Market Commentary: April 2007
First Quarter Overview
- Volatility was re-introduced to the markets in February, as many indexes had significant one-day drops. Further volatility followed in mid-March, leaving investors skittish. We expect that this strengthens the case for higher quality investments, such as large cap stocks and investment grade bonds.
- As anticipated, the Federal Reserve held its benchmark Fed Funds rate steady at 5.25% during the first quarter. Moderate changes in the language used in the Fed’s March statement contributed to investors’ perception that the Fed’s hard line view on inflation may be softening relative to their concern about the degree of slowdown in economic growth.
- Inflation ticked slightly higher during the quarter. The trailing 1-year core CPI reached 2.7% in February, above the Fed’s comfort zone. While the Fed has made statements concerning the moderating economy, it has emphasized that fighting inflation is its primary concern. Its resolve may be tested if the economy slows further, while increased energy prices drive inflationary pressures higher.
- The yield curve steepened during the quarter, as investors adjusted their expectations for inflation and interest rates. The resulting sell-off in longer-term Treasuries pushed 10-year yields to 4.64% at March 31. The 2-year Treasury yield ended at 4.59% marking the first time since August 2006 that that portion of the curve was not inverted.
- Employment continues to buoy the moderating economy. March’s unemployment rate came in at 4.4%, supporting hourly wage growth. Preliminary estimates for first quarter job creation were 455,000, which was better than anticipated, but still well below that of the comparable period in 2006.
- Consumer spending, the primary driver of economic growth, rose 0.6% in February and 0.5% in January. Such growth signaled to economists that the economy remains supported by consumers despite a worsening housing market and suppressed fourth quarter business spending.
- The housing market declined in the first quarter, a result of an excessive inventory build up of unsold homes and uncertainty about the outlook for housing prices and a tightening of credit standards. As a result, the median sales price for existing homes in February fell 1.3% over the trailing 12-month period. Concerns about the deteriorating sub-prime mortgage market have compounded woes in the housing market.
- Oil prices increased 7.9% to end the quarter near $65/barrel. Reignited tensions in the Middle East due to Iran’s continued pursuit of nuclear capabilities and its detainment of 15 British Navy personnel contributed to the price hike.
- The U.S. Dollar declined nominally relative to the Yen and the Euro during the quarter. Emerging market currencies did not move appreciably relative to the dollar during the same period.
April 2007
Capital Markets
When painting, artists often step back from their work to gain perspective and a sense of direction. From a distance, the view can be meaningfully different than that which can be seen up close. When analyzing the financial markets, it is often helpful for investors to do the same. During the first quarter of 2007, the economy continued its below trend rate of growth. Concern that the economy may slip even further piqued investors’ interest, and briefly resulted in a "flight to quality" by investors that translated to higher volatility, culminating in a 3.5% one-day drop in the S&P 500 during February. This was followed by several days of increased volatility over the remainder of the quarter.
As we noted in our Special Commentary issued shortly after February’s brief selloff, such stark corrections, while staggering in the short-term, serve a vital role in the efficiency of the markets by draining excesses from potentially over-priced investments. Simply put, volatility is not necessarily a bad thing. However, much like the small dots used by the pointillist painter George Seurat in his work Sunday Afternoon on La Grande Jatte, a more distant viewpoint (or in our case a longer-time horizon) is required to perhaps appreciate the role that it plays.
During such times, it may be helpful to consider the observations outlined in our 2007 Economic and Capital Markets Outlook and compare those to the broad themes relevant in the first quarter. In doing so, it becomes evident that the broad themes we outlined have started to play out, although one must look beyond the “noise” in the market to make that observation. The economy continues to grow at a moderate rate. The dragging contributors have been the lagging effects from two years of monetary tightening and the downturn in the housing market. In line with our outlook, the Fed has continued to maintain interest rates at 5.25% as they expect prior rate hikes and the slowing economy to curtail inflation. Despite this, the persistence of elevated inflation in the first quarter has been noteworthy, helped considerably by increasing energy prices.
The housing market continues to stumble, exacerbated by the turmoil in the sub-prime mortgage market. While the deterioration of this sector started last year, concerns have continued to mount about the potential severity of the impact on housing and the ripple effect into other sectors of the economy. While housing represents a relatively small portion of the overall economy, the marginal effects of a significant correction could have a sustained effect. We expect that it will continue to be a focal point for the Fed, investors, and other market observers until the picture becomes clearer.
