Prima Capital’s Nathan Behan: First-quarter commentary

Nathan Behan, a senior investment analyst at Prima Capital Holdings, outlines some key recent and long-term trends in the markets in an economic report and analysis on the first quarter.

DOMESTIC EQUITY

The domestic market launched 2011 with mixed results in January as the Russell large-cap and midcap indexes were up about 2%, while the small-cap index was down just less than 1%.

This would be quickly reversed over the remainder of the quarter as small-cap stocks outperformed over the final 60 days.

For the quarter, the Russell 2000 Growth Index was up 9.2% to lead the domestic indexes, while at 6%, the Russell 1000 Value was the “laggard” for the quarter. The second week in March brought the second anniversary of the market low in 2009.

Over the two-year period ended March 31, the Russell 2000 is up 104.7% while the Russell 1000 is up 76.9%. The shortest bull market in the last 60 years was 26 months, and seven of the last 10 bull markets have lasted at least three years.

Breaking down the returns for the quarter is relatively easy for the small-cap managers.

The energy and technology sectors of the Russell 2000 were up 19.4% and 12.2%, respectively. Managers who were overweight in the financial (+3.2%) or consumer discretionary (+3.3%) sectors likely lagged both the index and their peers.

For the large-cap managers, the energy (+16.7%) and industrial (+8.9%) sectors were the leaders, while consumer staples (+3.0%) and financials (+3.5%) were the significant drags on most portfolios.

There seems to be little consensus among the managers we spoke to this quarter, other than the expectation for continued moderate growth across the economy. Most think that there will be a larger gap between the leaders and laggards in each industry in 2011 than has been the case the past two years, creating the opportunity to add value through security selection.

But the managers are split over which areas of the market offer the most potential.

Some think that the financial sector, which has seen only minimal gains relative to the other sectors over the past year, is ripe for substantial increases, particularly in large cap, where many of the banks were given the approval to increase dividends. Other managers remain in favor of the more cyclical sectors as slow growth, still-high unemployment and the weak housing market could keep the high-fliers such as technology and health care in check.

INTERNATIONAL MARKETS

The international indexes were broadly positive during the first quarter, though the country-specific results were highly variable. The Russell Developed ex-U.S. Index was up just over 4% during the quarter, while the Emerging Markets Index was up 2.2%, both in dollar terms.

The obvious exception was Japan, which fell sharply after the earthquake and ended the quarter down about 6% in dollar terms.

In Europe, the returns ranged from less than 3% in Finland and Switzerland to double-digit gains in France, Greece, Italy and Spain. The euro appreciated about 6% against the dollar during the quarter, boosting returns for U.S. investors.

The results were mixed in Asia as well, with modest gains in Australia and New Zealand, and small losses in Hong Kong and Singapore.

The emerging-markets country indexes were widely varied as well with double-digit losses in Egypt (after the civil unrest) and Peru to double-digit gains in the Czech Republic, Hungary and Russia (all in dollar terms).

After more than a year of emphasizing the emerging-markets holdings within their portfolios, we began to see a shift in attitude among many of our managers in the global and international space in the first quarter. The managers began to voice concerns about rising inflation and the inevitable government response of increased interest rates to cool off said economies.

But growth in Europe is seen as having limited upside potential and the developed Asian economies are seen as peaking.

Several managers are seeking select opportunities in Japan in the wake of the crisis there.

FIXED INCOME

The domestic fixed-income markets were generally positive in the first quarter, despite a modest upward shift in most of the Treasury yield curve.

Short-term rates were actually slightly lower at the end of the first quarter than at the end of the year. The overall curve flattened slightly as both the 2-10 (3 basis points) and 2-30 year (5 basis points) spreads narrowed.

Nominal Treasuries were the only segment of the taxable market to post a loss for the quarter, while the TIPS Index (+2.1%) posted the best return of the investment-grade segments. Continued signs of economic growth pushed rates higher for most of the quarter, though a flight-to-quality rally in early March in response to the Japanese earthquake and political unrest in the Middle East pushed the 10-year Treasury back under 3.5%, minimizing the losses in the Treasury market except in the 20+ year maturities.

This environment is conducive for active managers to outperform their indexes, as the conventional methodology is to underweight Treasuries and overweight the spread sectors.

The Barclays CMBS Index (+2.0%) was a leader again, outpacing the Barclays MBS Index (+58 basis points). The Barclays Corporate Index (+86 basis points) were again led by the financial subsector index (+1.4%).

The managers we spoke to this quarter were unanimous in their belief that the Federal Reserve will continue to be on hold through the third quarter, with most thinking that the first rate hike will come either very late in the fourth quarter or early in 2012.

As was the case at this time last year, the consensus among the managers is that rates will rise this year, even without Fed intervention at the shorter end. This has led most managers to continue to shorten the duration of their portfolios and, in some cases, begin reaching down the credit spectrum for additional income.

The overall expectation is that total return for this year will be in line with or slightly lower than the current coupon rates.

The non-investment-grade market had another strong quarter, with the Barclays High Yield Index up 3.9%. The average option-adjusted spread on the index fell more than 60 basis points, after falling more than 1% in the fourth quarter.

There is some argument as to whether risk is being underpriced, particularly in the lower -rated credits (which outperformed again in the first quarter).

MUNICIPAL BONDS

The municipal market had a substantial rebound in the first quarter as the fear of an increase in defaults proved unwarranted. The Barclays Municipal Index was up 51 basis points, with the 15-year index up nearly 1.1%.

New issuance in the first quarter was dismal, though this was expected, given the massive issuance in the fourth quarter. Along with the low level of new supply, there seems to be limited demand for the asset class as well, with more than $17 billion flowing out of muni bond funds in the first two months of the quarter.

As with the taxable managers, the consensus is for slowly rising rates through the end of the year. Many of the managers are finding values in the heart of the curve (five- to 10-year maturities) and offsetting these positions with overweights to the very shortest maturities. Unlike in the taxable market, there seems to be limited interest in the BBB rated segment.

Related Topics: Investor Research, Separately Managed Accounts (SMAs)