Equity markets slide lower
Equity markets softened during May, as investors eased back on the risk trade. After several months of volatility, the S&P 500 Index is trading at levels similar to those seen in February of this year. For the month, the S&P 500 lost 1.31 percent, though it is still up 7.82 percent since January 1. The Dow Jones Industrial Average was down 1.53 percent for the month, but it, too, is positive for the year, up 9.79 percent.
Â
In the first quarter, 68 percent of companies in the S&P 500 beat earnings expectations, and earnings per share grew 19.70 percent. Although still very strong, earnings and net income growth were less robust than they were in every quarter last year. On the other hand, sales grew 9.19 percent year over year, which was slightly faster than in the previous two quarters. The data suggests that companies may be reaching the limit of their cost-cutting measures and that, going forward, they may have to rely more on revenue growth. Firms may also have to battle higher commodity prices, which could impact margins as the year progresses.
Â
Markets in developed foreign nations were lower for the month but still generally able to shrug off renewed debt concerns. The MSCI EAFE Index lost 2.95 percent in May for U.S. investors, who were sharply impacted by a strengthening U.S. dollar. Returns for European investors, unaffected by the dollar, were down only 0.51 percent. Year-to-date, the EAFE has returned 6.31 percent for U.S. investors.
Â
Bonds add support for investors
Bond prices pushed higher in May, and rates fell. The Treasury rally boosted the Barclays Capital Aggregate Bond Index 1.31 percent. For the year, the index is up 3.20 percent. Yields for the 10-year Treasury are now hovering above 3 percent, having closed May at 3.06 percent.
Â
Thus far, speculation that rates would rise has proven unfounded. The conventional argument has been that the reduction in purchases by the Federal Reserve (the Fed) would curtail demand for Treasuries, causing prices to fall and yields to rise. Instead, 10-year Treasury yields dropped more than 20 basis points in May, possibly signaling that the slowing recovery will hold inflation at bay. But the real test will come when the quantitative easing program (QE2) expires in June and the Fed suspends additional Treasury purchases. For now, it appears that Treasuries are continuing to rally; however, in the longer term, it seems inevitable to us that interest rates will rise from these historically low levels.
Municipal bonds have performed well, despite continued rhetoric on the part of some pundits regarding the potential for escalating defaults. In reality, only 14 issuers have defaulted since January 1, totaling just $605 million in assets. This compares with $3.23 billion in assets that defaulted last year and $7.69 billion in 2009. It seems to us that municipalities are making the tough decisions needed to balance budgets and service debt and other ongoing obligations.
Â
The recovery hits a soft spot
Domestic equity markets took notice this month, as a variety of economic indicators began to signal a weaker environment for growth. A number of regional manufacturing indices fell below expectations, including surveys out of the New York, Philadelphia, and Richmond areas. The slower growth wasn’t limited to the manufacturing sector, as the April ISM Non-Manufacturing Index caused a negative market reaction as well. In general, businesses complained about higher commodity prices and weaker end demand for products. The slowdown wasn’t good news, but manufacturing and business growth still appear to be increasing in absolute terms.
Â
Economists have been receiving mixed signals on the employment front. A strong payrolls report in mid-May suggested an improving environment for American workers; however, recent initial jobless claims data hinted that the arrival of spring may have coincided with a higher incidence of layoffs. Meanwhile, the percentage of personal income that Americans must allot to paying down debt has steadily decreased (see Figure 1). We believe this is a good sign for future consumption.
Â
Â
Although the volume of new home sales has recently improved, the housing market overall has continued to languish. According to the S&P/Case-Shiller Index, home prices fell 4.20 percent in the first quarter of 2011.
Â
In general, the slowing of the economic recovery first observed in April seems to have continued into May. That doesn’t mean the economy is hitting a double-dip—it means that the recovery has been less robust recently than economists had expected at the beginning of the year.
Â
Our debt and beyond
As we look ahead, we are faced with a rising debt burden, which the government will need to address. An impending decision by Congress to raise the debt ceiling looms large. It seems likely that it will do so eventually, given that 74 similar measures have passed since 1962. But there will surely be a good deal of political posturing on both sides of the aisle before this occurs. Washington has shown an inability to reduce spending in the past, but this time may be different. Perhaps leaders will show prudence in order to satisfy concerned voters.
Â
We believe the nation’s debt is a long-term concern. The larger short-term issue facing the federal government is the economy, especially because elections are only 17 months away. The economy still seems to be chugging along, and we have likely avoided the double-dip scenario that some had predicted.
Â
The challenge for any presidential candidate will be to spur organic economic growth and increase the number of jobs in the absence of government stimulus. As always, investors should continue to monitor the situation in Washington and in the broader economy. But they should also bear in mind that market performance does not always perfectly reflect domestic political and economic events.
Â
Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.
Â
Authored by Simon Heslop, CFA®, director of asset management, at Commonwealth Financial Network.
Â
© 2011 Commonwealth Financial Network®
Â
Â