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Market Update -- In the Markets

Written by Derrick Wulf, CFA, Portfolio Manager

April 16, 2010

Here's a brief summary of what transpired in the economy and the financial markets during the past three months. We hope you'll find it a handy reference.
 
Growth
Recent estimates indicate that GDP grew at a rate of about 3% in the first quarter following growth of 2.2% and 5.6% in the third and fourth quarters of 2009, respectively. Increases in business investment, consumer spending and exports all contributed to the growth in GDP, with particular strength in manufacturing. Consumption also showed improvement, growing at an annualized rate of more than 3.5% according to some estimates. Recent improvements in labor markets suggest that this strength in consumption may continue, and current estimates for GDP growth in coming quarters are now approaching 3% as well.

Inflation
Weak housing markets, high unemployment, and significant excess production capacity kept downward pressure on core inflation during the first quarter, pushing Core CPI down to just 1.1% on a year-over-year basis in March. This level matches the lows recorded at the end of 2003, and it may fall further before stabilizing later this year. On a three-month annualized basis, the core CPI was essentially flat after registering a small monthly decline in January, its first negative monthly reading in over 25 years. Headline CPI, which bounced late last year from a 60-year low on rising energy costs, remained fairly stable in the first quarter, ending March at 2.3%. The Bureau of Economic Analysis, meanwhile, reported that its Personal Consumption Expenditure Core Price Index remained unchanged in January and February, leaving the index only 1.3% higher than its reading from a year earlier. Though near-term inflation forecasts remain well below long-term averages, the longer term outlook remains less certain. A massive expansion of the monetary base coupled with the lagging effects of monetary and fiscal stimulus amid the ongoing economic recovery have stoked fears that inflationary pressures may begin to build over the coming months. Indeed, despite subdued inflation data in recent months, the University of Michigan's consumer sentiment survey indicates that 5-year ahead inflation expectations have remained stable at 2.7%. Inflation expectations implied by Treasury Inflation-Protected Securities (TIPS) prices have also remained fairly steady. Ten-year TIPS breakevens ended the first quarter at 2.26%, down slightly from their 2009 year-end close of 2.41%, but up almost 1% from a year earlier. The five-year forward five-year breakeven inflation rate, meanwhile, remained near 3%—meaningfully higher than the long-term average inflation rate of about 2.5%.

Jobs
The employment situation continued to improve in the first quarter, with nonfarm payrolls adding 162 thousand jobs in March; the largest increase since March of 2007. While the impact of census hiring was less than expected in the March nonfarm payrolls, it is expected to contribute meaningfully to job growth in the months to come. After falling 0.3% in January the unemployment rate remained at 9.7% in both February and March, suggesting that we might have seen peak in unemployment back in October of 2009. Meanwhile, initial jobless claims continued to trend downward with the four-week moving average declining from 474,000 at the end of December to 448,000 in March. Census hiring and overall improving economic conditions are expected to add additional payroll growth in the months to come, but the unemployment rate is likely to remain at elevated levels as discouraged workers reenter the labor force.

Income
Individuals remained prices takers with respect to wages during the first quarter given their low bargaining power resulting from high rates of unemployment. Year-over-year average hourly earnings, as reported by the Bureau of Labor Statistics, fell to 1.8%, its lowest level in recent history and well below the three-year average of 3.0%. On a month-over-month basis average earnings actually turned negative in March as the ramp up in low-paying census jobs skewed the data downward. Regardless, personal income growth will continue to run well below long-term averages until we see sustained job growth.

Manufacturing
The manufacturing sector continued to be a strong source of growth during the first quarter with the March ISM manufacturing report marking the eighth consecutive month of expansion. The headline number of 59.6 was the highest since June 2004 and soundly beat the consensus forecast of 57.0. Despite a rallying U.S. dollar, new export orders remained firmly in expansionary territory in the first quarter, and the new orders component of the survey also experienced a sizeable increase in March, rising to 72 from 56 in February. Industrial production data reported by the Federal Reserve also showed continued growth during the first quarter, while capacity utilization continued its climb, up nearly 5% from its recent lows. Durable goods orders also showed solid growth in the first quarter as businesses restocked inventories and increased spending on new equipment. Meanwhile, firms reporting improving business conditions outnumbered those reporting deteriorating conditions for the last eight months according to the Chicago Purchasing Managers Index.

Retail
Despite strong winter storms in Mid-Atlantic and Northeastern states and only modest improvements on the employment front, consumers found their way to retail establishments during the first quarter. March's advanced retail sales report solidly beat expectations posting a gain of 1.6%, while February's headline number was revised upwards to 0.5%. All retail sectors had a strong March except for gas, which is inherently volatile, and electronics and appliances, where a decline in March followed a surge in February. Thus far consumers have shown a willingness to spend early in this economic recovery and future job and income growth should help underpin consumption going forward.

Housing
Housing markets suffered a bit of a setback in the first part of 2010 after a very strong fourth quarter when tax credits helped propel home sales meaningfully higher. Existing home sales, which had risen to nearly 6.5 million units in November, fell to just over 5 million units in February. Inventories also rose, pushing the months' supply measure back up to 8.6 months from a recent low of 6.5 months in November. New home sales also slipped from their late 2009 pace, hitting new lows in February with just 308,000 units sold as home buyers have been lured away from new homes by heavy discounts on foreclosed properties. Despite the pullback in sales, overall market conditions continue to point to stabilization in the housing markets, with home prices increasing modestly for the eighth consecutive month in January, according to the S&P/Case-Shiller Home Price Index. As we head into the summer selling season, high levels of housing affordability and improving labor markets give reason for cautious optimism in the coming months.

