May 2011

 Executive Summary

• Bond returns were generally positive in April, as declining long-term yields flattened the yield curve. Longer-term municipal bonds continued to recover from their fourth-quarter selloff.
• Stocks were positive for the month as volatility eased. The falling Dollar boosted returns of international equities, precious metals, and other commodities.
• The economic picture remains mixed, as overall growth in Q1 slipped and inflationary pressures – particularly in food and energy – increased.
• Indications of labor market strength were mixed in April. Jobless claims rose unexpectedly, even as nonfarm payroll growth maintained a positive trend. The unemployment rate ticked back up to 9.0%.

Capital Markets

Nothing is certain but death and taxes.

It was Benjamin Franklin who conveyed the spirit of this idea in a letter to Jean-Baptiste Leroy back in 1789. Now, more than two hundred years later, the saying still rings true. Since the discussion of death is best left for a much different venue, this missive will focus on that second certainty in life (taxes), as well as one of the pressing “uncertainties” that exist today. Taxes, specifically, is a topic of timeliness from our collective personal experience, with the April 15 (which happened to be April 18 this year) tax deadline recently past. As many Americans pulled out their pocket books for Uncle Sam, it was a friendly reminder of what Franklin D. Roosevelt quipped was “the dues that we pay for the privileges of membership in an organized society.”

From a historical perspective, current income tax rates are comparatively low, although we suspect this will inevitably trend higher over time. Progressive tax rates, structured such that individuals with higher incomes pay a higher average tax rate and are responsible for a large percentage of total taxes collected, are unlikely to go away.

Indeed, they may ultimately become more pronounced as policymakers grapple with a clearly unsustainable path of rising deficit spending. While politicians intermittently quibble over details and trumpet comparatively minute cuts in government spending and deficits, another more subtle regressive tax has been brewing for consumers. This implied tax is found in the form of rising fuel prices. The average price of gasoline in the U.S., at just under the $4.00 mark, has risen 37% since May of last year. With the cost to fill up a tank absorbing a larger portion of income and year-over-year wage growth slowing, discretionary spending will most certainly be curtailed.

Research suggests that, in broad terms, every sustained $0.25 increase in the cost of a gallon of gasoline shaves about 0.2% from GDP. The over $1.00 increase in the last year alone would have resulted in a drag of about 0.8%. While this by itself is not enough to push the economy back into recession given current growth, it will certainly trim growth if prices remain at current levels or trend higher. This concern, however, was not enough to derail the continued rally in equities in April. Domestic stock indexes advanced in a narrow range around 3.0% for the month, led fractionally by mega-cap companies. Unlike stocks, what did fall during the month was the greenback. The Dollar pulled back considerably, boosting foreign stock returns for U.S.-based investors. That decline contributed a noteworthy boost in excess of 4% to EAFE performance in April.


Source: PMFA

Inflation is one of those outstanding “uncertainties” of today, and its impact can be significant. In April, the European Central Bank (ECB) adjusted their key interest rate higher for the first time since October 2008. Their primary justification for the transition to a tightening cycle was what they referred to as growing inflationary risks from “second round effects.” The first round effects of inflation have been evident worldwide in the rising costs of food and energy. The “second-round” then would be from workers requiring higher wages to help compensate for the decline in discretionary income as their non-discretionary costs increase. Commodities, in general, represent a smaller component of corporate costs than wages, although it varies significantly between industries. While rising commodity costs can often be more easily absorbed for some time, broad wage increases generally results in the need to pass on price hikes to the consumer, perpetuating what can become a self-reinforcing inflationary cycle. It can be argued whether or not an upward push from wage pressure could manifest itself in an environment of high unemployment and moderate capacity utilization, where companies would appear to have more leverage. This is effectively the case that the Fed has been making against near-term inflation risks and justification of their continuation of loose monetary policy.

In contrast to the U.S., the Eurozone area has a rather bifurcated outlook. At one extreme is Germany with comparatively low unemployment and stronger anticipated growth, and at the other is Greece with high unemployment amidst a deep, albeit easing, recession. Policy mandates are another imperative difference between the European Union and the United States. The European Central Bank (ECB) manages monetary policy in accordance with one goal, to maintain price stability, while the Federal Reserve manages monetary policy based on a dual mandate, full employment, and price stability. The expectation is that the ECB will tighten further in the near term in accordance with their inflation focus. However, the undesirable effect of higher rates will not be welcome in Greece or other EU member states already struggling with excessive debt and weak economic conditions.


Source: PMFA

While rates have risen elsewhere around the globe, U.S. Treasury yields fell in April across all maturities. The contraction was more considerable for longer-term yields, resulting in a flattening of the yield curve and boosting prices. The Barclays Aggregate Bond Index returned 1.27% for the month. High yield bonds were also positive in April, while year-to-date returns still land between equities and core bonds. April was, however, comparatively quiet as compared with a memorable March. The receding fears from last month’s unprecedented events helped market volatility subside.


Source: PMFA

Alternative investments, also positive in April, had a few standout performers. The Precious Metals index spiked a remarkable 13.74% in the month, much of which came following Bernanke’s remarks from April’s FOMC meeting. Fears of further Dollar devaluation drove interest in hard assets, including gold and silver. REITs were also positive in April, but, having appreciated materially from their trough in early 2009, appear less attractive from a valuation perspective. Direct real estate has been slower to recover from the savage real estate bear market. Valuations are comparatively favorable, and direct real estate may warrant consideration for investors with sufficient capital, tolerance for risk, and interest in the asset class from a strategic perspective.


