Executive Summary

• What had been a mixed economic outlook received more poignant signs of deceleration via multiple leading indicators in May. In an already slow growth environment, these weak results suggest more challenges lay ahead for the economy.
• Job creation slowed appreciably in May while the unemployment rate again
  ticked upward to 9.1%.
• A flight to quality pushed the U.S. Dollar higher as Treasuries rallied, while the yield curve flattened further in May.
• Continued uncertainty, negatively trending leading economic indicators, and ongoing debt issues domestically and abroad led to a pullback in equities, commodities, and other risk assets this month.

Capital Markets

A turtle crossing the road...

John Steinbeck took us on a metaphorical journey in his 1939 novel, “The Grapes of Wrath,” in which he dedicated an entire chapter to a turtle crossing the road. The imagery associated with this feat is almost agonizing as you consider the challenged rate at which this reptile travels, its unrelenting lack of agility, and the disproportionate obstacles that plagued its path. Steinbeck’s detailed description of a turtle’s journey was symbolic for what would be the blight of his characters throughout their long journey. While this missive will instead focus on the capital markets and the economy, the analogy is just as fitting in today’s context. However, in the interest of full disclosure, I must acknowledge that these comments will lack both the eloquence, and more importantly, the stamina of Steinbeck.

Gratuitously Unnecessary Perspective of the Month American Express Sends Credit Card Application to Three-Year-Old According to CNNMoney writer Jessica Dickler, her three-year-old daughter recently received a surprise in the mail: an application for an American Express credit card. After some investigation, it was determined that the child received the application because either clothing or furniture had been sent directly to her over the last few years. The fact that she received this offer at all points to the fact that credit card marketing efforts have increased dramatically over the past two years. In the third quarter of last year, U.S. households received 1.2 billion credit card offers, an increase of 200 percent from the year before. There is a catch, though: the people receiving these offers are those with good or excellent credit—those that offer less chance of default. Well, those people and, apparently, three-year-olds. Source: CNNMoney

A Challenged Rate

There’s no question that turtles are almost synonymous with slowness, although you can hardly blame them when you consider they’re burdened by the weight of carrying their home everywhere they go. While the economy too is burdened by homes, it’s primarily attributable to the persistent slide in home prices. The residential housing market is still showing signs of weakness, and with mounting foreclosures flooding the market, the supply of homes rose to a five-month high in April. High inventory levels coupled with a more restrictive credit environment are a clear headwind to prices, which are once again losing ground.

The employment market has also been moving along at a turtle’s pace throughout this recovery/expansion. June marks the two-year point since the recovery began, and the employment market has lagged considerably. The Great Recession was accompanied by job losses which tallied over 8 million. Since job creation began again in March 2010, less than 1.8 million of those jobs have been replaced. The unemployment rate peaked at 10.1% in October 2009, and has receded by only 1.0% since that time. The challenged rate of progress does not stop with the housing and employment market, as deceleration has become increasingly apparent in several other areas of the economy of late. The Institute for Supply Management (ISM), which reports business activity in the manufacturing and service sectors, shows evident deceleration in the rate of activity in both of their broad index readings. The ISM report sums up the current economic situation rather appropriately by characterizing the overall economy by direction (growing) and rate of change (slower).


Source: PMFA

Fears of further economic weakness both here and abroad resulted in a pullback in the equity markets during the month of May. Domestic equities, as measured by the Russell 3000 Index, fell by 1.1% while losses on international equities totaled nearly 3.0% for the month. While correlations on many risk assets remain relatively high, the opposite is true of correlations between the U.S. Dollar and domestic equities. The negative correlation that recently developed carried into May. As the U.S. Dollar rallied, it detracted somewhat from what had been a handsome boost to U.S.-based international investors over the first four months the year. Even in the midst of the recent pullback, volatility levels remained relatively subdued.


Source: PMFA

Lack of Agility

Few, if any, would consider a turtle agile. They generally lack the ability to quickly maneuver in their environment as compared with many other reptiles or, frankly, just about any living creature. Similarly, the economy remains in a position in which the Fed has limited tools in its arsenal to utilize if the recent slowdown in growth worsens. The Fed Funds rate remains at historically low levels, while the Fed’s balance sheet has grown dramatically as they’ve attempted to provide liquidity and buoy asset prices. The second round of quantitative easing will end this month, and, as other stimulus also recedes from the economy, what’s left is an economy that would ideally be self-sustaining. Whether that will be the case remains a question mark.

Bonds benefited from the “risk-off” trade, having an inverse relationship with equities this month as high-quality bond prices rose up and yields fell. The Barclay’s Aggregate Index rallied 1.3% in May, a move which accounted for over 40% of its year-to-date gains. High yield bonds provided a more modest return of 0.5% for the month. Long-term municipal bonds continued their rally, as overblown fears of mass defaults subside and tax revenues surpass expectations, easing budgetary tensions at the margins.


