Q3 Commentary (2009)
Noted economist Paul Krugman in a recent piece for the New York Times Magazine noted that a central cause of the financial crisis may be found in the oversimplification of assumptions and models. The view of efficient markets and rational participants ignored all things that could go wrong. Human behavior often clings to ideas and relationships we feel we know and understand. Unfortunately, it may just be this irrationality that often leads to booms and busts. One such anchor that Wall Street strategists often cling to is the stock market as a barometer of economic performance. That turned out well in October of 2007.
From a purely statistical perspective, it is apparent that the recession probably ended in the third quarter. However, it is important to understand that the end of a recession only denotes the trough of economic activity, not the magnitude or sustainability of the recovery. Well, to those that view the stock market performance as a leading indicator, we are in for a heck of a bounce back.
The S&P 500 and NASDAQ indices have enjoyed seven consecutive monthly gains and the best such period since 1938. The S&P 500 followed a 2nd quarter gain of 15.9% with a near matching 15.6% painting the best consecutive quarterly gains since 1975. The tidal wave of liquidity intended to jump start the economy had a more pronounced impact on virtually all asset classes. The Russell 2000 index of small cap stocks surged 19.3% for the quarter while the MSCI EAFE and MSCI Emerging Market Indices returned 19.5% and 21% respectively.
The equity markets were not the sole beneficiaries of the excess liquidity. While we noted in our 1Q Commentary the attractiveness of U.S. equities, our views on the fixed income markets were even more sanguine on a risk-adjusted basis. Indeed, while the equity markets enjoy all of the headlines many categories of fixed income have actually out-performed the 19.3% 2009 return of the S&P 500. The Barclay’s High Yield Index has powered ahead 48.9% with the Merrill Lynch Convertible Bond index up 39.6%. Even the Barclay’s Municipal Bond Index has returned over 14%.
The continued bullish case is predicted on the anticipation of a successful handoff from unprecedented global stimulus to sustainable private consumption in 2010. According to James Grant of the Interest Rate Observer, the average post World War II recession has been followed by U.S. Government stimulus both fiscal and monetary of about 3% of Gross Domestic Product. He estimates the current stimulus to be almost 20% of GDP.
As we anniversary the beginning of the Great Recession we are indeed seeing statistical improvement from areas often viewed as leading indicators. Both the Institute of Supply Management (ISM) manufacturing and non-manufacturing (services) have jumped from the lows of March to 52.9 and 50.9 respectively, levels that indicate economic expansion. Consumer confidence has improved from the recorded lows of 25.3 in February to 53.1 in September while the Conference Boards weighted set of leading Economic Indicator (LEI) has now risen for 5 months in a row. Even, the canary in the coal mine of Housing has shown improvement as the Federal Reserve program to purchase 1.25 trillion of Mortgage Backed Securities has succeeded in reducing mortgage rates below 5% and raising affordability to all-time highs. Existing home sales are now annualizing at 510K units which is up 13% from the levels of early this year while new home sales have risen for five consecutive months.
After declining 5.4% and 6.4% in the prior two quarters and almost 4% from peak levels, GDP in the second quarter contracted by only 0.7%. Consensus estimates have now increased to over 3% in the second half with an early forecast of 2.4% growth in 2010. However, the important questions remain. While the stimulus and inventory rebuilding cycles are necessary for a recovery are they enough to stimulate private demand consumption in 2010?