July 2012 Economic & Financial Market Analysis

Overview

• After the strongest first quarter for stocks since 1998, equities took a step backwards in the second quarter with the major U.S. equity indices all ending the quarter in negative territory.  The decline in equities in the second quarter can be attributed to a number of factors, most notably increasing concern about the European sovereign debt crisis, slowing growth in China, and softening economic data in the United States.
• Corporate earnings have been a bright spot throughout the current recovery.  However, there are signs that the upcoming quarter could be a disappointing earnings season.  So far, 72 companies have issued negative guidance for the second quarter, while only 29 have lifted guidance.  Overall, analysts are expecting a 0.6% decline in earnings, compared to 6.2% growth in the first quarter.
• Estimates indicate U.S. Gross Domestic Product grew at a pace of approximately 1.5% for the second quarter of 2012.  This is a disappointing pace even for the current “slow growth” recovery.  Any substantial recovery in U.S. employment is unlikely to occur with growth below 3%.
• The U.S. labor market also took a step back during the second quarter as employers were hesitant to add to their payrolls amongst general uncertainty.  In the second quarter, employment growth averaged 75,000 jobs per month, compared with an average monthly gain of 226,000 for the first quarter of the year, with slower job growth in the second quarter occurring in most major industries.
• The European sovereign debt crisis continued to dominate headlines as worries increased throughout the quarter.  However, the European Summit, held on June 28th and 29th, provided a catalyst for a “risk-on” rally at the end of the quarter.  Despite a lack of concrete details, the Summit seemed to provide some relief to worried investors that Europe had put in place a solid framework for moving forward and addressing many of the issues that have plagued the region over the last several years.   
• Despite the above challenges in the second quarter, markets showed tremendous resilience with only modest declines in the major indices.  Positive factors during the quarter included a continued recovery in the housing market, belief the Federal Reserve will step in once again if additional support is needed, improving balance sheets at the major banks and declining oil prices.

Economic and Financial Markets Analysis
The rally in U.S. equity markets that began in October 2011 ended in the second quarter of 2012 with most major indices posting negative returns for the quarter.  The S&P 500 Index was down 2.75%, including dividends, for the quarter.  Global indices suffered steeper losses than U.S. indices, with the MSCI EAFE Index down 7.13% for the quarter and the MSCI Emerging Markets Index down 8.89%

The weak performance of the second quarter can be attributed to a number of factors.  Data from the second quarter shows that economic activity in the U.S. slowed in the second quarter compared to previous quarters.  The labor market is improving at a much slower pace as only 225,000 jobs were added in the second quarter compared to 625,000 jobs created in the first quarter of 2012.  Manufacturing activity and retail sales have also slowed compared to the first quarter and consumer sentiment has declined.  The softening economic data has introduced additional uncertainty about future gains, contributing to the loss of investor appetite for risk.

Perhaps the biggest factor weighing on markets for the second quarter was the volatile situation in Europe.  What began as a problem in Greece, as May elections failed to elect a majority party and threw Greece’s future participation in the Euro into doubt, quickly found its way to Spain and Italy as yields soared to dangerous levels at times throughout the quarter.  Markets responded with increased volatility, seemingly reacting to every headline and rumor to come out of Europe.  Markets rallied in June with the election of a pro-bailout party in Greece and renewed hopes that European leaders may finally be able to make substantial progress in curbing the spiraling sovereign debt issues plaguing Europe.


Fixed Income

• 10-year Treasury yields began 2012 at 1.88% and peaked in March at 2.38% before ending the first quarter at 2.21%.  Yields continued to decline in the second quarter, eventually reaching an all-time low of 1.45% on June 1st before recovering somewhat and ending the quarter at 1.64%.  The yield on the 10-year Treasury is now lower than the yield on the S&P 500 Index.  This is only the second occurrence since the 1950’s and illustrates the flight to safety as global uncertainty prevails (see chart below).

• U.S. fixed income markets still face similar uncertainties as those affecting markets in 2011 – debt ceiling crisis and potential U.S. debt downgrade.  Standard & Poor’s has reaffirmed the AA+ rating for U.S government debt while maintaining a negative outlook due to political and fiscal risks.  
• Uncertainty in the bond markets remain due to the Eurozone crisis and the “fiscal cliff” (expiration of the Bush-era tax cuts and pressure to reduce federal spending).
• We continue to recommend bond investors hold positions with maturities under four years and in the highest quality of investment grade credit.  While we believe rates are likely to remain low for the foreseeable future, we feel strongly those chasing yield in less secure bond investments are ultimately risking a loss of principal.

