April 20, 2011

Investor risk appetite was tested last month by the March 11 East Japan earthquake and tsunami. As the economic impact was analyzed and the scale of the nuclear disaster assessed, most equity markets outside of Japan rebounded by the end of the month to their pre-earthquake levels. At the same time, early signs of potential slowing U.S. economic growth have surfaced. The negative economic effect of the Japanese disaster will likely prove temporary, and the rebuilding efforts may provide a boost to future Japanese and global output. But continuing high oil prices are a risk to both near- and long-term global economic growth. Additionally, the scheduled June completion of the Federal Reserve's program of Treasury security purchases (dubbed QE2) raises the specter of less-accommodative monetary policy and, therefore, lower prospective growth.

While we think the primary driver of oil prices is global economic growth, the current turmoil in the Middle East and North Africa has added a risk premium. We don't see a clear path to eliminating this premium over the near term, as political progress in the most tumultuous countries is slow. Central banks are also powerless to address a price hike caused by a supply shock, such as the current situation in Libya. However, the European Central Bank (ECB) has recently joined many emerging market central banks in raising interest rates in response to rising inflation concerns.

We don't see the Fed joining this party until the first quarter of 2012 at the earliest. We believe the Fed will embark on "QE2.5" this summer, by reinvesting portfolio proceeds, to keep its balance sheet from contracting and tightening monetary conditions. In the face of potential fiscal drag from spending cuts, and a growth headwind from high oil prices, this would mitigate another drag to growth. While we see it as unlikely, we don't completely rule out the prospects for QE3 should U.S. economic growth begin to falter.

U.S. Equity

• Cash-flow yields relative to bonds have continued at elevated levels
• U.S. equities are expected to withstand a potential economic slowdown

EAFE and Emerging Markets

• Emerging-market inflationary pressures have continued to build
• The European Central Bank has joined the rate-raising crowd

Fixed Income

• Borrowing costs for investment-grade financial companies have continued to decline
• Bond investors have been gaining confidence that large financial institutions have the ability to weather another shock

High Yield

• The collapse in leveraged loan issuance in 2008 and 2009 was expected to pressure the high yield market in confronting financing needs in 2013–2016
• The recovery in leveraged loan issuance has relieved the burden on the high yield market

Global Real Estate

• Global real estate investment trusts (REITs) posted negative total returns in the month of March
• The FTSE EPRA/NAREIT Global Index has returned more than 18% during the last 12 months

Hedge Funds

• Hedge funds, on average, declined slightly in March
• Asian hedge fund managers nimbly invested during the disaster

Commodities

• The weak dollar continued to drive commodity prices higher
• Poor weather and emerging-market demand also boosted prices

Conclusion
The first quarter of 2011 was an excellent one for risk assets, with the S&P 500 Index returning nearly 6%, large European stocks up 4.5% and Chinese shares gaining 4.3%. The strength of the global economic recovery was enough to offset the exogenous risks of the East Japan earthquake, rising oil prices and the European debt crisis. But early in the second quarter, some concerns have started to surface about the recovery's pace.

Our current view is that a slowing in economic growth will not lead to a recession, and in that environment, we think an investor can experience positive returns from both stock and bond markets.