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2011 – Year of the Bond (and Bund)

Big questions about economic growth around the world were the primary drivers for investment returns in 2011. Equally as important, though, headlines about policy makers’ attempts to address the important sovereign debt issues in the Eurozone (but also in the U.S around the super-committee’s failures) moved markets dramatically in both directions. Because of the uncertainty, markets bounced back and forth between optimism (risk-on) and pessimism (risk-off). This continued a trend of the last few years but can make investing maddeningly frustrating for many of us used to focusing more on fundamentals than headlines.

In this environment, there were a limited number of big beneficiaries for 2011 and one was clearly U.S. Treasury Bonds. The Barclays U.S. Aggregate Government/Credit Index generated a positive return during the quarter and returned 8.74% for the full year as investors flocked to relative safety of bonds, and most particularly U.S. Treasuries, which are currently enjoying safe haven status in contrast to most sovereign bond markets in Europe. The exceptions in Europe were a few other safe havens, such as German Bunds (their equivalent of treasuries; up 10% for 2011!), which we do not own.

Balanced Funds also benefitted from exposure to bonds but were held back somewhat by equity holdings. While equity markets in the U.S. had a dramatic rebound off of the September 30, 2011 lows, the Standard & Poor’s (S&P) 500 finished the year barely positive; and smaller stocks fared worse. International equities took the brunt of the damage, with the MSCI All Country World Index Ex-U.S. down 9.4%.

As mentioned, market benchmark performances were impacted by the sea changes occurring in Europe. Fiscal concerns in Greece spread through the year to Italy, Spain, France, Belgium and the Netherlands. The most recent European “Summit” in December resulted in a promise to pursue greater fiscal integration, to relax terms and collateral requirements for banks to receive liquidity from the European Central Bank (ECB), a pledge by the European Union (EU) to loan the International Monetary Fund (IMF) $268 billion, and, most significantly, a pledge by the ECB to extend loans to banks for three years. Markets participants were somewhat satisfied, but were hoping for more direct ECB intervention in sovereign debt markets.

There were positive developments; especially here in the U.S., where it is clear we can avoid recession for now, despite a dramatic slowdown in Europe. Economists forecast that Q4 GDP will come in around 3%. Here in the U.S., economic fundamentals have improved, but with some important caveats. New unemployment claims have fallen recently and the unemployment rate dropped to 8.5% (although part of the improvement is being caused by a lowering of participation rates). Auto and holiday sales have been consistent with 3% plus growth in Q4, but the personal savings rate has declined from 5.2% in early 2011 to 3.5% in October, raising questions about whether these personal consumption expenditure increases are sustainable. Business spending has been improving, buffered by record corporate profitability and margins. All in all, there’s reason to be optimistic but not overly so. High government and consumer debt and continued political gridlock persist as hindrances.

For 2012, real GDP is likely to be moderate – in a range from 2.0% to 3.0%, while inflation is generally expected to be in the 2-2.5% range. The Federal Reserve is likely to keep its benchmark interest rate at zero to ¼ percent for an extended period while they consider other forms of monetary easing to help re-ignite the economy. Risks include the end of the payroll tax holiday (which, at the time of this writing, had only been extended by Congress through February 29, 2012) and cessation of emergency unemployment compensation in 2012, a more severe slowdown in Europe than currently expected, and slower economic growth in other parts of the world, including China. It is important to mention, however, that policy makers around the world have started to cut interest rates, and there is much room to lower rates further as global inflation expectations moderate.

As for equities, valuations remain at attractive levels, with the S&P 500 Index trading at just over 12 times the next-12 months’ earnings forecasts. Corporate balance sheets remain strong, supported by record levels ($2 trillion) of cash. The rampant pessimism among markets participants means that any positive resolution out of Europe may result in large-scale allocation towards equities from bonds. Within equities, we like high quality issues in the U.S. but also increasingly favor emerging markets equities, where valuations, dividend yields, and home country fiscal situations are markedly better than those in many developed nations.

Bonds remain a safe haven in this difficult period of uncertainty and volatility, but the favorable recent performance of U.S. Treasuries, in particular, make it hard to imagine that the upcoming decade can be as strong versus equities. In this light, we are continuing to look for opportunities to tilt the balanced portfolios (those that own both stocks and bonds) toward equities.

- Dave Klassen
Chief Investment Officer

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