Market Overview

The global rally in financial assets that began in March marked a sharp reversal in investor sentiment and, by year-end, helped recover a substantial portion of the prior year’s losses. Buoyed by improving economic data in many global markets and rising confidence among both consumers and manufacturers, U.S. stocks rose 25% to 30% for the year as a whole. Contrary to the risk aversion which characterized the financial markets in late 2008, riskier assets such as emerging market stocks and below-investment-grade bonds led the markets higher in 2009.

Government stimulus made a significant positive contribution to growth, whether through the support of auto sales or delinquent mortgages. Despite an increase in long-term interest rates as the year progressed, most bond portfolios posted strong results on the considerable improvement in credit spreads for corporate and structured debt, while bond market liquidity vastly improved due to aggressive government intervention and near-zero short-term lending rates. Government deficit spending and stimulus spending were initially well-received, but concerns grew by year-end over the consequences of the unwinding of these massive programs. By the fourth quarter, sovereign debt risk had replaced credit risk as investors’ foremost worry, and questions about the stability of the European Union pressured the euro and strengthened the dollar.

Inflation expectations in Europe and in the U.S. remained subdued, despite an uptick in the consumer price index (CPI) in the fourth quarter driven by rising energy prices. At year-end, expectations for consumer price inflation in 2010 averaged 1.2% to 1.5%. Japan remained the exception, with deflation there expected to deepen as fiscal remedies continued to prove ineffective. In the U.S., the Federal Reserve’s intent to maintain its near-zero interest rate policy for the foreseeable future penalized savers as cash investment returns were negligible. Despite this unusual level of financial easing, meaningful inflation remains unlikely over the near term due to high unemployment, excess capacity globally and ongoing consumer debt reduction.

Equities
After a weak start to the year, stocks rallied strongly beginning in early March as investors gained confidence that the worst of the financial crisis had abated. The market was led higher by the previous year’s most downtrodden issues, many of which (financials in particular) had fallen by 90% or more. Cyclical stocks outperformed the more defensive staples and healthcare issues, while currency gains against a weak U.S. dollar augmented returns from non-U.S. stocks. Valuations had reached relatively depressed levels by March, although price-to-earnings multiples returned to normal levels by year-end and future returns will depend more on top-line revenue growth than the cost-cutting and inventory replenishment that supported performance in 2009.

Cash and Bonds
The flight to safety at the end of 2008 drove long-term government yields down to extremely low levels, and 2009 saw a substantial steepening of the U.S. Treasury yield curve. Cash yields remained near zero and, aside from extending maturity, investors found little ability to enhance returns. Such moves tightened interest rate spreads on short-maturity debt as the year progressed. Longer-term interest rates rose on worries over the massive levels of federal debt issuance expected over coming years, as well as on concern over the planned withdrawal of government support in the Agency and Treasury markets in 2010. Corporate bonds, particularly financial issues, as well as commercial mortgage-backed and asset-backed issues posted very strong results on demand improvement. Low cash yields and abundant market liquidity encouraged investors to take on more bond risk as the year progressed.