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Market Update -- In the Markets

Written by Derrick Wulf, CFA, Portfolio Manager

July 14, 2009

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
The pace of economic contraction slowed in the second quarter, with GDP declining an estimated 1.8% after falling 5.5% in the first quarter. Improving financial conditions, rising consumer confidence, and a rebuilding of depleted inventories by manufacturers all helped stem the decline in economic growth, but real demand by both consumers and businesses remained weak. Continued deterioration in the labor markets weighed heavily on consumers, while sluggish sales and an uncertain outlook kept businesses on the defensive. Aided by an ongoing recovery in the financial markets and aggressive spending measures enacted by Congress earlier this year, the economy is widely expected to return to positive growth in the third quarter.

Inflation
The contracting economy, slowing income growth, and excess capacity all kept consumer prices well contained during the second quarter, with the Consumer Price Index remaining unchanged in April and rising just 0.1% in May. On a year-over-year basis, the index slipped deeper into negative territory, extending its recent declines to register a 1.3% drop in the 12 months through May, its largest decline since 1950. Core CPI remained relatively stable, rising 1.8% on a year-over-year basis in May, while Core PCE also registered a 1.8% year-over-year gain in May. Producer Prices, meanwhile, registered large year-over-year declines reflecting the base-effects from last year's run-up in commodity prices, leaving PPI down 5.0% in May, its largest 12-month decline in nearly 60 years. Despite the weaker inflation data, however, the Fed's quantitative easing initiatives, a weaker dollar, and recovering commodity prices sparked concerns that longer-term inflationary pressures were starting to build. According to the Reuters/University of Michigan Index of Consumer Sentiment, 1-year-ahead inflation expectations rose to 3.1% in June from 2.0% in March, while 5-year-ahead inflation expectations rose to 3.0% from 2.6% in March. The breakeven inflation rate on five-year TIPs, meanwhile, rose from less than 0.50% in the first quarter to 1.37% at the end of June.

Jobs
Labor markets deteriorated further in the second quarter, though the rapid pace of job losses slowed and began to show some early signs of stabilizing. The unemployment rate, which rose 1.3 percentage points in the first quarter, climbed another 1% in the second quarter to hit a 26-year high of 9.5% in June. Nonfarm payrolls declined by the smallest amount in eight months in May, and despite an increase in job losses again in June, the average monthly decline in payrolls in the second quarter slowed by more than 150,000 from the 691,000 jobs lost on average in the first three months of the year. Payroll losses since the beginning of 2008 now total nearly 6.5 million, however, and both wages and hours worked remain under pressure, suggesting that, while the pace of deterioration in the labor markets has moderated, the bottom has not yet been seen.

Income
Ongoing weakness in the labor markets led to further declines in average hourly earnings growth according to the Bureau of Labor Statistics (BLS), while average weekly earnings fell slightly due to fewer hours worked. On a year-over-year basis, earnings were up 2.7% in June after averaging roughly 4% annual growth in the previous few years, while average weekly hours fell to just 33.0, the lowest reading in 45 years of BLS data. Offsetting some of the weakness in wage income, however, were tax cuts and benefit payments associated with the government's stimulus package passed earlier this year, leading to a 1.4% rise in personal income in May, according to the Commerce Department.

Manufacturing
The manufacturing sector continued to show signs of stabilizing during the second quarter, reflecting a partial rebuilding of depleted inventories. While the June reading of 44.8 in the ISM Manufacturing Index still implies a moderate rate of contraction, the index has shown steady improvement from its low of 32.9 in December and now stands at the highest level since August 2008. Though the auto industry remained under sever pressure, other parts of the manufacturing sector saw encouraging signs, with durable goods orders increasing 1.8% and non-defense capital goods orders rising 4.8% in May, according to the Commerce Department. The new orders component of the ISM Index also rose back into expansionary territory, reaching 51.1% in May before retreating again slightly in June.

Retail
Retail sales remained relatively stable in the second quarter after a modest bounce earlier in the year. Although headline retail sales rose 0.5% in May and 0.6% in June, however, much of the strength was attributable to gasoline and food sales. Consumer discretionary demand remained soft, and real consumption actually declined slightly in the second quarter. The American Recovery and Reinvestment Act is expected to help boost consumer spending in the second half of the year, but rising unemployment, anemic earnings growth, and shifting consumer attitudes are likely to impede the pace of recovery in the retail sector.

