Market Commentary: July 2008
(To view charts in full resolution, download full commentary at right.)

Capital Markets

The second quarter ended much like the first quarter did – on a down note.  While there were no bailouts or Fed-backed rescues, headlines highlighting further weakness in the housing market, a deteriorating job market, surging crude oil prices, and rising inflationary concerns dotted the landscape.  These headlines and resulting concerns brought with them continued weakness and volatility in both the equity and fixed income markets.   

The financial sector again took center stage in the second quarter.  Much of the attention came from additional capital infusions, continued asset write-downs, earnings disappointments, and dividend cuts.  Investors persisted in their approach of sell first and ask questions later when an institution announced a need for outside capital.  This theme played out particularly for those who decided to slash their dividend at the same time.  The write-downs associated with the sub-prime contagion have now reached an estimated $400 billion.

 
Source: PMFA

Outside of the financial sector, pain continued to be felt by the auto manufacturers.  These companies are feeling the effects from weaker consumer demand as well as at least a temporary shift in consumer taste.  Would-be vehicle buyers are feeling the sting from both tighter credit and rising unemployment.  Additionally, with gas prices eclipsing $4.00 per gallon, drivers’ interest in larger gas-guzzlers has virtually dried up in favor of hybrids and more fuel efficient models.  Those auto makers that had a bulk of their product portfolio dedicated to trucks and SUVs have been particularly harmed.  To add insult to injury, some auto makers are turning to richer incentives to move inventory with the likely result of driving revenue and profits per vehicle lower.


Source: PMFA

During April and May, fixed income markets generally experienced a reversal of their Q1 fortunes.  More specifically, bonds sold off as investors began to feel better about the relative prospects for riskier asset classes.  Riskier bond segments, such as high yield and emerging markets, experienced the most investor interest.  June brought with it a renewed “flight to quality,” however, and the Lehman Brothers Aggregate index ended the quarter down -1.02%.  Emerging market currencies continued their impressive run, adding 3.87% in total return for the quarter.


Source: PMFA

Those alternative investments tied in some manner to the inflation story (commodities and precious metals) posted strongly positive returns for the month.  REITs, which had experienced a resurgence in returns in recent months, came under massive pressure, pulling the year-to-date return for the Wilshire REIT Index deeply back into negative territory. 

Economy

GDP

At a 1.0% annualized growth rate, Q1 GDP fractionally outpaced Q4’s result of 0.60%.  This improvement can be traced back to both strong exports, and a surprisingly resilient consumer.  Exports as a percentage of real GDP have been steadily increasing and are at their highest level on record going back to 1947.  Since consumer spending represents approximately 70% of GDP, the trajectory will be monitored closely.  It appears as though the recent tax stimulus checks provided a temporary boost to consumer spending in recent months, but after that cash infusion is absorbed, the consumer appears likely to struggle to continue spending at the same pace.  Given the current state of the housing market and the unfolding credit crunch, it would not be surprising to see a further slowdown in GDP growth over the next few quarters. 

Real GDP & Personal Consumption – Quarterly % Change

Source: PMFA, Bureau of Economic Analysis (BEA)

Employment

The labor market showed continued deterioration for the sixth consecutive month, with estimated job losses during June of 62,000.  Additionally, the pace of job loss for April and May were revised upward in recent days, although the unemployment rate held steady at 5.5%, its high water mark since mid-2004.
 
Nonfarm Payrolls & Unemployment Rate – Monthly

Source: PMFA, BLS

Inflation

Inflationary pressures are once again making headlines.  One of the Fed’s most watched measures of inflation, the core (excluding food and energy) PCE deflator remained elevated at a year-over-year rate of 2.1%. 


Source: PMFA, BEA, Bureau of Labor Statistics (BLS)

When adding back food and energy to PCE, the pace of price growth rose to 3.1% over the past 12 months.  While the Fed has stepped up its rhetoric indicating a willingness to raise rates in order to rein in inflation, they may be forced to wait until the economy is expanding at a healthier rate or at least showing signs of turning the corner.  Until then, a significant rebound in the Dollar appears unlikely, particularly in the face of monetary policy tightening abroad (i.e., Europe).

