September 2011

 Executive Summary

• Volatility soared as equities lost more traction in August, falling into negative territory for the year.
• Fears of recession, along with the perpetuation of the Eurozone crisis, prodded a flight to quality that resulted in falling Treasury yields and positive returns for high-quality bonds for the month.
• Inflation accelerated in July but remained in a moderate range over the last year. Bernanke’s speech at Jackson Hole stated that the Fed would take action as necessary but delivered no assurance of additional easing in the near term.
• The employment situation once again disappointed with zero jobs added in the month of August. The unemployment rate remained a high but steady 9.1%.

Capital Markets

The Law of the Instrument…

In 1964, the American philosopher Abraham Kaplan introduced a concept he called the Law of the Instrument: “Give a small boy a hammer, and he will find that everything he encounters needs pounding.” Just a few years later, “The Psychology of Science: A Reconnaissance” was published by Abraham Maslow, a professor of psychology. In it, he referenced the more common version of this notion, popularly phrased, “If all you have is a hammer, everything looks like a nail.” Why this brief foray into psychology? Although the hammer and the nail analogy could be a fitting intro into discussions of the still-ailing housing market, this idiom also provides a fitting depiction for the major problem facing policymakers today.

“If all you have is a hammer…”

Through much of August, anticipation mounted for the Annual Jackson Hole Economic Policy Symposium. It was at this meeting last year that Federal Reserve Chairman Ben Bernanke hinted of a pending second round of quantitative easing. That message, along with the subsequent $600 billion in Treasury purchases, propped up risk assets and helped to alleviate concerns of a double-dip recession. Despite some hopes to the contrary, this year’s speech yielded no direct indications that further easing was imminent. While the late summer was again characterized by heightened volatility, conditions are somewhat different now versus then. Inflation, specifically, is higher, although pressures are easing. The 12-month change in the core Consumer Price Index (CPI) was at 0.9% in August 2010, just half of where it stands today. The unemployment rate is now 9.1%, having fallen moderately from 9.6% in the past year. Meanwhile, the Treasury yield curve has been volatile, although the 10-year Treasury was just 24 basis points lower on August 31 than one year prior. Still, inflation doesn’t currently appear problematic, and the economy is still not creating a sufficient number of jobs.


Source: PMFA

Taking a step back first, the Fed’s traditional tool of choice when adjustments are needed to either stimulate or dampen economic growth is the federal funds rate. Over time, this has been the primary tool used to fulfill their dual mandate of full employment within the context of price stability. At the onset of the Great Recession, the Fed hastened to reduce this rate to the historically low range of zero to 0.25%. Two years after the recession ended, the funds rate remains unchanged; with the economy slowing, that tool lacks its historical effectiveness should further easing be needed.

There are other tools in the Fed’s arsenal that could be effective, although most are grounded in theory with little or no precedent in practice. One example is quantitative easing, or large-scale asset purchases of Treasuries or other assets to push money into the economy and attempt to hold down interest rates. This was introduced at the peak of the Great Recession (QE1), where it provided some stability, then again introduced in the fall of 2010 (QE2) as the recovery was at risk of stalling. Its ultimate effectiveness remains subject to intense debate, and based on the real world experience of QE1 and QE2, the results have appeared to be transitory at best. The so-called “operation twist” that’s been recently proposed is a form of quantitative easing, which would target a flattening of the yield curve through the Fed selling short-term Treasuries and buying debt further out on the yield curve. Cutting interest rates on excess reserves has also been suggested, but with that rate at an already low 0.25%, there’s little expectation that it would have significant – if any – impact. Increased transparency may be yet another way to encourage risk-taking and growth by providing greater clarity on the timing of any potential rate hike or adjustments to the size of the Fed’s balance sheet. (The FOMC’s August announcement that they intended to maintain current rates through mid-2013 exemplified that move toward increased clarity around policy expectations.)

