October 31, 2010
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Commentary
The Economy
Economic numbers are positive, but growth is sluggish. At the same time, October’s stock market gains built on September’s strong performance.
The Commerce Department’s advance estimate for third quarter GDP growth came in at a positive 2.0%. While this indicates the country is not heading back into recession, it shows the economy crawling in second gear. In spite of slow economic growth, stocks as measured by the Dow Jones Industrial Average (DJIA) and the S&P 500, have gained 12.0% in this September to October rally. The technology heavy NASDAQ is up 18.0% during the same period. Our “Stock Market” section highlights third quarter performance.
Consumers (almost 70% of the economy) are sending mixed signals about future spending. Consumer confidence surveys are at very low levels, while, consumer spending grew at a 2.6% annualized rate. This follows consumer spending gains of 2.2% in the second quarter and 1.9% in the first quarter. Due to spending on imports, the trade deficit was likely responsible for cutting third quarter growth by 2.0%.
While consumer spending was up, our savings rate also increased 6.0% and household debt fell by a record $900 billion since 2008. Statistically, the decline in household debt is not entirely positive. Those numbers include debt that has been paid off and written off as uncollectible. Consumer mood will be carefully scrutinized during the final two months of the year. Mid-term elections and the following Fed meeting will also inform future actions.
We do not expect any change in the Federal Funds target rate at the November meeting, and expect it to remain at 0.00% to 0.25% level. At the last FOMC meeting, the Fed stated that it intends to “keep rates low for an extended period of time.” Since the target rate cannot go lower, the Fed will begin a second round of quantitative easing to provide additional economic stimulus.
The housing and employment numbers continue to have an impact on consumers and businesses. Job numbers remain weak, with unemployment stuck above 9.0% for 16 consecutive months. The Labor Department will report October’s unemployment and job growth at the end of the first week of November.
Consensus estimates call for a continuation of unemployment at 9.6% and creation of 75,000 net new jobs by private employers. Although these are positive numbers, net new jobs should exceed 100,000 a month to bring the economy out of its doldrums. Because unemployment is a lagging indicator, it will remain weak as the economy slowly recovers.
In a joint release by the Census Bureau and the Department of Housing and Urban Development, housing starts were at a seasonally adjusted annual rate of 610,000 units in September. Although this is 4.0% higher than last September’s report, building permits were 10.0% lower than September 2009 as a result from the end of the housing credit. Low mortgage rates and indications of easing bank lending standards could provide stabilization in housing during 2011.
Inflation, as reported in the Consumer Price Index (CPI), was up only 1.1% year-over-year. The closely watched “core” rate (excluding food and fuel) was up 0.9%, year-over-year. In our last monthly letter, we noted the U.S. economy is experiencing a period of neither inflation nor deflation or “disinflation.” The Fed has elevated its concern regarding disinflation and would like to see inflation slightly higher than the reported 1.1%.
Gasoline prices (at the pump) advanced $0.52 in October. According to the Lundberg Survey (October 24, 2010), the national average price at the pump for self-service, regular gas was $2.82 a gallon. This is an increase of $0.30 over a year ago. Crude prices increased 12.0% over the past two months, and were above $81.00 a barrel at the end of October
Between now and year-end, “political economics” will be in focus. We have a split Congress with the resulting possibility of legislative gridlock, consideration of additional stimulus, and a possible end to the Bush tax cuts. Many economists and business leaders support extending the tax cuts, but it will be up to the political leaders to determine the outcome. We noted last month that former Federal Reserve Chairman Greenspan was, “very much in favor of tax cuts, but not with borrowed money.” It will be an interesting finale to a volatile year.
Stock Market
As we noted earlier, equity prices continued to rally in October and entered the closing two months of the year on a positive note. Please find the equity total return performance below:
Equity Total Return Performance as of October 31, 2010
| |
|
 |
October |
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Year-to-Date |
|
| |
S & P 500 |
|
3.8% |
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7.8% |
|
| |
DJIA |
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3.2% |
|
8.9% |
|
| |
NASDAQ |
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5.9% |
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11.3% |
|
| |
MSCI EAFE |
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3.6% |
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5.1% |
|
| |
MSCI EMERGING MARKETS |
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2.9% |
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14.3% |
(Source: Factset)
Past performance does not guarantee future results.
We have added two international indices to our Equity Performance data: The Morgan Stanley Capital International EAFE (Europe, Australia, Far East) and the MSCI Emerging Markets. The global nature of markets has become undeniable and we continue to recommend international representation in balanced portfolios.
Volatility continues, with many trading days ending with a gain-or-loss of 1.0% or more. On October 19th, the DJIA fell 1.5%. The following day, it was up 1.3%. Wall Street analysts estimated S&P 500 earnings per share of $83.75 this year, and we look for a 7.5% increase to $90.00 in 2011. Using historical price-earnings valuations, this could equate to 1,260 on the widely watched S&P 500 Index by year-end 2010 and the early months of 2011.
We expect faster growth in international markets, and favor an overweight in international developed countries with representation in selected emerging markets. Our rationale for the inclusion of major emerging markets is based on estimated economic growth rates of 4.0% to 10.0%, while major developed markets are growing at only 1.0% to 3.0% per year.
Fixed Income Market
Spread products continued to shine in October, outperforming the Treasury market. The risk trade was on, driven by the prospect of a second round of quantitative easing. Corporate risk premiums narrowed and government-backed mortgages beat Treasuries as the yield curve steepened. After underperforming Treasuries in August and September, agency mortgages had excess returns of 89 basis points as prepayment rates were somewhat lower than anticipated.
Tighter corporate spreads reflected the continued search for yield as investors traded down in credit quality and reduced the probability of the economy slipping back into recession.
