Monthly Market Monitor - August 2009

Rally Continues, But What’s Next?

The third quarter got off to a good start with most major indexes continuing to rally off of March lows. A renewed appetite for risk coupled with some hopeful signs that the economy is on its way to recovery drove the gains. The Commerce department released its preliminary GDP report for the second quarter and estimated a 1.0% decline, which was slightly better than the consensus forecast of a 1.5% contraction. The number is likely to be revised in the future as more data becomes available. For example, along with the preliminary Q2 GDP report, the Commerce Department also stated that Q1 GDP actually fell by 6.4%, as opposed to the initial estimate of a drop of 5.5%. Of course, the second quarter number could potentially be revised upward as well. Investors focus has now begun to shift to Q3, and some strategists are predicting positive GDP growth in that quarter and beyond. Others, however, don’t see positive GDP growth until the fourth quarter. Another potentially positive sign of stabilization emerged from recent housing data. New home sales rose 11% in June, which was the largest increase in eight and half years and the third straight monthly gain. However, median home prices are still down 12% from a year ago. While these recent trends are encouraging, some analysts think that a significant supply of foreclosed homes remain unsold and are likely to depress the market for some time.

As June was heavy with corporate earnings reports, many investors were looking for signs of improvement in corporate profits. As of July 24, about 40% of the companies in the S&P 500 had reported second quarter earnings.¹ Of these, 76% managed to top consensus forecasts.¹ Market strategists generally attribute these positive surprises to two factors. First, expectations had been set very low given the sharp contraction in the global economy. The lower the bar is set, the easier it is for companies to beat earnings estimates. Secondly, and more importantly, many companies went through significant cost reduction initiatives recently. These are beginning to pay off as evidenced by recent earnings reports. Over the long term, corporate profits drive stock prices. Some strategists, while encouraged by recently reported earnings, caution that this is only one quarter of data and that earnings growth might not be sustainable if the economic recovery takes longer than expected.

Interest Rates and the Deficit

Last fall, credit markets froze up and interest rates on various types of debt, from bank loans to corporate bonds, soared. Unthawing these markets is an important step towards recovery and several recent data points suggest notable improvement. In late July, 3-month LIBOR (London Interbank Offered Rate) fell to its lowest level on record at 0.49%. LIBOR is an average rate at which banks borrow unsecured funds from one another and is an important proxy as it forms the basis for a number of credit products. These include things such as mortgages, student loans, and credit cards. At the peak of the financial crisis, LIBOR had spiked to 4.8%. Some analysts argue that the decline is due increased confidence among banks, while others believe that it is the result of the numerous central-bank programs aimed at restoring normalcy to credit markets. Either way, the fall is good news for the many products that derive their interest rates from underlying LIBOR rates. Other fixed income rates have also shown notable declines. For example, the spread between high yield corporate bonds and 10-year Treasuries rose to nearly 22% at the height of the panic.¹ As of June 30, the spread had fallen to 8.6%.¹ These compare to a 25-year average of slightly over 5%. While some of the contraction is due to a rise in Treasury yields, most of the decline stemmed from buyers stepping back into the high yield market and driving up prices of these bonds (which in turn lowers the yield, as yields move inversely to price.)

One ongoing concern among many economists is the size of the U.S. budget deficit. The unprecedented amount of borrowing and spending has led to record deficits and nobody expects the gap to be closed soon. For the first nine months of fiscal year 2009 (which began on 10/01/08), the Congressional Budget Office (CBO) estimated the federal budget deficit at $1.1 trillion.² It sees an FY 09 total deficit of $1.8 trillion, followed by deficits of $1.4 trillion on FY ‘10 and $974 billion in FY ‘11.² While it is possible that the actual numbers won’t be this large, the deficit is going to be significant. In order to finance these gaps, the government must sell Treasury bonds. A large portion of such sales go to foreigners and China in particular. If these countries pull back on their purchases of U.S. debt, it will become more difficult to finance the deficits. Such buyers would likely demand higher interest rates, which would in turn raise the interest costs to the U.S. government. Thus far, however, such problems have not arisen. If the Fed is successful at removing a good portion of the liquidity from the markets and the government undertakes real efforts to reign in future deficits, holders (and future buyers) of Treasury bonds will likely be relieved.

1. Wall Street Journal, 8/1/09
2. Ned Davis Research, 7/31/09
3. Congressional Budget Office, 7/31/09

The views are those of Cameron Lavey, Senior Investment Analyst, Research Department/ING Advisors Network, and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy.

All economic and performance information is historical and not indicative of future results. The market indices discussed are unmanaged. Investors cannot directly invest in unmanaged indices. Please consult your financial advisor for more information.

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