Bernanke, in acknowledgment of the potentially blunted impact of the Fed’s remaining tools, called out for additional fiscal stimulus to help prop up the recent deceleration in growth. President Obama has already announced his plan to spur job growth and stimulate the economy through fiscal policy. Implementation, however, could prove difficult given the battle lines that have been drawn in Washington, driven by both legitimate philosophical differences and tactical positioning in advance of the 2012 elections. After watching the political debacle that transpired in recent months, there’s little reason to believe that any agreement will be easily reached. Moreover, as our comments herein were being finalized, the details of the package that were lacking in the President’s address related to funding for the plan began to surface. Given that the President’s proposal included no cuts in spending in future years and instead focuses purely on higher taxes, there is little chance of it passing the House in anything close to its current form. The question at this point is whether the two sides are able to reach some agreement on moving forward with a bill in some form, or whether the process will be reduced to partisan bickering and a lack of meaningful action. Recent history provides more reason for doubt than hope.


Source: PMFA

Amidst slowing growth and reemerging fears of sovereign default in the Eurozone region and the risk to the European banking system, stocks pulled back sharply in August. International equities led the retreat, followed closely by domestic small caps. Mega caps faired the best, with losses of 5.3%, as measured by the Russell 200 Index. Year-to-date returns fell into negative territory across the board, with the most significant loss posted by international equities priced in their local currencies. The loss of more than 11.0% has been mitigated for U.S.-based investors as the dollar has depreciated on a year-to-date basis, despite its recent rally.


Source: PMFA

High-quality bonds were once again the beneficiary of the investor flight to quality, as falling yields contributed to positive returns for the month. The Barclays Aggregate Index returned 1.5% last month, which boosted year-to-date performance to a solid 5.9%. The spike in aversion to risk assets did not bode well for high yield bonds, however, as the Barclays High Yield Index gave back 4.0% for the month.

“…everything looks like a nail.”

Just three years ago, the Federal Reserve (along with fiscal policymakers and other central bankers across the globe) was furiously hammering in an effort to repair the global economy and banking system. Today, while the global economy has resumed growth, signs of stress are again becoming apparent. Policymakers are again weighing the need for stimulus in some form and examining the tools at their disposal.

The federal funds rate, until recently, has been an effective tool that could be used to impact the rate of growth within the economy. Credit created by banks has a multiplying effect. Since banks are only required to hold a portion of their assets in reserve, borrowed money has exponential benefits when deployed into the economy. Traditionally, as rates fall, demand for credit increases, and this multiplying effect naturally occurs. What’s different today is that bank credit has not expanded. Demand for credit remains relatively constrained, while banks are much less inclined to lend to marginal borrowers than they were in the heyday before the crisis. These variables have effectively turned the nail upside down, making the sharp end a harder target and diminishing its overall effectiveness. Cash injected by the Fed (i.e., quantitative easing) has not had that same multiplying effect and, thus, has been far less impactful at sustaining expansionary growth.


Source: PMFA

While policymakers contemplate the effectiveness of other tools needed in the exercise of post-“hammer and nail” monetary policy, investors still have a number of tools at their disposal. Against the current sober backdrop of challenges, a number of alternatives can be used to complement traditional investments and help mitigate downside risks while still allowing for upside participation. Gold, known for its ability to act as a crisis hedge, is one example. Flexible mandate and hedged strategies have more tools than traditional long-only funds focused on a single asset class and can mitigate some downside risk in periods of excessive volatility, as evidenced by August’s returns. These tools, as well as others, can make it easier for investors to maintain a long-term approach in periods of excessive fear.

Also important at times like this, investors should ensure that they have adequate liquidity to meet their near-term needs. Investors should also acknowledge their true tolerance for risk and position their portfolio accordingly so they can absorb the inevitable market decline without deviating from their plan, allowing their investment portfolio to work over their investment time horizon.

Economy

GDP
 
A second look at GDP in August revealed that the economy grew at a slower rate than previously estimated in the second quarter. Economic growth was just 1.0%, revised lower from the initial estimate of 1.3%. When coupled with the 0.4% growth in the first quarter, growth was clearly anemic for the first six months of the year. Primary contributors to growth this quarter were accelerating business investment and a spike in federal defense spending, while consumer spending and exports grew but more slowly than in the prior quarter.