The trailing one-year inflation indicators have eased recently.  In June, both CPI and PCE increased just 0.1% at the core level.  This puts the one-year Core PCE just outside of the Fed’s implied comfort zone of 1.0–2.0%.

Inflation Indices – 12-Month % Change

Source: PMFA, BLS, Bloomberg

Also concerning was the most recent survey on inflation expectations.  As indicated by May’s consumer sentiment survey, consumers expect inflation to rise to 7.7% over the next 12 months – the highest result in the 21-year history of the survey.  A material, sustained rise in consumer inflation expectations suggests that faith in the Fed’s ability to maintain price stability is waning.  Should that expectation remain elevated, the potential for workers to  demand higher wages to offset higher expected living expenses would result in further reinforcement of inflationary pressure.  While this is not yet happening within the U.S., signs of it are beginning to show in emerging economies.  

Interest Rates

While the Fed cut both the Fed Funds and Discount rates by 25 basis points during the quarter, Chairman Bernanke began to increase his rhetoric around the Fed’s growing concern over rising inflationary pressures.   

The Fed held interest rates steady at June’s FOMC meeting, their first without a rate cut since last summer.  Fed Funds futures are increasingly pointing to higher rates by the end of 2008, largely in anticipation of a need for the Fed to face inflation head-on.

Current Probabilities for future FOMC Meetings

Source: PMFA, Bloomberg

As the Fed began to telegraph its intention of ending the cycle of rate cuts, bonds sold off.  This occurred in a rather orderly fashion, with longer-term interest rates rising a bit more than shorter-term yields.  After bottoming near the end of the first quarter, the yield curve has since shifted upward. 

Treasury Yield Curve – History


Source: PMFA, U.S. Treasury

At 3.99%, the 10-year Treasury is over 50 basis points higher than at the end of the first quarter.  While widely expected, this run-up in rates did not help the housing market.  As most conventional mortgage rates move in the  same direction as the 10-year Treasury, the recent rebound in Treasury yields was also reflected in the rate tied to 30-year mortgages.

Housing

On the minds of homeowners, economists, and presidential candidates alike is the current state of the housing market.  New home sales have declined over 60% since their peak three years ago, taking home prices down as well.  The health of the housing market will depend on the availability and price of credit, as well as the length of time needed to work off the inventory.  While the availability of credit has improved slightly, the cost of that credit has risen at a healthy clip.  A conventional 30-year fixed rate mortgage now carries a rate of about 6.30%, nearly a full percentage point higher than the rate in January.

Home Prices & Home Inventories – History

Source: BEA, Motor Intelligence

Our Views

GDP growth has been slow, but not negative, since Q4 of last year.  Significant export growth helped keep GDP growth out of negative territory.  There is no doubt that we are truly in a global economy, and equity markets around the world are becoming much more highly correlated, especially during periods of duress.  During the first half of the year, equity values were down around the globe, from U.S. mega caps to small caps, and international developed to emerging markets.  Equity market winners have been narrowly focused in the energy, materials, and utilities sectors due to the market’s myopic focus on commodity prices in general and oil in particular.

Can it get worse from here?  Yes, it can.  Will it get worse from here?  We don’t believe that anyone can reliably predict the answer to that question.  It is likely that the equity markets have already priced in expectations for slower GDP growth and higher inflation.  The market may have also priced in $142/barrel oil for an extended period of time.  During periods such as this, bad news tends to feed on itself, as a constant stream of it flows through the popular press.  We have been talking about  increased inflation expectations for some time now, and we continue to expect that robust global demand will drive elevated inflation expectations for the next few years.  This expectation in part drove us to implement inflation-protected bonds a number of years ago in client portfolios whenever prudent, given individual tax considerations.  However, will we see double-digit inflation such as we saw in the 1970s?  We believe that remains highly unlikely, particularly if the global economy were to slow down, as widely anticipated.  That said, even an increase in the core rate of inflation to 4 or 5% would have negative short-term effects on both the bond and equity markets.  