Business spending was one component of GDP that we regarded as a source of uncertainty at the outset of 2007. Subsequent results have proven to be even worse than many anticipated, as corporate America remains hesitant to invest heavily in the face of short-term economic uncertainty. During the fourth quarter, business investment fell 3.1%, a significant decline from the 10% growth posted in the preceding quarter. As the degree of the retrenchment became clear, the result was a significant downward revision to the advance fourth quarter GDP estimate. The final estimate of fourth quarter GDP recently came in at 2.5% annualized, a full point below the advance estimate of 3.5% annualized. Some have attributed the steep decline in business investment to slowing profit growth and a desire to avoid deterioration in corporate balance sheets. Others have acknowledged that corporate America’s concern over the ability of consumers to continue to spend has tightened their purse strings. Both may be playing a role, however it is still too early to predict the sustainability of the slowdown and its overall effect on the economy.
Offsetting the potential threats has been strength from the traditional economic bellwethers: employment and consumer spending. Shrugging off a prior uptick in joblessness, the March unemployment rate dipped back to 4.4%, matching its post-9/11 low and continuing to suggest a generally strong employment outlook. Persistently tight labor markets have resulted in a pickup in the rate of real wage growth, in turn sustaining the largest component of GDP: consumer spending. Despite falling home values and increasingly tight standards for credit, consumers continue to spend at a moderate pace. Reported figures from the fourth quarter estimate that consumption rose by 4.2%, nearly 1.5% higher than the third quarter rate. Continued strength in consumer spending will likely be necessary to maintain the economy’s course and avoid further softening. The consumer not only accounts for the largest portion of GDP (nearly 70%), but could buoy the confidence of cash-rich companies in the short-term economic outlook sufficient for corporate America to resume spending as well.
Equities
The first quarter of 2007 marked the re-introduction of volatility into the markets after several quarters of steady appreciation. Even in February, many benchmarks continued to trade near all time highs, despite growing concerns about the economy. The tipping point came on February 27th, when a sudden drop in the Chinese stock market and talk of recession by former Federal Reserve Chief Alan Greenspan sent the markets into a sharp sell-off. In the domestic market, the sell-off was widespread, crossing over all style and market cap boundaries. In one day, the S&P 500 Index declined 3.5%, while the Russell 2000 Index lost 3.8%. Most markets battled back in the weeks following the pullback, albeit with a more noticeable shroud of uncertainty weighing on investors.
In response to the market downturn, investors initially sought refuge in higher quality investments, sending Treasuries higher. Investors have since begun to return to equities, albeit perhaps with increased skittishness and an eye still on the exit. For the quarter, mid cap stocks took the domestic performance lead returning 4.4% as measured by the Russell Mid Cap Index. Reflecting stronger performance earlier in the quarter, small cap stocks outpaced large cap stocks with the Russell 2000 index returning 2.0%. Large cap stocks rounded out domestic equity returns with a quarterly return of 0.6%, according to the S&P 500 Index.
The breadth of February’s market correction and the subsequent volatility was not limited to domestic markets. Asian and European stocks also experienced sharp single day declines, as well as increased subsequent volatility. Higher quality foreign investments benefited from increased volatility, as stocks of companies domiciled in developed nations surpassed comparatively risky emerging market stocks. For the quarter, the MSCI EAFE Index returned 4.1%, besting the MSCI Emerging Markets Index by nearly 1.8%. With increased volatility, foreign investors remain focused on the U.S. economy. In Asian economies, which remain heavily dependent on the seemingly insatiable spending habits of U.S. consumers, investors worry that a continued slowdown could result in decreased exports. In Europe, the deteriorating conditions in the sub-prime mortgage market stirred concerns about financial stocks’ exposure to low quality mortgages and a potential credit tightening that may spread overseas.
Short-term market volatility such as that exhibited in late February tends to receive more attention than it often deserves. Moving forward, we expect that volatility could remain elevated given the potential for continued sub-par growth and the probability of further slowdown in corporate earnings. Nonetheless, the perspective that can be gained by stepping back from the day-to-day noise to focus on the big picture can make all the difference to the investor.
