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Equity markets gained 3 – 5% during Q1/2011, with the US posting the best performance globally (see chart below).
US equities have been rising over the last 2-3 quarters due to a slow and steadily improving economy, continued stimulus from the Fed Reserve, and a lower US dollar relative to other currencies which improves the exports and profits of multi-national US companies.
Additionally, continued slack in labor markets has kept down the price of this large input cost, keeping inflation in check for the time being.
Q1/2011 Returns for US Equities versus Emerging Market Equities
Inflation Has Been Flaring Up In Emerging Markets (EMs)
The excess supply of US dollars internationally, as well as one-time supply-restricting events (e.g. Middle East conflict reducing oil supplies, and poor Russian/Australian crop yields), have contributed to higher prices of many commodities.
These commodities are heavily utilized in EMs, where the main industries are raw material intensive (e.g. manufacturing).
In contrast, US industries are more labor-intensive and consequently are affected less. While EMs underperformed for the quarter, they began to regain strength in March and remain in a much stronger long-term growth trend.
Overall, there is evidence of greater firmness in the global economy, with only initial signs of inflation and policy tightening due to overheating.
However, inflation and interest rates are two of the largest influencers on the economy and investments, and if they continue to advance rapidly, we may see equity markets become skittish and take a breather around mid-year.
However, if commodities cool off and we see greater stability in the Middle East, equity markets should continue their bull run.
Opportunities for Active Strategies
Looking forward into Q2/2011 and beyond, we believe that the uptrend in markets will remain intact, albeit with greater levels of volatility.
As outlined in the Market Overview and Commentary section on page 1, we expect markets to continue swinging between sentiments of a strengthening US economy and risks of Emerging Markets overheating and/or global conflict/crisis.
Catalysts for volatility also exist domestically, with Congressional budget squabbles, public union fights against budget-austere governors, and the Fed’s massive Quantitative Easing program ending mid-year.
This greater level of volatility should play well with our newly rolled out Volatility Timing Model (VTM).
LGA clients in Active portfolios will participate in the action as our models flash intra-quarter signals for protecting portfolios from potential declines or exposing them to opportunities for gain.
In our asset allocation models, we have reduced US equity market exposure slightly while increasing our exposure to Emerging Markets on expectations of renewed strength.
In fixed income, we remain committed to our short US Treasuries and long high-yield debt positions that have continued to deliver gains.
In commodities, we reduced our energy exposure slightly, taking gains in positions that have risen significantly in recent months (selling high and taking profits when others are euphoric).
We continue to believe the US dollar will fall in the near term, and are holding the Canadian Dollar and Brazilian Real as a hedge against this potential decline.
Finally, we are maintaining our positions in diversifiers (long/short funds, managed futures, merger-arbitrage, etc.) as protection against any unforeseen market declines.
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