Q2 Commentary (2007)
It took the Dow Jones Industrial Average 2,726 days to move from 11,000 to 12,000 but only 188 days to move to 13,000 and only 23 days to move to 13,500 as the U.S. and global equity markets enjoyed a sterling second quarter of 2007. A seeming flood of liquidity-driven demand overwhelmed a shrinking supply of available equities to generate one of the strongest quarterly returns during the current economic expansion. Interestingly, this powerful move took place in the face of some strong headwinds facing both the consumer and the credit markets as headlines continue to focus on the housing downturn, the unwinding of lending excesses and the subprime concerns.
As final three quarters of 2006 saw U.S. GDP slow towards 2%, fears of a more pronounced slowdown led by housing and the consumer seemed to gain traction as 1Q GDP in 2007 crawled forward at only a .7% pace. This below expectations print was led by an unusual inventory liquidation and a decline in export volumes and not by consumer spending which continued at a strong pace of 4.2% albeit below the 5%+ pace of the prior two years. Perhaps due to the still resilient consumer, the early read on the second quarter exhibits an inventory rebuild which combined with stronger exports are indicating a bounce back towards trend growth of over 3%. As quarterly numbers may always advertise greater volatility, averaging these two quarters rather than extrapolating a trend brings us to still below trend growth of about 2%, typical of a mid cycle slowdown. While consensus estimates place GDP approaching 2.8% growth in the second half of the year, we must be mindful of the potential pressures on the U.S. consumer that we have discussed for several quarters.
Continued falling demand and increasing supply of homes show no signs of reaching a bottom. Despite this, the drag of residential construction on gross domestic product will abate somewhat as we start to anniversary some of these declines. However residential construction comprises less than 5% of GDP and, for the consumer who represents almost 70%, there are additional hurdles to overcome as rising interest rates combine with excess inventories to put further pressure on prices. The excessive lending practices that contributed to the housing boom are unwinding as legislative pressures intensify the process. As rates rise and many mortgage rates reset in 2007 and 2008, there will be additional challenges for consumer spending. Additionally, while the 4th quarter of 2006 enjoyed the largest drop in gas prices in decades and may have contributed to the solid spending numbers in the first quarter, the recent rise in oil from $50 in early January to over $70 at the end of the quarter is being felt at the pump. When combined with rising food prices, spending may be facing its sternest challenge. Indeed, the early reports on 2Q consumer spending show a drop towards a 1.5% level, the lowest (outside of the Katrina disaster) since the fourth quarter of 2002.
Despite those concerns, the best predictor of the consumer is the job market that despite predictions of rising unemployment has continued to underpin the economy. For the first half of the year, job growth has approximated 145K per month a level that sustains economic activity though below the 189K average of 2006. Though the unemployment rate remains surprisingly low at 4.5%, wage pressures have seemed to abate while real income growth and record net worth levels maintain consumer confidence.
Higher food and energy prices have created a greater divergence between headline inflation and core that has sparked continued debate among economists regarding what reading the Fed should be more closely monitoring. While the core CPI has moderated into the “comfort zone” of the Fed of 1.9% year over year and 1.6% annualized over the last 3 months this contrasts sharply with the total reading coming in at 2.3% and 4.4% over the same periods. A continued divergence would be more alarming.
While we mentioned in our last letter that the unprecedented string of 14 consecutive double-digit earnings increases in the S&P 500 would assuredly come to an end in Q1 2007, we were pleasantly surprised that we were almost wrong. An expected slowing to a 3.3% gain ended up just short of 8% as strong foreign demand, a weaker dollar, and major share count reduction from U.S. corporations awash with cash added additional fuel to continued growth. This strong earnings season helped propel the S&P 500 to a gain of 6.3% led by economically sensitive sectors of Energy, Technology and Industrials that logged gains of 14%, 10% and 9% respectively as any domestic slowdown was swamped by the global demand story. The more domestically-oriented mid and small cap indices did less well but still logged gains over 4% while the MSCI EAFE and MSCI Emerging Markets indices powered ahead by 6% and 14% respectively.
As we enter earnings season for the second quarter, increased focus will be on the Financial sector to assess any fallout from the expanding subprime meltdown. Concerns facing investors currently are centered on the consumer and housing but the credit markets may hold the greatest key as the risk to this area unfolds and credit spreads and risk premiums widen. As global liquidity has been the greatest tailwind to this market rally, the impact of tightened lending standards and rising global interest rates may have the effect of slowing this spigot. The Coho portfolio has avoided any direct exposure to the housing industry and maintains an extreme underweight to the Financial sector. We are still finding opportunities to invest in high quality companies where we see excellent risk/return characteristics. These types of companies have helped us produce a long-term pattern of results that have out performed the S&P 500 and provided significantly less volatility.