Housing
Housing markets stabilized in the second quarter amid increased affordability and improvements in consumer confidence. Existing home sales posted their third consecutive month of growth in May and their highest level since October as lower prices helped lure in buyers. Distressed sales, which include foreclosures, accounted for one third of existing home sales in May, and while this proportion remained elevated, it showed steady improvement since the start of the year. New home sales also showed signs of stabilization after hitting a multi-decade low in January, and months' supply of both new and existing homes declined as well. Although home prices continued to fall, the rate of decline slowed from the record pace seen earlier in the year, with the year-over-year change in the S&P/Case-Shiller home price index improving to -18.1% in April from -19.0% in January. With mortgage rates still quite low and inventories declining, the housing markets are expected to continue to repair themselves in the second half of the year.

Confidence
The Conference Board's index of consumer confidence showed dramatic improvements in the second quarter after posting a series low of 25.3 in February. The index reached 54.8 in May before giving back 5.5 points in June. The modest setback in the June report was primarily driven by higher gas prices and a weak labor market. The University of Michigan Survey of Consumer Confidence, which tends to be less influenced by labor market sentiment, increased in all three months during the quarter, posting its highest reading since February of 2008 in June. Both indices saw substantial gains in consumer expectations, but a slight moderation in expectations in June suggests that consumers are not yet ready to call the turn.

The Fed
The FOMC convened two formal meetings during the second quarter, but after having reduced the target fed funds rate to its effective floor in December and announcing an expanded asset purchase program in March, the Fed voted to keep its various monetary policy initiatives largely on hold. Among those initiatives, the Fed's asset purchase programs continued to receive the most attention from financial market participants. Specifically, the market focused first on whether the Fed would expand its Treasury purchase program in response to rising Treasury yields in May and June, and then how the Fed would go about eventually unwinding these initiatives once economic growth returned and inflation pressures began to mount. The latter, of course, being a more academic discussion, as economic indicators continued to point towards risks of near-term deflation.

By the end of June, through its regular open market operations, the Fed had purchased $188 billion in Treasuries, putting them on schedule to complete their $300 billion of announced purchases by September of this year. The Fed had also purchased close to $700 billion in mortgages, leaving a little more than half a trillion to go. Also, in May, the Fed announced an expansion of its Term Asset-Backed Securities Loan Facility (TALF) to include certain legacy assets, including high-quality commercial mortgage backed securities.

In its June 24 statement, the FOMC reiterated that it would likely maintain "exceptionally low levels of the federal funds rate for an extended period." It also stated that it "is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted."

Treasuries
Treasury yields rose sharply in the second quarter as improving financial market conditions reduced the safe-haven demand for Treasuries while issuance soared amid ballooning budget deficits. Uncertainty surrounding the Fed's exit strategy from quantitative easing, as well as fears of an eventual rise in inflation also led to a sharp steepening of the yield curve. The benchmark ten-year Treasury note yield, which had traded as low as 2.05% at the end of last year, rose from its March 31 close of 2.67% up to almost 4% in June before trading back down just above 3.5% at the end of the quarter. The yield on five-year notes rose by a similar amount, ending the quarter at 2.56%, an increase of 90 basis points from March. The yield on two-year notes remained in a much narrower range during the period but still rose to a seven-month high of 1.40% in June before settling back in to 1.11% at the end of the month. The spread between two- and ten-year notes, meanwhile, rose 56 basis points to 2.42%.

Bond Markets
An ongoing recovery in credit markets led the bond markets higher in the second quarter despite a sharp rise in Treasury yields. The Barclays Capital Aggregate Index registered a total return of 1.78% for the quarter, led by strong performance in corporate bonds and commercial mortgage backed securities (CMBS). Improving liquidity conditions and growing indications that the economy was poised to return to positive growth in the second half of the year helped corporate bonds post returns in excess of 10% for the period, outperforming treasuries by 13.61% on a duration-matched basis, according to Barclays Capital index data, as spreads tightened 237 basis points to end the period at 306. CMBS spreads tightened 286 basis points, leading to excess returns of nearly 14.5% as the Fed expanded its TALF program to allow for the inclusion of high-quality, legacy CMBS assets. The ongoing success of TALF also led to strong performance by the ABS sector, which outperformed Treasuries by 8.75%. Mortgage-backed securities (MBS), meanwhile, also outperformed Treasuries, posting 123 basis points of excess returns as spreads tightened to a mere 36 basis points over Treasuries on an option-adjusted basis.

Non-investment-grade corporate bonds staged a huge rally, as many of the same themes boosting investment-grade corporates had an exaggerated impact on the more volatile high-yield sector. For the three months ended June 30, the Barclays Capital High Yield Index returned over 23%, with spreads tightening some 569 basis points. Municipal bonds returned over 2% during the second quarter as attractive valuations lured in buyers despite ongoing budgetary problems among many state and local government issuers. Lastly, non-dollar fixed income markets also performed well, reflecting a weaker dollar and improving credit conditions in overseas markets.

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