Executive Summary

• After five consecutive months of losses, risk assets surged in October. The combination of an apparent near-term resolution to the Greek debt crisis along with better than expected economic data and strong earnings results contributed to the “risk-on” trade.
• Traditional high-quality bonds posted modest gains for the month. Longer-term interest rates moved higher with the increase in investor risk appetite.
• U.S. economic growth of 2.5% for the third quarter was generally in line with expectations and sufficient to temporarily ease investor concerns that a recession was imminent. The outlook over the next several quarters remains challenging, however, and recession risk remains heightened.
• The employment market provided some positive news in October as the jobless rate dipped to 9%, but overall remains relatively weak.

Gratuitously Unnecessary Statistic of the Month Do Not Pass Go, Do Not Collect $30 Billion  According to cnbc.com, the U.S. Bureau of Engraving and Printing printed $974 million in real money last year. Parker Brothers, which manufactures Monopoly and its money, printed a whopping $30 billion. Put them both together and the nearly $31 billion in real and Monopoly money would cover President Obama’s proposed 2012 budgets for the Small Business Administration, Department of Commerce, and Department of Treasury, with about $7 billion left to cover half of the budget for the Department of Transportation. By way of comparison, that $31 billion of mostly Monopoly money could be used to cover the cost of Social Security, Medicare, and Medicaid and related federally funded Health Insurance programs. The catch: all that Monopoly money obviously isn’t legal tender. The bigger catch: even using all that funny money would barely put a dent in those liabilities, covering the cost for the programs for about one week.  Source: CNBC and Whitehouse.gov

Capital Markets

We are the 7 billion…

According to the United Nations (U.N.), October 31, 2011 marked the day that the global population count reached an amazing 7 billion. While the difference between 6,999,999,999 and 7 billion people is just one more birth, within the context of where we were just a century ago, this event is significant. For proper disclosure, the U.S. Census Bureau actually suggests this mile marker in population won’t be reached until March 2012; however, plus or minus a few months seems like a reasonable margin for error considering the complexity of the estimating process. Although the specific date is arbitrary, the implications of a rapidly growing world population and the demographic changes that are accompanying it will continue to have widespread influence for decades to come.

The world’s population reached the 1 billion mark around 1800. Since then the population has multiplied at an exponential rate. Around 1930 it doubled to 2 billion (after 130 years) and then doubled again just 44 years later to 4 billion in 1974. Declining fertility rates in the developed world have allowed the overall population growth rate to decelerate since the 1960s. The U.N. now projects global population to reach 8 billion in 2024 – 50 years after reaching the 4 billion mark. While growth rates have come down, they’ve not been lowered as substantially as earlier projections assumed. With new births totaling more than 100 million people this year alone, by the turn of the next century, the U.N. anticipates that more than 10 billion people will populate the globe.


Source: Population Institute

In the last 12 years, during which roughly a billion people joined the global family, the impact of changing dynamics has been apparent. The addition of 1 billion more mouths to feed, backs to clothe, and heads to shelter, drove dramatic changes in the prices of non-discretionary goods. Although broad inflationary gauges in most developed countries remained in a moderate range, core goods crucial to the developing world have spiked. The Food and Agriculture Organization World Food Price Index has more than doubled since 1999. Prices for broad-based commodities, as measured by the DJ-UBS Commodity Index, have also increased twofold during that timeframe. The price of crude oil, a primary energy source across the globe, has more than tripled. Some of this volatility may be attributed to the increased investment and speculation in commodities in recent years, but the upward price trends in food, energy, and other basic commodity costs have been felt by global consumers, particularly those in the developing world, where these represent a much higher portion of spending for a typical household.