Source: PMFA, Bureau of Economic Analysis (BEA)

It’s that consumer variable that was an important catalyst of the dwindling growth pace. Spending was positive in the second quarter, but the 0.4 pace was the slowest since December 2009 – far from what would be expected in a more traditional expansion. Consumers account for more than 70% of GDP, but those same consumers have been forced to deleverage their personal balance sheets because of tighter lending standards and homes that, on average, are worth 30% less than just a few years ago. They may be out of work or just fearful of losing their jobs, with unemployment at persistently high levels, and the primary message being delivered by the media is a bleak one. It’s no surprise that confidence levels today are commensurate with that of past recessions (or even lower by some measures). While the deleveraging process can be long and painful, it will eventually leave consumers in a better place with healthier balance sheets. When that process will end, however, is difficult to foresee.

As we wrap up the final month of the third quarter, expectations for growth have pulled back considerably. In general, broad expectations for growth in the second half of the year are better than the first half results, but still subdued. As the economy balances on a thin thread and additional stimulus efforts are considered, there’s no question the possibility of another recession has increased.

Inflation

Headline inflation pushed higher in July, with about half of the 0.5% increase in the CPI attributable to rising gas prices. The one-year change in CPI remained at 3.6%, matching its highest level since October 2008. The Personal Consumption Expenditures (PCE) index also edged up in July, by 0.4%, pushing the year-over-year change to 2.8%. Excluding volatile food and energy prices, core inflation was more muted in comparison. The core CPI rose 0.2% for the month and 1.8% over the last 12 months, staying in line with the Fed’s implied target range.


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

Price stability remains a core focus for the Fed’s policy actions; however, we believe that elevated employment remains the greater of the two risks at this time. Although inflation has edged up over the last year, price pressures have been easing in recent months. Even so, the Fed’s tolerance for inflation may be slightly higher today than would be the case if economic growth was strong and jobs were plentiful. The greater risk may be persistently high unemployment and another bout of disinflation, or even deflation, if the economy slows further. Instead, expectations are increasing that the Fed may announce additional stimulus efforts in the weeks ahead.


Source: PMFA, BEA, BLS

Interest Rates

The Treasury yield curve flattened in August, as an ailing domestic economy and concern over Europe’s sovereign-debt crisis contributed to a flight to quality, pushing yields lower across the curve. Over the last three months, yield curve contraction has been significant with the 10-year Treasury falling more than 80 basis points, ending the month at 2.23%. As fear and volatility rose further in early September, the 10-year Treasury yield reached a historical low in intraday trading of 1.91% following the Labor Day weekend. The short end of the curve, measured by the three-month Treasury, has been relatively flat but contracted eight basis points to end August at just 0.02%.


Source: PMFA, U.S. Treasury

September’s FOMC meeting was expanded to two days “to allow a fuller discussion” to take place. In their August 9 meeting minutes, the Fed acknowledged that not all of the recent slowing can be attributable to the dampening effect of rising food and energy prices or the supply chain disruptions from the Japan earthquake. Market participants will wait in anticipation of any hints of further stimulus to support growth, which “has been considerably slower than the Committee had expected.” Thus far, individual members of the FOMC continue to deliver somewhat mixed messages about what, if any, additional actions may be needed.

Employment

There was much ado about nothing this month, as the Bureau of Labor Statistics announced zero new jobs were created in the month of August. Given that the natural expansion in the employable population is somewhere around 100,000 to 200,000 per month, no new jobs is a step backward for the economy. Looking back over the prior three months (May through July), additions to payrolls averaged just 53,000 jobs, which was a marked slowdown from earlier in the year.


Source: PMFA, BLS

The unemployment rate remained at 9.1% in August and has held above 9.0% for four consecutive months. While part of the Fed’s dual mandate is encouraging maximum employment along with keeping a watchful eye on price levels, the Fed arguably has fewer tools at its disposal today to bring to bear on the problem. In his recent speech at the annual Jackson Hole conference, Fed Chairman Ben Bernanke expressed the view that a fiscal response was needed. President Obama recently announced a jobs bill, the details of which are still taking shape. Whether or not that bill takes a form that Congressional Republicans would support or would be meaningful in terms of job creation remains to be seen. There’s no question, however, that the stalling economy and a weak job climate are quickly moving to center stage as jockeying in advance of the 2012 presidential election begins to heat up.



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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.