2011 in Review and 2012 Outlook By: Gabriel PotterMBA, AIFA® 2012.01.05


Reviewing 2011:  Highlights by Sector

The sound and fury of 2011’s explosive volatility was, ultimately, anticlimactic.  2011 was marred by inconsistent or anemic progress in broad economic measures such as employment, housing, or consumer confidence.  The conclusion is that US broad market - measured by the S&P 500 - ends 2011 almost precisely where it started on January 1st.  In our ongoing effort to approach the world in new ways, let us consider some of 2011’s biggest news stories and their impact to different market sectors.

The Arab Spring and the Energy sector

The Arab Spring has seen the outright fall of 3 governments thus far:  Tunisia, Egypt and Libya.   Other countries in the region have had to respond to the popular demands for economic and political reform with economic concessions (e.g. - Saudi Arabia), transition deals (e.g. - Yemen) or military action (e.g. - Syria).  This area of the world is a major region in oil production.  Thus, the Arab Spring has put undue volatility on the price of oil.  Constant threats from Iran indicate continued tension though 2012.  Given that energy is a significant input to nearly every economic endeavor, the volatility in energy prices put a strain on the already tenuous global recovery. 

Many energy producers, acknowledging the additional political volatility of the eastern hemisphere, have gradually moved fuel production back towards the western hemisphere.  Technological advances (oil-sand refinement; hydraulic fracturing) have created opportunities in North America energy stores previously thought to be depleted or inaccessible.  Going forward, we expect energy producers to continue their trend and shun politically challenging regions in favor of domestic & regional (Canada, Mexico) production.  We also expect continued diversification through alternative energy.  This sector is moderately outperforming the broad market.

Japanese 2011 earthquake and the Information Technology sector

The Japanese government estimates damage from the March 2011 earthquake at $300 billion, but the indirect effect of the tsunami and radiation fears surrounding the Fukushima nuclear power plant were also significant.  Japanese components are integral to global supply chains.  Japan manufactures one fifth of global semiconductors and is also a major producer for flash memory.  To date, Japan’s economy has mostly recovered from the disruption.  This sector is performing in line with the broad market.

Occupy Wall Street and the Financial sector

The Occupy Wall Street protest which began in September 2011 may not have a cohesive platform, but it is hard to ignore.  The financial industry, already under additional regulatory pressure from the Dodd-Frank Wall Street Reform bill, now has to cope with a public relations problem, the threat of additional regulation (e.g. – reinstatement of the Glass-Steagall Act) and decreased legal protections (e.g. – revocation of corporate personhood).  Furthermore, the housing market – facilitated by financials – continues to dig through distressed properties and the aftermath of the 2008 Subprime Mortgage collapse.  This sector is sharply underperforming the broad market.

Healthcare reform and the Healthcare sector

The passage of the Health Care Reform bill in 2010 is definitely not the end of the health care debate.  There are active legal challenges to the bill – prompting the Supreme Court to rule on the constitutionality of its individual mandate provision.  Arguments are slated for March 2012 and the ruling is expected by June.  Also, there are ongoing efforts to design alternative health care plans; most recently, on December 19th, Representatives Paul Ryan and Ron Wyden submitted an alternative proposal to restructure Medicare.

In practical terms, most of the provisions of the Health Care Reform bill have not yet taken effect.  Furthermore, the largest companies in the sector are pharmaceutical companies (Johnson & Johnson, Pfizer, and Merck) which are not likely to see diminished demand given the demographics of the United States and a retiring baby boomer population.  This sector is strongly outperforming the broad market.

International weakness and the Materials sector

The United States, for all of its problems, is doing better than other countries this year.  US equity is outperforming global equity.  US sovereign debt is outperforming global debt.  A great proportion of the global developed market is represented by the Eurozone.  Readers of global news events - or Westminster Consulting’s monthly newsletters – will know that the Eurozone crisis has shook up developed markets rather painfully.  Furthermore, some large emerging market economies - such as China - have relied on providing cheap labor and cheap exports to developed markets, rather than promoting domestic demand.  Thus, the weakness in the developed markets actually formed a disproportionately bad impact towards emerging market economies. 

The materials sector provides the raw materials for economic expansion – including mining, refining, and chemical production.  Merrill Lynch research notes that the materials sector is largely driven by foreign sales and foreign sales growth.  This sector’s relative performance depends heavily on global growth.  Given the diminished expectations for international growth, it should be no surprise that materials sector has sharply underperformed the broad market year-to-date.