Emerging and developing countries tend to have higher rates of population growth, which can be a favorable dynamic when infrastructure and investment begin to create a path toward the emergence of a middle class. On the flip side, however, they also generally have higher poverty rates, making it even more difficult to endure periods of rising prices of non-discretionary goods and potentially acting has a headwind to growth. For most developed nations, population growth rates are low or even negative (as in Germany and Japan, for example). As we consider the Eurozone crisis, slow to negative population growth is a critical variable, inhibiting the region’s ability to grow its way out of their massive indebtedness without a greater focus on exports and increased demand from abroad. In a competitive global marketplace, even that solution will prove difficult.


Source: PMFA

After significant volatility in the third quarter, October’s Eurozone summit agreement briefly assuaged fears that a near-term escalation in the crisis could be avoided. Details on this plan were outlined in our recent Special Market Commentary released on October 28 that is available at pmfa.com. The announcement of this grand deal, however, boosted investor spirits and drove a sharp (although fleeting) rally in risk assets. Most equity indices posted double-digit returns for the month, with smaller caps leading the rally. Nonetheless, excluding large caps, most risk assets remain in the red year-to-date through October 31.


Source: PMFA

Traditional high-quality bonds posted marginal gains for the month, even with a slight uptick in longer-term Treasury yields in October. The Barclays Aggregate Index rose 0.11% for the month, boosting already strong year-to-date gains to 6.76%. Municipal bonds took a small hit, as concerns about the muni market escalated when the city of Harrisburg, Pennsylvania filed for bankruptcy. High yield bond spreads had widened significantly in September, pricing in default rates close to prior recessions. Better-than-expected economic data and a temporary easing of fears related to the Eurozone crisis helped produce solid gains of nearly 6.0% in October for the Barclays High Yield Bond Index.


Source: PMFA

Commodities rallied as tensions eased and the U.S. Dollar fell. Gold, after a brief retreat, rallied in October. REITs have been exceptionally volatile over the last several months, gaining back much of their losses from the prior quarter. The fragile economy continues to pose a risk to improving fundamentals, while the anticipation of low interest rates for an extended period has acted as a tailwind.


Source: PMFA

The United States, the third most populous nation in the world, has a population growth rate estimated at just 0.963% for 2011, according to the Central Intelligence Agency’s The World Factbook. As we’ve discussed in past missives, one of a few scenarios to bring our deficit levels back to sustainable levels would be for the U.S. to grow our way out of debt. This, of course, would seemingly be the most comfortable option, but doing so would be a massive feat as our population continues to age and our fertility rate slows. As emerging market nations harness the developed world’s technologies to efficiently add to their capital and infrastructure, their learning curve will likely be abbreviated as the push toward a higher standard of living naturally develops. (For example, many nations are bypassing the infrastructure efforts required to install land line telephones to remote areas as their citizens instead go directly to cellular phones.) Ultimately, the emergence of a consumer class in these countries will benefit developed economies, including the U.S., as new markets for consumer products expand. This will take place over a period of decades, however, and not in a suitable timeframe that will meaningfully contribute to a solution to the current fiscal deficits. Thus, other measures will be necessary to curtail our currently unsustainable debt levels. This topic is going to again become a greater focus in the days ahead, as the members of the congressional supercommittee, tasked with creating a plan to reduce an additional $1.2 trillion before Nov. 23, appear increasingly at odds with each other.

Long-term opportunity for growth throughout the world abounds and innovations continue to emerge, but today’s economic horizon is wrought with significant uncertainty, greatly dependent on the choices of policymakers (who have been prone to missteps and ideological intransigence in the past). While recent data suggests the economy is still on a slow growth path, the fragile pace leaves little room to absorb potential setbacks along the way without falling into recession. At this time, we continue to remain cautious in our outlook, recommending portfolio diversification into areas that offer attractive near-term risk/return profiles. At the same time, investors should confirm that they have sufficient cash and liquid resources to weather any potential downturn and reconfirm that their portfolio allocations are consistent with their tolerance for risk.

