Key U.S. Economic News

■ Non-farm payrolls increased by 114,000 in September and payroll gains in July and August were revised higher by +86,000.  The household survey showed a significant increase in employment following three months of little change, pushing the unemployment rate down to 7.8%.  However, due to an increase in those working part time for economic reasons, the broader U-6 measure of unemployment stayed at 14.7%.

■ The Institute of Management Supply Purchasing Managers Index (ISM Manufacturing PMI) moved back into expansion territory in September, increasing +1.9 points to 51.5%.  The more leading new orders component increased +5.2 points, and the employment measure improved as well.  Eleven of the eighteen industries surveyed reported growth.

■ The ISM Non-Manufacturing PMI increased +1.4 points to a healthy 55.1%.  The business activity component climbed over 4 points to 59.9%.  The employment component fell but remains in expansion territory.  Twelve of the sixteen industries surveyed reported growth.

■ Second quarter Gross Domestic Product (GDP) growth was revised downward to +1.3% (from +1.7%).

■ Industrial production fell by -1.2% in August.  Output in the gulf coast region was restrained by Hurricane Isaac.  Industrial production is 2.8% above its year-ago level.  Capacity utilization fell by 1 percent to 78.2%, a level 2.1 points below its long-term average.

■ Durable goods orders fell -13.2% in August, the largest decrease since January 2009.  Excluding transportation, orders fell -1.6%.

■ Retail sales rose +0.9% in August and are up +4.7% year-over-year.  

■ Real disposable personal income fell -0.3% in August and real personal consumption expenditures increased +0.1%.  The savings rate fell to 3.7%.

■ Inflation measures moved higher on higher energy prices. 

■ The producer price index climbed +1.7% in August, the largest monthly rise since June 2009.  Excluding food and energy, prices were up only +0.2% for the month.  Over the last 12 months, prices are up +2.0%.

■ The consumer price index (CPI) increased +0.6% in August, with 80% of the increase coming from the gasoline index.  CPI inflation is up +1.7% over the last 12 months, still below the Fed’s target.  Core CPI, which excludes food and energy prices, edged up +0.1% for the month and is up +1.9% over the last 12 months.

■ Housing market data released in September was mixed but leans positive.

■ Existing home sales increased +7.8% to a Seasonally Adjusted Annual Rate (SAAR) of 4.82 million.

■ New home sales fell -0.3% from July’s revised rate, to a SAAR of 373,000.  Median and average sale prices increased 1%.

■ Housing starts increased +2.3% to a SAAR of 750,000, but building permits fell -1.0%.

■ The S&P/Case-Shiller Home Price Index increased +1.6% in July.  For the third consecutive month, all 20 cities recorded positive monthly changes.  16 of the 20 cities recorded year-over-year price gains.

■ The Conference Board Leading Economic Index declined -0.1%, but the coincident indicator, which measures current economic activity, increased +0.1%.

Key U.S. Policy News

The Federal Reserve launched an open-ended quantitative easing program.  The Fed will purchase $40 billion of agency mortgage-backed securities (MBS) per month until they see substantial improvement in the labor market. The Fed will continue its Operation Twist program through December, which includes the purchase of $45 billion per month of longer-dated Treasuries.  The Fed also pushed out their expectation for the continuation of zero-bound rates until at least mid-2015.

Annualized for periods greater than one year.  Past performance is no guarantee of future results.  Source: FactSet, Red Rocks Capital, Hedge Fund Research.  Total returns as of 9/30/12.

■ Investors’ risk appetite returned in the third quarter, helped by promises of additional liquidity by central banks including the Federal Reserve and the European Central Bank (ECB).  The S&P 500 Index gained +6.4% in the third quarter and is up +30.2% over the last twelve months.  

■ Through the first nine months of the year the NASDAQ has been the best performing broad market index, gaining +19.6%.  Apple (AAPL) is responsible for 5.6 percentage points of that gain.

■ Earnings growth has remained strong, with 67% of companies beating earnings estimates for the second quarter; however, only 41% of companies beat expectations for revenue growth.  

■ Energy was the strongest performing sector in the third quarter, gaining over +10%, followed by consumer discretionary (+7.5%) and information technology (+7.5%).  The utilities sector actually posted a slight decline, falling -0.5%.

■ Large caps led both mid and small caps in the third quarter and value was slightly ahead of growth.  For the year to date period, large caps have a nice lead over mid and small caps, but there has been little differentiation by style.