Areas of Focus Going Forward

• The European sovereign debt crisis continues to be a major concern for the global economy.  The Summit of Eurozone leaders held on June 28th and 29th was initially seen as a “breakthrough” in providing a road map to solving the debt crisis that has plagued the region for the last several years. Among the “favorable” outcomes of the Summit was the injection of capital directly into the Spanish banking system.  This avoids the negative feedback loop where lending to the government simply burdens it with more debt and causes investors to demand cripplingly high interest rates on Spanish government bonds.  Leaders also agreed to use bailout funds set aside by the EFSF (European Financial Stability Facility) and ESM (European Stability Mechanism) in a more flexible manner in order to stabilize Eurozone markets.  Finally, the leaders announced plans to create a 120 billion Euro fund to stimulate growth across Europe and create jobs.  The initial reaction created by the Summit was exuberance, as risk assets rallied strongly to end the quarter.  However, the initial enthusiasm is likely to fade as investors realize that the Summit lacked details and any tangible progress will likely be delayed until the next major Summit in October.
• The U.S. housing market has been one of the largest headwinds to U.S. economic growth since prices peaked in 2006.  However, there are signs that the housing market may be bottoming.  The top 50 metro markets generally made positive headway in June. The large majority of markets saw quarterly gains, while only seven markets saw prices slide. Of those markets that posted quarterly losses, only four saw declines greater than 1%.  The remaining 43 MSAs turned out growth over the last quarter, with average gains of 3.0% doubling the rate of average declines. Additionally, 10 of the 43 advancing markets saw quarter over quarter price growth exceed 5%, providing evidence the recovery is also picking up steam on a metro market level.  The market is undoubtedly healing as the recovery unfolds, and is now the strongest it’s been since the collapse in 2006. Excluding a major economic obstacle, an extended housing rebound should continue through year’s end.  The housing market is on track to see progress outweigh minor setbacks as only eight out of 50 MSAs have negative projections through 2012.  The progression of the recovery, however, remains vulnerable to peripheral risks in the jobs market, an uncertain regulatory environment, and global economic threats.
• Worries about the pace of China’s economic growth continue as the world's second-largest economy is entering a phase of more modest expansion relative to the 10 percent annual average rate over the past three decades.  China has increasingly become an important trade partner to the world’s developed economies and any slow-down in Chinese growth will likely have a large impact on the global economy.  Economic data has continued to soften throughout the second quarter and analysts predict economic growth probably slowed further in the second quarter to 7.6 percent, its worst performance since the 2008 financial crisis, as investment, factory output and retail sales weakened.  Low inflation has allowed China’s central bank more room to ease policy without stoking price pressure.  Since November 2011, Beijing has lowered banks' required reserves three times, each time by 50 basis points, freeing an estimated 1.2 trillion Yuan ($190 billion) for lending.   The Chinese economy is likely to stabilize and even recover modestly in the second half of 2012 as such policy measures begin to show results.
• The November elections (presidential and congressional) are shaping up to be historical given the likely turnout of voters and the significant issues that have been in gridlock for over three years.  Among the issues that may be resolved by the November elections include the rising deficit, the expiration of the Bush-era tax cuts, automatic spending cuts, healthcare, and energy programs.  While all of these issues could impact the markets, none have a greater impact than the scheduled expiration of the current tax structure.  Tax rates on dividends, capital gains and estates are all scheduled to move materially higher on January 1, 2013, and the outcome of the elections will likely determine if the rates will be renewed or allowed to expire.  The anticipated “electoral anxiety” will most certainly create volatility in the markets as the elections draw near.

Investment Conclusions
Although global markets rallied after the European Summit in late June, enthusiasm is likely to be short-lived as there are few positive catalysts in the short term to drive markets substantially higher.  Therefore, a cautious outlook is warranted over the coming quarter.  Probabilities favor markets moving lower through the end of summer before a rally to end the year.  We recommend using the likely volatility to reduce risk by generating cash on market rallies.  If weak economic numbers turn out to be seasonal and more clarity is provided regarding the European crisis and the U.S. elections, there will be ample opportunity to deploy this cash at more attractive entry points than currently exist.