“Spring Swoon – The Sequel”
Investors may still be a little skittish, but they seem to be growing a thicker skin. The Second Quarter followed a very similar pattern to the pullback we experienced in May and June of 2010. This year and last year alike, business managers took pause after dramatic geopolitical events. You may recall that optimism was temporarily put on hold following 2010’s Gulf oil spill and Grecian debt crisis. This year it took pause following the tragic Japanese earthquake and unresolved U.S. debt ceiling standoff (as well as another round of European debt uncertainty). Both periods saw lack in clarity going forward for both future-demand as well as the direction of government policy. This type of uncertainty shook the fragile confidence of business executives and consumers alike. However, the reaction this time appears to be muted in comparison to last year (a 7% decline from the highs versus 2010’s 13% retracement). It simply may be that markets are growing less emotional and developing a broader based outlook.
How the markets fared
Thanks to a sharp rally in equities in the final days of June, intra-quarter losses were largelyerased. Global equity markets were mostly unchanged during Q2, posting returns plus or minus a couple of percent. Growth stocks marginally led their value-oriented peers. The only standout was Latin America, where loses approached 4% due to spikes in the Brazilian Real. There, floods of foreign capital and a booming economy appear to be less well managed than the emerging economies of Asia and Eastern Europe.
The real action of the quarter was in global debt markets. Shocking to many (including yours truly), in the face of a debt ceiling crisis and the end of the Fed’s latest round of support for the U.S. Treasury market (QE2), bond prices actually rallied during the quarter pushing yields down 30 basis points on the 10-Year Treasury. The bellwether 10-Year Note had started the quarter yielding 3.45% before it plunged to 2.9%; eventually recovering back to the 3.15% level in the last week of the quarter. Investors continued to stampede into the TIPS market for a second quarter in a row. North Pier is now warning of a displacement in this market, as real yields have turned sharply negative in the face of inflation-fear based demand. This market is at risk for a meaningful price reversal if certain conditions don’t materialize. (Please request our position piece on TIPS for more information.) Due to a decline in the Dollar, global bonds posted a strong showing for the period. The high yield market was the weakest performer in debt. As doubts of the economy surfaced, credit spreads widened eating into coupon returns. Net-net however, high yield still posted slightly positive returns.
By The Numbers
Work Break – Job growth stalled during the last two months of the quarter, after firming in the first four months of 2011. Losses in government jobs were offset by modest gains in the private sector, led by services and healthcare. Of note, the Government began reporting on “incorporated self-employed” for the first time in January, which is data not represented in broader labor statistics. This is significant as it represents over 5 million people, mostly small business owners. We will monitor this data going forward to see if entrepreneurism, which typically ticks up into an economic recovery, registers improvement in these numbers. So far, they have been flat compared to last year.
Demand-a-Break – In a nearly identical pattern to last year, the Purchasing Managers Indexes (both for Manufacturing and Services) pulled back into the low-mid 50s from the 60 level seen throughout Q1. Another reading, The Conference Board Measure of CEO Confidence™, plunged to 55 from 67 last quarter. As with 2010’s dip, I am not ready to place too much weight on this change in sentiment, as these same ‘leaders’ reacted similarly last year. Back then, many of these same CEO’s parroted reactionary predictions of a “double-dip” recession, which as we know failed to materialize. Although this recent decline does represent a slowdown in growth, readings above 50 still indicate advances in the business sector. If this recent ebb fails to gather downward-momentum, these corporate leaders are likely to reverse their cautious positions as they did in Q3 & Q4 last year.
Prices Break
– One upside to the recent swoon is that inflation may be gettin
g some relief.As questions of global demand spread, commodity prices pulled back nearly 10% (with few exceptions). As these costs are more quickly reflected in the non-core food and energy statistics than in the broad CPI and PPI figures, it will be several months before this relief is reflected in comprehensive terms. In the very least, consumers and business felt some relief at the gas pump as energy prices declined 1% in May and another 4.4% in June. However, the sharp increases of the last year may have started to trickle into costs presently being paid for goods and services now. The latest reading of core CPI showed prices advancing 3.6% year over year. If the global economy does firm from here, it is likely that this dip in material costs will be short lived as demand reaccelerates. If the inverse occurs, further declines in prices may add a cushion for consumers and corporate profits. It appears that inflation may initially provide a moderating effect, no matter which way it heads.
Diet Break? – As would be expected, the major thermometers of consumer sentiment all registered pullbacks going into the end of the Second Quarter. The central reason for these declines was the “expectation” component of these surveys, not sentiment on “current conditions”. This may be a silver lining, as expectations can be more emotionally based and subject to the news cycle (which turned markedly cynical on the economy over the last quarter). We find evidence that this change in mood may not actually be translating into real alterations in behavior patterns, as consumer spending has actually been increasing of late and the personal savings rate has declined (to 5.1% in Q2 from a peak of 6.2% in Q3 2011). As we commented on last quarter, Americans may have increased savings enough and paid down sufficient debt to begin easing back into purchasing again. A drop in prices at the gas pump is likely helping as well.
PIERing Ahead
History does not always repeat itself, but patterns in behavior often do. If the gridlock in Washington surrounding the debt ceiling is not dealt with in an irresponsible manner, then we believe the recovery will continue forward this fall. Neither party stands to gain from a decline in the faith in America’s sovereign debt and that it will eventually pan out in a short or long-term solution. (My money’s on short.) Assuming we are not thrown into any form of default this August, as near-term fears and doubts abate, confidence and spending will return to both households and businesses. To restate our prior commentary’s key structural supports for this assertion:
- The emerging consumer class of the world continues to explode. China, India, South America and Eastern Europe are adding tens of millions of new buyers of products and services each quarter. This ripple bodes well for multi-national corporations and those that serve them both domestically and abroad.
- The U.S. consumer has improved their balance sheet to some of their best levels of the last 25 years. (See Spring 2011 commentary.) Further, they have deprived themselves of spending for nearly three years now, resulting in meaningful pent up demand.
- Though the pace of growth has recently moderated, business-to-business conditions are still pointing towards expansion, also due largely to pent-up demand.
- Corporations have record levels of cash on their books ($3 trillion +) and have paired expenses to precision levels. This water stored behind the damn that eventually will be deployed either through stock buybacks, M&A or investment in equipment and/or labor. Either way, it should prove to be quite additive to equity values.
- Valuations on stocks continue to be near a 20% discount to norms despite substantive growth in earnings. Given our present projections, the S&P 500 will approach 2007 highs at some point in 2012. Our models for an eventual Dow 20,000 and NADAQ 5000 are logically supportable from these levels with projected growth and a return to normalized valuations.
Again, it is my PIERspective that CEO’s, investors and consumers alike are all growing thicker skins. The pain of the financial crisis is fading, and though Chicken Little has called for it a few times now, the sky simply has not fallen. This latest swoon is likely similar to last year’s, when we said it was “more likely…just a pot-hole on the bumpy road to better economic conditions.” (See Summer 2010 commentary.) As long as our politicians don’t knock us off this road to recovery, this next year should see the winds shift to our backs. But as we know all too well, when dealing with politicians in America these days, that’s a big enough unknown to remain on guard.