A quick note before we get started- 2012 marks the beginning of our third year publishing the IHA Monthly. A great source of pride for us. We thank-you for your encouraging feedback and we thank-you for reading. Here's to another great year.

Without further ado...

One of the features of the financial markets over the last decade has been increased correlation of world equity markets. With interconnections between national financial systems and global business cycles it often seems that all markets move together. Over the last couple of years, the terms "risk -on" and "risk-off" have been adopted by the financial media to describe this phenomenon, highlighted by the introduction of two new exchange traded notes that allow investors to trade either strategy. What has been lost in this view is that even if markets are correlated, they do not always produce the same return. Looking at 2011: daily correlation between U.S. and international developed markets was 94%... and between U.S. and emerging markets the correlation was 87%. Keep reading because as U.S. large caps had a mildly positive year in 2011, international developed markets lost over 12% and emerging markets were the big loser- down over 18%. In this month's newsletter we look at some of the key indicators from each of those regions.

United States

The U.S. was the safe-haven market in 2011 as economic performance continued to muddle forward despite the train-wreck unfolding in southern Europe and the mid-year slowdown in emerging markets. The primary indicator of national economic health is employment and the number of jobs in the U.S. grew by 1.2% in 2011. Employment growth will continue to be the focus in 2012. One of the strengths of the U.S. is labor mobility and the fluidity of capital towards areas with the perceived highest return. The following chart  shows the overall employment level for the country since the start of the recession in December 2007 along with the employment levels for two of industries that were leaders before the recession (Real Estate Sales/Leasing and Residential Construction) and two of the industries that have been growing employment since the recession started (Oil and Gas Extraction and Computer Design/Support).  

This shows that even in the worst of times, some industries can expand and help lead a recovery. Some key points to mention: the total number of people employed by the expanding industries is much smaller than those employed by the shrinking industries; and there is a skill gap to overcome-selling condos in Vegas doesn't prepare you very well for extracting oil in North Dakota. However, jobs dynamism is the primary reason the U.S. market outperformed last year. 

International Developed Markets 

This includes much of Europe, Japan  and Australia. As we detailed last newsletter, it is the lack of jobs dynamism in much of Euroland that is having such a significant effect on their sovereign debts. Those debts are held in European banks and the question of whether the problems associated with them will be contained within those European banks is the question of 2012. If it appears the Europeans are reaching a deal whereby Germany and the northern European countries will guarantee everyone's bonds, then the rates paid by the southern European countries will decline to a level closer to their German counterpart. If a deal is not reached those widening spreads will force one of the big, southern nations to default and very possibly cause the dissolution of the Euro.  

The tightening of spreads over the last month (as indicated in the above chart) is due to the announcement of a three-year financing facility for Euro banks by the European Central Bank. This was seen as a welcome measure by the market which has been looking for the ECB to massively expand their purchase of European sovereign bonds (similar to what the Fed has done here). The ECB has been unwilling to do this without the express authority of its member governments and the facility they opened is not a long term answer but the markets have taken it as an indication that the ECB wants to do more and is willing to be a little creative in how it accomplishes that.

Emerging Markets

In light of 'forced' U.S. and European deleveraging, due to the massive build-up of debt in their public and private sectors, a reasonable expectation would be for investor attention to move toward the growing emerging markets. After all, Goldman Sachs famously predicted that the BRIC nations (Brazil, Russia, India, China) could constitute four of the six biggest economies in the world by 2050. But after a quick recovery to the financial crisis of 2008-2009, most emerging markets had a very disappointing year.  The following chart shows the performance of the primary stock indexes for the BRIC nations in 2011.

Black- Brazil    Red- India    Green- Russia    Purple- China

The question with emerging markets is whether they can develop the internal demand necessary to sustain economic growth regardless of what happens in the developed world. Most of the countries that fall into this category, led notably by China, tout an economic model that emphasizes trade surpluses and tight currency controls. It is a legitimate question to wonder whether this simply makes them high beta plays on economic growth in the developed world. 

Looking forward into 2012, it appears the biggest risks to U.S. financial markets will come from abroad, either the Euroland sovereign debt/banking crisis or a hard landing in China. Barring bad news on those fronts, the U.S. markets should gain even if the lackluster domestic growth continues (this seems the most likely scenario). On the bond front, interest rates are at historic lows but with the ECB's new President Mario Draghi already cutting rates, China and Brazil recently announcing plans to ease monetary policy and with the Federal Reserve ever more dovish there does not appear to be much pressure on rates to rise.  

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