The defense budget and the Industrial sector

The wind down of the Iraq war and the sequestration of the defense budget following the Super-Committee failure in November is projected to limit the growth of the defense industry within the industrial sector.  Other industries in the materials sector such as freight & courier service (e.g. – FedEx), industrial conglomerates (e.g. – General Electric) and industrial equipment (e.g. - Caterpillar) are strongly influenced by global growth trends – which are, again, weak.  This sector is modestly underperforming the broad market.

How recession fears impact the Consumer Staples sector and the Utilities sector.

Even in a recession, consumers will still buy essential products (food, beverages, tobacco, essential toiletries).  Thus, the companies that make these indispensible products tend to outperform in markets that are driven down by fears of a global recession.  So, we are unsurprised that this defensive sector has moderately outperformed the broad market.

Like consumer staples products, consumers will still tend to keep their utilities running (water, gas, electricity) even in a recession.  More accurately, programs like the Home Energy Assistance Program (HEAP) exist to keep utilities running for low-income households.  Thus, the companies that produce these indispensible services tend to outperform in recession wary markets.  Again, we are unsurprised that this defensive sector has significantly outperformed the broad market.

Spending habits and the Consumer Discretionary sector

It is unsurprising that the Consumer Discretionary sector is a little weak this year given the recession fears that knocked the markets back in the 3rd quarter of 2011.  Job growth numbers have improved recently, but unemployment is still roughly 9%; unemployed consumers simply have less disposable income to spend on non-essential goods and services.  Furthermore, consumers have not demonstrated eagerness to spend all of their income, opting instead to increase their savings or to pay down outstanding debts.   2011 Holiday retail sales have been strong, but sales have been sharply driven by discounted goods (with smaller profit margins) as cost-conscious consumers hunt for bargains.  This sector has moderately underperformed the broad market.

Company specific activities and the Telecommunications sector

The Telecommunications sector is notably concentrated to a single industry and in its largest players (AT&T, Verizon), so the discussion of this sector reflects individual company narratives.  For instance, AT&T accounts for 20% of the Telecom sector all by itself.  AT&T has had a rough year; in August, the Justice Department blocked a $39 billion merger with T-Mobile.  Furthermore, AT&T lost exclusive rights to the successful Apple iPhone in February 2011. 

Consumers have more leverage as key products and cell phone services are sold separately (“unbundling”), but this is somewhat offset by rising global demand for voice and data plans.  Overall, the sector continues to face pressure as wary consumers continue to bundle services (television, internet and phone) when prices are best.  Alternatively, many consumers are cutting fixed telephone lines and exclusively using cellphones, or eschewing costly cable TV subscriptions for online streaming options (e.g. - Netflix, Hulu).  Meanwhile, wireless & internet carriers suffer higher capital costs from high and increasing network demands.  AT&T did relatively better than the Telecom sector, but both AT&T and the Telecommunications sector underperformed the broad market.

The Outlook for 2012

Looking backwards is relatively easy.   The harder question is:  What’s going to happen in 2012?  Of course, there are no guarantees, but our base case scenario is that the markets will continue to be pulled by technical factors:  market momentum, energy shocks, crisis driven declines and – potentially – quick recoveries.  At the ground level, fundamental analysis suggests that the corporate America continues to dig through its problems at a slow, but encouraging, pace.  The greatest threats to the continued recovery are technical, but not immaterial.  For instance, a poorly conceived proposal to break up the European Union combined with weak macroeconomics could push investors from heightened anxiety to full-fledged market panic. 

Interest Rates:  In August 2011, the Federal Reserve made a rare promise to keep short term interest rates near zero through 2013.  To maintain credibility, we expect the Federal Reserve to keep that promise.

Inflation:  The Fed has a dual mandate – maximum employment and stable prices.  Given their explicit long term promise, the Federal Reserve sees no imminent danger from over-target inflation despite the exceptionally low rates and the expansion of the monetary base.  The Federal Reserve does not have an explicit inflation target, but informal analysis suggests that the Fed is comfortable when inflation is between 0% and 3%.  Disinflation, always a threat in economic downturns, will be attacked as necessary by further expansion of the monetary base.

