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Capital Markets

The figurative winds of change continue to blow, but they have been reduced to a brisk, steady breeze as compared with the tornadic winds of just a few months ago. The damage that was inflicted has been assessed by policymakers, and plans for recovery and restructuring continue to emerge, but the economy remains in a fragile state as it regains its bearings. The level of uncertainty surrounding many of the fundamental drivers of the economy leave way for large gusts of unexpected change to cause further turmoil, potentially prolonging plans of a revival. However, at this time, some economic indicators appear to be potentially bottoming, while others point toward a substantial slowing in the rate of deterioration. These trends are encouraging, and anticipation is mounting for the turning point where these indicators develop into positive economic growth. The sustainability of that growth after the massive fiscal and monetary stimulus fades remains a concern.

Meanwhile, market anticipation of these shifting winds has clearly improved investor sentiment. Given the forward-looking nature of the market, a recovery is being priced in through the four-month rally that has occurred. Although this rally was likely, in part, a correction from the fear-induced overshoot to the downside, its continuation likely remains contingent on an economic recovery which has the potential to be slow to materialize. The possibility certainly exists for a reversion to the mean to occur, in which consumers resume their prior pace of consumption, economic growth trends back to a 2-3% annual range, and employment statistics improve. Whether or not the market rally falters or is sustained further will be dependent upon rising expectations for an end to the recession and an improving outlook for growth in the months ahead. That could, in fact, develop. However, if growth fails to meet expectations, or if the economy again slips into a recession next year, the rally may prove to be illusory.  

Gratuitously Unnecessary Perspective of the Month Let’s Go to the Movies! That seems to be a near battle cry when times get tough. Want proof? According to the National Association of Theatre Owners (NATO), the number of movie tickets sold in the first quarter of 2009 increased more than nine percent from last year—even though the average ticket price reached an all-time high of $7.18 in 2008. According to NATO, box office sales have increased in all of the last five recession years, because movies are one of the least expensive entertainment options out of the house. That’s good news for summer blockbusters! Source: www.natoonline.org

Domestic equities furthered their rally in the month of July, with more economically sensitive small caps outperforming their larger counterparts. Aided by the continued weakening of the U.S. Dollar, international equities followed suit with a nearly double-digit advance for the month. Considering losses in the neighborhood of 20% through the end of February, the turnaround in year-to-date equity returns are impressive. However, the strength of the foundation of this rally and its sustainability remains a question.


Source: PMFA

This month, returns were largely spurred by positive reported earnings for the second quarter, with many exceeding expectations. However, positive results appear to have been largely led by cost-reduction efforts rather than top-line growth. If consumption is slow to return to prior growth rates, earnings growth could lag as compared with previous recoveries.


Source: PMFA, Yahoo Finance

Regardless of the motivation surrounding this rally, investor fears have clearly subsided and volatility has followed suit. Based on historical ranges, a reading above 20 on the VIX Index indicates heightened volatility, while results below 20 tend to be more benign. Although the index remains slightly above 20, its downward trajectory has taken it back to pre-September levels when Lehman Brothers failed. If the ultimate recovery fails to meet expectations, however, heightened volatility levels will likely ensue.


Source: PMFA

The disarray in fixed income markets continues to heal, as particularly evident in higher risk sectors. Rising prices have accompanied spreads declining toward typical recessionary levels. Both taxable and municipal bonds provided positive returns for the month. Treasury Inflation Protected Securities, which were previously carried higher during the rush to Treasuries, were flat over the month but have performed respectably on a year-to-date basis.


Source: PMFA

Alternative investments have also benefited from increased tolerance for risk. Commodities advanced in July largely on the back of rising industrial metal prices with precious metals also providing a boost. The Dow Jones REIT Index rebounded in July, but remains underwater on a year-to-date basis and well below its peak in 2007. Despite the rally in REITs, we retain a cautious outlook for commercial real estate. Whether or not further downside in the sector is appropriately reflected in REIT valuations, however, is difficult to say. Nonetheless, we cannot sufficiently reconcile a negative outlook for the underlying assets with REIT pricing to justify taking a positive stance today.

Economy

GDP

The economy contracted for the fourth consecutive quarter according to the advance estimate from the Bureau of Economic Analysis (BEA), extending the longest period of U.S. contraction since 1947. The second-quarter estimate reported a decline of 1.0%. While this estimate bested consensus expectations and is clearly an improvement as compared to the preceding quarters, the underlying details contain mixed messages.

On one hand, consumer spending, which makes up effectively two-thirds of GDP, retreated back into negative territory at a 1.2% rate after an uptick in the first quarter. Based on the severity and duration of this recession, consumers remain focused on mending their balance sheets, causing the personal savings rate to tick higher. As consumers likely continue to retrench, we believe that a strong case can be made that this significant component could lag other post-recessionary periods resulting in slower GDP growth as the economy recovers.


Source: PMFA, Bureau of Economic Analysis (BEA)

On the brighter side, inventory levels are becoming very low after five consecutive quarters of decline. Although shrinking inventories detract from growth, a rapid ramp-up in production may be needed, to not only fulfill rising demands for goods, but to build back stock as well. This factor alone should provide a timely boost to GDP as the rebuilding cycle gathers steam. Government spending, to no surprise, was a substantial contributor to GDP – a trend that appears poised to continue through 2009.

Also included with their most recent release were the BEA’s 2009 comprehensive revisions to prior years. In general the revisions were small; however, revisions to recent quarters were noteworthy. The three most recent quarters were adjusted downward to reflect larger declines than previously reported. The chart shows the clear deterioration the economy experienced through the first quarter of 2009.

Inflation


Source: PMFA, BEA, Bureau of Labor Statistics (BLS)

Headline inflation indices surged during the month of June as energy prices furthered their advances. The Consumer Price Index rose 0.9% while the Producer Price Index reported the largest one-month change since 1990. Over the last 12 months, the economy has experienced deflation led by the fallout of energy. Excluding food and energy, core inflation indices remain positive but continue to edge downward.


Source: PMFA, BEA, BLS

The excess slack in the economy caused by high unemployment and low capacity utilization should help to contain inflation in the near term. Longer term, however, we remain cautious about the inflationary outlook given multiple factors which could potentially trigger undesirably high price pressures, including massive government spending and borrowing, rising commodity prices, and continued U.S. Dollar weakness.

Interest Rates

The U.S. Treasury yield curve was relatively unchanged over the month. Since December 2008, the short end of the curve has remained virtually flat, while longer-term yields have risen. Historically, the yield curve has been an excellent indicator of both impending recessions and recoveries. Recessions traditionally are signaled by an inversion in the curve, whereas steepening of the curve similar to what we see today often forecasts a recovery.


Source: PMFA, U.S. Treasury

Employment

The July employment release extended the trend of slowing in the rate of deterioration for the labor markets. As the severity of this recession became clearer, employers engaged in heavy cost reduction measures in late 2008 and early 2009, resulting in a steady upward climb in the unemployment rate over the last 15 months. This rate dipped fractionally in July to 9.4% as more discouraged job seekers simply stopped seeking employment.


Source: PMFA, BLS

This month, an additional 247,000 jobs were lost, bringing the running tally to 6.7 million since the beginning of this recession. We expect jobs losses to continue, even after the economy begins to turn. Confidence that economic growth has resumed will be necessary for companies to once again ramp up payrolls.



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Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.