|Y-T-D||1 Year||3 Year||5 Year|
|MSCI Emerging Markets||-9.97%||-0.86%||-11.76%||4.63%||27.14%||29.75%|
|Lehman Muni Bond||-1.13%||0.64%||0.02%||3.24%||2.93%||3.53%|
|ML High Yield||-2.68%||1.81%||-1.28%||-2.11%||4.63%||6.90%|
|Citi World Government Bond||0.45%||-4.23%||5.02%||17.00%||6.24%||6.39%|
Despite posting positive returns during April and May, equities in June suffered their worst one-month decline since September 2002. In April, the markets shrugged off skyrocketing oil prices and the ongoing weakness in the economy — especially in the labor and housing markets — and were lifted by upbeat earnings reports and another 25-basis-point cut in the Fed Funds rate. In May, despite renewed credit concerns in the financial sector, the upward revision in first quarter GDP to 0.9%, the Fed’s rhetoric on inflation, and the rising dollar all kept the market advance on track.
However, on June 6 the Dow experienced its eighth largest point decline, dropping 394.64 points in response to May’s unemployment rate moving up to 5.5% (higher than analysts’ estimates), and oil prices reaching sky-high levels. During the month, downgrades in the financial industry, deteriorating industry conditions for automakers, and a record $143.67/barrel crude oil price crushed most non-commodity equity issues. The 2008 change in commodity prices has been staggering: for the first six months of the year, the price of crude oil leapt 45.9%, and gold climbed 10.9%.
Financial jitters also returned to the market for the first time since the Fed backed the JPMorgan Chase bailout of Bear Stearns. Speculation increased that Lehman Brothers Holdings, whose stock has lost more than a third of its value in one month, would report a second-quarter loss and be forced to raise cash to make up for mortgage write-downs. The company's shares went through a dramatic drop after reports that the firm had borrowed from the Fed's discount window. Adding to concerns about the health of the financial services sector were Wachovia's ouster of its chief executive, Kennedy Thompson, and AIG’s removal of CEO Martin Sullivan, both due mainly to write-downs that more than halved the companies’ market values in the past year.
Despite these jitters in the financial sector, it appeared that the markets were being driven by fear of inflation and the rising price of oil. Investors were increasingly worried about the toll that expensive energy will exact on corporate profits in the months ahead as companies struggle to pass along fuel costs. In addition, consumers were expected to cut back on purchases of various goods and services to cover their bills at the pump.
Inflation appeared to be a bigger issue for the emerging economies that refused to allow their currencies to rise relative to the U.S. dollar. By maintaining too tight a peg to the dollar, some countries have been led to largely import the U.S. monetary policy, which is often totally unsuited to their economic situation; their domestic economies may require higher interest rates. This policy may result in inflationary pressures that are difficult to contain.
In developed countries where wage growth has been slow, corporations in general have not over-hired or over-leveraged and broad inflationary measures are lower. Although the headlines have focused on higher energy and food costs, it is important to remember that those two components only comprise about 25% of the price index in the United States. There has been little evidence of pass-through to other price sectors. Wages and home prices, traditionally the largest drivers of inflation, are not rising rapidly.
The second quarter earnings season is right around the corner, and investors should expect continued diverse results. Companies in some sectors and industries have more trouble passing along increased costs to customers. The current business climate will likely contribute to continued weakness in financial and consumer discretionary stocks. Higher energy and commodity prices should propel earnings in the energy and agricultural sectors, and a weak dollar is boosting profits of the big multi-nationals.
Around the world, Central Banks are increasingly turning their attention to inflation and wrestling with the twin problems of slow growth and rising prices. The banks are shifting their policy stance from one of protecting growth to that of fighting inflation, sending a signal to the markets that rates are likely to remain at current levels or rise.
While the Federal Reserve is also under pressure to respond to the recent spikes in commodity prices, to date there has been little evidence that businesses have been able to pass the higher input costs on to the U.S. consumer. It seems likely that the Fed will remain on hold and will not start to raise rates before the end of the year. Contributing factors include the uncertainties still surrounding financial institutions, slumping housing values, the deterioration in labor conditions, ongoing credit stresses and a general lack of broad inflationary pressures. Despite all the negativity permeating the financial markets, the U.S. economy has still not registered a quarter of negative growth in the most recent slowdown. While job losses have risen, they are still not at the levels seen in earlier recessions. Although the Fed has probably finished cutting rates, there is every indication that it expects to continue to use its special lending mechanisms, meaning that relaxed monetary conditions are likely to persist.
A positive move in the markets will likely be driven by some relief in commodity prices in general, and oil prices in particular. This relief could occur if the current economic weakness leads to declining demand and falling oil prices. Alternatively, a slowing of the deterioration in home prices and the easing of credit conditions could help the markets. This scenario appears less likely to occur as the housing and credit markets remain under tremendous stress.
Consensus views indicate that a v-shaped economic recovery may not be in the offing. Growth in the U.S. is likely to remain sluggish for the remainder of the year amid soft consumer spending and the continued drag from housing. The pressures created by the credit bust and the de-leveraging forces that contributed to the slowdown have been joined by additional stagflationary factors. The potential effect of this double whammy on the U.S. economy could create an extended u-shaped recovery.
Gordon Tewell, CFA