The Storm after the Calm

- 2012 2nd Quarter

We have all heard the expression that if something appears too good to be true then it normally is. After two consecutive quarters of double-digit returns, reality has set in. While first quarter was unexpectedly calm both domestically and internationally, 2nd quarter was anything but. In fact, what we encountered was “The Storm after the Calm”. While the S&P 500, which fell 2.75% but is still up 9.49% year-to-date, looks positive, the economic data indicates that we may be in the midst of a global slowdown (BTN Research).

The intent of this commentary is to give a summary of what is taking place in the economy and world markets. While retirement is for the long haul, our intent is to keep our clients informed about what has taken place in the recent past, as well as to give some indication of what the future may hold.

Despite a good second quarter corporate earnings season, the strongest negative headwinds came from the ongoing Eurozone crisis, a slowdown in China, and the U.S. policy stalemate—which will likely worsen later in this election year—keeping investors on edge and dragging down the equity markets globally. At the same time, fears of a significant slowdown in China have resulted in the energy, materials, and industrials sectors lagging the market for the year-to-date through the end of June.

While earnings estimates for U.S. companies were revised down in the first quarter, the U.S. corporate sector remained strong and provided some upside surprises for investors. There was good news in corporate earnings reports with 69% of companies in the S&P 500 beating earnings expectations. Importantly, 67% of companies also beat their revenue estimates, which speaks to the improvements in the top-line numbers and the strength of the U.S. economy.

While the overall economic picture in the U.S. continued to be positive, economic indicators were negatively impacted by the European recession and slowdown in the emerging markets. Also, while the manufacturing sector continued to boost employment and the economy there was a slight slowdown late in the quarter likely driven by near-term uncertainty about U.S. policy outcomes and the tumultuous global economic landscape.

Business inventories continued to increase and vehicle sales also remained strong as domestic demand continued to pick up. However, the pull-forward of economic activity due to unseasonably warm weather earlier in the year had an effect of dampening some economic data in the second quarter, including hiring and consumer spending. The unemployment rate edged back up to 8.2% as U.S. labor market improvements seemed to slow down somewhat, although public sector jobs accounted for a large portion of the losses (BTN Research).

Commodity prices, especially food and energy, have softened, driven by the global economic slowdown and the slowdown in China in particular. Gasoline prices also softened throughout the quarter, providing another source of support for the U.S. consumer. The previously reported first quarter GDP annual growth rate of 2.2% was revised down to 1.9%, but overall, U.S. economic data reported during the quarter, while somewhat less robust, was still generally positive (Bureau of Economic Analysis 6/30/12).

On the housing front, most data continued to point to an improving environment in the residential housing market with historically low mortgage rates and low home prices supporting housing activity. While housing prices are still in the process of bottoming out, housing activity has now been on the mend for several months. Though some activity seems to have been pulled forward into the earlier part of the year due to unseasonably good weather, given the significant size of the U.S. housing market and its impact on consumer wealth, confidence, and spending, any good news is doubly good for the U.S. economy as it leverages the positive impact on consumers, which represent two-thirds of the U.S. economy.

As we anticipated earlier in the year, the international markets have fallen as a result of the policy action in Europe and the possibility of a more severe economic recession in the euro-zone. Considerable fiscal drag and austerity measures that have been implemented in Europe are likely to result in a more severe economic downturn, which will worsen the sovereign debt crisis through bond vigilante actions as well as potential further sovereign debt and European bank downgrades by credit rating agencies. Core European economies also continued to show signs of weakness, indicating they are not immune to the crisis engulfing the region.

The Chinese economy continued to show signs of slower growth during the quarter with the manufacturing sector contracting for the eighth consecutive month. While the GDP in China expanded 8.1% in the first quarter of 2012, it is the slowest pace since the first quarter of 2009, and below the consensus forecast of 8.4% National Bureau of Statistics of China 4/13/12). A Slowdown in China—a more probable outcome than ever before— would have a significant negative impact on the global economy and investor sentiment. Commodities markets will likely be hit hardest.

We remain quite positive on the long-term (three- to five-year) prospects for U.S. equities and view potential near-term volatility as a buying opportunity given the relative attractiveness of current equity valuations and the health of U.S. corporate earnings.

Overall, while a global economic slowdown is likely having a marginally negative impact on the U.S. economy, particularly on the U.S. large capitalization companies, the U.S. is still likely to be able to stay on its path of slow economic expansion.

As you take all of this information in, please remember that you are investing for the long-term in your Retirement Plan. When meeting with participants, we work to determine your investment suitability which monitors your age, time horizon for investment, and risk tolerance. If you do not remember when you have last reviewed your Investment Suitability or investment account, now may be the time to do so. While the market peaked in early May, your account is at or near its high point, and if you felt you were investing too aggressively; then now may be a time to reallocate your portfolio.

I hope everyone is enjoying the summer and staying cool - if we can be of any assistance, please do not hesitate to contact me directly at (216) 595-0700.

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