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Capital Markets

"People don't notice whether it's winter or summer when they're happy."
Anton Chekhov, Russian Author

“Our senses don’t deceive us: our judgment does.”
Johann Wolfgang von Goethe, German Playwright

Is the recent recovery likely to continue or will we re-test the lows of last March? Is the economy poised for recovery? Will we be able to achieve the kind of growth to which we have become accustomed?

These are the questions that dominate discussion both within the ranks of everyday investors and in the halls of the world’s monetary policymakers. Economists, strategists, money managers, politicians, and interested observers – all have their hypotheses about where we stand today and where we will head from here. It is difficult to recall a time in recent history in which the range of opinions have been so wide as has been the case in the past several months. As we have noted many times in the past, consistently accurate forecasting is difficult at best, even under comparatively temperate market conditions. Without question, current economic circumstances could not be reasonably considered benign. Although it appears that the global economy has stepped back from the precipice of the so-called “worst-case scenario” that engendered such fear last fall, the range of challenges ahead remains broad. 
 

Gratuitously Unnecessary Perspective of the Month The Fruits of Our Labor A trying economy coupled with concerns about food safety has led to a 19 percent increase in households that grow their own fruits, vegetables, and herbs, according to the National Gardening Association. Even First Lady Michelle Obama has gotten into the act, recently helping a variety of fifth grade students harvest 73 pounds of lettuce and 12 pounds of peas. Those with green thumbs say gardening is fun and relaxing, but as do-it-yourself projects go, this one appears motivated more by money than an affinity for the outdoors. More than half of those growing their own food cite saving money on groceries is what’s driving their sudden interest in gardening. It appears that these “green shoots” may even be real. Source: www.kiplinger.com

In evaluating the strong resurgence in the price of risk assets that occurred through much of the second quarter, one could easily speculate about the underlying causes and what it means for the markets. We believe that the rally was consistent with the market repricing its aggregate expectations for the economy. Forecasts of a depression have largely been relegated again to the “low probability” category, although we clearly remain mired in the so-called “Great Recession.” Investment returns are greatly influenced by expectations. As those improved in recent months, investors began to re-deploy capital into risk assets.

Global equities surged during the quarter - a rally that crossed borders, styles, and capitalization thresholds. The S&P 500 Index return of nearly 16% represented its single best quarterly return since the final three months of 1998. Small cap stocks boasted returns in excess of 20% for the quarter, while international markets followed suit. The ebbing of the global fear trade allowed the dollar to begin to chip away at its recently elevated valuation relative to foreign currencies, further enhancing returns for U.S.-based investors in foreign securities.



Source: PMFA

During that same period of increased investor risk appetite and subsiding fear, market volatility declined markedly. From a historical perspective, however, volatility remains high – comparable to peaks reached during prior bear markets.


Source: PMFA, Yahoo Finance

As the degree of investor gloom declined, high-quality bond returns sputtered. The yield on the 10-year Treasury spiked nearly 0.8% during the quarter, ending June at about 3.5%. The Barclays Aggregate Index managed a fractional gain for the month of June; municipal bonds failed to keep pace, however, as concerns about municipal financial strength increased. High yield bonds posted positive gains to close out a quarter in which their performance exceeded even the broad U.S. stock market.
 

Source: PMFA

Commodities gave ground during June, but remained strongly positive for the quarter. Consistent with declining fear and increasing risk appetite, precious metals fell for the month. Despite the equity rally, both precious metals and the broad commodity complex have provided year-to-date returns through June 30 that exceeded the Russell 3000 Index.


Source: PMFA

Given this robust rally, perhaps one of the more significant risks to investors is misinterpreting what it means. We often speak of the personal tug-of-war between fear and greed with which investors frequently wrestle. In recent months, many headlines – and we would argue too many – have been devoted to the so-called “green shoots” in the economy. We do not dispute that evidence exists pointing to improvement in the economic climate over the past several months. As we’ve cautioned before, we believe that there is ample reason to expect that any economic recovery, when it arrives, may not be of the typical strong, sustainable bounce that has been the case emerging from the past few recessions. Investor confidence may be constrained to a degree by the memory of recent losses. Even so, consumer sentiment and investor confidence have improved in anticipation of a return to positive economic growth projected by many economists to arrive later this year. Investors risk the potential for disappointment if they remain anchored to the mindset that stocks will always quickly provide above-average returns after a recession and concurrent cyclical bear market.

As Anton Chekhov stated, “People don’t notice if it’s winter or summer when they are happy.” Broadly speaking, investors must be very happy with the performance of the market since mid-March. However, the ultimate distinction between an allegorical “winter” and “summer” in terms of the economic climate does matter. Optimism alone isn’t an investment strategy. Distinguishing between a recovery resulting from a repricing of risk as “depressionary” fear dissipated and a recovery in anticipation of a robust, sustainable economic recovery is critical.

Much discussion has surrounded the “alphabet soup” of recovery scenarios. Will we experience a typical V-shaped recovery – a sharp bounce off the lows that is sustained? Might the economy instead give us a “W” recovery – a sharp bounce back followed by a quick dip back into contraction? Is an L-shaped recovery more likely, in which the economy does not bounce but instead experiences an extended period of sub-par growth? In economic circles, the predominant view tends to be more in line with one of the latter two scenarios. While some are pointing to improvement in the rate of decline in certain economic indicators as evidence that the economy has turned the corner, it is far from clear that traveling conditions down the road will be smooth.

