The stock market finally took a pause to refresh during the second quarter of 2011 after two years of scorching returns. We are now eight full quarters into a less than impressive recovery from the Great Recession which ended in June, 2009. Last quarter’s pause was certainly due in large part to fears that the little economic engine that could is starting to run out of steam. Numerous Wall Street analysts revised downward their estimates for 2nd half GDP growth, and then the Fed threw in the towel on June 23 when it officially lowered its GDP outlook for the remainder of this year and 2012.
The quarter witnessed numerous significant events including one of the worst outbreaks of deadly tornados which devastated Tuscaloosa, AL and Joplin, MO, killing hundreds and leaving thousands homeless. U.S. Special Ops forces fought their way into a Pakistani compound and put an end to Osama bin Laden bringing some measure of closure to the families of 9/11 victims. Japan officially fell back into a recession as the after-effects of the earthquake and tsunami created supply chain disruptions, especially in their big auto manufacturers. And then there’s Greece and the U.S. deficit situation.
Silver stole the investing spotlight during the quarter as it hit new highs in May and then suffered a truly spectacular crash, falling 25% over four days, the largest such drop in over 30 years. The CME raised margin requirements 84% trying to temper a speculative bubble and boy was it effective. The sell-off spilled over into other commodities including crude oil which fell 10% in one day.
Economic Summary
The struggle between opposing economic and political forces continued to play out in the second quarter, with the housing recession, high unemployment and massive debt levels undermining more substantial economic advances. 1st quarter GDP increased at an annual rate of 1.9% and early estimates for 2Q11 are no better. These numbers compare with a 3.1% growth rate in the 4th quarter of 2010 and 2.9% for all of last year. Obviously the economy is slowing down at a time when it should be picking up steam. Things look starkly different from March’s numbers of 216,000 new jobs and an unemployment rate down to 8.8%. Just three months later the unemployment rate has jumped back up to 9.2% and the June non-farm payroll number was a dismal 18,000 net new jobs. We need 200,000 to 300,000 new jobs per month to get back to full employment.
The Federal Reserve has used about every tool in its monetary toolbox trying to shift the economy into a higher gear without creating hyper-inflation. While holding short-term borrowing costs extremely low, they did allow their second program of Treasury bond purchases (QE2) to expire as of June 30. This may be due to a perception that a third round of Treasury bond purchases (QE3) would further undermine confidence. Standard & Poor’s issued a “negative” outlook warning on the long-term U.S. AAA credit rating, citing a “material risk” the nation’s leaders will fail to deal with the budget deficit and rapidly compounding debt. As bad as our fiscal and monetary situation may look, at least the U.S. is not as bad as Greece. Greece and the other troubled EU countries do have Germany to backstop their debt. Unfortunately, there is no one who can stand behind our debt except the U.S. taxpayer.
Market Summary
Stock returns were mixed during the 2nd quarter. Large companies as measured by the S&P 500 Index were up only 0.10% for the period. Mid-size and smaller companies (S&P 400 and S&P 600) lost ground during the quarter, down -0.73% and -0.16%, respectively. Year-to-date however, investors faired much better with large, mid and small domestic returns of 6.02%, 8.56% and 7.54%, respectively. International equity markets had mixed results with the MSCI EAFE Index (mature countries) up 1.56% and MSCI EM (emerging markets) down -1.15% for the quarter. For the first half of 2011 those indexes were up 4.98% and 0.88%, respectively.
Bond investors experienced better results during the quarter since interest rates fell with the softening economy. A drop in interest rates typically produces a gain in the underlying bond principal. 2nd quarter returns were +1.49%, +3.26% and +3.30% for short, intermediate and long-term bonds, respectively, as measured by the appropriate Barclays Government/Credit indexes. Longer bonds typically out-perform shorter maturities when interest rates fall. Precious metals had mixed results with gold up 4.62% and silver down -7.53% during the period.
What’s Next?
As of this writing all eyes are on Washington as the politicos try to reach a compromise between spending cuts and tax increases in an attempt to raise the debt ceiling, avoid defaulting on the nation’s debt obligations and still get re-elected in 2012. Few experts believe the country will actually default since payments of bond interest and principal can be made without an increase in the debt ceiling. No one said this was going to be easy as we have allowed our entitlements to grow to more than 100% of Federal revenue.
On a more optimistic note, our bleak domestic picture contrasts with a booming global economy which is lifting the fortunes of U.S. companies abroad. Also, we have had 19 consecutive months of growth in the service sector which employs the majority of U.S. workers. American corporations are sitting on hoards of cash just waiting for the green light from Washington in terms of a favorable and clear tax policy to invest that capital. Once that happens, and it eventually will, the economy and financial markets will recover and reach new highs. We may have to endure more pain first, but we will get there. America is a nation of problem solvers and doers. Many of the greatest generation that ever lived are still living among us. We simply need to look over our shoulder for an example of how to roll up our sleeves and overcome difficult obstacles.