Fixed Income
As stocks around the world plunged in late February, many investors moved directly from risky assets to high quality bonds. This migration, coupled with sub-par economic growth, boded well for bond investors. During the quarter, the taxable bond market led the way with a return of 1.5%, as measured by the Lehman Brothers Aggregate Bond Index. Short-term taxable bonds also fared well with the Lehman Bond 1-3 Year Government Index returning 1.4%. Municipal bonds trailed their taxable counterparts by approximately 50 basis points, as the Lehman Muni 3-year Index returned 1.0% and the Lehman Muni 5-year Index returned 0.9%.
One detractor from bond performance during the quarter was persistently high inflation, which moved up again in recent months. The Core Consumer Price Index ticked up to 2.7% for the twelve months through February, erasing a fractional decline in the fourth quarter of 2006. It is not unusual to see a short-term pickup in consumer prices in the first quarter of the year. Beyond that seasonal advance, however, energy prices have again surged recently due primarily to elevated tensions with Iran and projections that the 2007 Atlantic hurricane season is expected to be more active than normal. In reaction, investors seeking to hedge against inflation risk have again turned to Treasury Inflation Protected Securities (TIPS). For the quarter, the JP Morgan U.S. TIPS Index appreciated 2.4%.
Despite some choppiness, foreign bonds were able to yield positive performance. For the quarter, the Citi World Government Bond Index returned 1.0%. Helping to get foreign bonds back on track was the U.S. central bank’s statement following their March Meeting. In the statement, the Fed reaffirmed that the soft rate of economic growth, in addition to inflation, remains a significant focal point for U.S. monetary policymakers. Although the Fed’s statement indicated that inflation continues to be the primary concern, the fixed income markets reacted positively to the change in language in the statement. In general, bond investors interpreted this change as a softening in the Fed’s outlook on inflation, potentially leading to interest rate cuts. Such a move would be particularly beneficial to foreign bonds issued by countries where interest rates are projected to continue to increase such as the United Kingdom. Enhancing the returns of foreign denominated bonds, the Dollar slipped nominally against major foreign currencies, falling 1.5% against the Yen and 1.0% against the Euro during the quarter.
Economists and investors have mixed forecasts for what exactly the economy and financial markets may do next. Even the Fed has indicated after the past several FOMC meetings that their decision-making is increasingly data-driven, suggesting that they are closely watching developments on a month-to-month basis to determine their next steps. Despite the availability of complex models and calculations for forecasting scenarios, the Feds’ tools are much more similar to spray cans and paint rollers, than a delicate camel hair brush. Because of this, the Fed is more apt for the sweeping brush strokes used in impressionistic works than the intricate detailing of trompe-l’oeil. Investors, on the other hand, often attempt to examine every detail and continue to make ill-advised changes to their portfolios based upon their short-term fear and greed. While attention to detail is critical, it is equally important for us to remember that the picture may look quite different if we take a few steps back.
By doing so, we see that things are not much different than we had anticipated, despite short-term volatility. The housing market and elevated interest rates continue to drag on the economy, as anticipated. The scope of the fallout in the sub-prime mortgage market and the resultant tightening of credit standards have not yet fully played themselves out. Weak business spending and softening corporate profits keep corporate America in a tentative stance. As expected, volatility in the financial markets has picked up as the economy continues to slow and risk is intermittently but undeniably being priced back in.
Nonetheless, despite the uncertainty, consumers continued to spend, jobs were created, and the economy continued its moderate growth during the first quarter. We continue to believe that we have taken appropriate steps and made recommendations that have positioned portfolios appropriately for this current environment. We believe that by adhering to a strategic plan and maintaining a long-term perspective, while prudently rebalancing asset classes in accordance with Investment Policy, investor's may respond appropriately to both risk and opportunities when the market may be trading irrationally.
As always, if you have any comments, questions or suggestions on the report, please do not hesitate to call.
This report is prepared solely to help you with your investment planning. Accordingly, it may be incomplete or contain other departures from generally accepted accounting principles and should not be used to obtain credit or for any purposes other than your investment planning. We have not performed an audit, review or compilation engagement in accordance with standards established by the American Institute of Certified Public Accountants.