Index performance is noted below:
(Source: Bloomberg)
Past performance does not guarantee future results.
Fear that quantitative easing may push the inflation rate higher than anticipated brought negative yields to the five-year Treasury Inflation Protected Security (TIPSs) auctioned late in October. With a negative yield, investors are anticipating inflation to rise 1.5 to 2.0% from current levels.
We continue to monitor the size and timing of the quantitative easing which seems destined to be announced early in November. With estimates ranging from $500 billion to $2 trillion, our recommended duration relative to the benchmark is subject to change. For now, we continue to advocate a neutral duration stance in taxable accounts.
Past market performance
is no guarantee of future results.
Index performance cited is for illustrative purposes only and is not indicative of the performance of any specific investment. An investment cannot be made directly into any index.
International investing involves special risks including currency risk, increased volatility of foreign securities, political risks, and differences in auditing and other financial standards.
Diversification does not assure a profit nor protect against loss.
Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices.
High yield, lower-rated securities generally entail greater market, credit and liquidity risks than investment grade securities, including higher volatility and higher risk of default.
The Dow Jones Industrial Average (“DJIA”) is an unmanaged index, which represents share prices of selected blue chip industrial corporations as well as public utility and transportation companies.
The Consumer Price Index (“CPI”) is a measure of change in consumer prices as determined by a monthly survey of the U.S. Bureau of Labor Statistics.
The Nasdaq Composite Index is an unmanaged index that measures all Nasdaq domestic and non U.S.-based common stocks listed on the Nasdaq Stock Market.
The S&P 500 Index is an unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Barclays Capital Government/Credit Bond Index is an unmanaged index which includes non-convertible bonds publicly issued by the U.S. government or its agencies; corporate bonds guaranteed by the U.S. government and quasi-federal corporations; and publicly issued, fixed rate, non-convertible domestic bonds of companies in industry, public utilities, and finance.
The Barclays Capital Intermediate Government/Credit Bond Index is an unmanaged index which includes non-convertible bonds publicly issued by the U.S. government or its agencies; corporate bonds guaranteed by the U.S. government and quasi-federal corporations; and publicly issued, fixed rate, non-convertible domestic bonds of companies in industry, public utilities, and finance.
The Barclays Capital Aggregate Bond Index is an unmanaged index composed of securities from the Barclays Capital Government/Corporate Bond Index, Mortgage-Backed Securities Index, and the Asset-Backed Securities Index.
The Barclays Capital Municipal Bond Index is a market-value-weighted index for the long-term tax-exempt bond market. To be included in the index, bonds must have a minimum credit rating of Baa. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date.
Morgan Stanley Capital International EAFE (Europe, Australia, Far East)- Is an unmanaged market capitalization-weighted equity index comprising 20 of the 48 countries in the MSCI universe and representing the developed world outside of North America. Each MSCI country index is created separately, then aggregated, without change, into regional MSCI indices. EAFE performance data is calculated in U.S. dollars and in local currency.
Morgan Stanley Capital International Emerging Markets- An index created by Morgan Stanley Capital International (MSCI) that is designed to measure equity market performance in global emerging markets.
FOMC ( Federal Open Market Committee)- A component of the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations.
The Federal Funds [{ate is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight.
GDP - Gross domestic product is a basic measure of a country's economic output.
Weekly Treasury Auctions – Treasury securities are sold through weekly auctions.
Treasury Bill- A short-term debt obligation backed by the U.S. government with a maturity of less than one year.
Treasury Note- A short-term debt obligation backed by the U.S. government with a maturity of one to ten years.
TIPS (Treasury Inflation Protected Securities) – A U.S. Treasury security that protects the bond holder from inflation.
Double Dip Recession- When gross domestic product (GDP) growth slides back to negative after a quarter or two of positive growth. A double-dip A double-dip recession refers to a recession followed by a short-lived recovery, followed by another recession
Price earnings valuation- A valuation ratio of a company's current share price compared to its per-share earnings.
Basis point- denoted as bp is a unit related to the change in an interest rate, and it is equal to 1/100th of a percentage point.
Examples of bond issuers are cited for illustrative purposes only and are not representative of any particular investment portfolio.
The Consumer Confidence Index – An index based on a monthly survey of representative sample of 5,000 U.S. households.
The Lundberg Report/Survey - A research report by an independent market research company (Lundberg) specializing in U.S. Petroleum marketing and related industries.
Municipal Bonds – These are debt securities that are issued by states, municipalities or counties, to help fund expenditures.
“Black Swan” – An event that deviates from a normal situation and that is difficult to predict
Federal Reserve Board Senior Loan Officer Survey – A quarterly survey of domestic and foreign bank branches by the Federal Reserve that often includes topics of current interest.
QE 2 aka quantitative easing- describes a monetary policy used by Federal Reserve Bank to increase the supply of money by increasing the excess reserves in the banking system. This policy is usually invoked when the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero. The Fed implements QE by first crediting its own account with money it creates and then purchases financial assets, including government bonds, agency debt, mortgage-backed securities and corporate bonds, from banks and other financial institutions in a process referred to as open market operations. The purchases, by way of account deposits, give banks the excess reserves required for them to create new money, and thus hopefully induce a stimulation of the economy, by the process of deposit multiplication from increased lending in the fractional reserve banking system. The designation QE2 is for the second round of easing offered by the Federal Reserve Bank.
The information contained in this Monthly Commentary was prepared from sources believed to be reliable, but we do not guarantee that the information is complete or accurate. Opinions and projections contained herein reflect our opinion as of the date of the analysis and are subject to change without notice. This report is distributed for information purposes only and in no way should be construed as advice on how to conduct an investment program. Before acting on any information, you should consult with your professional advisor.
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