October 2011

Executive Summary

• Investor anxiety has risen with the threat of recession both in the U.S. and globally, as well as with the continued European debt crisis struggle.
• The “risk off” trade permeated the global markets in September. Compounding losses from the preceding two months, the result was the worst quarter for stocks since the fourth-quarter 2008.
• Falling yields, increasing fears, and multiple sources of global uncertainty were tailwinds for high-quality bonds in the third quarter. Both the global fear trade and additional Fed intervention, the so-called “Operation Twist,” brought the 10-year Treasury yield to the lowest levels on Fed record.
• Economic growth in the first half of 2011 was anemic. Expectations for growth in the second half are also challenged given the pronounced slowdown underway.

Capital Markets

To Dip or Not To Dip…

A little over two years have passed since the end of the so-called Great Recession, the end of which was dated as June 2009 according to the National Bureau of Economic Research (NBER). While having no sanctioned authority, the private, nonprofit NBER has become most widely recognized as the unofficial arbiter determining turning points in the business cycle. Their organization is an esteemed one, and their process for making those determinations are cautiously deliberate, focused on accuracy over timeliness. The result is that a declaration of recession or recovery by the NBER is newsworthy. The problem for those who would use that information to trade the markets is that it only occurs well after the actual turning point has transpired and is generally widely understood by both economists and the markets. Not surprisingly, the NBER has thus far been silent on their assessment of the state of the economy. We’re not likely to hear from them for some time, even if the economy were to tip into recession today.

At the other end of the spectrum are perhaps those in the small minority that have suggested that the economy never exited the last recession. Their thesis is largely predicated on arguments that, while consistent with a sluggish economy, still don’t support the textbook definition of recession. While the consensus view of economists (as measured by the results of various independent surveys) has been for slow growth, a handful of economists were calling for recession more than a year ago, some even confidently – although mistakenly – announcing in the late summer of 2010 that a double dip had arrived or was imminent. The economy instead rebounded and the risk of a double dip faded into the background.

In recent months, economic data has again pointed toward an impending slowdown in the economy. The result has largely been a reduction in economists’ growth expectations for the U.S. economy, but comparatively few have called for outright recession. In the past month, that has started to change. Within the last week, Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) made headlines by stating that their forward looking indicators have led them to believe that the U.S. economy is on a recessionary path. (It’s worth noting that when some were calling for recession in 2010, ECRI was unambiguously and forcefully stating that a double dip would be avoided.) As an independent research firm focused solely on business cycle research, ECRI’s goal is not to be the first to necessarily call a turning point in the cycle, but still be timely and definitive when making those calls in advance of the actual recession starting.

One of the most prominent luminaries in the investing world, PIMCO’s Bill Gross, hasn’t called for a recession, but has acknowledged in recent days that risk of recession in developed economies (including the U.S.) has increased to what he characterized as 50%. A number of other economists, strategists, and commentators have joined that chorus, while others continue to vociferously argue that the economy will reaccelerate from here and that recession risk is still minimal.
 
Today, the camp calling for recession in the near term still appears to be in the minority, although the public debate appears to be moving in that general direction. If there is common ground to be found in economist opinions, it is in the general expectation that growth will slow. Whatever the next several quarters holds in store – recession, slower growth, or a surprise bounce – remains to be seen.

To a point, the debate over slow growth or recession matters little to capital market participants, as it is a virtual impossibility to distinguish between the two in the early stages of a cyclical slowdown. In the months after the economy shifts from growth at a steady or accelerating pace to growth at a slower pace, there’s no means to reliably predict what the ultimate outcome will be. The Nobel Prize-winning economist Paul Samuelson essentially observed that phenomenon in his now famous quip that “the stock market has forecast nine of the last five recessions.” As a practical matter, investors tend to react by trimming their risks and seeking marginal safety well before the economy actually begins to shrink. Today, with stock market returns already toying with technical bear market territory, the economy appears to still be clawing its way forward. Even those calling for a recession in the U.S. are not suggesting it has already arrived, but that they expect the economy to stumble in the months or quarters ahead.


Source: PMFA

Benjamin Graham, the legendary father of value investing, characterized the market in the short term as a voting machine, while over the long term it is a weighing machine. At present, market participants are casting their ballots on (among other things) the outlook for the economy and, in a sense, the probability of recession. However, that doesn’t mean that the implied probability of an outcome is consistently priced across markets or asset classes.

As an analogy, consider the inevitable outcome of U.S. presidential elections. While many voters cast their ballot along party lines, it is not unusual for a presidential candidate from one party to win a specific congressional district, and a candidate from the opposing party to win their congressional seat. Likewise, “voters” (investors) in the stock market can and do price in a different probability of an outcome (like a recession) than “voters” in other markets, such as Treasuries or high yield bonds. We discussed this in greater detail in our September 23 commentary entitled “Global markets sell off: Is recession in the cards?” (That commentary can be found at www.pmfa.com.) In short, even today, stocks do not appear to be fully pricing in a recession, whereas the Treasury market is not only pricing in a recession, but exceptionally low growth and inflation for the next decade.


Source: PMFA

Why does this matter? In part, it matters because this seeming anomaly across markets creates opportunities for investors. At any given point in time, certain asset classes may appear more attractive than others. Periods of volatility can alter not only the attractiveness of a given investment relative to its historical pricing, but its relative appeal when compared with other investment alternatives as well.
 
