Market Commentary: August 2007
Commentary
For some time, we have highlighted the probability that market volatility was likely to increase from the unsustainably low levels of the past few years. By its very nature, the capital markets are driven by risk and uncertainty. Without those factors, the primary inducement for investors to shun risk-free assets -- the ability to achieve returns in excess of the risk-free rate – would be eliminated, drying up the flow of capital to those with the ability to create value in a capitalistic system.
While it was difficult at best to predict the specific catalyst for a re-pricing of risk, let alone the timing or magnitude, over the past several weeks those factors became painfully clear. Increasing defaults and the re-pricing of risk in the sub-prime mortgage market spilled over into the overall credit market, ultimately resonating throughout the financial markets in the form of increased volatility.
VIX Market Volatility Index – as of August 2, 2007
Source: Yahoo Finance
Just over a week after the S&P 500 reached an all-time high, investors closed July with a selloff that led to negative returns and very high volume. At one point in July, the S&P 500 was up 3.3% for the month. By July 31, however, index returns had turned sharply negative, ending the month down 3.1%. Weakness in smaller company stocks was even more pronounced, as the Russell Midcap Index fell 3.7% and the Russell 2000 Index lost 6.8%.
Source: PMFA
Source: PMFA
Despite good overall economic signs, economic risks persist. In July, the dragging housing sector and surging oil prices remained predominant issues. Housing prices continue to decline as oil prices shot to new highs. If these continue, it may have an impact on consumers’ perceived wealth and lead to less spending. Signs show that this may already be occurring. During the second quarter, consumer spending rose by a meek 1.3% after rising 3.7% during the first quarter. Moreover, consumer purchases of goods were effectively flat, with only services demonstrating any growth.
Source: PMFA
While it may take some time for the markets to flush out the full implications of the tightening credit picture, we consider the recent mild correction in stocks to be constructive to long-term investor prosperity and part of the normal market cycle. Moreover, it is possible that the recent volatility could persist for some time. We continue to recommend minimizing risk by remaining diversified globally and underweighting domestic small cap and mid cap equities. Doing so should not only result in less exposure to companies most afflicted by a credit tightening, but reduces exposure to asset classes that have been increasingly pricey.
Although second quarter GDP growth rebounded to a 3.4% annualized rate, we believe that some underlying risks to the economy remain in the short-term. The housing market remains very soft and appears positioned to weaken further as a large number of sub-prime and adjustable rate mortgages are scheduled to reset over the next fifteen months, potentially peaking in the first quarter of 2008. Continued weakness in housing is likely to negatively affect consumer spending and bottom line GDP growth.
However, we continue to be bullish on the global economy’s long-term potential. While periods of volatility and negative market moves are alarming at times, we believe that appropriate portfolio allocations should position investors well to navigate increased choppiness in the markets.
Economy
GDP
The advance estimate for Q2 2007 GDP growth was a strong 3.4% annualized. The average growth for the first half of 2007 was 2.1%, in line with the Fed’s projected growth of 2-3%.
The main contributors to Q2 growth were significant increases in business investment (8.1%) and government spending (4.2%), as well as a surge in net exports.
Quarter-to-Quarter Growth in Real GDP
Source: Bureau of Economic Analysis (BEA)
Inflation
The Consumer Price Index (CPI) was up 0.2% in June, while Core CPI was up 0.1%. The Producer Price Index (PPI) decreased 0.2% in June on the heels of a large increase of 0.9% in May.
The 12-month trailing core PCE Deflator remained at 1.9% in June. As their preferred inflationary gauge, the core PCE remains just inside the high end of the Fed’s implied target range.
Inflation Indices – 12 Month % Change
Source: PMFA, Bureau of Labor Statistics (BLS)
Source: PMFA, BLS, BEA
Employment
The unemployment rate increased a tick to 4.6% in July. Since September 2006, that rate has remained in a fairly narrow range of 4.4% to 4.6%. An estimated 92,000 jobs were created during the month, slightly below the consensus forecast.
Unemployment Rate, Seasonally Adjusted
Source: BLS
Interest Rates
Longer term yields decreased throughout July as assets shifted to take shelter from the increased volatility within the equity markets.
Ten-Year Treasury Yield History
Source: Yahoo Finance
The 10-year Treasury closed the month of July at 4.78%, decreasing 0.25% throughout the month. Meanwhile shorter term rates increased. The one-month Treasury yield closed July at 5.13%, pushing short rates back above long-term rates and back to an inverted curve.
Treasury Yield Curve History
Source: PMFA, U.S. Treasury
The Federal Reserve appears likely to maintain the Fed Funds rate of 5.25% at their August meeting, although some market observers have suggested that the recent credit market meltdown might spur the Fed to hold an emergency meeting and cut rates. This is an optimistic outlook and, while possible, one which appears unlikely. While it can create short-term pain, the Fed has often taken the stance that investors need an occasional reminder of the downsides of risk-taking rather than interceding immediately. The challenge is to balance out that perceived need with appropriate intervention to avoid broader fallout in the markets.
Exports vs. Imports
Since the beginning of 2006, net exports (exports minus imports) have surged. Exports specifically have increased at a more rapid pace, while import growth has steadied along with oil prices. This can partly be explained by the depreciation of the dollar relative to currencies of other major trading partners of the U.S. as measured by the Broad Dollar Index as well as a strong global economy despite the slowdown in the U.S.
Net Exports & Broad Dollar Index History
Source: PMFA, U.S. Treasury, BEA
Gratuitously Unnecessary Statistic of the Month
So, about exports…
Based on a recent report from the USDA – lamb and mutton exports have declined significantly year to date through May. Projections for 2Q 2007 exports are for a decline of 60% from the same period last year.
Taking this news especially hard are fans of a certain 90’s sitcom that made famous the phrase “Nuttin’ beats mutton,” as well as perhaps the citizens of Western Kentucky, often hailed as the mutton capital of the world.
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 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 Plante Moran Financial Advisors for investment advice regarding your own situation.