■ After ECB President Mario Draghi pledged to do whatever it takes to save the euro, including sovereign bond purchases, Europe staged a nice rally, gaining over +7% in the third quarter, slightly ahead of U.S. equity markets.  International equity returns were boosted by a weaker U.S. dollar, which fell over -2% during the quarter as risk appetites returned.  For the year to date period, U.S. markets maintain a sizeable six point lead over international markets.

■ Emerging markets gained almost 8% in the third quarter and are now ahead of developed international equity markets for the year to date period.  The strong gains in the emerging markets index have come despite significant relative underperformance by two large markets, Brazil and China.  India, Mexico and Thailand have all posted returns above +20% so far this year.

■ U.S. Treasury yields remain at extremely low levels and yield volatility remains low.  The 10-year Treasury note closed out September at a yield of 1.65%, just 2 basis points lower than where it began the quarter.  Yields are about 20 basis points lower than where they started the year.  

■ Corporate credit, both investment grade and high yield, has delivered very strong returns.  Spreads have tightened meaningfully on solid fundamentals and robust investor demand for yield.  In the third quarter, the Barclays Credit Index gained +3.5% in the Barclays High Yield Index gained +4.5%, outperforming the Barclays Aggregate Index by 190 basis points and 290 basis points respectively.  High yield, a beneficiary of strong mutual fund and Exchange Traded Fund (ETF) flows, has returned over +12% so far this year.

■ The technicals in the municipal bond market remain favorable as net new supply is light and investor demand for tax free income is strong.  Munis edged out taxable bonds in the third quarter.

■ Overall hedge funds have had a lackluster year as most have kept market exposure too low and have not participated in the strong equity market performance.

■ Commodities were beneficiaries of the “risk on” trade and were the top performer of all of the major asset classes in the third quarter.  The gains were broad based across the commodity complex, with only soft commodities falling in price.  Gold was up over +10 during the quarter as investors sought a hard asset in the face of more central bank easing.

■ Global Real Estate Investment Trusts (REITs) lagged equities in the third quarter but are still ahead so far this year with a gain of over +21%.  Asia has been the best performing geography while industrial REITs have been the best performing property type.

Outlook

Investors reacted to the announcement of more liquidity provided by central banks by bidding up the prices for risk assets.  With an open-ended asset purchase program and their intent to keep interest rates “low for longer”, the Federal Reserve has gone all in to promote growth.  The ECB’s commitment to purchase sovereign bonds should buy time for the peripheral European countries to put credible plans into place.  Emerging economies have greater policy flexibility to ease further if growth slows to an unacceptable level.

There are some positives in addition to accommodative monetary policy.  The housing market is healing, which could serve as a boost to economic growth as well as consumer net worth, and as a result, consumer confidence.  Low mortgage rates and rising rents have driven housing affordability to record levels; however, credit remains tight.  U.S. companies remain in solid shape.  They have solid balance sheets that are flush with cash that could be put to work through mergers and acquisitions, capital expenditures or hiring, or returned to shareholders in the form of dividends or share buybacks.  Valuation of U.S. equities remains reasonable and more attractive valuations can be found outside the U.S.

It is unclear how long this liquidity-fueled rally can continue in the face of a number of major risks.  As investor sentiment has shifted more bullish, the equity markets may have moved ahead of the fundamentals.  The major risks that concern us include:

■ U.S. fiscal cliff / U.S. election: We face a significant fiscal cliff in 2013 due to expiring tax cuts and spending measures.  With economic growth in the U.S. at stall speed, the size of the fiscal cliff could tip us into recession territory.  There will be no resolution of the fiscal cliff until after the election is decided, which will result in greater uncertainty.  We hope for a short-term extension of some of the measures, setting up for a larger tax and entitlement reform package to be debated in 2013.  Fiscal policy uncertainty has led U.S. companies to put plans for additional hires and/or capital expenditures on hold until it is clear what the rules are.

■ European sovereign debt crisis and recession: While the ECB and European Union  leaders have pledged support to the euro, actions need to follow words. Bond purchases by the ECB will not solve the problems in Europe, but it can buy policymakers time to make real reforms.  However, growth will continue to weaken in the region.  High unemployment combined with planned austerity measures have led to more social unrest.  

■ Global growth slowdown: There is evidence of a slowdown in growth not only in developed markets, but also in emerging markets. Growth in the U.S. continues to be sluggish, leaving the economy susceptible to shocks.  Europe is in recession territory.  Growth in China has slowed and continues to show signs of further weakening.  Weaker economic growth will soon flow through to earnings.

■ Tensions in the Middle East: Geopolitical risks in the Middle East are cause for concern.  A sharp rise in oil prices will be a negative shock to the global economy.