At the same time, it’s important to maintain a long-term view of the relative attractiveness, return potential, and diversification benefits of the range of asset classes and strategies. While it can be tempting during times of uncertainty to think in terms of relatively brief periods (what do I think the market will do in the next month, week, or even day?), few investors actually have true investment time horizons that are that brief. If return expectations for stocks over a five-year period, for example, are attractive, but the near-term outlook is cloudy, maintaining an appropriate allocation consistent with one’s investment time horizon and tolerance for risk should result in the investor being rewarded over that longer timeframe. Heightened volatility can challenge that patience and may cause an investor to consider deviating from that plan, but periods of volatility do pass.


Source: PMFA

Today, we cannot say definitively whether the economy is about to enter a recession. We continue to have the view that risks are heightened on many fronts, including risks to continued economic growth. The risk posed by policy decisions – and the potential for a misstep – both in the U.S. and abroad shouldn’t be overlooked. On the other hand, strong policy responses could also be very effective in shoring up the outlook on a host of global issues, and the potential for a positive reaction by the market also shouldn’t be discounted.


Source: PMFA

We will continue to approach the process of consulting with you on your investment portfolios in a rational manner, seeking opportunities where we believe they exist, carefully evaluating the risks that are presented, and melding those with your individual tolerance for risk, available resources, investment time horizon, and financial goals.

Economy

GDP

The economy grew at a 1.3% annualized pace in the second quarter, according to the Bureau of Economic Analysis’ (BEA) third estimate. Coupled with anemic growth of 0.4% in the first quarter, along with the significant slowing in several economic indicators in recent months, calendar year 2011 growth is expected to be south of 2%. Contributors to growth in the second quarter included increased business investment, a stronger export picture, consumer spending on services, and federal governmental spending. Detractors included reductions to inventories, declines in durable goods purchases, and continued spending cuts by state and local governments.


Source: PMFA, Bureau of Economic Analysis (BEA)

The third-quarter earnings season will ramp up in the next few weeks and investors will be looking toward not only announced results, but adjustments to revenue and earnings expectations over the next several quarters. The last two years have resulted in sharp earnings growth and announced results generally surpassing expectations. A slower growth environment, even in the absence of recession, will challenge corporations to grow their top line and would likely also show up in slower earnings growth as well.

Inflation

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

Inflation remains a hot button issue at Federal Open Market Committee (FOMC) meetings as the doves and hawks debate about the near-term risks of a slowing economy versus the long-term inflationary risks of additional policy response. Dissention over recent policy moves has been widely publicized. Three hawkish members of the committee have opposed further easing as being unnecessary at best with the potential that these moves could even do more harm than good.


Source: PMFA, BEA, BLS

In August, headline consumer inflation edged upward, maintaining its upward trend on a year-over-year basis. Producer prices were unchanged for the month allowing the one-year change to ease from recent peaks. The one-year change for the Consumer Price Index (CPI) reached its highest point in three years, at 3.8%. The contraction in commodity prices, as the U.S. Dollar strengthened in September, should help to level off the recent upward trend. Stripping out the more volatile food and energy components, inflation rose at a more tepid pace in August. Core inflation remains within the Fed’s implied target, well above levels that would drum up deflationary fears. However, it is likely current levels would recede if a recession occurred.

Interest Rates

The 10-year Treasury yield, in September, reached its lowest point since Fed figures began (in 1953), as the global fear trade drove a flight to the Dollar and chatter surrounding the so-called “Operation Twist” intensified. The question at hand remains whether or not the actual implementation of the Fed’s plan will lower long-term Treasury yields even further, in turn pushing investors toward taking on more risk and incentivizing an increased demand for credit, thus spurring economic growth. Although QE1 and QE2 were followed by a figurative rising tide in risk assets, lower yields proved ineffective in igniting credit demand among households still intent on reducing their debt burdens. Moreover, increasing skepticism in the effectiveness of the Fed’s remaining monetary tools and pervasive economic uncertainty could pose an even greater headwind to the Fed initiatives. While Operation Twist is likely to help at the margins, it’s unlikely to materially alter the renewed emphasis on frugality, savings, and debt reduction.


Source: PMFA, U.S. Treasury

The 10-year Treasury yield fell over 50 basis points in September on increasing fears of recession and perceived deterioration in conditions in Europe. Anticipation of the Fed’s announcement that it would reconfigure its current balance sheet by selling short-term Treasuries and buying further out on the yield curve likely played some role, but seems likely to have been a less powerful driver than the global fear trade. At its low point, the 10-year reached 1.72% but edged higher to end the month at 1.92%, or 31 basis points lower than August 31. With short-term Treasuries at already extremely low yields, the three-month Treasury bill ended the month where it began, at 0.02%, although T-bills traded for a portion of the month at negative yields.

Employment

The September Employment Situation report from the Bureau of Labor Statistics (BLS) showed nonfarm payrolls surpassed expectations, rising by 103,000 during the month. However, that rate is still below what is necessary to meaningfully reduce the unemployment rate. It was also materially inflated by the return of striking Verizon workers during the month, which added an estimated 45,000 to that 103,000. With the economy at what appears to be a potential inflection point, it was enough to temporarily allay fears of an impending recession, at least temporarily.


Source: PMFA, BLS

The unemployment rate remained stuck at 9.1% in September, while another measure (U-6) which includes discouraged and underutilized workers rose to 16.5%. Hourly earnings rose this month, but the rate of growth in the past year has been less than 2%, or effectively stagnant when adjusted for inflation. Overall, the theme on the employment front is consistent with the broader economy – it’s moving forward, but at an uneven, slow pace.

Policy response to this data will likely have a significant influence on the performance of markets and the economy in the months ahead. Therefore, we expect that volatility may remain heightened as the news flow causes market reaction.


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.