While the advance estimate of Q2 GDP growth will not be available for a few weeks, the consensus among economists is that the economy almost certainly stalled further during the quarter.  With Q1 growth clocking in at 1.0% annualized, the margin for slipping into a period of economic contraction is very thin.  Despite the numerous headwinds for consumers, however, retail sales for the quarter actually appear poised to rebound slightly.  Taxpayers appeared to begin spending at least a portion of their rebate checks, contributing to (if not accounting completely for) that boost.  New home construction will continue to be a material drag on growth, although exports should again help to cushion domestic weakness.  However, accelerating weakness in the job market, bubbling inflation (particularly in food and energy), and falling real income levels appear likely to keep consumer spending from edging higher from here.  

We have been expecting for some time that market volatility would increase due to the credit crises, housing bubble, and the uncertainty that accompanies a presidential election and first term presidency.  This theme has certainly played out, and we believe that we will continue to see increased market volatility over the next year or two.  This will occasionally afford long-term investors the opportunity to take advantage of the fear and irrationality that accompanies these periods.  Rebalancing your portfolio to target allocations based on your long-term investment strategy is the most disciplined way to do this, but other opportunities will undoubtedly present themselves.

VIX  - CBOE S&P Market Volatility Index – History

Source: Yahoo Finance

Export growth should continue to help the earnings of large cap companies.  Valuations of these companies are still relatively favorable compared to small and mid cap companies, although to a lesser degree than was the case a year ago.  We continue to overweight the larger cap area of the domestic equity market, but are watching valuations closely to determine when an increase to the small and mid cap stocks may be prudent.  Small cap stocks may benefit from any increased risk appetite by investors.  

Unlike the last bear market in stocks that signaled the end of the tech bubble, equity valuations are much more reasonable today than in 2000.  While the possibility exists for a further correction in equity prices, the current bear market appears to be driven by cyclical earnings declines, the uncertainty surrounding the housing market, the resulting impact on the financial sector, and inflation concerns.  However, assuming that earnings rebound as many market analysts project, valuations for U.S. equities are cheap from a historical perspective, particularly relative to current interest rates.  Analysts are notoriously bad at forecasting earnings, but there can be no question that, in time, earnings will recover.  The fact that the U.S. market doesn’t appear grossly overvalued as it did earlier this decade provides one less drag on the market and may bode well for equity investors.  

International stock market valuations continue to look favorable compared to U.S. stocks, although much of the excess return that has been achieved by developed international equities during the last six years has been a result of the falling dollar, not necessarily better local market performance.  While the dollar may fall further against developed currencies, another 60% drop from these levels is highly unlikely.  Therefore, we don’t expect that international stocks will be able to repeat the magnitude of their outperformance of the last six years.  However, significant international diversification, including ownership of emerging market equities, will be a continued theme within our client portfolios.  

Commodities continue to garner a great deal of press, which is to be expected given that they are one of the few “asset classes” that has significantly increased in value during the last six months.  While the long term diversification benefits of commodity investing are well documented, small allocations to commodities of 3% to 5% of an investment portfolio would not have prevented equity market investors from seeing declines in their portfolios during the first half of this year.  We have been cautious about entering the commodities market at current price levels.  While we believe in the long-term secular view that there will be increased demand for commodities, it is very possible that this view is already reflected in current prices.  We will continue to proceed cautiously in this area.

We will continue to look for other investment opportunities that demonstrate a lower correlation with traditional stocks and bonds and may provide incremental diversification benefits in client portfolios with the potential for similar or improved rates of return.  There are a number of options in the private placement market (direct real estate, hedge fund of funds, private equity) that are relatively complicated, both from a tax and implementation standpoint.  A number of implementation options also exist within the separate account and mutual fund universes that attempt to capture some of the benefits of these private placement markets, including REITs (Real Estate), 130/30 funds, Long/Short Equity, and Market Neutral mutual funds (Hedge Fund of funds), and Concentrated Equity Managers (Private Equity).   

We have reviewed all of these options, and believe that while there may be some benefits to implementing with them, current valuations are either unfavorable (REITs) or performance of the majority of these public market implementation vehicles has not replicated the use of private placement vehicles, either from a performance or risk reduction perspective.  We will continue to search for implementation options that we believe can reduce volatility while providing appropriate returns to investors.

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 (PMFA) 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 PMFA for investment advice regarding your own situation.