July 2010
The US economy continued its tepid growth for the second quarter as global events dominated the headlines. Fears of continued sovereign debt worries in Europe, the tragic oil spill in the Gulf of Mexico, and concerns over Chinese real estate and stock markets weighed heavily on markets worldwide. Worries over the impact of these potentially significant shocks led to a strengthening of the dollar which, in turn, has eased pressure on the Federal Reserve to raise interest rates. Investors also took note of the deteriorating conditions and fled stocks for the safety of US Treasuries. This has resulted in investors holding record amounts of short-term liquid assets as they wait for the economic data to improve.
In response to the increasing level of uncertainty, the equity markets sold off sharply. For the second quarter, the S&P 500 declined almost 12%, easily erasing all of the gains for the year. Every sector experienced a sell-off, but the pain was not shared equally. Income oriented sectors such as utilities, telecommunications, and staples stocks held up relatively well, while the more volatile sectors of materials, energy, and financials witnessed steep losses. The losses, however, masked a strong earnings season with over 80% of the S&P 500 reporting positive earnings surprises and 78% of all firms showing revenue growth, which averaged over 12%. In addition, non-bank US corporations are holding almost $2 trillion in cash on their balance sheets. This is the highest level in half a century.
The bond markets, especially the treasury market, were the big beneficiaries of the flight to safety. Longer maturity treasuries posted double-digit returns as yields fell across the entire yield curve. Municipal securities also posted gains, albeit much more modestly, as concern continued over the difficult fiscal situation in which many states find themselves. Many state budgets will be tested in the coming year.
As we look to finish out the second half of the year, markets still face some daunting headwinds. The housing market remains very challenged. Banks are holding approximately 1.1 million homes in inventory, which is an increase of 20% from a year ago as foreclosures continue to rise. In addition, commercial vacancies are also rising as businesses either fail or reduce their store count in response to sluggish consumer demand. Consumers, of course, are still laboring to pay down their high debt loads while facing the worst job market in a generation.
Although the obstacles facing the market are significant, there are many signs of improvement. Capacity utilization is up 11% from year ago levels and is approaching its historical average. Exports have continued to grow. Small business confidence is rising from what were very depressed levels and job growth has turned positive. Both inflation and interest rates remain very low and the dollar continues to strengthen. All in all, we are still moving from a period of “less bad” to one of “mildly good”.