Recovery Still on Track
The U.S. economy remains on a solid but not spectacular recovery track. Real Gross Domestic Product was up 2.7% in the first quarter of 2010, marking the third positive quarter of growth. While financial conditions have improved considerably since the crisis of 2008/2009, the rebound has been hampered by still constrained credit markets and the housing overhang. The course of the economy is still uncertain. Some evidence such as the U.S. purchasing manager survey suggests that factory output has expanded for eleven months in a row. On the other hand, U.S. consumer confidence fell sharply in June. With the somewhat muted recovery in place, inflation remains subdued, as evidenced by the consumer price index rising a modest 2% over the twelve months ending in May.
Corporate profits are on an upswing due to lean cost structures. They are exhibiting positive comparisons against low earnings from a year earlier. However, improved corporate earnings have not yet led to job growth. Often, there is a lag (and today, a pronounced hesitancy) for companies to hire for fear of unsustainable recovery. The unemployment rate fell slightly to 9.5% in June from the previous 9.7% rate (though many point out that the rate benefited from temporary hiring of Census workers and that payrolls actually fell in June).
The Stock Market
Worries Take Stock Prices Down
Investors’ worries of subdued recovery without job growth were compounded by the European debt crisis. The negative sentiment of the economy translated into falling equity prices in the second quarter of 2010. The S&P 500 declined 12% in the quarter, well more than erasing the gain of the first quarter, with a year-to-date return of –6.7%. These large cap stocks with more global exposure fared slightly worse than U.S. mid and small cap stocks (reinforcing the merits of a diversified portfolio.) The significant drop in the Euro versus the dollar had a negative impact on the value of those international stocks for U.S. investors. The Morgan Stanley Europe Australia Far East Index declined 14.9% for the second quarter of 2010 and is now down 14.7% year-to-date.
While stock prices gave up ground, earnings for companies continued to progress upward resulting in more attractive valuations for stock. The P/E ratio (price divided by trailing twelve month earnings) is now 17x compared to 21x at year-end 2009.
The Bond Market
Rates Linger at Lows
The Federal Reserve kept its easy monetary stance, by leaving short term rates near zero. They have been and are likely to stay put until they’re confident the economy is in a strong, self-sustaining recovery. The added concerns of the European debt crisis led to a renewed flight to quality for U.S. Treasury notes, pushing the 10 year yield down to 2.95% (from 3.8% at the start of 2010). The gap between short and long yields (yield curve) has shrunk. A flatter yield curve tends to be more associated with a weak economy and a positive upward sloping yield curve normally reflects a growing economy. While it is clear to most that interest rates are at depressed levels, there is great divergence of opinion with regard to if, when and how much rates will rise.
Schenck Investment Solutions
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