Despite the so-called “green shoots,” several headwinds remain. Global deleveraging, decreased consumer spending, higher savings rates, a persistently soft labor market, potentially higher tax rates, anticipation of excessive inflation down the road, and a domestic housing market that remains far from normalized all are likely to weigh on the economy for the foreseeable future. Most economists are pointing to a recovery later this year, but few are predicting a typical rebound or a return to long-term trend growth. As von Goethe noted, “Our senses don’t deceive us: our judgment does.” There is a risk in seizing only on positive news. We believe that a balanced view of current circumstances – not a perspective myopically focused on these “green shoots” – should lead us to a better understanding of what the future may hold and ultimately to more realistic expectations.

Sentiment often carries the market for some time. But ultimately, only fundamentals, including the pace of economic growth and changes in profit margins that lead to higher corporate earnings and potentially higher multiples, will fuel longer-term results. We continue to believe that, over the long term, equity returns are likely to outpace those provided by bonds, particularly high-quality bonds such as Treasuries. Long-term investors should continue to remain flexible in the implementation of their portfolios, recognizing that opportunities exist outside of stocks to secure returns that may be comparable to those historically associated with equities, potentially with less risk. Treasury bonds still have the protection afforded by the full faith and credit of the U.S. Government, but they may not be as “safe” (in terms of performance potential) over the long term as expectations increase for higher inflation and the potential for U.S. Dollar devaluation down the road, both of which would push rates higher and values lower. It is also our opinion that active management should have the opportunity to provide substantial value over the next few years of this particular market cycle. Remaining nimble and prudent in portfolio implementation strategies, rebalancing in a disciplined manner, and maintaining an appropriate long-term view should continue to position investors well to navigate the choppy markets.

Economy

GDP

The Bureau of Economic Analysis recently released their final report on first quarter GDP indicating that the economy contracted at a 5.5% annualized pace. This result represented a slight improvement from both previous estimates for the quarter and from the decline of 6.3% for the fourth quarter of 2008. Personal consumption, which provided a welcome boost in the first quarter, is expected to detract from GDP growth this quarter. Consensus views for Q2 suggest a decline of 2.0% with the expectation for marginal growth in the third quarter.


Source: PMFA, Bureau of Economic Analysis (BEA)
 
Earnings season has effectively passed for the first quarter with positive earnings reported for the S&P 500 Index. The year-over-year change in operating earnings remains negative, but results bounced back significantly compared to Q4 2008. With second-quarter earnings announcements coming soon, the market will be watching closely. If earnings do not meet expectations for further improvement, investors should be prepared for another uptick in volatility.


Source: PMFA, BEA, Standard & Poor’s

Inflation

Headline inflation increased during May as energy prices shifted upward. The one-year change in the inflation rate remains flat to negative as the surge in costs during the second quarter of 2008 remains in the calculation. As these monthly data points drop out over the next few months, we anticipate that the trailing one-year number will slip further into negative territory. Core inflation indicators were effectively flat for the month, while the trailing one-year measure remains within the Fed’s implied target range.


Source: PMFA, BEA, Bureau of Labor Statistics (BLS)
 
Moderate inflation is a key desirable corollary to economic growth and price stability. Recent dollar weakness, increasing commodity prices, and global monetary and fiscal stimulus have all stoked concerns about undesirably high inflationary pressures in the future.
 

Source: PMFA, BEA, BLS

The FOMC attempted to calm these fears with their June 24 statement noting that, “Substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.” While we anticipate that this will likely be true in the near term, we believe that incorporating some long-term inflation protection in portfolios remains prudent. In most cases, the market moves in anticipation of future events; waiting until inflation actually heats up would likely result in missing the best window of opportunity to implement inflation-oriented strategies.

Interest Rates

As the pace of economic deterioration began to moderate and related fears have subsided, Fed Fund futures have begun pricing in the potential for rate hikes as early as the end of this year. To reset expectations, the FOMC reiterated in their statement on June 24 that, “Economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Some quantitative measures even indicate that, under current conditions, interest rates should theoretically be negative to provide sufficient support for growth. In practice, that is an impossibility, which has led to the Fed taking other aggressive actions in the form of quantitative easing to complement their low policy rate. The Fed will undoubtedly be cautious not to increase rates or reverse their other activities prematurely to avoid dampening the recovery.
 

Source: PMFA, U.S. Treasury

The yield curve was active in the month of June, as the 10-year Treasury yield spiked to nearly 4.0% before closing the month at just over 3.5%. Shorter-term yields have remained exceptionally low for more than eight months.

Employment

While May employment data surpassed expectations, June failed to follow course. After four consecutive months of improvement, the pace of job loss increased in June with losses totaling over 460,000. Non-farm payrolls have been consistently negative since January 2008. The pace of loss has improved in recent months, however, after the monthly losses reached a crescendo in the final months of last year.


Source: PMFA, BLS

The unemployment rate reached a 26-year high in June at 9.5%. Economists nearly universally expect this rate to continue edging upward to 10% or more. A high unemployment rate will contribute to the slack within the economy, reducing the potential of elevated inflation in the short term.



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.