2012 Economic and Investment Forecast

Similar to last year, this is the forecast of what we expect may happen in the economy and the equity and fixed income markets this year. While we will rely on this forecast as we manage portfolios, it is subject to change as conditions warrant. Like 2011, we will offer a review and update mid-year and then an end of year summary.

Economic forecast

We expect modest growth that is in the middle of the range set by the Federal Reserve. The Fed’s estimate of 2.2% to 2.7% growth in GDP is substantially lower than last year. Our estimate for GDP growth is in the range of 2.0% to 3.0% but we are targeting 2.5% for the year. The World Bank has forecasted global growth of 2.5% with strong growth in emerging markets offsetting weakness in Europe. The World Bank has also warned that global growth could be derailed by a potential hard landing in China, an expansion of the fiscal crisis in Europe, or something like an oil shock. We share those concerns. As in 2011, if things do not unfold as we see them, investors would likely retreat to cash, treasuries (safe haven), and gold. We do need to see consumer spending continue to grow to offset a decline in government spending. Expectations are that the consumer will show slow, but steady progress and that businesses will likely show a positive increase in spending too. Throw in a soft landing in China, some positive news from Europe, and progress on U.S. budget deficit and overall debt picture and this could be a good year. However, because things seem to change on a daily basis, volatility is probably one thing that won’t change.

Summary of 2012 Economic Forecast

• GDP will grow around 2.5% for the year
• Europe likely in a recession and may become the “new” Japan with very slow growth and potential deflation
• Policy makers in the U.S. will likely not make significant progress on fiscal issues until after the fall elections
• The Federal Reserve has initiated a new “open door” policy on their discussions and have indicated that they will likely not adjust short term interest rates until late 2014
• Interest rates will likely hold steady due to little or no Fed action
• Unemployment will likely moderate in the 8.5% range
• Inflation will settle slightly to around 2.5% although food and energy prices could force adjustments to the expected rate
• The U.S. dollar will likely increase slightly due to U.S. growth and safe haven status which will impact exports negatively
• Consumer and business spending will pick up slightly

EQUITY MARKETS

Last year we were coming off a year in which domestic equity markets all posted double digit gains and so we expected a return to more average returns in 2011. While lower returns were forecast, no one really expected the level of volatility that we saw, nor the flat to negative returns that were experienced. Many of the same investment advisors are bullish on stocks again this year and look for the broader equity markets to show an approximate 9% gain, which, interestingly enough, is virtually the same as what the consensus said last year. Why? Several factors weigh in just like last year, including concerns over the bond market, a stronger economy, and stock valuations that are below long-term averages. Stocks should benefit from fund outflows in bond funds into equity funds as the economy heats up and fears over rising interest rates take hold. Our expectations are slightly more muted as we expect the broader markets to continue trading in a wide range but end the year approximately 8% higher on the S&P 500 while the mid and small cap indexes could finish slightly better.

Certainly this year will have its share of ups and downs and various sectors will be impacted at different times. As usual, this means that diversification will be very important element to portfolio management. Finally, we have seen the market move very strongly both upward and downward at times over the past couple of years but history tells us that we may still be in a trading range and not yet ready to break out and start a new bull market. If that is the case, we will likely see volatility in returns as well.

SUMMARY OF 2012 EQUITY MARKETS FORECAST

• Consensus bullish feeling on stocks forecasting 9% gains in the market
• Our outlook is somewhat more muted at an 8% gain on the S&P 500
• Corporate earnings will grow by approximately 10%
• Earnings comparisons will be more difficult than the past year or two
• Large, multinational dividend paying corporations will lead the way
• Small cap stocks will benefit from a growing economy
• Tech, consumer discretionary, and industrials will be leading industries
• Healthcare stocks will continue to show strength
• Emerging markets may present some opportunities
• Commodity prices may moderate
• Dividend paying stocks will outperform

FIXED INCOME MARKETS

The performance of the bond market was one of the shining stars in 2011 as interest rates generally remained low and the volatility in the equity markets caused investors to seek more stability. While we expected the bond market to show a reasonable return last year, we expected most of the return to come from the yield and only minimal return from a capital gain standpoint. The returns surprised to the upside as capital growth was strong again. We do not expect 2012 to show the same strength as in 2011 as the Fed has announced that they intend to keep short term rates down until late in 2014 at the earliest and we do not expect the same, extreme level of volatility this year. The bubble bursting scenario that has been talked about on and off again over the last few years seems to have subsided as well. Slow, steady economic growth should continue to minimize those concerns. Returns will be lower than the last couple of years, however, if the economy continues to improve, progress is made on the fiscal crisis in Europe, and inflation cools down as expected. Adding pressure will be the real possibility of market rates ticking higher in the second half of the year, especially on the ten year treasury.

Finally, because we do not expect rates to move dramatically higher, certificate of deposit and money market tools will not add value to portfolios in 2012. Seeking alternative tools to invest short term funds will again be a critical evil for portfolio managers. Short-term individual bonds, ultra-short bond funds, and other similar tools will be used to add some value in the short run. As rates begin to tick higher, dollars invested in these alternative investments will be moved back into more traditional vehicles for parking cash.

SUMMARY OF 2012 Fixed income MARKET FORECAST

• Interest rates not likely to move dramatically higher
• Interest rates likely to tick higher later in the year as the ten year treasury could hit 2.5% plus
• Fixed income return expectations should be lowered and returns will primarily be determined by yield
• Slowly growing economy should prevent a bond bubble bursting scenario
• Corporate bonds preferred over treasuries
• High yield securities will be main source of additional yield although less so than in the past
• Opportunities will be available in muni markets but budget problems do pose some risk
• Treasury Inflation Protected Securities may be under some pressure in the short run but long term prospects continue to show strength
• Floating rate securities provide some protection should rates slowly rise
• Alternative tools such as ultra-short bond funds and short-term individual bonds will be used to park short term cash not needed for distribution needs
• Economic and political turmoil may stress markets but likely less so than 2011
• Budget deficit concerns may force rates higher should no progress be made in Washington

Should be a fun year!  Let us know what you think.

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