August 2011

 Executive Summary

• A looming U.S. default and stalemated policymakers gripped equity markets in July, driving them lower for the third consecutive month.
• Bonds were once again the beneficiaries of uncertainty and fear, as a flight to quality pushed Treasury yields lower and bond prices higher.
• The pace of economic growth slowed more than expected in the second quarter and revisions to prior periods were also surprisingly negative.
• The July jobs report was better than anticipated, but the pace of job growth continued to disappoint.
• Inflationary pressures are showing signs of ebbing, providing some relief to consumers.
• Against the backdrop of a slowing economy, contained inflation, and languishing jobs market, the potential for the Fed to provide additional stimulus is increasing.

Capital Markets

The Importance of Being Earnest …

“Anyone who lives within their means suffers from a lack of imagination.” - Oscar Wilde, Playwright and Poet

Perhaps the Irish playwright was trying to live up to his surname, but we cannot endorse Wilde’s quip. At risk of being accused of stating the obvious, living within one’s means is just the starting point for sound financial advice. As such, we can’t help but appreciate the irony of his statement within the context of today. By Wilde’s measure, policymakers in many developed nations have demonstrated imagination commensurate with creative genius. There’s been anything but a lack of imagination, as countries including Greece, Spain, Portugal, and, arguably even the United States, have extended their fiscal wherewithal well beyond their sustainable means. In recent months, headlines surrounding debt, deficits, and defaults have been unavoidable. These issues are unlikely to be resolved for some time, but a temporary reprieve from these defaults was again delivered in July for both the United States and affected Eurozone nations.

“…I don’t mind hard work where there is no definite object of any kind.” - Oscar Wilde

Unfortunately for U.S. elected officials, there was a definite object at hand: reach an agreement to reduce the deficit and allow an increase in the debt ceiling by the Treasury’s August 2 deadline. Our view, shared by most political observers, was that there was a very low probability of an outright failure to extend the debt ceiling, triggering a default. As the month progressed and the deadline neared, equity markets were quite tolerant of the unwavering party lines and inability or unwillingness to strike a compromise. By the end of the third week of the month, the S&P 500 had gained nearly 2.0%, boosted in part by the Eurozone agreement for another Greek bailout and predominantly positive corporate earnings announcements. By week four, however, the market’s patience had run out, and fears of what could be a “self-inflicted wound” – a byproduct of apparent ideological intransigence – became evident. Memories of the 2008 Troubled Asset Rescue Plan (TARP) debacle, in which the U.S. House voted down the initial plan at the peak of the financial crisis, gave recent evidence that policy mistakes can happen. Equity markets gave policymakers a reminder of the importance of being earnest, as the S&P 500 Index fell 3.9% in the final week of the month, and volatility peaked sharply on the back of stalled negotiations and a slowing economy.


Source: PMFA

Just two days before the impending deadline, President Obama announced an agreement had been reached to reduce spending by $917 billion over the next 10 years, raise the debt ceiling in staggered increases to avoid a default, and create a Congressional Joint Select Committee on Deficit Reduction to cut an additional $1.5 trillion through 2021. To motivate this committee to make bipartisan concessions and reach a viable deal to be voted on by year end, a trigger was put in place to automatically institute an additional $1.2 trillion in across-the-board cuts if additional reductions weren’t passed. (Social Security, Medicaid, and low-income programs remained exempt.) While neither side was fully satisfied by the terms of the compromise, it successfully passed both houses and was signed by the President before Treasury Secretary Geithner had to begin prioritizing payments. This agreement to reduce spending by as much as $2.4 trillion over the next 10 years came on the tail of the Department of Commerce announcement that the economy had slowed markedly in the first half of the year.

The political stalemate that pushed into the eleventh hour fueled fear and uncertainty, contributing to equity losses in July. Broad equities, as measured by the Russell 3000 Index, fell 2.3% for the month, bringing year-to-date gains down to 3.9%. After the first week of August, these gains were completely wiped away as fears of recession intensified. International stocks also declined, although a weaker U.S. Dollar benefited U.S-based investors, cutting those losses by more than half. Mega caps fared better than smaller companies by a margin of more than 2.0% in July.


Source: PMFA

Losses in equities precipitated a flight to quality for the fixed income market. Deterioration in broad economic indicators along with continued uncertainty drove longer-term yields lower and contributed to positive returns for bond investors in July. The Barclays Aggregate Index rallied 1.6% for the month, boosting year-to-date returns above traditional equities. Falling long-term Treasury yields and a slight uptick in inflation expectations contributed to strong performance for Treasury Inflation Protected Securities (TIPS) for the month, returning 3.9%. Although falling yields have been a tailwind for Treasuries, we continue to believe absolute yields remain unattractive in this environment. Given slow income growth, moderate capacity utilization, the retrenchment in oil prices, and limited wage pressures, we believe inflation expectations will remain muted in the near term as well.


Source: PMFA

Those same themes played through to alternative indices, especially gold and silver, as investors sought out hard assets while potential default fears intensified and the U.S. AAA credit rating was threatened. Broad commodities, boosted by the strong rally in precious metals, were positive in July but have been virtually flat since the start of the year. Hedge funds’ performance fell between stocks and bonds, with a slight increase of 0.65% in July.


