U.S. stocks advanced for the third straight month on improving economic data and expectations that the Federal Reserve will keep interest rates low despite rising commodity prices.

Large cap’s 3.43% return in February trailed their smaller counterparts during the month as investors embraced riskier investments.  Micro cap was the best performing U.S. asset class, returning 4.72%, closely trailed by Mid cap (4.65%) and Small cap (4.41%). 

The MSCI EAFE Index of international equities increased 3.38%, lifted by European stocks on hopes of progress toward a “grand bargain” solution to address the problems of weaker European countries.  Emerging Markets finished in the red as investors are concerned that aggressive monetary tightening, which would slow economic growth, is necessary to prevent inflation in these economies.

The Energy sector continued to lead all S&P 500 sector returns, as unrest in the Middle East and Northern Africa drove oil above $100 a barrel in New York for the first time since October 2008.  Utilities and Telecom – both viewed as “defensive” sectors – were the worst performers in the S&P 500.

Treasurys declined in February as investors grew more confident in global economic growth prospects.  Tax-exempt municipal bonds outperformed Treasurys in February and provided investors with a positive return for the first time in six months as record low supply helped drive up prices.  Junk bonds were the best performing investment within fixed income as the search for yield continues and corporate defaults are expected to drop to 2% in 2011 compared to the 14% default rate at the end of 2009.  The average yield on junk debt fell to a record low 7.285% on February 22 from 22.7% in 2008. 

The outperformance by junk bonds may be a sign of investors’ preference for credit risk over duration risk when seeking to increase yield.  Longer-maturity debt offers higher yield, but comes with higher duration, which means it is more sensitive to changes in interest rates.  With interest rates at record lows and expected to eventually rise, a longer-term bond with higher duration will lose more than short-term bond.  The alternative to buying longer-term debt to increase returns is to buy bonds with lower credit quality.

Soaring oil prices in response to turmoil in the Middle East and Northern Africa dominated the headlines, but all commodities made gains with the S&P GSCI Total Return Index of 24 commodities up 3.8% in February.  Commodity inflation is a concern for the U.S. economy because it tends to act like a tax on consumers – consumers spending more on food and gas have less discretionary income to spend elsewhere.  Commodity inflation is different than core inflation, which the Fed uses to guide their monetary policy and remains relatively muted in the U.S. at the present.

For Emerging Market central banks, however, broad based inflation is a bigger threat presently.  Low interest rates, high foreign capital inflows, and elevated levels of lending were already stoking inflation concerns.  Spiking commodity prices magnify the problem because food costs (as a percent of spending) make up a much more significant portion of consumer budgets and have a better chance of passing through to general prices across the economy.

The general trend in stocks continues to be higher, but there are a myriad of risks and pullbacks should be expected.  Still, investing is a long-term process and you should not overreact to likely near-term volatility.

Peter Lazaroff, Investment Analyst

St. Louis, MO

www.acrinv.com