Source: PMFA

Disproportionate Obstacles

Much like the vehicle that swerves to try to miss the turtle crossing the road, or the one that swerved instead to hit it in Steinbeck’s depiction, the economy also faces mammoth issues today. Raising the debt ceiling is one issue that has come to the forefront in recent months. What had been a rather routine process that occurred ten times since President George W. Bush took office in 2001 has been turned it into a very heated debate. While we do not anticipate that policymakers would allow a default to occur, a clear outcome does not exist at this point on any agreement that may be reached. Other sizable issues facing the global economy include the sovereign debt problems in the Eurozone, inflationary pressures in emerging markets, and near-term manufacturing supply chain disruptions that emerged in the aftermath of Japan’s earthquake.


Source: PMFA

These obstacles, which pose some risks to future growth, contributed to a pullback in broad commodities and a second month of weakness in precious metals. REITs were more resilient in May and added to respectable year-to-date gains of 13.3%. We continue to anticipate the allegorical turtle’s pace will be the most likely scenario for the economy for some time. The extraordinary measures of the Fed, which helped pull us out of the Great Recession, have left the economy perhaps more limited to further defend from unforeseen risks. The mound of uncertainty that exists surrounding the many obstacles in our path only reinforces the fact that the economic landscape and capital markets remain vulnerable.

Economy

GDP

Economic growth slowed to 1.8% for the first quarter, following a 3.1% increase in the fourth quarter, according to the second estimate of GDP by the Bureau of Economic Analysis. This result was in line with the first estimate in April, with just slight revisions in exports and inventories which were offset by imports and consumer spending. Consumer spending slowed, while government, state, and local spending for the second consecutive quarter were negative contributors to growth. As budgetary concerns again come into focus, with the deficit still at unsustainable levels, the economy will be more reliant on business and consumer spending to perpetuate growth.


Source: PMFA, Bureau of Economic Analysis (BEA)

Economic indicators in the last few months have pointed to a marked slowdown, which is causing economists to reconsider growth projections for the second quarter and beyond. Economists expected GDP growth for the period of April-June to be in the neighborhood of 3.5%; but, as manufacturing and service sector activity, retail sales, and confidence all point to a slower rate of growth, these estimates have been revised downward. With June being the final month of the second quarter, indicators will be closely watched for any further evidence of slowing.

Inflation

In April, both headline and core inflation rose. The Consumer Price Index increased 0.4% in April, while the rate for producers was twice that. The 12-month change for CPI reached 3.2%, even as the 12-month change on the PPI continued to climb, reaching 6.8%. However, it’s noteworthy that the recent peak of $113.39 in Brent Crude was on April 30, the end of the measurement period for the reported data. Since then, the cost of oil has averaged around $100 a barrel, over 10% lower, suggesting that some easing in the headline rates could be forthcoming in the next month.


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

The dynamics that played out in May, with the dollar rally and the pullback in oil and other commodity prices, will undoubtedly reverse some of the recent acceleration in headline inflation indices. Increases in core inflation, on the other hand, have been much more muted. The one-year change in core CPI reached 1.3% in April, still well within the Fed’s implied range of 1% to 2%. The inflation versus deflation debate has abated somewhat, and the focus has now shifted to the broad-based economic slowdown that is becoming more evident.


Source: PMFA, BEA, BLS

Interest Rates

The yield curve continued to flatten once again this month as longer term yields fell. Short-term yields, which arguably have been kept artificially low, remained at virtually zero. The one-month Treasury ended May at 0.04%. The 10-year Treasury’s recent peak of 3.59% in early April didn’t last, as the yield has since fallen over 50 basis points to end the month at 3.05%.


Source: PMFA, U.S. Treasury

The FOMC had no regularly scheduled meeting in May but will reconvene in June to reevaluate the pressures facing the economy and determine their next set of actions. They have been very transparent regarding their current round of quantitative easing, with a clear expectation of long-term Treasury asset purchases ending in June. The recent Dollar rally and some easing in global tensions have allowed commodity prices to pull back, providing some relief from near-term inflationary pressures. Meanwhile, the employment situation remains quite weak. Given those variables at play, the Fed appears to still have sufficient flexibility to maintain their currently stimulative stance. It still appears that the hurdles facing an extension of QEII, what the market would coin as QEIII, remain high, although a continued slowdown would up the ante and make further easing much more palatable or even necessary to policymakers.

Employment

The Employment Situation release from the Bureau of Labor Statistics this month was once again foreshadowed with an ADP National Employment Report result well below expectations just days before. This time, however, the monthly increase in nonfarm payrolls was much weaker than in April. Job creation stalled as the economy created just 54,000 jobs in May. This was a notable slowdown from the prior month’s reading of 232,000 and well below the expectation of around 170,000 jobs. Additionally, the release was accompanied by downward revisions for the preceding two months of a combined 39,000 jobs.


Source: PMFA, BLS

Meanwhile, the unemployment rate rose to 9.1% as more job seekers re-entered the workforce. We’ve been suggesting for some time that the jobless rate was at risk of reversing its gradual cyclical downward trend, as previously discouraged workers re-enter the workforce. The marked slowdown in the pace of job creation, however, wasn’t as apparent even a few months ago given the broad expectation that economic growth for 2011 would accelerate. That expectation is now in doubt.


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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.