Source: PMFA

“The pure and simple truth is rarely pure and never simple.” - Oscar Wilde
 
Investment decisions are rarely simple and sometimes as much art as science. The debt ceiling compromise extended the waiting game a few more months before more meaningful closure occurs. It also left the door open for a downgrade given the lack of broad-based spending cuts. That downgrade actually occurred, surprising an already unsteady equity market, and was announced by Standard & Poor’s late on the evening of Friday, August 5. While Moody’s and Fitch, the other two major ratings houses, have reaffirmed their AAA rating, the potential certainly exists for either or both to also downgrade U.S. government debt in the months ahead. The reaction in the market was swift, as equity markets sold off sharply for the second time in three days.
 
Turning the corner on the second half of the year, growth has virtually stalled, and the economy may be at an inflection point. The measures potentially needed for the U.S. to bring its fiscal house in order may cause economic growth to be further constrained in the years ahead and more vulnerable to future shocks. Given the economic slowdown already underway, our outlook remains cautious. At this point, it’s too soon to suggest a recession is unavoidable, although there’s no question that risks have increased in recent months.

What’s been referred to as the “Bernanke Put,” or the implication that the Fed will step in to prop up the economy, helped to support risk assets as a summer lull set in this time last year. A continuation of the recent softening, contained inflation, and deterioration in the jobs market could provide sufficient impetus for the Fed to inject additional stimulus. While some question the degree of effectiveness of the most recent quantitative easing program in boosting the economy, it did help to boost risk asset prices and could do so again. We will continue to monitor developments in the economic landscape and make tactical shifts as we see opportunity or excessive risk. Even in these uncertain times, we believe in the importance of being earnest and maintaining a balanced approach within the context of one’s stated risk tolerance.

Economy

GDP
 
The economy grew at a sluggish pace in the first half of the year. GDP increased at a subpar pace of 1.3% in the second quarter, while a revision to the first quarter revealed the slowest pace of growth since the recession ended – just 0.4%. The report also increased the degree of contraction in GDP during the Great Recession to a cumulative -5.1% over that six-quarter period from the previous estimate of -4.1%.


Source: PMFA, Bureau of Economic Analysis (BEA)

As illustrated above, there has been a sharp slowdown in consumer spending over the past few quarters. Offsetting the slowdown in personal consumption in the second quarter was growth in federal government and business spending and a decline in imports.

In recent weeks, expectations for the rate of growth in the second half of the year have been more tempered given this most recent report. There is a growing sense that recession risks are rising, although few economists are suggesting that a recession is imminent. Our view is that, while the economy is clearly in a cyclical slowdown, data does not yet point definitively to either reacceleration in the quarters ahead or a double-dip. That picture should become clearer in the weeks and months ahead.

Inflation
 

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

Inflation indexes were mixed in June, as headline inflation receded while core inflation pushed higher. The Consumer Price Index (CPI) fell 0.1% in June, resulting in a year-over-year change of 3.6%. Producer prices also receded, but the run up in food and energy prices kept the one-year increase at 7.0%. Excluding volatile food and energy components from the calculation, core inflation indicators rose for the month. Core CPI increased 0.3% in June, while the Fed’s preferred gauge core PCE rose a more tepid 0.1%.


Source: PMFA, BEA, BLS

As the Fed contemplates additional easing in the face of a slowing economy, actual and expected inflation will continue to play a key role. Although core measures remain relatively low, further easing could lead to additional downward pressure on the dollar, reigniting gains in commodity prices and pushing the headline reading higher. Fundamental drivers of inflation, including wage pressures, high capacity utilization, and lower unemployment are relatively benign at this point, but more stimulus has the potential to result in unhinged future inflation expectations – an unwanted outcome.
 
Interest Rates
 
The Treasury yield curve flattened in July, as longer-term yields fell and shorter-term yields rose. The middle of the curve saw the most significant change, with the five-year yield falling 41 basis points to 1.35%. On the short end of the curve, the one-month Treasury yield ticked upward to 0.16% after ending June at virtually zero. The 10-year Treasury yield, which has hovered above 3.0% since December 2010, fell to 2.82% in July. As the market sold off in early August, the flight to quality drove Treasury yields sharply lower, particularly at the long end of the curve. The yield on the 10-year Treasury was below 2.2% as this commentary was released.


Source: PMFA, U.S. Treasury

The FOMC met on August 9 to discuss recent developments and its monetary policy stance. While no significant policy changes were implemented, the FOMC replaced their “extended period” language related to the maintenance of the fed funds rate at “exceptionally low” levels. Instead, the Fed indicated their expectation that the rate would be kept low at least through mid-2013. While this change was undoubtedly intended to provide additional clarity to the market about the Fed’s line of thinking and expectations, it does create the potential for risk down the road, as it is clearly conditional on the underpinning outlook not materially changing in the intervening period. While no additional stimulus was approved at that meeting, further deterioration in economic conditions in the months ahead would likely force the Fed’s hand.

Employment

Employment is really the backbone of our economy. For most households, income from employment provides the primary means for consumption – far and away, the single largest component of economic activity. A weak employment environment not only reduces spending among the jobless, but it also weighs on the psyche of others who restrain spending in fear of losing a job. After the fallout from the Great Recession, in which over 8.7 million jobs were lost, the recovery on the employment front has been slow. Since job creation resumed in March 2010, less than a quarter of those jobs have been replaced.


Source: PMFA, BLS

July’s report showed that the unemployment rate ticked marginally lower to 9.1%. Meanwhile, job creation remained muted at 117,000. Although it surpassed economist expectations for the month, it was a far cry from a strong result. The fragile state of the economy has left employers fearful to ramp up staffing. Productivity gains have contributed to earnings growth, but have allowed employers to proceed slowly in expanding their payrolls, contributing to a “jobless recovery.” If the current economic lull worsens, deterioration within the job market is a near certainty.




Disclaimer: Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

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.