Market Commentary: October 2006
As the economy continued to show signs of moderating in October, both stocks and bonds appreciated for the third consecutive month. Much of the market’s ability to stay buoyant despite a slowing economy can be attributed to the Fed’s pause in its rate hike cycle and the expectation that cuts may be needed in the next year. At its October 25th meeting, the Fed decided to maintain the Fed Funds rate at 5.25%. This is the third consecutive meeting with no action by the Fed. While widely expected by investors, a more dovish tone in the Fed’s formal statement was evident. Many considered this to be further evidence that the Fed may be done tightening rates.
These are positive developments, but economists and market observers remain vigilant. Inflation, while moderating, remains a concern. For the third quarter, the Fed’s preferred measure of core inflation, the price index for personal consumption (PCE deflator) fell to 2.3%. This represented a 0.4% decrease from the second quarter, although it remains well above the Fed’s stated target range of 1% to 2%. It appears that the Fed expects that the lagging effects of interest rate hikes made earlier in the year, along with the sagging housing market, will continue to unwind inflationary pressures. Additionally, falling oil prices helped to alleviate additional pressure, while putting money back in consumers’ pockets. In October, crude oil prices fell more than $4 per barrel to below $59, nearly $20 below its high reached in July. It is likely that the sharp decline in energy costs provided some relief, although the potential magnitude of the decline in housing is likely to have a greater effect until a bottom is reached. Meanwhile, companies reported strong third quarter earnings in October. An average earnings growth rate of 12.3% was realized by companies who have reported third quarter earnings thus far. Those companies beating Wall Street’s projections outnumbered those falling short by four to one.
All told, with inflationary pressures subsiding and companies and consumers increasing their potential for spending, the economy seems to be guided toward a “soft landing”. The advance estimate of third quarter GDP growth released in October suggested that the economy is slowing more rapidly than consensus expectations. While revisions are expected, the 1.6% annualized growth rate for the quarter was well below the 2.6% second quarter rate and signals the effectiveness of prior rate hikes and the slowdown in the housing sector. The Fed will be watching economic developments closely to attempt to find that delicate balance between nurturing growth while maintaining an acceptable degree of price stability.
As mentioned above, October was another month marked by positive returns from all segments of the stock and bond markets. Despite all of the press documenting the new highs hit by the Dow Jones Industrial Average, small cap stocks led the domestic equity market, returning 5.8% for the month as measured by the Russell 2000, a sign that investors may be extending their tolerance for riskier assets. Mid and large cap stocks also provided attractive returns as the Russell Midcap Index gained 3.9% and the S&P 500 returned 3.3%. The most discussed index of the month, the Dow Jones Industrial Average was up 3.6%. Despite the solid performance of the index, its prominence in the news was based on investors celebrating its resurgence to new highs rather than significant outperformance of the rest of the market. International markets also rallied, although the possibility that foreign central banks may not be done raising rates continues to create some headwinds in those markets. The MSCI EAFE Index gained 3.9%, while the MSCI Emerging Markets Free Index returned 3.4%.
In fixed income markets, increasing expectations of short-term rate cuts on the horizon and lower inflationary readings gave bond investors the needed impetus to drive up prices. Leading the way were intermediate term domestic bonds, as the Lehman Aggregate Bond Index returned 0.7% in October, outpacing short-term issues. Municipal bonds also fared well, with the Lehman 5-Year Muni Index posting a 0.4% gain for the month. Despite concerns of increasing interest rates, international bonds yielded positive results. A favorable outlook for the global economy and a moderate resurgence in commodity prices outweighed the negative sentiments about international interest rates; riding this optimistic sentiment, the Citi World Government Bond Index returned 0.5%. The U.S. dollar was generally flat against other major currencies. Compared to the Yen, the Euro, and the British Pound the dollar fell by less than 0.5% for the month, reflecting the increased probability that interest rates are more likely to rise in these countries compared with expected stable or even declining yields in the United States.
As we progress through the final quarter of 2006, we expect that economic conditions will continue to moderate. We believe that the risk of a recession in the near term remains improbable, but the marked slowdown in third quarter GDP growth remains concerning. If inflationary pressures continue to moderate, the Fed will certainly find it easier to justify holding rates at current levels or lowering them to support sagging growth. As they have previously indicated, the Fed will be looking closely at economic data to determine their next steps. Navigating the markets during such times can be difficult, as each threat may be accompanied by volatile market swings. We continue to be vigilant, and recommend that clients stay committed to a strategically diversified portfolio, which will provide participation in strong market performance without excessive exposure to the very real risks that remain.