Source: PMFA

Since we know death and taxes are givens in life, it’s the successful navigation around the other uncertainties in life that is important. Although the economic landscape remains in constant flux, we are cognizant of both upside (opportunities) and downside (risks) as we employ tactical shifts within our strategic investment positioning. We continue to believe a well-diversified approach, within the context of one’s stated risk tolerance and investment objectives, still represents a prudent approach for long-term investors.

Economy

GDP

The pace of economic growth decelerated in the first quarter of 2011 to a pace of just 1.8%. This followed fourth-quarter growth of 3.1%, which was more in line with historical averages. Imports, which reduce GDP, increased during the quarter, while exports, business investment, and consumer spending all slowed. Declines in government spending at the Federal, state, and local levels also directly detracted from economic growth.


Source: PMFA, Bureau of Economic Analysis (BEA)

First-quarter corporate earnings season is nearly over, and the results were once again vastly positive. Over two-thirds of companies surpassed estimates this quarter and profits remained strong. The CEO Confidence Index, which reached its highest point in over two years in February, pulled back with the March reading in reaction to the tragedy in Japan, political unrest occurring throughout the Middle East and North Africa, and the rise in oil prices. Exasperation of any of these concerns could lead to further safeguards from companies who have maintained lean operations since the onset of the Great Recession.

Interest Rates

Interest rates were once again volatile in April, but, in aggregate, the yield curve flattened during the month. Short-term yields, as measured by the three-month Treasury, with little room for downward movement, contracted in April by five basis points. The yield dipped as low as 0.04% during the month, its lowest point since January 2010. Yields for the one-month Treasury are virtually non-existent with a current yield of just 0.02%. Longer-term yields also turned downward in April. The 10-year Treasury fell 15 basis points to end the month at 3.32%.


Source: PMFA, U.S. Treasury

The statement from the April 27 Federal Open Market Committee meeting yielded no surprises. The fed funds rate remained unchanged at 0-0.25%, the “extended period” language was maintained, and the plan to complete the $600 billion of longer-term Treasury purchases stayed intact. Perhaps the most noteworthy development from a historical perspective was that Fed Chairman Bernanke held the first ever news conference following the FOMC meeting, with the intent being to continue to improve the transparency to the public. Unavoidable questions addressed inflationary fears, commodity prices, and QE3 expectations. Mr. Bernanke reiterated their expectation that the influence of commodity price increases should prove to be transitory and not seep into longer-term inflation expectations. At the same time, he noted in an obvious tongue-in-cheek manner that “the Fed can’t create more oil,” and they “don’t control the growth rates of emerging-market economies.”

At this point, the market is anticipating a rise in interest rates at the beginning of 2012, with some compression of the Fed’s balance sheet to occur even before then. Bernanke has suggested that the hurdle is high to initiate QE3, with the trade-offs becoming increasingly less attractive. Inflation expectations will be closely monitored over the coming months, even though substantial economic slack persists.

Inflation

Comments on inflation have peppered headlines of late, as the pace of inflation has clearly accelerated over recent months. There are two distinct views that are drawn from the inflation story, one which maintains a deflationary tilt and another that fears an inflationary spiral. Those focused on the risk of inflation would note the massive stimulus pushed into the system in recent years, the favorable demographic trends and economic development in emerging markets driving commodity demand, and the growing global economy. The question is whether these factors will all contribute to rising inflationary expectations that may become unanchored. The deflationary argument suggests that the rising oil prices will actually act as a disinflationary tax on consumers, and that slowing wage pressures, a low velocity of money, and a high unemployment rate will weigh on spending and ultimately squelch inflation. We see inflation as a risk but are very aware that the three-month surge in commodity prices cannot be perpetuated indefinitely without having the effect of cooling the economy and reducing demand for those commodities. That process may have already started, given the sharp correction in May in prices of numerous commodities (including oil and silver) that are sensitive to the business cycle. As always, we should be appropriately aware of risks, while not subconsciously extrapolating short-term moves into long-term, open-ended trends.


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

Headline inflation rose once again in March with increases of 0.5% for the Consumer Price Index and a 0.7% increase for the Producer Price Index. In the past 12 months, the CPI has increased 2.7%, largely driven by rising commodity prices. Core inflation remains more muted, as the core PPI and CPI indexes rose just 0.3% and 0.1% respectively in March. The one-year core CPI change remains well-grounded at 1.2%.


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

Employment

The employment market remains somewhat mixed, as illustrated by recent employment-related data. First released was the ADP National Employment Report that was much softer than anticipated. That was followed by the Initial Jobless Claims report for the week ended April 30 that reported newly unemployed workers were well over 400,000, the highest in eight months. With an expectation of disappointment with the Employment Situation Report, market participants were pleasantly surprised that the increase in nonfarm payrolls exceeded the consensus estimate. The economy added 244,000 jobs in April, capping the economy’s strongest quarter of job creation in five years.


Source: PMFA, BLS

Improving economic conditions have prodded unemployed workers, who had stopped looking for work, to recommence their job search. The greater pool of workers seeking employment contributed to the uptick in the unemployment rate for the month from 8.8% to 9.0%. We suspect this rate will continue to show volatility, but should continue its slow downward trend so long as the economy expands at least at a decent pace. While this is our baseline scenario, the uncertainty that continues to hang over both the domestic and global outlooks could lead to conservative corporate action, curtailing the continued recovery in job growth.



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.