August Market Commentary

August 2012

by David C. Blough, Senior Vice President, Investment Management

The Summer Doldrums

We have once again settled into another summer slowdown! Like the movie, Groundhog Day, we are repeating 2010’s and 2011’s mid-year slump. Despite a strong finish to 2011 and a solid first quarter in 2012, the U.S. economy seems to have temporarily run out of gas. Last week, the second quarter Real GDP (Gross Domestic Product) data was released and the 1.5% annualized rate of growth confirmed the weakness we have been seeing in recent economic indicators. Despite the painfully slow growth rate, there was some good news too. The fourth quarter of 2011’s growth was revised upward to 4% from 3.5%, while the first quarter’s growth was revised slightly higher to 2.0%.

Our economy is feeling the effects of the recession-like conditions that Europe is experiencing. Europe is an important market for U.S. exports, and their economic turmoil has reduced orders for U.S. goods. The sovereign debt crisis that Greece is going through and the spill-over into its neighbors, Italy, Spain and Portugal, continue to pressure all of the seventeen nations that use the Euro as their currency. The European Central Bank continues to search for a long-term solution to the “PIGS” (Portugal, Italy, Greece and Spain) high debt levels and poor economic growth.                    

Meanwhile, the ECB’s promise to inject $100 billion EUROs into Spanish banks to strengthen their capital after huge real estate loan losses, has not significantly lowered Spain and Italy’s high borrowing costs. The odds are increasing that Greece will eventually exit the European Monetary Union. If the exit is orderly, it could cause about a 2% contraction in the Eurozone’s real GDP. If disorderly, the contraction would be deeper and longer lasting.

The stock market, so far, has taken the slowdown and Europe’s struggles in stride, with the Dow Jones Industrial Average ending the June quarter at 12,880. The DJIA returned 6.8%, while the S & P 500 Stock Index earned 9.5% for the first half of 2012. Mid-cap U.S. stocks returned 7.9% year-to-date, while Small-cap U.S. stocks were up 6.4%. International stocks once again lagged U.S. stock returns. The EAFE (Developed Markets) Index returned 2.9% and the Emerging Markets Index was up 3.9%. Corporate profits were modestly higher for the quarter ending June 30, 2012, rising only about 5% compared to the year before. Profits have been hurt by the order slowdown occurring in both Europe and China, as the global economy cools after several quarters of robust growth. We now expect 6-8% profit growth for U.S. companies for all of 2012. Looking forward, we expect the U.S. economy to grow by 1.5% to 2.0% this year. Two positive trends should offset the current slow pace of growth as the year progresses. Housing is beginning to add to growth, as housing starts rise at a slow but steady pace. The housing market is turning around, with inventories of unsold homes falling and house prices starting to rise. A housing rebound could easily add one-half percent to U.S. annual economic growth. In addition, it will boost consumer confidence and spending, as under-water home prices eventually resurface. It will also help strengthen the U.S. financial system as home mortgage default rates begin to decline.  

An Emphasis on Income 

We expect continued low rates of inflation and interest rates over the next two to three years. Our investment strategy over the last twelve months has been to increase income for our investment clients, whenever we could do so using quality investments in stocks paying higher than average dividends, as well as alternative investments such as master limited partnerships or real estate investment trusts. In today’s difficult slow growth economic environment, higher income is an important way we can add value to client returns. A bird in the hand is worth two in the bush! Similarly, over the last year we have been reducing our exposure to international stocks in favor of high quality large and mid-sized U. S. companies, to reduce risk and increase near-term return potential.