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June 2010
Bumps in the Road
It looks like we finally got our market correction, which was way overdue after stocks appreciated from their lows by over 80% without a significant retracement. As you know, the market never goes straight up or straight down. Usually there are temporary corrections or changes in the primary trend of the market - typically one step back for every two steps forward. Unfortunately, this had not occurred since the market bottomed a year ago. So it is not surprising to see a broad decline in stocks now. And if the market takes ten steps forward without a correction, it is more likely the correction that eventually occurs could be more severe than usual.
If Europe sneezes, does the rest of the world catch a cold? That seems to be the worry du jour this quarter. The ongoing problems containing the oil spill in the Gulf and a little saber rattling by North Korea didn't help matters.
In May the market became increasingly concerned that Greece was going to default on its debt. But Greece's economy is no bigger than the State of Michigan's, so what's the big deal?
Well, it turns out that there was also some concern about Portugal's and Italy's debt and even Spain's ability to service their debt. And the reason this was important is because many banks, still in a somewhat fragile state, owned a fair amount of this debt. So, in the end, the bailout wasn't done just to help the Greeks; it was also done to help the French and German banks. Even American financial institutions are closely intertwined with many big European banks, which in turn have large investments in the weaker European nations.
For example, Portuguese banks owe $86 billion to banks in Spain, which in turn owe German banks $238 billion and French banks $220 billion. American banks are also big owners of Spanish bank debt, holding nearly $200 billion. Clearly, many of the banks are interconnected.
The good news is that the finance ministers from the EU created a $1 trillion package consisting of loans available to assist Euro-zone countries experiencing financial difficulties, while Greece, Portugal and Spain have committed to further reducing government spending in order to limit deficit increases. The bad news is that this move could eventually be inflationary and it might just delay the inevitable default of some sovereign debt.
While we are not insulated from the events in Europe, it does not appear that we are entirely dependent on the growth of Europe's economy either. Most economists believe the financial issues and economic slowdown in Europe might only reduce annual U.S. economic growth by ½ of 1%.
The U.S. economy and the emerging markets continue to improve, albeit slowly. However, in the past few weeks there has been some negative news that contributed to the market decline. Does this news mean the bull market is over and it's time to sell stocks, buy gold and head for the hills? We think not.
The news will not always be positive. The recent recession was very severe and it will take time to recover. But we do believe the economy is on the road to recovery. There is some good economic news out there and we should not lose focus of that.
In March the Treasury Secretary, White House Budget Director and Chair of the Council of Economic Advisers issued a joint statement forecasting moderate economic growth of 3.0 percent in 2010, followed by somewhat higher growth of 4.3 percent in both 2011 and 2012. More recently 46 economists surveyed in early May by the National Association for Business Economics (NABE) predicted the U.S. GDP would expand by 3.2% annually in 2010 and 2011, up slightly from their previous prediction in February. Even Federal Reserve officials stated in a new forecast that they thought the economy could grow between 3.2 percent and 3.7 percent this year. That's an upward revision from their January forecast.
Overseas, China's manufacturing sector grew for the 13th straight month and Germany experienced its strongest manufacturing growth in a decade. In the U.S., new orders for factory goods increased in March for the 11th time in the last 12 months. The Institute for Supply Management also reported recently that U.S. manufacturing activity was expanding at the fastest pace in nearly six years and the index of export orders increased in May to its highest level since 1988.
U.S. auto sales rose for the seventh month in a row in May. Sales of cars and light trucks jumped 19% in May from a year earlier to 1.1 million vehicles. U.S. auto sales also surged 20% in April and 24% in March, compared to a year earlier. Even GM managed to post its first quarterly profit in three years: reporting an $863 million profit on revenue of $31 billion, up 40% from last year.
Retail sales rose for the seventh straight month in April and the U.S. Consumer Confidence Index increased from 57.7 in April to 63.3 in May, the highest reading in two years.
The U.S. has added jobs every month so far in 2010. Payrolls increased by 290,000 in April, the most in four years, after a 230,000 gain in March. Manufacturers in April added the most jobs since 1998. Even construction companies increased jobs for the second straight month. Indeed, construction spending rose 2.7% in April from a month earlier, the biggest increase in a decade.
As the recent events in Europe have demonstrated, the economic recovery is clearly fragile. It is likely the Fed might delay increasing interest rates for a while until world economies stabilize. However, we believe the U.S. economy will continue to expand, though at a pace below average recovery growth rates. The bottom line is that it will take many years before things get back to normal.
No doubt there will be a few bumps in the long road to recovery - that should be expected, so keep those seat belts fastened. But it's not the end of the road and we still think the economy is heading in the right direction.
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