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August 2008
Equity Markets
Global equity markets, which have been moving more or less in tandem in recent months, found stability in the latter half of July after reaching new cyclical lows earlier in the month. We increased our allocation to equity markets in response to this market weakness, heightened volatility, and sentiment measures that showed extreme pessimism early in the month. Nonetheless, we remain slightly underweight in our overall equity allocation and would likely reduce our exposure in response to any further market strength. The sharp decline in energy and commodity prices during the past few weeks is supportive of equity valuations, as it reduces inflationary pressure and should contribute to a more supportive monetary policy stance domestically. But weakening economic conditions abroad, along with subdued growth domestically, are likely to provide an increasingly challenging environment for corporate profit growth. We have made moderate reductions to our forecast for 2008 and 2009 earnings as a result. Earnings sourced domestically have been under pressure for some time, but very large gains in profits generated from foreign operations have worked to support overall profit levels, particularly in the nonfinancial segment of the market. But nominal GDP growth in the United States has now fallen to a level that has historically corresponded with declining EPS growth, and incipient weakness in economic readings in the major foreign economies including Japan, Germany, Spain, Italy, the United Kingdom, and others suggests that this source of support is likely in the process of fading. Consensus earnings estimates for 2008 have been sharply reduced over the past few months, but are likely still too optimistic, while 2009 expectations appear unrealistic and will likely be subject to major downward revisions in the coming quarters. The process of reconciling earnings expectations with the economic environment will likely continue to pose a challenge for equity markets in the coming months.
Fixed-Income Markets
The Lehman Brothers U.S. Aggregate Bond Index continued to essentially tread water in July with a slight negative total return of eight basis points, following similar results in June. Treasury sector returns reflected coupon income and incremental price appreciation. Treasury yields were generally steady in spite of the 5.0% year-over-year increase in the Consumer Price Index (CPI) reported during the month, reflecting market expectations that the increase in inflation will not persist. Despite the relative calm that the market has exhibited in response to the elevated inflation readings, futures markets continue to price in a likelihood of Federal Reserve (Fed) tightening over the course of the next six months. In contrast to the expectations expressed in the futures market, the underlying weakness expected in our forecast suggests a likelihood of Fed easing rather than tightening in the coming quarters. Should the forecast prove accurate, those conditions would be expected to be supportive of fixed-income returns as a lower funds rate would be supportive of lower Treasury yields. In addition, with domestic inflation likely in the process of peaking, lower inflation risk should also be supportive of the Treasury market. Inflation typically falls in a lagged response to increases in the unemployment rate and other broad measures of slack resources across the economy. The non-Treasury sectors of the market have remained under pressure, as spreads have continued to widen. The Lehman Brothers U.S. High Yield Bond Index saw the option-adjusted spread widen to 767 basis points above Treasury yields by month end, while investment-grade spreads also widened, causing the non-Treasury sectors to underperform during the month. We remain modestly overweight fixed income in our allocation strategy.
General Economy
Economic growth during the first half of 2008 was somewhat better than anticipated at the beginning of the year. The better-than-expected performance was the result of continued strength in economic activity abroad and tax rebates, which provided a substantial boost to real disposable income during the second quarter. With the rebate distribution now behind us, the household sector will likely show renewed weakness as labor markets continue to deteriorate and home prices continue to fall. Real consumer spending in June was below the level of the second-quarter average, setting the stage for third-quarter weakening. In addition, economic growth abroad is now showing signs of substantial weakening. This weakening will likely erode the very substantial support that strong export growth and the narrowing trade gap have provided to the U.S. economy and domestic corporate earnings growth. To highlight the contribution that foreign strength has made to the domestic economy: if it were not for the contribution from strong export growth and a narrowing trade deficit, gross domestic product (GDP) would have contracted by an average of 0.5% during the past three quarters. Manufacturing sector indicators have displayed disproportionate strength relative to other indicators during this period, but we are likely to see this source of support for domestic economic activity fade in the coming months. Purchasing manager indices for both the manufacturing and nonmanufacturing sectors showed a sharp decline in new export orders in July in addition to the key indicators for major foreign economies that point to upcoming weakness. With the housing contraction ongoing, we will likely see the broader economy weaken during the second half of this year and likely into early 2009. The 2009 economic forecast has been reduced to expect growth of just under 1% for the full year, and we will likely see the unemployment rise to 6.8% by late next year. Inflation pressures are likely to moderate as economic slack continues to build domestically, and additional Fed easing is likely at some point as the unemployment rate continues to climb. Lower inflation and interest rates are supportive of equity valuations, but earnings are likely to be weaker than anticipated in this environment.
Special Notice
Keith Hembre, chief economist and primary contributor to the Monthly Review and Outlook, was named “The most accurate economic forecaster, based on a 2007 economic forecast survey conducted by BusinessWeek.”
- “Hembre’s Farsighted Forecasts” BusinessWeek, December 20, 2007.
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This information represents the opinion of FAF Advisors, Inc., and is not intended to be a forecast of future events, a guarantee of future results, or investment advice. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. The factual information has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Past performance does not guarantee future results.
FAF Advisors, Inc., is a registered investment advisor and subsidiary of U.S. Bank National Association.
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