The path remains treacherous for equity market participants these days. A lack of route markers and limited visibility has made navigation of the trail extremely challenging. During the third quarter there was simply very little ability to gain any solid foothold as the pathway deteriorated precipitously. September proved to be the most difficult month as equity prices could not find any firm ground, pushing the S&P 500 Index down -7.03% and the Russell 1000 Index off a greater -7.37%. These declines contributed to a plunge of -13.87% in the S&P 500 Index and a similarly painful -13.14% drop in the Russell 1000 Growth Index in the third quarter.
The predominant theme weighing on investors psyche is the ongoing drama plaguing Greece and other members of the European Union. The question as to whether Greece will be allowed to default and what the resultant impact will be on not only European financial institutions but global financial institutions has left investors wanting to be less exposed to equity markets. The threat of broader financial contagion leading to global economic stress and the potential for the US economy to fall back into recession has amplified the de-risking of investment positions. Further adding to investor distress is the uncertainty surrounding the deficit reduction deliberations and the seeming unwillingness of Congress and the Administration to act in a bipartisan manner to develop a solution to spending and tax reform and support jobs action. Consumer and business confidence is suffering from the Washington bad theater which has led to a slowing in investment and also sapped investor enthusiasm.
There is no doubt the global economy is on tenuous footing. Manufacturing has slowed around the globe with the Global PMI slipping below 50% in September. The US housing market remains depressed and shows no sign of near term acceleration as prices continue to weaken and demand is lacking despite low mortgage rates. The employment environment is not improving as many companies are still cutting jobs in an effort to better manage the cost structure while others are loath to hire given the uncertain business climate. Yet not all is bleak. While consumer confidence has certainly been damaged, consumer spending has not deteriorated significantly. However, the spending is being driven more at the tails than in the middle, the high end consumer continues to spend, while the middle to lower end are searching for more bargains and moving downstream, while tailoring their discretionary spending. Lower energy prices should be a positive for the consumers’ wallet as the fourth quarter unfolds. From a corporate perspective, a lack of wage pressure has supported margins, while balance sheets have benefited from low interest rates and an increase in cash, which is being increasingly utilized to boost dividends and share repurchase.
The volatility of the equity markets has made it difficult for investors to gain traction and the continued uncertainty of the economic and political environment is not likely to minimize the instability in the short term. The Swarthmore Group believes those companies with the ability to manage input costs, attract consumer spending and gain market share, and utilize cash to support and grow share buybacks and dividends are best poised to better perform given current market conditions.
FIXED INCOME - THIRD QUARTER 2011 REVIEW The US economy continued to grow during the third quarter, but barely. The unemployment rate ended the quarter unchanged at 9.1% after moving 0.1% higher before moving back down. Nonfarm payrolls disappointed each month, including a dismal no change for the month of September. The inflationary measure based on core CPI continued to trend higher, ending the quarter at 2.0%. Manufacturing indicators were weak as well, touching levels not seen since July 2009. At the macro level, GDP for the first quarter was revised downward to 0.4% while second quarter’s figures came in at 1.3%. The housing sector remained weak, as any positive signs were attributed to distressed prices and a sizeable backlog of supply. But the major news event for the quarter was not the economic releases; it was news from the Federal Reserve. Just prior to quarter’s end the Fed announced “Operation Twist”; that is, selling short-dated Treasuries from its portfolio and placing the proceeds in longer maturities, as well as its intention to reinvest the proceeds from its mortgage portfolio back into mortgages. The former operation is intended to keep longer interest rates low, while the latter’s goal was to keep capital flowing in the housing arena. Globally, economic indicators suggested that the world economy was slowing and sovereign risks in Europe were continuing to build beyond Greece. Additional measures to stabilize and aid the Europeans were openly discussed. These events led global investors to view the US markets as a safe haven, despite the S&P downgrade early in September for the US government’s debt. As a result spread product experienced one of the worst quarters in decades, while Treasury yields plummeted. In the mortgage sector, rumors flew over the possibility of a plan to help underwater borrowers take advantage of the historically low interest rate environment. Such a plan would give mortgage borrowers additional funds, but investors in this sector would be penalized as mortgages would be paid off at par, while current market prices are above par.
Last quarter we expressed a conviction that there were going to be challenges in the second half of the year, but we did not foresee the market’s reaction to the uncertainty and weakness in Europe, the results of the debt ceiling debacle, or to S&P’s ratings downgrade of the US. Some of these events, like the European sovereign weakness may unwind over the near-term as the various European and world government and financial leaders devise a plan to stabilize that region. Others, such as the ratings downgrade in the US may not have a material effect for some time. The US and other economies are teetering on the edge of negative growth, with no immediate signs of substantive economic expansion on the horizon. Unemployment at slightly more than 9% is a hindrance; however, inflationary pressures do not appear to be building at this point. Corporate earnings continue to be healthy, along with balance sheets; however, the continuation of the strength seen over the last several years may be difficult to sustain. We continue to look for signs of weakness. With each passing quarter we’re getting closer to the bottom in the housing sector, but the shadow inventory, which remains at almost a full years’ supply of homes between actual and pending foreclosures needs to be worked down. This sector needs to continue to improve for the economy to regain its strength. Banks must be able to lend without concern over regulatory challenges while not taking on an inordinate amount of risk relating to valuation issues. Then there is the Fed. While Operation Twist does not directly affect monetary policy, it does remove one more option for the central bankers to address economic weakness and it also raises the question of an exit strategy from the quantitative easing measures implemented over the last 3 years. Once again, investors will have to be nimble in identifying valuation opportunities within the fixed income markets, but they will be there.
|