These unresolved macro risks will keep the markets susceptible to bouts of volatility as we enter the last few months of the year.  Because of massive government intervention in the global financial markets, we will continue to be susceptible to event risk.  As a result, our portfolios will continue to be positioned with a modestly defensive bias.  Instead of taking a strong position on the direction of the markets, we seek to take advantage of high conviction opportunities and strategies within asset classes.  

Notable Numbers

In Short Supply – The inventory of existing homes for sale in the United States declined by 750,000 in the last 12 months, a drop of 24% (source: National Association of Realtors).

Green Acres – Net farm income in America is projected to reach an all-time record of $122.2 billion in

2012. Net farm income was $63.0 billion in 2009 (source: Department of Agriculture).

The Biggest – 7 of the 10 largest corporations in the world (based upon 2011 sales) are in the oil industry

(source: Fortune). 

This newsletter is intended to provide opinions and analysis of the general conditions of the market and economy, but is not intended to provide personalized investment advice. Statements referring to future actions or events, such as the future financial performance of certain asset classes or market segments, are based on the current expectations and projections about future events provided by various. sources, including Brinker Capital's Investment Management Group. These statements are not guarantees of future performance and actual events may differ materially from those discussed. This commentary includes statistical information obtained from various third-party sources. Brinker Capital believes those sources to be accurate and reliable; however, we are not responsible for errors by third-party sources on which we reasonably rely. Performance data represents general indexes representative of certain asset classes and are not indicative of actual past performance of any specific portfolio managed or sponsored by Brinker Capital. 

Source: FactSet

Glossary

Barclays Capital Municipal Bond Index – A benchmark index that includes investment-grade, tax-exempt, and fixed-rate bonds with long-term maturities (greater than two years) selected from issues larger than $50 million.

Barclays Capital U.S. Aggregate Bond Index – An unmanaged market-value-weighted performance benchmark for investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of at least one year.

Barclays Capital U.S. TIPS Index (Treasury Inflation-Protected Securities) –The Barclays U.S. TIPS Index consists of inflation-protection securities issued by the U.S. Treasury. 

BofA Merrill Lynch 3-7 Year Municipal Bond Index – The index measures the performance of mutual bonds with maturities between three and seven years.

Conference Board Leading Economic Index –An American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a non-governmental organization, which determines the value of the index from the values of ten key variables. These variables have historically turned downward before a recession and upward before an expansion.

Consumer Price Index (CPI) –Consumer Price Index is a measure of the cost of goods purchased by average U.S. household. It is calculated by the U.S. government's Bureau of Labor Statistics. 

Dow Jones Industrial Average (DJIA) – The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ. The DJIA was invented by Charles Dow back in 1896.

Dow Jones/UBS Commodity Index – A rolling commodities index composed of futures contracts on 19 physical commodities traded on U.S. exchanges. The index serves as a liquid and diversified benchmark for the commodities asset class.

Dow Jones U.S. Total Stock Market – The Dow Jones U.S. Total Stock Market Index represents the broadest index for the U.S. equity market, measuring the performance of all U.S. equity securities with readily available price data.  The index was created in 1974.

Emerging Markets (EM) – A foreign economy with a low to middle per capita income that is developing in response to the spread of capitalism and has created its own stock market.  Analogous to small growth companies, emerging markets have high potential as well as high risk.  Such countries constitute approximately 80% of the global population, and represent about 20% of the world's economies.  

Exchange Traded Fund (ETF) – A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange.

FTSE EPRA/NAREIT Global Real Estate  (Financial Times and London Stock Exchange European Public Real Estate Association/National Association of Real Estate Investment Trusts®) –The FTSE EPRA/NAREIT Global Real Estate Index is designed to represent general trends in eligible listed real estate stocks worldwide.  Relevant real estate activities are defined as the ownership, trading and development of income-producing real estate.  Only closed-end companies listed on an official stock exchange are included in the index.

Gross Domestic Product (GDP) – GDP is commonly used as an indicator of the economic health of a country, as well as to gauge a country's standard of living. 

HFRX Global Hedge Fund Index – The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It comprises eight strategies: convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage. The strategies are asset-weighted based on the distribution of assets in the hedge fund industry.  

ISM Manufacturing PMI – A monthly index released by the Institute of Supply Management which tracks the amount of manufacturing activity that occurred in the previous month. This data is considered a very important and trusted economic measure. If the index has a value below 50, due to a decrease in activity, it tends to indicate an economic recession, especially if the trend continues over several months. A value substantially above 50 likely indicates a time of economic growth. The values for the index can be between 0 and 100.

