Commentary

“The beat goes on….And the beat goes on…” Sonny and Cher certainly had no intention of describing the stock market in their 1967 hit song, but it was an appropriate anthem for the upward movement of the stock market during the latter part of May. In the closing days of the month, both the S&P 500 and the Dow Jones Industrial Average closed at new highs, despite mounting challenges. Events such as another down draft in the Chinese Stock Market and a slower-than-expected economic backdrop might have, under different circumstances, precipitated a correction. Instead stock prices continued to march upward.

Only a week after agreeing to triple the quota of foreign investment in China’s stock market, the Chinese Government concluded to raise a security trading tax. Chinese investors responded to the tax with a 6.5% drop in Shanghai Composite Index. As news of the new tax and resulting market selloff spread, many anticipated that markets worldwide would swoon again, as they did in February. One day later, the preliminary estimate from the Bureau of Economic Analysis suggested that the U.S. economy not only slowed in the first quarter, but it slowed to a pace less than half of rate reported in their advance estimate. That revision indicated that the economy grew at a 0.6% annualized clip, down from 2.5% in the fourth quarter of 2006.


Source: PMFA


Rather than run from the markets, investors paused only briefly and then continued to push equity indices higher. Two major components of the economy, consumer spending and business spending, showed signs of strength, contributing to market momentum. Consumer spending, the largest component of GDP, grew 4.4% in the first quarter and eased investors’ concerns about a slumping housing market and increasing energy prices and their effect on the primary drivers of U.S. economic activity. Business spending was reported to have increased 2.9% in the first quarter, showing that Corporate America’s concern about weakness in consumer spending may be on the decline.


Source: PMFA


A significant underpinning for strong consumer spending as the economy slows continues to be the healthy job market. In May, the unemployment rate was unchanged at 4.5%. Wages also increased 0.3% for the month. Tight labor markets may provide some buoyancy to the economy while the Fed waits for inflationary pressures to subside further. Nonetheless, part of the Fed’s concern stems from the high rate of wage increases and the “high level of resource utilization” in the economy. In “Fed speak,” that is a reference in part to the tight labor markets. At this point, some softness in the labor market would be needed to pave the way for any Fed easing and might actually be warmly received by investors. The key, however, is in avoiding an excessive softening in the labor market that could lead to recession.

So far the Fed’s plan for a “soft landing” appears to be on track. Subsiding price growth seems to support this assertion. In April, the CPI remained above 2.0%, however the personal consumption expenditures price index less food and energy (PCE), a measure of inflation many believed to be the Fed’s preferred measurement of inflation, reportedly fell in line with the upper end of the Fed’s target range of 1.0% - 2.0% for the 12-month period ended April 30. Although elevated energy prices and increasing wages continue to pose inflationary threats, they remained in check during April.

These conditions led to the Fed’s conclusion to once again leave interest rates at 5.25% at their May 9th meeting. The Fed’s statement following that meeting reflected little change in its relative outlook for inflation and the economy. Despite the soft patch in the economy, persistent inflationary concerns are likely to keep the Fed on the sidelines until some tangible evidence of sustained disinflation appears.


Source: PMFA


As the song said, “History has turned the page.” The S&P 500, Dow Jones Industrial Average, and a slew of other indexes have recently broken through prior historical records, leaving many investors unsure of where the markets will go next. Are record index levels a sign that the market has peaked or perhaps a signal that the next leg of the bull market awaits? While today’s equity market valuations are generally much healthier than those in the late 1990’s, it is perhaps a bit premature to assume that an S&P 1600 or a Dow Jones 14000 will soon be reached. While we continue to look for opportunities to add value to client portfolios through tactical moves, rebalancing back to diversified asset class targets remains the best way to retain exposure to potential further positive market developments while limiting downside risk.

“La de da de dee, la de da de da…” Despite slower than anticipated growth, the equity markets remain resilient. And the beat goes on.

