Economic Review and Market Perspective |
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By the end of the first quarter of 2010, the global economy had been propped up by fiscal and monetary stimulus; inventories were rebuilding; and the final stage of economic recovery, namely job creation and the emergence of self-sustaining final demand, was hoped for although not yet in evidence. Markets, especially in the U.S., started the second quarter of 2010 on an optimistic note on the heels what had already been a remarkable recovery of prices for risk-based assets. In mid-May, however, markets reversed course amid concerns about the ongoing sovereign debt crisis in Europe and whether the U.S. economic recovery could be sustained. Investors were left to ponder two opposing scenarios: one, a short-lived and limited correction amid the on-going bull market begun in March 2009; and the negative one, the start in May of another bear market. Economic Review The U.S. economy grew at a pace that is actually faster than previous expansions following severe recessions. The level of gross domestic product (GDP) is on track to reach a new high this year, which is quite noteworthy considering the severity of the recent economic downturn. After the Great Depression, it took 15 years for GDP to get back to its pre-depression level. In the first quarter of 2010, U.S. GDP grew at an annualized rate of 2.7% (preliminary second quarter GDP will be released at the end of July, while revised numbers will be released in August). The economy grew at a slower pace in the first quarter of 2010 than in 2009’s fourth quarter, which saw GDP increase by 5.6% on an annualized basis. The Federal Reserve is currently predicting 3-3.5% growth of real GDP in 2010. The Federal Reserve’s most recent Summary of Commentary on Current Economic Conditions (“Beige Book”) reported that economic activity continued to improve in April and May across all twelve Federal Reserve Districts, although many Districts described the pace of growth as “modest.” Economic growth was attributed to an increase in consumer spending, business spending, and a pickup in residential real estate fueled by the April deadline for the homebuyer tax credit. Data released later in the quarter and in July, however, showed that residential housing weakened after the expiration of the homebuyer tax credit, and consumer spending was down in June. The Federal Reserve’s modestly positive Beige Book is consistent with the data from other economic indicators. The data on the employment front for the second quarter was encouraging. The Bureau of Labor Statistics reported that the private sector added 241,000, 33,000, and 83,000 jobs in April, May, and June, respectively. It should be noted that looking at only the private sector excludes the temporary census jobs added primarily in April and May and lost in June. So far this year, private-sector employment has increased by 593,000, or about 100,000 per month (for perspective, over a full economic cycle, employment averages a gain of 200,000-300,000 jobs per month). Unfortunately, it is a long way to more complete recovery of the jobs market because private-sector employment is still 7.9 million jobs below its December 2007 level. Unemployment declined from 10.0% in December 2009, to 9.7% in March 2010, to 9.5% in June 2010. Job gains were generally across the board with modest gains in leisure and hospitality, professional and business services, transportation and warehousing, healthcare, mining, and manufacturing. Construction employment was little changed over the last four months. Aside from the temporary census employment changes, there was little change in federal, state, and local government employment. The Manufacturing ISM Index fluctuated over the first half of the year from 58.4 in January to 56.2 in June, with a high of 60.4 in April. The Non-Manufacturing or Service ISM Index improved from 50.5 in January to 53.8 in June. Readings above 50 indicate that the economy is generally expanding while readings below 50 indicate a contracting economy. June was the eleventh consecutive month of expansion in the manufacturing sector, the sixth month of growth for the service sector, and the fourteenth straight month of expansion in the overall economy. The Conference Board Consumer Confidence Index® had been on the rise for three consecutive months but declined sharply in June. U.S. consumers continued to increase savings, limit spending, and reduce debt. In May, the personal savings rate was 4%, the highest rate in almost a year, as global equity values fell and European debt concerns spread. Consumer spending has been rising at a rate of 2.5 percent per quarter since the recession ended last year, less than half the rate of growth following the deep recession in the early 1980’s. Finally, consumers have continued to reduce their debt since early 2009. The modest improvement in employment does not appear to be producing upward pressure on wages, which is typically a critical component of rising inflation scenarios. In April and May, the consumer price index unexpectedly declined by 0.1% and 0.2%, the first such declines since March of 2009. As a result, the CPI was up only 2.0% in May over the last year. The Federal Reserve does not consider inflation to be an imminent concern as evidenced by Federal Reserve Chairman Ben Bernanke’s early June report to the House Budget Committee, forecasting solid economic growth for this calendar year and “a somewhat faster pace next year.” Further, Bernanke warned that this recovery “would probably be associated with only a slow reduction in the unemployment rate over time. In this environment, inflation is likely to remain subdued.” On the real estate front, results for the quarter were mixed. In April, sales of existing and new homes jumped 7.6% and14.8%, respectively, to seasonally adjusted annual rates of 5.77 million units and 504,000 units. The increases largely reflected expiration of the first-time home buyers’ credit. In contrast, existing home sales in May were only 5.66 million units, well below the 6.12 million units expected. And new home sales plummeted