Economy

GDP

Gross Domestic Product for the United States mildly surpassed expectations in the third quarter, rising at a 2.5% annualized pace. The report, along with other recent positive surprises in economic data, was enough to briefly ease fears of an imminent recession that had been building in recent months. Resilient consumers contributed positively to growth this quarter, with an increase in both durable goods and services. That uptick may be transitory, as the boost provided by pent-up demand for autos after the global supply chain disruptions earlier in the year reduced production of some imports and prompted some car buyers to delay their purchases. Some economists have estimated that factor alone might account for one percentage point of growth for the quarter. Business investment accelerated, which could be a positive sign for the economy.


Source: PMFA, Bureau of Economic Analysis (BEA)

Earnings season is slowly wrapping up for the third quarter, and with less than 25% of companies left to report, it’s once again been a positive quarter. The vast majority of companies exceeded earnings expectations (after significant downward adjustments to expectations in anticipation of slower economic growth ahead), yielding positive top-line results and cautiously optimistic outlooks.

Inflation

Prices tended to rise in September, with a particularly strong increase in producer prices. Rising energy and food prices were the main culprits, as the core indicators were flat or had nominal gains. The Producer Price Index (PPI) rose 0.8%, the largest change in five months. The one-year change remains at a relatively high 6.9%, but recent gains in food and energy are expected to be transitory, which should contribute to some easing in the months ahead. These rising prices also reflected in the Consumer Price Index (CPI), which gained 0.3% for the month, bringing the one-year change to its highest point in three years.


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

Core inflation posted more muted results. The core CPI, which excludes food and energy, gained 0.1% in September, while core producer prices edged up 0.2%. At this point, inflation remains in line with the Fed’s implied target, and deflation is once again becoming a greater concern. Given the soft employment market, moderate capacity utilization, and excessive debt issues, it would not be surprising for the Fed to tolerate inflation even above the high end of its acceptable range before making any changes in course. In their statement following the most recent meeting, the FOMC noted that it “anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further.”


Source: PMFA, BEA, BLS

Interest Rates

It was one year ago that the Fed announced QE2 and began its injection of an additional $600 billion in long-term Treasuries over a stated eight-month period. Just three months after its QE2 purchases ended, the Fed pulled out its next tool by implementing the so-called “Operation Twist.” In its November 2 statement, the FOMC acknowledged slight improvements in the broad economy and expressed its commitment to hold the course for now. It will continue its program to extend the duration of its Treasury portfolio and maintain the funds rate at virtually zero. One dissenting voter, Charles L. Evans, voted in favor of additional policy accommodation, while the three most hawkish members of the committee conceded to the current plan after voicing dissenting votes in prior meetings. These changes in tone seemingly reflect the evident weakness in the economy and the Fed’s increased consensus about their need to act.


Source: PMFA, U.S. Treasury

The Treasury yield curve has been quite volatile this year. The 10-year Treasury reached a high of 3.75% in February, as the economy had appeared to be building steam, before falling to a low of 1.72% in late September when it was clear that steam had evaporated. After bottoming, the 10-year Treasury rose by 45 basis points to end the month of October at 2.17%. Shorter-term yields already close to zero have maintained a much narrower trading range over the year. The three-month Treasury yield fell one basis point to end October at just 0.01%.

Employment

The October Employment Situation Report provided a bit more optimism to the market. The unemployment rate broke through its three-month holding pattern of 9.1%, and ticked downward to 9.0%. New job creation for the month was a modest 80,000, but significant upward revisions were made to prior months. This year, the economy has added 1.26 million jobs (an average rate of 126,000 per month); while near the approximate replacement rate needed to satisfy the growing labor force, it remains well below the rate of creation needed to meaningfully reduce the nation’s jobless rate.


Source: PMFA, BLS

The backdrop of a weak employment situation remains a focal point for both the Fed and government officials. With comparatively limited monetary and fiscal ammunition to encourage job creation, the Fed has attempted to prod fiscal policymakers to move beyond their stalemate and pass policy measures that could begin to chip away at the stagnant jobs market. High joblessness inhibits confidence levels, limits more rapid improvement in the housing market, and restrains consumption – making it detrimental to stronger economic growth.



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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.