Q2 Overview (2005)
The US economy entered the 2nd quarter of 2005 on a continued healthy and robust pace with final first quarter GDP revised upward to 3.8%. Corporate earnings growth exceeded estimates with 13% growth while inflation remained tame as the core CPI rose 2.3%.
With the Federal Reserve hiking interest rates two more times in the second quarter to 3.25%, the anticipation of a pause in housing and the subsequent impact on consumer spending was thought to lead to a slowdown in second quarter economic growth. While manufacturing has slowed, job growth continues on a solid pace averaging over 180,000 new jobs per month and unemployment falling towards 5%, the lowest level since 2001. These employment trends along with continuing attractive mortgage rates have fostered the perpetuation of strong housing and the addition to our lexicon of a new phrase, the “Greenspan conundrum” referencing declining long-term mortgage rates in the face of rising short-term rates. In turn this has helped sustain additional consumer spending.
There is still reason to anticipate that the economy should be decelerating from recent levels. Oil prices have now risen from $43 per barrel at the end of 2004 to $60 per barrel and averaged over $53 during the second quarter. This impact has yet only moderately impacted the consumer as 2nd quarter real spending appears to be around 3.0% down from 3.6% in the first quarter. As with interest rates though, rising oil prices tend to have a lag effect on consumer behavior. Additionally, rising production costs due to these commodity increases may subsequently pressure corporate profit margins which have so far remained near historical peak levels. Indeed, second quarter earnings growth is expected to decelerate to a still healthy 7%. Ex-Energy this number is below 5%.
For the quarter the S&P and Nasdaq gained 1.37% and 2.89% respectively pulling the 500 stock index to -.81% for 2005 while the Nasdaq still shows a decline of 5.45%. The quarter caught many by surprise as interest rates on the 10 year Treasury actually declined from 4.45% to 3.94% in the face of Federal Reserve tightening. While the yield curve flattened further, credit spreads widened as the downgrade to junk status of the debt of General Motors and Ford was felt throughout much of lower rated bond arena. Concurrently, the decline in longer yields precipitated interest-sensitive sectors such as Utilities and Financials to lead performance, up 7.94% and 5.16% respectively. For the year, only Energy, Utilities and Healthcare have exhibited positive returns of the 10 S&P economic sectors.
Unlike the first quarter, the second quarter saw a modest return of equity investors to higher beta areas. Small Cap and Emerging Markets outperformed other equity asset classes with the Russell 2000 and MSCI Emerging Markets indices up 4.31 % and 4.24% respectively.
Concerns regarding oil prices, interest rates, and the US dollar, as well as housing bubbles and global trade imbalances continue to dominate our headlines and result in a seemingly trendless, range-bound equity market. So far this year, the S&P 500 has ranged less than 7% from high to low, one of the least volatile years in memory. Yet continued earnings growth has now placed the market valuations at price/earnings levels that according to consensus estimates would be comparable to historical averages of the last 70 years and the lowest since 1996. Additionally, companies continue to increase dividends at an accelerating rate and with corporate dividend payout ratios near 40 year lows and corporate America awash with cash, this trend can continue and even increase. As such, a continued focus on high quality, demand-defensive companies with strong yields and attractive valuations should continue to provide solid returns with lower volatility to reward the long term investor.
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