Confidence
After falling 10 points in February, the Conference Board's index of consumer confidence rebounded nicely in March to 52.5, slightly above its 3-month average. Consumers' future expectations remain optimistic while they have yet to report any meaningful improvement in their present situation. The labor differential also improved marginally, suggesting that consumers are seeing modest improvements in the labor market. The University of Michigan Survey of Consumer Confidence, meanwhile, remained steady in the first quarter with all three readings in the low 70s. Strong stocks and a stabilizing labor market have helped lift confidence indices from historical lows, but any true improvement going forward will hinge on job creation.

The Fed
The Fed completed its large-scale asset purchase program as scheduled at the end of March, but made no official policy changes and held its target overnight lending rate between 0 and 25 basis points, where it has been since December 2008. In light of ongoing improvement in financial conditions, the Fed also closed, as scheduled, most of the temporary emergency liquidity facilities it had set up early on in the financial crisis. In the official statement released after its most recent policy meeting on March 16, the FOMC maintained its long-held stance to keep "exceptionally low levels of the federal funds rate for an extended period." Kansas City Fed President Thomas Hoenig dissented in favor of removing the "extended period" language first in January and again in March, "because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability." Other Fed officials, however, including Chairman Ben Bernanke, emphasized that they believe the risks of removing monetary policy accommodation too soon outweigh the risks of waiting, and that they want to see confirmation in the data that the economic recovery is strong enough to withstand rate hikes before taking any concrete action.

Ihe Fed also continued to work on the development and testing of new policy tools to help drain excess reserves from the banking system if and when warranted. Among these tools are the paying of interest on excess reserves, term repos and time deposits, though none of them have been implemented yet. That said, as the economy continues to grow in the second quarter the markets may begin to anticipate a shift in Fed rhetoric and an eventual effort to reduce the Fed's balance sheet and remove excess liquidity. While rate hikes still appear to be at least a few FOMC meetings away, Fed funds futures markets were pricing in an increasing likelihood of rate hikes in the fourth quarter, with December contracts implying a rate of 0.5% by yearend.

Treasuries
The Treasury component of the Barclays Capital Aggregate Index returned 1.12% in the first quarter as oversold market conditions and concerns about the deteriorating fiscal situation in Greece helped contain rates to a narrow range despite ongoing improvement on the economic front. The yield curve continued to steepen as the Fed repeated its commitment to maintain its target overnight lending rate at its effective floor while President Obama managed to pass his estimated trillion-dollar healthcare overhaul. The Treasury extended the average duration of its debt in the first quarter and increased the total public debt outstanding by $460 billion, bringing total debt to just shy of $12.8 trillion. Two-year yields rallied 12 basis points, while 10s were basically unchanged and 30s sold off marginally, leaving the spread between 2s and 10s at 281 basis points, slightly below the mid-February highs.

TIPS inflation breakevens fell during the first quarter as key inflation data continued their trend lower. Five-year forward 5-year inflation breakevens, a commonly watched measure of future long-term inflation expectations, ended the period just over 3.00%, down almost 20 basis points from their 2009 year-end close but still above their long-term historical average. While sluggish income growth and general economic slack should keep inflation well contained in the near term, improving economic conditions, an expanded monetary base, and lagged effects of monetary and fiscal stimulus may build a foundation for higher inflation in the years ahead. If realized, this should put upward pressure on TIPS breakevens and nominal Treasury yields as well.

Bond Markets
Spreads on non-Treasury sectors continued their march tighter as ongoing improvement in economic data coupled with limited new supply of high grade spread product left the bullish case for spreads firmly intact. With Treasury yields confined to a fairly tight range during the period, the Barclays Capital Aggregate Index produced a return of 1.78%, with excess returns of 0.78%. Corporate bonds outperformed Treasuries by 114 basis points as strong balance sheets, rising profits, and improving outlooks created a favorable fundamental backdrop for credit. As a result, credit spreads had their tightest weekly closed since November of 2007. Mortgages also outperformed Treasuries as the Fed continued to take supply out of the market, but lagged other non-Treasury sectors as spreads had little room to improve from already tight levels. The commercial mortgage backed securities (CMBS) sector was once again the best performing sector with an excess return of 7.95%. Despite rising delinquencies and ongoing concerns about credit fundamentals, compelling valuations and lack of supply helped drive spreads materially tighter. Asset backed securities (ABS) also produced solid returns during the period, outperforming duration matched treasuries by 133 basis points. Like CMBS the ABS sector was propelled higher by attractive relative value considerations and light supply. The high yield bond market, meanwhile, enjoyed another strong quarter as well, returning 3.5% as economic and credit fundamentals continued to lure in buyers. Municipal bonds were also able to put in a reasonable quarter of performance despite ongoing pressures on state and local balance sheets.

While credit spreads have recovered meaningfully from their crisis wides, there may still be room for improvement. Barring any significant exogenous shocks, improving economic conditions and limited new supply should continue to bolster the case for outperformance of spread product. That said, rising Treasury yields could threaten the absolute return potential for bond markets in the coming months.

Some additional data about the U.S. bond markets are shown in the charts below.