to a record low in May, down 32.7% to a seasonally adjusted annual rate of 300,000. This is the slowest sales pace since the Commerce Department began tracking data in 1963. For perspective, the normal annual level of new home sales is 800,000-900,000 units. Outside the U.S., the focus continued to be on the sovereign debt crisis in Greece and the potential for contagion to spread throughout Europe, particularly other Eurozone countries similarly overburdened by debt, the foremost being Portugal, Italy, Ireland, and Spain. Fear over the possible collapse of the Euro further exacerbated investor concerns about the European economy. Finally, the region’s most recent GDP report, which was released in May and showed that growth continued to be sluggish, was also disconcerting. Specifically, GDP for both the Euro area (EA161) and EU271 grew by a meager 0.2% compared to the prior quarter. Underlying investors’ fear is the uncertainty regarding how the European debt crisis (and its remedies) will affect future growth. Heading into and at the recent G20 Summit in Toronto, Canada, European nations argued vociferously for the importance of quickly implementing austerity measures to combat large deficits and related debt problems. This European stance is considered somewhat at odds with the U.S.’s evaluation. While U.S. leaders generally agree that increased fiscal discipline is a worthy endeavor, the timing of any such measures is critical. More specifically, the U.S. administration has expressed its concern that an immediate and synchronized European effort to implement austerity measures would hamper the global recovery. In response to the U.S.’s concerns, the G20 leaders came to an agreement that countries would reduce their deficits at different paces. While growth in Europe remained subdued, the pace of activity in Japan continued to be decent, with the large Asian economy growing by 1.2% during the first quarter compared to the fourth quarter of last year. In June, Japanese GDP was revised upward to 5% annualized, which suggests that Japan’s recovery is gaining momentum unlike Europe’s. China’s projected GDP was revised upward to 10.5% for 2010 and 9.6% for 2011. China ranks first in terms of GDP growth among all economies listed in the World Economic Outlook of the International Monetary Fund, followed by India, which is forecast to grow 9.4% in 2010 and 8.4% in 2011. The U.S. Dollar strengthened against most developed currencies during the second quarter of 2010. Most notably, the Dollar gained 10.5% against the Euro and rose 8.7% against the Australin Dollar. In contrast, the greenback actually lost -5.3% versus the Japanese Yen, which is considered by many investors to be a safe haven. Summing up, some investors may have viewed the news coming out of Europe as new information, but economic conditions have not changed materially abroad or in the U.S. over the past few months. Market Perspective The unfolding situation in Europe and spread of potential outcomes have helped create a very ambiguous environment for investors. The corollary has been a dramatic increase in volatility; markets seem hyper-sensitive to any new piece of news. A tug of war persists between positive corporate results and not-so-optimistic economic reports. Some of the weakness in U.S. equities can also be attributed to continuing uncertainty about the impact on business of Obama administration policies and major legislative initiatives recently passed by the Democratic Congress. The latter include healthcare reform and stepped-up regulation of Wall Street and other parts of the U.S. financial system believed to be at the heart of the recent credit crisis. Potential future legislation regarding the environment, oil exploration, and immigration are also cause for concern among investors. Given the volatility and uncertainty of the last two years, how are investors responding? According to Morningstar, net investments in mutual funds totaled $166.7 billion in the first half of 2010, which is about 24% higher than inflows for the same period in 2009. The table below summarizes the estimated net flow by broad investment type (Dollars in Millions).
Source Morningstar Direct FundFlows Salient observations are as follows:
As indicated in the table below, since March 2000 U.S. financial markets have experienced two market tops, two bottoms, and a possible third top (namely, as of April 23, 2010).
The negative impact on asset class returns of the two deep bear markets and the recent dip in May has been dramatic. Annualized returns for global stocks were about breakeven over the entire 10.25-year period covered by the text table above. Small cap U.S. stocks were actually somewhat in the black and outperformed large caps consistent with the seminal Fama-French research. Over the 10.25-year period, global bonds provided annualized returns somewhat over 6% and also were fairly consistent performers (except the second half of 2008). Further, U.S. real estate funds were the surprising winners over the period, providing total returns of almost 10% annually. However, all of the gain occurred before the latest 5-year period; in other words, real estate funds were also hard hit by the 2007-2009 bear market. Finally, emerging market stocks were also good performers over the 10.25 years and were especially strong in the last five years when other stocks were very weak. The table below shows the 10.25-year data and also one-year and five-year returns as of June 30, 2010.
1 The euro area (EA16) consists of Belgium, Germany, Ireland, Greece, Spain, France, Italy, Cyprus, Luxembourg, Malta, the Netherlands, Austria, Portugal, Slovenia, Slovakia and Finland. The EU27 includes Belgium (BE), Bulgaria (BG), the Czech Republic (CZ), Denmark (DK), Germany (DE), Estonia (EE), Ireland (IE), Greece (EL), Spain (ES), France (FR), Italy (IT), Cyprus (CY), Latvia (LV), Lithuania (LT), Luxembourg (LU), Hungary (HU), Malta (MT), the Netherlands (NL), Austria (AT), Poland (PL), Portugal (PT), Romania (RO), Slovenia (SI), Slovakia (SK), Finland (FI), Sweden (SE) and the United Kingdom (UK). |
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