Economy

GDP

The preliminary estimate for Q1 2007 GDP growth was a reported 0.6% annualized. This is a reduction of over half from the advance estimate 1.3% and represents the lowest quarterly growth rate in over four years (since Q4 2002) and a considerable deceleration from the 2.5% annualized rate from Q4 2007.

The adjustment resulted primarily from a larger than anticipated decline in net exports (caused by a surge of imports in March), and a decrease in federal government spending.


Source: Bureau of Economic Analysis

Inflation

The Consumer Price Index (CPI) was up 0.6% in April, while core CPI advanced at a slower pace of 0.2%. The Producer Price Index (PPI) increased at a slightly higher rate of 0.7% for the month.


Source: PMFA, Bureau of Labor Statistics


By most measures, inflation remains elevated. The Fed anticipates inflation will moderate, but it remains their predominant concern.


Source: PMFA, Bureau of Labor Statistics


Employment

The unemployment rate for May remained unchanged at 4.5%. Job creation was higher than forecasted in May at 157,000, a meaningful boost compared to April’s increase of just 80,000.

Unemployment Rate

Source: Bureau of Labor Statistics


Interest Rates

The Federal Reserve maintained the Fed Funds rate at 5.25% at their May meeting. One year ago, the Fed was nearing the end of their rate hikes with an increase to 5.0%.

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

Futures Market Implied Probability - Fed Funds Rate

Source: Federal Reserve Bank of Cleveland


The 10-year Treasury edged higher throughout the month, closing at 4.9% on May 31, in line with its high point for the year reached in late January.

The Treasury yield curve remains relatively flat. As of May 31, the 10-year yield was only slightly lower than the 4.96% yield on the 6–month Treasury.

Ten-Year Treasury Yield History

Source: Yahoo Finance


Energy

Gasoline prices recently reached all time highs, now at a weekly US average of $3.25 per gallon for regular unleaded. Although prices declined slightly in early June, they still remain uncomfortably elevated, 12% higher than at this time last year. Meanwhile, crude oil prices were materially unchanged over the last six months. If crude oil costs have not increased, what has been the main cause for elevated gasoline prices?

Gasoline Prices vs. Crude Oil Prices

Source: PMFA, EIA


Simplified, there are three main factors which affect the price of gasoline: supply, demand, and competition for crude oil. Supply is limited by tight refinery production capacity and, coupled with relatively low inventories, any “hiccups” in the supply chain are quickly reflected as price increases. Recently, domestic production and imports have increased, however continued maintenance and unplanned outages may reduce production capabilities.

Despite increased interest in alternative sources of energy, there are few substitutes for gasoline, making demand relatively insensitive to price. The alternatives that do exist can be far from convenient (public transportation) or not readily available or functional in certain vehicles (ethanol), forcing most consumers to maintain consumption levels. Demand also increases with the “summer driving season,” which officially started with the Memorial Day weekend. This typically increases demand an estimated 5% per the Energy Information Administration. While consumer demand may adjust at the margins, the greater impact is felt in other areas of discretionary consumer spending.

With very little slack in supply and increasing demand, it appears likely that fuel costs will remain elevated for some time.

Gratuitously Unnecessary Statistic of the Month

The true cost of inflation?

Because of the increases in metal prices in recent years, the cost of producing a penny now stands at 1.73 cents. Nickels are also a losing proposition, with a cost of 8.34 cents. In response, the U.S. government issued final regulations in April that prohibited the melting of all nickels and pennies. Travelers are also limited to taking $5 in pennies and nickels out of the country. Violators face a potential fine of up to $10,000 – sufficient to fund the shortfall on the production of about 1.37 million pennies or nearly 300,000 nickels. Through May 31, the U.S. mint had produced an estimated 3.9 billion pennies and 675 million nickels in 2007, suggesting that about 5,100 successful prosecutions would be necessary to fund the shortfall. (Source: ABC News, U.S. Mint, PMFA)



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.