Commentary

We are not so brash or deluded to think that it was our recommendation in our recent quarterly market commentary that investors step back and take a look at the big picture that resulted in a return to less volatile markets. Nonetheless, investors seemed to follow our advice. In April, it appeared that everyone took a step back to look at the big picture. Some might speculate, however, that investors may have stepped back too far.

As the month unfolded, the markets’ vision seemed periodically blurred as stock market reaction often appeared contradictory to economic developments. The most poignant example may have come at the end of April when the Dow Jones Industrial Average crossed the 13,000 threshold for the first time just days before the advance estimate of first quarter GDP was released, with disappointing results. At first glance, the annualized growth rate of 1.3% represented a meaningful slowdown and might have been sufficient to give the markets pause. Instead, the markets moved upward again.

Housing continued to drag on the economy. Year-over-year existing home sales declined by 11.3% and new home sales fell 23.5% indicating that it may be some time before the high number of homes on the market is sufficiently absorbed and prices are buoyed. Meanwhile, inflationary pressures continue to bubble. In March, trailing 12-month CPI was up 2.8% as energy prices contributed to a slight increase. Twelve-month trailing Core CPI, which excludes volatile energy and food prices, fell slightly to 2.5% at the end of March, although it still remains higher than the Fed’s preferred range. Despite a continuation of these downside trends, the stock market continued to gather steam.

While one market commentator deemed the phenomena as “Irrational Complacency,” a number of positive developments seem to be contributing to the market’s current ascent. The April unemployment rate will be released on May 4 and it is expected to remain near a low level of 4.5%. Tightness in the job market typically paves the way for other positive developments, such as wage growth and consumer spending. This was the case in the first quarter as average hourly earnings increased by 0.9% and consumer spending rose by 3.8%. Stronger-than-expected corporate profits and a turnaround in business spending also added to the bullish sentiment. After a decline of 3.1% at the close of 2006, business spending rebounded 2.0% in the first quarter of 2007.


Source: PMFA

As demonstrated by the strength of the equity market in April, a slower growth economy is not necessarily viewed as a cause for bearishness by investors. This is especially true when other underlying factors continue to be healthy. The market demonstrated this to some extent last year, when investors embraced the slowdown in economic growth that they hoped would lead to a Fed pause in interest rate hikes.

The current situation could be similar, particularly as the Fed maintains the delicate balance between fighting inflation and sustaining economic growth. Once again, investors may perceive this as a sign that an easing of monetary policy may come sooner rather than later. Despite hopeful sentiments from investors, the Fed remained at 5.25% during the month and appears unlikely to cut rates until inflationary pressures abate to a greater degree.


Source: PMFA

After a month in which the market collectively shrugged off unexpectedly weak results in the economy and stock market indices surpassed previous record highs, some investors may be concerned about what may be left to carry the market higher. At times of conflicting economic data, the level of uncertainty about the short-term direction of the market becomes heightened. Appropriate portfolio diversification across a variety of asset classes and investment strategies should provide for appropriate participation in future market upside, while providing commensurate protection against potential downside risk.

Economy

The advance estimate Q1 2007 GDP growth came in at a meager 1.3% annualized, well below forecasts of 1.5% - 2.0%. This was the lowest quarterly U.S. growth rate since the first quarter of 2003 and represented a considerable deceleration from the 2.5% annualized rate for Q4 2007. The Fed has stated they expect sub-3% growth per quarter to continue through the remainder of the year and into 2008.

The deceleration in GDP growth appeared to primarily result from a decrease in exports and increase in imports (which are a subtraction from the GDP calculation), a slowdown in consumer spending, and a decline in federal government spending.



Source: Bureau of Economic Analysis


INFLATION

The Consumer Price Index (CPI) was up 0.9% in March, while core CPI advanced at a slower, yet still relatively rapid, pace. The Producer Price Index (PPI) increased at a slightly higher rate of 1.0% for the month.

By most measures, inflation remains elevated and a primary cause for concern for the Fed.


Source: PMFA


Source: PMFA

EMPLOYMENT

The unemployment rate for April ticked back up 0.1% to 4.5%. While still positive, the rate of job creation continues to slow. For the first quarter, an estimated 429,000 new jobs were created, well below the 755,000 created during the comparable period in 2006. The preliminary estimate for April indicated continuing softness, coming in at just 88,000.


Source: Bureau of Labor Statistics


INTEREST RATES

The Federal Reserve continues to hold its benchmark rate at 5.25% (unchanged since June 2006). One year ago, the rate was 4.75%.

The 10-year Treasury closed at 4.63% on April 30, fractionally lower than its 4.71% yield at the outset of the year.

The inversion in the Treasury yield curve has been substantially reduced, although a 40 basis point difference between the 6-month and 10-year yield remained as of April 30. The yields of the benchmark 10-year Treasury remains slightly higher than that of the 2-year instrument.


Source: Yahoo Finance

The implied probability for a reduction of the Fed Funds rate from 5.25% at the August FOMC meeting has decreased.

Futures Market Implied Probability - Fed Funds Rate
Source: Federal Reserve Bank of Cleveland


HOUSING MARKET

After moderate increases for three consecutive months, existing home sales decreased by 8.4% in March (trailing 12-month down 11.3%). Regionally, the Midwest contributed the largest amount to that decline with a drop of 10.9% in March.