The European sovereign debt crisis dominated the second quarter of 2012, much as it did the first quarter.  Only this time, the results were not so pleasant.   In the first quarter, markets celebrated yet another agreement negotiated with Greece resulting in the largest sovereign debt restructuring in history.   Everyone went home thinking a crisis was averted. 

As part of the agreement, Greece was to implement severe austerity measures and their political leaders were to guarantee their support for such measures in writing, before and after the May elections.  Unfortunately, someone forgot to consult the Greek people who rioted in the streets and voted in many anti-austerity politicians.  All of this created genuine concerns that Greece’s exit from the Euro was inevitable and increased predictions of an EU break-up.  The situation worsened when investors started pulling money from Greek and Spanish banks, worried they would face a devaluation of their Euro deposits if were converted back into a local currency. 

When it looked like the quarter was going to be a complete wash out, a June summit in Brussels saved the day and the month.  EU leaders announced an agreement in which they would eventually authorize its rescue fund (the European Sovereign Mechanism) to directly aid troubled banks rather than lending to and through the sovereigns.  If the EU lends to sovereigns who in turn re-lend the money to their banks it hurts those countries’ already delicate finances by increasing their debt to GDP ratios.  The announcement also hinted at a more flexible posture by German Chancellor Angela Merkel.  Investors cheered sending the Dow Jones Industrial Average up 277.83 points or 2.20%, and the broader S&P 500 logged its best day of the year, rising 2.50%. 

If the Euro crisis wasn’t enough, the reality of a global economic slowdown compounded investor fears resulting in losses for most equity markets during the quarter.   Fortunately, thanks to the EU Brussels summit, 2Q-12 ended on a high note.  June posted the best monthly equity gains since February. 

Market Summary 

Large, mid and small U.S. stocks all lost ground in the second quarter, down -2.75%, -4.93% and -3.58%, respectively.   During the same period, developed and emerging international stocks suffered worse losses of -7.13% and -8.89% respectively, as worries over the global economic slowdown took its toll. 

Financial stocks (the best performing sector during the first quarter) fell -5.21% during Q2, almost twice the loss of the broader S&P 500.  This just demonstrates why we believe it is virtually impossible to consistently predict the short-term direction of any company, sector or asset class.   Year-to-date, equity investors fared much better, with the S&P 500 leading the major indexes, up 9.49% during the year’s first half. 

As expected, bonds outgained stocks during the second quarter.  The Barclays 1-5 Year Corporate Bond index posted a modest gain of 0.64% for the quarter, but its 3.09% gain for the year’s first half was much less than most equity indexes for the same period. 

Economic Summary 

Europe is in a recession and most non-European economies are slowing.  The Euro zone unemployment rate is now 11.2%, the highest since the EU was formed in 1999.  It matters because what happens overseas affects us here at home.  As evidence, U.S. corporate profits from abroad fell 12% during the first three months of the year compared to a gain of 10% in the U.S. (year-over-year comparisons).   The final estimate for first quarter U.S. GDP showed that our economy grew at a 1.9% annualized pace in the first quarter.  Estimates for the second quarter just ended are coming in at around 1.5% so it’s obvious that we are slowing down.  Last year, GDP grew at 1.7% and in 2010 our economy grew at a 3.0% pace. 

The June employment report revealed an increase in non-farm payrolls of 80,000 jobs, less than the 100,000 expected and much less than needed to produce decent reductions in the ranks of the unemployed.  The unemployment rate held steady at 8.2%.  The June payroll number represents annualized employment growth of 0.7% and followed similar modest gains of 68,000 in April and 77,000 in May.  This is far from the type of employment growth that occurs three years after a recession ends.  

The ISM purchasing managers index slipped 3.8 points in June to 49.7 from May’s 53.5 reading.  This was the first time since July 2009 the index fell below 50 indicating contraction in the manufacturing sector.  However, our economy has grown for 37 consecutive months and shows resilience in some areas.  Inflation remains tame and auto sales continue to gain, while falling energy prices are helping to ease strains on consumers. 

The Federal Reserve announced last month it will expand its Operation Twist program to extend the maturities of assets on its balance sheet and stands ready to take further action to put unemployed Americans back to work.  The purpose of this operation is to put downward pressure on interest rates to help make the cost of borrowing more affordable.  Policy makers repeated their view that economic conditions will probably warrant keeping interest rates “exceptionally low” at least through late 2014.  The FOMC has kept the main interest rate in a range of zero to 0.25% since December 2008. 

What’s Next?  

It’s all about the E’s and the U’s.  Earnings, employment, Europe and the elections will most impact the market’s direction for the foreseeable future.  Uncertainty about domestic policy, including what happens at year-end with the looming fiscal cliff and the future of the health care bill following the Supreme Court’s recent decision can cause businesses to hold off on hiring. 

The “fiscal cliff” is the dilemma lawmakers face at year-end when a number of tax increases and spending cuts go into effect.  They have two choices; they can either let current policy go into effect which would raise taxes and cut spending (especially in defense); or they can cut taxes and spending which could add to the deficit in the short term.  Given the partisan environment that exists currently, most bets are on a stop-gap measure that would delay more permanent decisions until after the fall elections. 

Recent payroll trends obviously suggest continued weak economic and earnings growth, but don’t portend a recession.  Our economy is still growing (37 straight months and counting).  It’s just growing too slow to make a meaningful impact on employment and create sustainable upside momentum. 

Second quarter earnings season is underway and aggregate earnings for the S&P 500 are projected rise about 6%.  Unfortunately, most of those earnings will be attributable to the financial sector which is forecast to increase 50% because of an easy comparison to last year when the sector took huge losses.  Backing out financials, earnings may only rise 1% in the quarter. Most companies are predicted to post lackluster results. 

If you are an investor in this wonderful experiment called capitalism, then these ups and downs are par for the course.  A pull back in prices like we are currently seeing represents an opportunity to purchase an ownership interest in great companies at a lower price than you would have otherwise paid.   Anyone attempting to create wealth must allocate a portion of their financial nest egg to companies that make and sell the products and services we all use.  These same companies will generate earnings that can be reinvested for future growth or paid out to their shareholders in the form of dividends.  Either way, it’s been a great way to grow your net worth at a pace greater than inflation and taxes.  That is one trend that is likely to continue.