Growth:  The downside is that the Federal Reserve does not project an economic expansion strong enough to drive up prices.  The consensus from other institutions and other investment banks reinforces this view.  For example, Goldman Sachs worries that the temporary fiscal stimulus (e.g. – tax cuts, infrastructure incentives) will expire too quickly and the fiscal drag will be too high for the economy to grow at full recovery levels.  Merrill Lynch worries that budget reduction measures, a weak Congress and a mild international recession will lead to weak US GDP growth.  Here is a sample of US Gross Domestic Product estimates for 2012:


US GDP growth (base case)

Last Updated

Morgan Stanley


Dec 2011

Goldman Sachs

1.5% - 2.0%

Dec 2011

Bank of America / Merrill Lynch

1.0% - 2.0%

Dec 2011

Federal Reserve

2.5% – 2.9%

Nov 2011

International Monetary Fund (IMF)


Sep 2011

World Bank


June 2011

Government Policy:  The actions of US policy makers, and their collective inactions, have had a disproportionately high effect on the markets this year.  (For example, the debt ceiling debate, the payroll tax fights, tariff threats, and so on.) We would hope that fundamentally-oriented, company & industry specific actions would resume control of the economy’s direction, but we find that unlikely.  Rather, we expect the heated rhetoric and policy proposals for the fast approaching 2012 election to dominate the national mood and, by extension, the market’s direction. 

Volatility:  Perhaps the one thing that nearly everyone - both market optimists and pessimists - agrees on is that volatility will continue to be high.  There is insufficient clarity over several large potential problems (US fiscal policy, Eurozone dissolution, tax cut expiration, geopolitical flashpoints, trade wars over currency manipulation, etcetera) to expect market stability.  

Bear Case Scenarios:  There are some truly spectacular ways that the global economy can fail, and worst case scenarios are not hard to imagine.  For example, it is not likely, but it is entirely possible that the new leadership in North Korea, in an effort to consolidate power, could provoke their neighbors beyond their tolerance and begin a dangerous regional conflict with painful consequences including weakened global growth.  Another bear-case scenario could be an immediate, poorly conceived dissolution of the Eurozone.  Continued sovereign downgrades are quite possible, even probable.   Even potential improvements in the economy may prompt another commodity price spike - like what happened in summer 2007- that would derail growth before it even starts.

Bull Case Scenarios:  On a fundamental level, corporate health is stable and global growth is projected to continue despite the ongoing pressure.  Positive scenarios would lower the risks that threaten continued growth and confidence.  A wish-list of positive events includes a solid plan for strengthening the Eurozone (with genuine enforcement and potential abrogation of delinquent countries), a practical strategy for long term fiscal solvency in the US without derailing the recovery, improved domestic consumption in China, or self-reinforcing improving consumer sentiment.

Our Base Case Scenario:  Recall that most of the issues that the US is currently dealing with existed last year, and the economy continued to advance, sporadically and inconsistently, but forward nonetheless.  Furthermore, the catalysts for improvement (discount valuations, robust earnings, improving housing starts), offer hope to US equity investors willing to tolerate the short term instability and the medium term risks to global growth.

In other words, our base case is “more of the same” because the underlying causes for optimism and pessimism have not moved much.  Some problems have gotten worse.  For example, the Eurozone crisis has moved from a low priority irritant to high profile disaster that many investors would like to have an immediate – but impossible - resolution.  Some problems have improved.  For example, job growth in the US has been only modest (with 1.6 million new jobs in 2011), but the unemployment rate has improved slightly and job cuts, especially in the public sector, are projected to ease.

In totality, however, our base case assumes an economy in 2012 that performs approximately as well as 2011 and 2010 before it – slow and subpar growth.  The market’s reaction to that environment is harder to predict.  In 2010, the market was getting over fears of a worst case scenario and reacted by moving sharply higher.  In 2011, the expectation was for a 2nd half improvement in global growth; that did not happen, so the market reversed the 1st half gains.  Naturally, we do not have the ability to predict the future, so we instead encourage our clients to maintain their prudent, long term approach to investing.  We look forward to continuing the conversation with you.













 http://online.wsj.com/article/SB10001424052970203479104577124494272500550.html?mod=googlenews_wsj http://money.cnn.com/2011/08/09/news/economy/federal_reserve_meeting/index.htm












Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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