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Capital Markets

Just over a year ago, the Fed warned about the threatening potential of a negative feedback loop arising in the economy -- a vicious circle in which weaker economic activity leads to further worsening of financial conditions, which in turn dampens economic growth even further. The economy appeared to be trapped in the onset of this self-reinforcing cycle as indicators spiraled downward, while massive fiscal and monetary stimuli were employed to combat it. Eventually, these significant efforts shored up financial conditions and spurred signs of economic stabilization leading to a reversal of this trend. Today, some question whether a virtuous feedback loop may instead be emerging, in which positive economic news triggers improving financial conditions, further stimulating economic growth, and ultimately escalating into an economic recovery. These loops can become self-perpetuating and ultimately have the potential of becoming self-fulfilling prophecies, although any kinks along the way could lead to a disconnect within the cycle.

The possibility of these circuit breakers may generate skepticism regarding the current momentum within equity markets and the ultimate realization of economic recovery. Whether or not these early signs of growth are enough to breathe life into the recovery, what appearance the recovery will take, and whether growth will be sustainable as stimulus measures dry up are all questions that remain unanswered. As time passes, the answers to these questions will emerge, bringing with them a new stream of questions surrounding future expectations for both the economy and equity markets. In the meantime, we anticipate volatility levels will remain elevated and potentially even increase, as investors measure results against their expectations. For investors, we recommend maintaining a prudent diversified investment approach within the context of their risk tolerance.   

Gratuitously Unnecessary Perspective of the Month Cleveland Rocks!  No, not the one in Ohio (although we like that one as well). We’re talking about Grover Cleveland, the 22nd and 24th President of the United States. Not only was Cleveland the first and only president to serve two non-consecutive terms, but in 1894, he also signed a bill into law that resulted in the holiday that gives us a much-earned day off the first Monday of every September. That’s right…we have Grover Cleveland to thank for Labor Day.  Source: www.encarta.msn.com

As history reveals, and as behavioral finance hypotheses are built upon, investors are often anything but rational. Irrational fear can lead to excessive selloffs, while irrational exuberance creates those notorious bubbles. At current equity levels, the market doesn’t appear to be in bubble territory, although the onset of “less negative” economic news has clearly been the catalyst for this rally, and stocks don’t appear to be particularly cheap as a result. 


Source: PMFA

August marked a six-month upward trend in equity markets. The leaders for the month were international equities and mid cap stocks; however, gains were seen across the board. Year-to-date returns are now well above historical annual averages; although in comparison with the declines from the prior year, equity indexes remain well below their previous peaks. An extended period of stabilization and growth across the global economy will likely be needed for those historical highs to once again be challenged.   


Source: PMFA, Yahoo Finance 

Volatility levels rose marginally during the month and remain in an elevated range, but well below the previously unimagined levels of last year. While some  investors were eager to participate in the market rally which helped to perpetuate it, substantial cash still remains on the sidelines while investors gain confidence that the recovery has legs. Even many less risk-averse investors remain cautious, leaving room for volatility levels to increase further if these early trends toward improvement do not continue.

Source: PMFA

Appetite for risk continued to increase in the more conservative side of portfolios as well. The fixed income market was generally positive in August. Areas that experienced greater downside as the recession intensified continue to post better-than-average returns. For example, high yield bond returns now exceed 40% year-to-date, while longer duration muni performance is also in the double digit range for 2009. 


Source: PMFA

Nontraditional sub-asset classes have also rallied over the course of this year. The most notable in August may have been REITS, as the Dow Jones U.S. REIT Index returned over 14% -- finally pulling the year-to-date tally into positive territory. The collapse in REIT prices was far greater than that of broad equities, as conditions in the real estate sector have been particularly tenuous. We remain cautious on the outlook for real estate at this time, although valuations are becoming more favorable than a year ago. Precious metals rallied in August, while a diversified basket of commodities was essentially flat.  

Economy

GDP

The second look at GDP growth was unchanged -- still indicating a decline of 1.0% for the second quarter. Although the U.S. economy continues to experience negative growth, the trend improved significantly as compared with the first quarter decline of 6.4%. Increased government spending and smaller declines in business investment, exports, inventories, and housing all contributed to this improvement.  

Source: PMFA, Bureau of Economic Analysis (BEA)

As the third quarter wraps up this month, consensus expectations point toward GDP growth in the range of 2.0%. While any growth is welcomed after four quarters of declines (six quarters, absent the perceived impact of tax rebates in early 2008), it will be important to understand the contributors to growth and the sustainability of those factors in future quarters. Increases are expected in inventory investment as companies realign inventory levels with consumer demand after five consecutive quarters of reduction. Government spending should continue to boost growth in the coming quarters as well.   

Inflation

As concerns about the return to and sustainability of growth take center stage, inflation concerns remain on the back burner. The Fed closely monitors the potential for both deflation and inflation, but recent improvement in the economic outlook has reduced deflation worries, while the sizable slack in the economy restrains upward inflationary pressures as well. The economy will likely need to be well into its recovery, however, before forces work to push inflation meaningfully higher. The Fed’s ability to maintain price stability while these forces persist will be challenged, although in the near term, the risk appears to remain quite low.   

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

The Producer Price Index fell by nearly 1% in July -- led mainly by declines in gasoline prices. Over the last 12 months, this index has declined 6.4% -- the largest decline since its inception. Other headline inflation indices also remain deflationary over the past year, although these should normalize to a degree as the impact of the collapse in commodity prices falls out of the year-over-year calculation.   


Source: PMFA, BEA, BLS

Core inflation, which excludes more volatile food and energy prices, has also been falling but remains in a positive range. As the recovery continues to take hold, the absorption of excess slack will take some time, keeping wage growth in check, but ultimately providing a foundation for price levels to stabilize.

Interest Rates

At their August meeting, the Federal Open Market Committee not surprisingly left the Fed Funds rate at its historically low range of 0-0.25% with the continued reiteration that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Their statement also indicated that data suggest that economic activity is leveling out and improvements are becoming evident.

The Treasury yield curve shifted downward in August. Short-term yields, with limited downside, fell marginally for the month. The three-month Treasury yield fell three basis points to 0.15%. Longer-term yields also declined during August, as the 10-year Treasury slipped 12 basis points to 3.4%.  


Source: PMFA, U.S. Treasury

Employment  

Source: PMFA, BLS

The employment situation remains a concerning variable that could affect the progress of the recovery. The economy has been shedding jobs since the beginning of 2008, and expectations are for this trend to continue until sustained growth reemerges, instilling confidence for companies to resume hiring. In August, the economy lost 216,000 jobs, the smallest monthly pace in a year. This beat consensus expectations, although the number remains meaningful. Meanwhile, the unemployment rate rose to 9.7% in August and appears likely to edge higher. 

U.S. Dollar

The relative strength of the U.S. Dollar plays a notable role in many economic variables. One example would be its impact on exports. As the Dollar declines relative to other currencies, U.S. goods become more competitively priced internationally, typically boosting exports. The exchange rate also affects oil and other commodity prices, which tend to be denominated in U.S. Dollars. Since March, the U.S. Dollar Index has been falling, as the “fear trade” continues to ease.

 
Source: PMFA, U.S. Treasury, BEA 

 

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 source 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 sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.