Q2 Commentary (2006)
Our often-enumerated themes in previous quarterly commentaries focusing on housing, the U.S. consumer and historically low market volatility appear to have met an inflection point in the 2nd quarter. Indeed, following the strongest 1st quarter for the S&P 500 since 2000 with a gain of 4.2%, the second quarter finished down over 1.4%. Had it not been for a strong rally in the final two weeks, the entire gains of the 1st quarter would have been eliminated.
We believe that we are witnessing a period of both economic and market transition. Following a powerful rebound in early 2006 that brought final Q1 GDP to a 5.6% quarterly gain and a year-over-year (YOY) increase of 3.7%, consumer spending and housing have seen demonstrable slowdowns in the spring. While we anticipate GDP growth for the 2nd quarter to be on par for a 3% gain, a 2% real GDP number appears to be where the back end of the year is headed.
Although consumer confidence has continued to be buoyed by a solid job market with the unemployment rate of 4.6% at a 5 year low, the housing market appears to be headed for a greater slowdown than anticipated with many housing indicators already moving towards multi-decade lows. The lagged impact of rising interest rates on housing affordability combined with rising energy costs is having a strong impact on consumer discretionary spending.
Rising energy costs have pushed inflation indices out of the comfort zone of Federal Reserve Chairman Ben Bernacke with the CPI moving over 4.5%, a level barely broached in the last 5 years. While we see CPI inflation rising over the balance of the year, we feel it to be a lagging indicator that will moderate in 2007 as slowing demand and declining overall employment costs override increased shelter costs.
A strong job market has contributed to an increase in average hourly earnings at 3.9% YOY but employers have offset this increased cost via reduced or shared benefit costs. This has aided corporate profits which have continued to surprise on the upside. We anticipate the 2nd quarter to show the 12th consecutive double digit EPS increase for the S&P 500 before moderating in the second half.
This economic transition has manifested itself in the capital markets via a sharp movement towards higher quality. For the quarter, the more volatile Nasdaq Composite, Russell 2000 small cap index and Emerging Markets index declined 7.2%, 5.0% and 4.3% respectively compared with a small decline of only 0.8% in the S&P 100 index of the largest U.S. companies. At the Sector level, top performers could be found in more traditional defensive areas such as Consumer Staples, Energy and Utilities. Additionally, the commodities markets, where much speculation could be found, suffered large corrections with precious and base metals all suffering declines of over 20% during the period before recovering modestly.
During the quarter, the Federal Reserve raised their target Fed Funds rate for the 16th and 17th times to 5.25%. With the lagging impact of previous increases now being felt in the economy, we certainly feel the end of rate increases is at hand with perhaps one more 25 basis point hike at either the August or September sessions. While interest rates have felt the impact of rising inflation and yields have increased on the 10- year Treasury from 4.37 % to 5.14% since the start of the year, we anticipate moderating inflation and a slowing economy that in turn should have the effect of lowering yields into 2007.
In addition to strong earnings growth, S&P dividend increases have totaled over 26% since the beginning of 2005. With dividend payout ratios still at historically low levels, continued increases are suggested even in a period of moderating corporate profits. In spite of a slowing economy, owners of demand-defensive, high quality companies with attractive cash flows and valuations should continue to be rewarded. Such companies continue to comprise the core of our portfolios.
Back