ISM Non-Manufacturing PMI – ISM Non-Manufacturing Index is a gauge of business conditions in non-manufacturing industries, based on measures of employment trends, prices and new orders. Though non-manufacturing sectors make up the majority of the economy, the ISM Non-Manufacturing has less market impact because non-manufacturing data tends to be more cyclical and predictable. However, these sectors do account for a considerable portion of CPI. As a result, the figure gives insight into conditions which can impact output growth and inflationary pressures. 

MSCI All Country World ex-U.S. (Morgan Stanley Capital International) –The MSCI All Country World Index ex-U.S. is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets, except the U.S.  The index consists of 47 country indices comprising 22 developed and 25 emerging market country indices.

MSCI EAFE (Morgan Stanley Capital International Europe, Australasia and Far East) –The MSCI EAFE Index is recognized as the preeminent benchmark in the United States to measure international equity performance. It comprises 21 MSCI country indices, representing the developed markets outside of North America: Europe, Australasia and the Far East.

MSCI Emerging Markets (Morgan Stanley Capital International) –The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of June 2006, the MSCI Emerging Markets Index consisted of the following 25 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

National Association of Securities Dealers Automated Quotations (NASDAQ) – The NASDAQ Composite Index is a market-capitalization-weighted, unmanaged index that is designed to represent the performance of the National Association of Securities Dealers Quotation System, which includes more than 5,000 stocks traded only over the counter and not on an exchange. The index does not include the reinvestment of dividends.

Real Estate Investment Trust (REIT) A security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.

Red Rocks Listed Private Equity Index – The Red Rocks Listed Private Equity Index is designed to track the performance of the largest and most liquid publicly traded private equity firms principally invested in the United States and publicly traded private equity portfolios with principal investments in the United States. The publicly traded stocks within the Index are traded on any nationally recognized exchange worldwide.

Russell 1000 – Measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index. As of the latest reconstitution, the average market capitalization was approximately $13.9 billion; the median market capitalization was approximately $4.9 billion. The smallest company in the Index had an approximate market capitalization of $2.0 billion.

Russell 1000 Growth – Measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.

Russell 1000 Value – Measures the performance of Russell 1000 companies with lower price-to-book ratios and forecasted growth values.

Russell 2000 Small Cap – Measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. As of the latest reconstitution, the average market capitalization was approximately $762.8 million; the median market capitalization was approximately $613.5 million. The largest company in the index had an approximate market capitalization of $2.0 billion and a smallest of $218.4 million.

Russell 2000 Small Cap Growth – Measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values.

Russell 2000 Small Cap Value – Measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.

Russell 2500 – Measures the performance of the 2,500 smallest companies in the Russell 3000 Index.

Russell 2500 Growth – Measures the performance of those Russell 2500 companies with higher price-to-book ratios and higher forecasted growth values.

Russell 2500 Value – Measures the performance of Russell 2500 companies with lower price-to-book ratios and forecasted growth values.

Russell 3000 – This index encompasses the 3,000 largest U.S.-traded stocks, in which the underlying companies are all incorporated in the U.S. 

Russell Mid Cap – Measures the performance of the 800 smallest companies in the Russell 1000 Index, which represents approximately 30% of the total market capitalization of the Russell 1000 Index. As of the latest reconstitution, the average market capitalization was approximately $5.3 billion; the median market capitalization was approximately $3.9 billion. The largest company in the index had an approximate market capitalization of $14.9 billion.

Russell Mid Cap Growth – Measures the performance of those Russell Midcap companies with higher price-to-book ratios and higher forecasted growth values. The stocks are also members of the Russell 1000 Growth Index.

Russell Mid Cap Value – Measures the performance of those Russell Midcap companies with lower price-to-book ratios and lower forecasted growth values. The stocks are also members of the Russell 1000 Value Index.

Seasonally Adjusted Annual Rate (SAAR) – Rate adjustment used for economic or business data that attempts to remove the seasonal variation in data.  Calculated by dividing the unadjusted annual rate for the month by its seasonality factor and crated an adjusted annual rate for the month. 

Standard & Poor's 500 Index (S&P 500) – An index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe. Companies included in the index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor's. The S&P 500 is a market-value-weighted index -- each stock's weight in the index is proportionate to its market value.  

Standard & Poor’s/Case-Shiller Home Price Index – The S&P/Case-Shiller Home Price Index measures the residential housing market, tracking changes in the value of the residential real estate market in 20 metropolitan regions across the United States.  The index uses the repeat sales pricing technique to measure housing markets.  The index is calculated monthly and published with a two-month lag.

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Brinker Capital. 

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