the fact that the economy was muddling along at a low pace relative to past expansions but the good news was that growth should continue unless something came along to stop it. In past cycles that something has more often than not been Fed tightening.

Despite much spirited debate about the advisability of tightening, the Fed last year delayed taking any action until their December meeting, when they announced a 0.25% increase in the Federal funds rate. Hence, growth continued to stumble along throughout most of the year. With the deed having been done, the question now is how much further will the Fed pull back on the credit reins.

In the past, the first move was typically followed relatively quickly by several more. In fact, many analysts are calling for a 1% funds rate no later than mid-year. That doesn’t sound like much and, by past standards, it isn’t. We must bear in mind, however, that what happens on the margin is most critical. We are witnessing a shift from the most extraordinary easing in history to a tightening. Modest though it may be by past standards, it is a risky bet in a world where deflationary pressures remain in evidence and massive amounts of debt are choking global growth. So, indeed, the FOMC once again finds itself in a conundrum.

We also mentioned last year that the virtuous cycle of growth can also be altered by factors that are exogenous to the economy. These tend to occur less frequently than central bank tightening, but they can be powerful, especially over short periods of time. These are typically unexpected events that precipitate a crisis in financial markets – a large default, a major bank failure, or a crash in a foreign market – factors that can be lumped together in the category of “things that go bump in the night.” The volatility in the Chinese stock market that precipitated the summer selloff in U.S. markets is an example.

So once again we begin a new year in an environment where growth can continue or falter. National election years tend to be about average as far as stock market returns are concerned (2008 was an unfortunate exception). But how can the economy founder with all of the election spending sloshing around? So relax and enjoy all of the posturing, propaganda and poll proliferation. But for safety’s sake, keep an eye on the Fed and a finger to China’s pulse.

Weaver C. Barksdale, CFA