 |
|
|
August 2010
Economic Situation
Benchmark revisions to gross domestic product (GDP) covering the past three years showed the economic downturn to be somewhat greater than originally estimated and the subsequent recovery to be slightly weaker, although personal income levels and savings rates are now estimated to be higher than originally estimated. But broadly speaking, the revisions do little to change the view of current economic conditions or the likely path ahead. GDP growth has decelerated throughout the first half of 2010 and appears poised to decelerate further during the second half of the year, as the contribution to growth from inventory rebuilding appears to be largely exhausted. The swing in inventory investment has accounted for nearly 60% of the increase in activity during the first year of recovery, but with an increase in inventory levels of $75 billion during the second quarter, the pace of inventory accumulation is close to the $91 billion peak quarterly rate of accumulation during the past economic expansion. Inventory-to-sales ratios have moved higher for durable goods and are at levels well above prior cycle lows, also suggesting the run up in inventories will soon abate. Final demand growth during the first year of the recovery has been weak relative to past experience despite substantially more policy stimulus. As the growth effect of fiscal policy turns from stimulus to drag in the coming quarters, it is likely to have a restraining effect on final demand and will work to partially offset the improved performance in private sector employment and hours worked during the first half of this year. These factors likely explain the persistently low readings for measures of income growth expectations and consumer confidence indices. The ISM Manufacturing Index, a key indicator of strength in manufacturing activity, has fallen for the past three months, though it currently remains at a level consistent with moderate growth in the broader economy in July. The new order component of the index has fallen more sharply than the overall index, while the inventory component rose – a pattern consistent with the expectation for further moderation in manufacturing growth in the coming months. The downward trend in inflation during much of the past year has been flattening out in recent months. Inflation is likely to drift slightly lower in the coming quarters, but the primary concern for policy makers in the near term appears to have quickly shifted from the inflation outlook to the softening growth environment. The shift in focus by Federal Reserve (Fed) policy makers away from policy normalization considerations to growth concerns reinforces the view that policy rate changes are many quarters away.
Equity Market Conditions and Outlook
There has been a significant divergence in the performance of corporate profit growth and the performance of the broader economy during the past year. While the economic recovery has been weak by historical standards and is currently in a decelerating growth trend, corporate profits continue to post strong gains. With most S&P 500 companies having reported second-quarter results, it appears as though operating earnings will come in at slightly more than $20 per share for the quarter – or an $80 per share annual rate and up roughly 45% from the second quarter of last year. The strength in profit growth has been the primary catalyst behind the sharp advance in the market from March 2009 through April 2010, and second-quarter results have been the primary catalyst behind the bounce in equities in July. With corporate profits having outperformed broader economic activity so dramatically in recent quarters, after-tax corporate profits as measured by the commerce department had risen to 9.5% of GDP through the first quarter of this year, just below the all time high of 10.3% of GDP reached during the first quarter of 2006. A further increase is likely to be reported for the second quarter based on the strength of company earnings reports and the relatively sluggish gain in GDP. To put the current level of profits into perspective, the average share of after-tax profits during the past several decades has been about 5.8% of GDP, and slightly lower if the unusually high readings for much of the 2005 through 2007 period are excluded. The very high profit share of the income distribution likely poses a challenge to potential further gains in profits in the coming quarters and beyond, particularly in light of what appears to be a decelerating trend in broader economic growth from a moderate level in the near term. The trend of increasing regulation and the impending trend toward higher taxes in the coming years are also likely to have a negative effect on this measure. So, while price-to-earnings multiples at roughly 14 times the annualized level of second-quarter earnings could be viewed as being relatively low today, especially given the low level interest rates, overall market capitalization relative to the size of the economy remains elevated compared to historical levels due to the high profit share of GDP. With economic growth and leading economic indicators decelerating, equity market performance through the balance of the year will likely reflect the extent to which the divergence between profit growth and economic growth continues.
International Market Conditions and Outlook
International equity performance in July was a partial reversal of many of the trends in place during the second quarter of the year, where European sovereign credit stress led to very weak performance broadly across the global equity markets, and European markets in particular. The support program put in place by the member countries of the euro zone during the second quarter, in exchange for fiscal austerity measures to be implemented by the recipients of support, has proven to be effective to date in stabilizing financial conditions in the region and has supported the recovery in equity market performance globally. For July, as reflected by the MSCI country indices, Greece and Spain were the top performing equity markets on a global basis in dollar terms, with returns of 29.7% and 21.4%, respectively, for the month. The European markets broadly outperformed other regions both in the developed and emerging market segments of the international markets, where Poland and Turkey were the best performers in emerging market space. In addition to the weakness in international equity markets originating from European issues during the first half of the year, policy tightening in China and fears of overheating had produced significant weakness in that equity market and cast a shadow over the performance of other markets globally, given the key role China’s economy is currently playing in driving global economic growth. Moderating economic growth indicators, adaptation of a more flexible currency exchange rate mechanism, and better liquidity conditions have led to a substantial improvement in China’s performance since early July. The outlook for continued strong growth, although below peak growth in China, along with moderating inflation pressures and a more benign policy outlook, should provide the basis for continued equity gains in China’s market through the balance of the year, and support the performance of markets that have significant economic interaction with China. In contrast, the European periphery markets have benefited from external financial support that broadly negated liquidity and funding risks for a period of time, but these countries have yet to fully experience the broader economic effects of the austerity measures required by the support program. Thus, the outperformance produced in these markets during the past month seems unlikely to persist.
Fixed-Income Market Conditions and Outlook
July was a relatively stable month in the domestic fixed-income markets as Treasury yields moved modestly lower at most points along the yield curve and spreads for non-Treasury sectors generally narrowed. Contributing to the low and generally stable rate environment were a growing sense of conviction around market expectations that the Fed will continue to hold short-term rates near zero for the foreseeable future, low inflation, and decelerating economic growth momentum. The two-year Treasury yield closed the month at its lowest historically recorded yield of just 55 basis points as expectations that Fed rates are unlikely to rise over the horizon of these securities was reinforced by Fed commentary and other suggestions that the Fed may choose to prevent its balance sheet from contracting in the coming months by reinvesting the proceeds of maturing or prepaid securities acquired through its quantitative easing program. Yields for 30-year Treasury securities, the only point along the curve to see yields move higher, rose by about 10 basis points during July. The upward movement in these yields likely reflects longer-term concerns about the potential effects of a shift toward more accommodative monetary policy over the intermediate term. At the same time that most Treasury yields moved lower, credit spreads narrowed moderately after rising the past couple of months. The combination of lower yields and narrower spreads produced a solid month of performance for the broader bond market, with the Barclays Capital Aggregate Bond Index producing a total return of 1.07% in July. The yield to maturity for the index had fallen to 2.58% by the end of July as a result of both the downward movement in yields and spreads, reflecting the current slow growth, low inflation, and low policy-rate environment. Yields seem likely to remain range bound, and prospective returns modest, given the outlook for current environment to persist through the balance of this year and into next.
|
| |
This information represents the opinion of FAF Advisors, Inc., and is not intended to be a forecast of future events, a guarantee of future results, or investment advice. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. The factual information has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Past performance does not guarantee future results.
FAF Advisors, Inc., is a registered investment advisor and subsidiary of U.S. Bank National Association.
|
| |
|
| |
|
|
|
|
|
