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4Q 2012 Barrow, Hanley, Mewhinney & Strauss Bond Commentary

March 29, 2013 | About:
Holly LaFon

Holly LaFon

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2012 MARKET REVIEW. U.S. stock and bond markets drifted through 4Q12 as investors awaited resolution of the Presidential election, fiscal cliff and debt ceiling uncertainty. With the status quo sustained in Congress and the Oval Office, all attention focused on a hoped for "Grand Compromise" on fiscal policy. Such hope was dashed when half the fiscal debate (the revenue side) was simply kicked into 2013. In a mere technicality, the U.S. government did drive off the much feared fiscal cliff on New Year's Eve. However, in classic "Wile E. Coyote" style, the financial and economic crashes were averted by bungee-cord jerking the dilemma back from over the brink via a legislative "Grand Charade" disguised as a bi-partisan compromise.

Optimism over a credible resolution of obstacles to more sustainable economic growth, fueled a 1.69% gain by the S&P 500 on 12/31/12, the largest final day gain since 1974. Though posting a disappointing -0.38% in 4Q12, the S&P generated a resounding 16.00% for the full year 2012. Uncertainty drove interest rates moderately higher during the quarter, resulting in a modest return for the Barclays Aggregate Index of 0.22% in 4Q12, raising the full year return to 4.22%. Investor demand for income/yield that had driven corporate bond spreads tighter and returns higher throughout 2012, continued in 4Q. The lower the quality rating, the higher the return during the quarter and the entire year. The biggest winner among 'spread sectors', was Ba/B issues which produced a 4Q return of 3.24% and a 1-year return of 15.12%. Prepayment fears from low rates and a technical spike in new supply at year-end dampened the MBS sector, which was the poorest performer of all spread product in both 4Q and the full year. Absolute returns for the respective periods were -0.22% and 2.60%, while excess returns for the same periods were -0.24% and 0.88%.

BHMS portfolios benefited from our continued overweight in spread product during 4Q, sustaining our relative performance advantage for the full year 2012. Our allocation to corporate bonds and the Financial sector in particular, contributed to performance. Portfolio strategies investing in MBS enjoyed a noticeable performance contribution from security selection based on prepayment protection.

THE U.S. ECONOMY. The economy did evidence mild improvement during 2012. After five years, the U.S. housing market finally showed life during 2012. New home sales rose, shrinking the available inventory to a respectable 4.7 month supply, an 11-year low (excluding shadow inventory). Property values in the Case-Shiller Index rose 4.3%, the strongest yr/yr gain since May 2010. Price gains have added an estimated $1T to household net worth since YE2011, which is crucial for increased household confidence and consumer spending.

While housing is recovering, manufacturing has been a different story. The ISM Manufacturing Index increased +1.2 points to 50.7 in December, indicating growth. Though manufacturing only represents 11% of U.S. GDP, there is optimism over an American manufacturing renaissance due to lower labor costs and cheaper energy (namely natural gas). While any incremental job growth is certainly welcome, most manufacturers are hiring fewer workers because of advances in technology and automation.

The most recent employment data confirms a strengthening trend with fewer first-time claims and modest additional hires. The December report showed 155K new jobs, including 25K in the manufacturing sector, but a slight rise in the unemployment rate to 7.8%. At the current rate of job gains, private-sector employment will not reach the 1Q08 peak until 4Q14. With an estimated 89M eligible workers not in the labor force, and nearly 1.4M new workers entering the eligible population during 2012, the U6 (underemployment rate) remains at 14.4%. Though the December data show a 2.1% yr/yr gain in average hourly earnings, real wages remain near 2003 levels and the median household income is now back to 1988 levels (Bloomberg).

Since consumer spending constitutes ~70% of domestic GDP, the economy still faces significant headwinds from stubbornly high unemployment and underemployment, plus zero real income growth and higher taxes. Though ironically titled "American Taxpayer Relief Act of 2012", the 'grand deal' effectively raised taxes for nearly all Americans, to the tune of ~$162B in 2013. Economists estimate this tax increase will reduce 1Q13 disposable personal income by 3.8%, a negative for consumer spending that an already tepid economy can ill afford. In addition, the debate over the $110B in across the board sequestration cuts from the still unresolved spending side of the fiscal cliff will be needed to avoid yet another rating downgrade on U.S. Treasury debt. The prospects for higher taxes coupled with any form of spending restraint will likely weigh on consumption and growth.

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