29 Jun 2007 More Good than Bad
With one day remaining, it’s safe to say that the second quarter was a good one for equity investors. The S&P 500 is up just a smidge under 6% and the NASDAQ increased by 7.7%. Much of the increases in both indices came in April as mega-corporate buyouts and mergers out did the former on a daily basis. Corporate earnings were surprisingly good as they climbed 11.6% on average during the second quarter, more than three times analysts’ estimates in March. And the economy showed signs of improving growth without significant inflation pressures.
But in May and June the winds shifted in key areas such as inflation, potential Fed policy, and economic expectations. The widely held view that the Fed would cut rates this year gave way to the realization that they would not – even the fear that they would increase rates. That realization reversed the fortunes of long-term US Treasury holders as prices began a steady decline in May and most of June losing almost 8% of their value and boosting yields to five-year highs. In the past couple of weeks the descent has reversed and bonds are off their lows by 3%.
The best performing economic sectors during the quarter were Oil & Gas, Materials, Technology, and Industrials.Latin America was the brightest star in the global universe rising 22% during the quarter. Outstanding country performance came fromBrazil(28%),China(23%),South Korea(19%), andGermany(16%). And these trends should continue. The global economy’s fastest five-year expansion since the 1970s has boosted European exports and invigorated German and European production and confidence. Unemployment has dropped to a record lows, due not only to economic strength, but to welfare reform that curtailed support for those unemployed more than a year.
Markets are up as of this writing on a report that the Federal Reserve’s most closely watched measure of inflation slowed in May and consumer spending increased less than economists forecast. Slower spending suggests to bondholders lower inflation pressures which erode the values of bonds. All investors worry whether the economy will continue growing fast enough to sustain employment and consumer confidence, yet not so fast to cause prices (inflation) to rise. Most economists and strategists have become comfortable with the Fed’s continued stance to hold rates at the 5.25% level for the foreseeable future, because of the current conviction that economy can handle the higher rates and inflation has not yet moderated. If the economy does begin showing signs of faltering, then the Fed will have a problem.
Aside from the actual numbers on inflation and economic growth, the real key to the inflation question is whether productivity remains low or continues to grow. The recently released Fed minutes indicated that policy makers believe that productivity (employee efficiency) will rebound as economic growth picks up. But a lower potential pace of expansion might force the central bank to keep interest rates higher than they would otherwise hold them. Growth in workers’ output per hour has averaged a 1.5% annual rate since the start of last year, less than half the 3.1% pace of the five years through 2005. Productivity will be a key indicator of future inflation and what the Fed will have to do in response.
Our outlook for the next quarter remains relatively optimistic, but conservative. The global economy continues to be strong, but with some signs of wear here and there.China’s growth continues to charge along in the 9-10% range. But the concern is that inflation will become uncontrollable and that unrealistic asset valuations will not be supported by current levels of growth. Consumer and business confidence inEuropeis high and growing as economic metrics indicate strength. And emerging markets continue doing exceptionally well as they supply the world’s raw materials for growth.
But hurricane season and tight energy supplies keep a lid on our enthusiasm. Our equity weighting is more toward dividend-paying stocks than usual as they will hold up better (or come back faster) during market shocks or prolonged uncertainty. Our global exposure is heavily toward developed countries rather than the volatile emerging markets. And finally, our bond exposure is seven years and shorter as we believe that interest rates may not have peaked.