The Economy
Reviving, But at a Modest Pace
An economic recovery is underway, but is characterized as “a fragile upturn” due to the still high unemployment rate at 9.7%. Real gross domestic product grew an average of 4% in the last half of 2009 (2.2% in the 3rd quarter and 5.6% in the 4th quarter of 2009). Much of the growth was attributable to inventory rebuilding and capital spending. The health of the consumer remains unclear due to debt levels and a weak labor market. The consumer component is important because it typically accounts for about 70% of US economic activity. This recovery merits close watch as history tells us that recovery periods following recessions triggered by financial crisis are followed by more subdued recoveries that can be longer in duration. Good news can be found in company reports of rising profits and inflation which remains at a moderate 2.2% annual rate (through February 2010).
The Stock Market
Investors Take Note of Improved Earnings
Investors appear to have recognized the strong earnings growth expected in upcoming announcements for the first quarter of 2010. The S&P 500 gained 5.4% for the first three months of this year, while mid-sized companies (S&P 400 Index) appreciated even more at 9.1%, and smaller sized companies (Russell 2000 Index), gained 8.9%. Investments in international stocks returned less than domestic stocks due to the weakness in foreign currencies relative to the US dollar. The Europe Australia Far East Index gained only .2%.
Last year’s unprecedented stimulus and easy monetary policies have helped to drive stock prices higher and the momentum of monetary and fiscal stimulus continued in the first quarter of 2010. The twelve month rally we have just experienced from the market lows of March 2009 to March 2010 was lead by lower-quality companies. These lower quality companies (higher debt levels, low margins and low return on equity) had the greatest relative benefit when the economy transitioned from recession to recovery. The reason is that investors had already wrote off the weak companies and then returned to them in mass when the economy improved.
Going forward, the stock market will need to see signs of sustainable growth in order to keep prices moving in a positive direction. Some strategists believe this will favor higher quality stocks. Since the end of March 2009, the twelve month rally has been absolutely phenomenal. Small company stocks on average are up 70% and large company stocks (S&P 500) are up nearly 50%. Those investors that resisted the urge to panic out of the stock market in March of 2009 have been amply rewarded for their patience.
The Bond Market
Prospects for Rising Rates Nearer
The Federal Reserve policy meetings in January and March of 2010 resulted in short term interest rates staying at the ultra low levels of a range between 0% and .25%. For a full 15 months now, an easy money policy has been maintained in an effort to assist companies and consumers to stay afloat during tough economic times. As the fed senses the economic recovery is taking a solid hold, it is likely to begin to raise rates. Similar to the stock market pattern of this recovery, the lowest quality bonds (junk or high yield) had the most to gain in the bond market rally and have led the bond performance charts with a 45% gain from March 2009 to March 2010. The gains from holding bonds in a declining interest rate environment are winding to an end in the first quarter of 2010. Government bonds, both short and long term have only slightly positive returns for the first 3 months of 2010, while the low quality bonds continued to provide a better return of approximately 4%. Going forward, the prospect of rising rates has fixed income investors jittery and more likely to seek refuge in short term bonds or money market funds. But with zero to little yield on money market funds and short term maturities, the environment for bond investing can best be described as challenging. Diversification across maturities can help investors successfully position themselves for changes in interest rates and changes in the shape of the yield curve.
Schenck Investment Solutions
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