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The third quarter started with a substantial rebound in equity markets as investors cheered corporate earnings reports. The S&P 500 rebounded more than 6% after falling 5.4% in June. Through July 30th, approximately 77% of S&P 500 companies reporting earnings have topped analysts’ estimates. While bottom lines have been expanding, top line figures have generally trailed estimates, suggesting cost cutting is still the preferred method to drive earnings. The Treasury market has also enjoyed a rally as yields across the maturity spectrum dropped.
The 2-year US Treasury traded at a record low 0.545% in mid July while the 10-year and 30-year bonds spent the second half of the month hovering below 3% and 4%, respectively. Stress tests on European banks revealed that only 7 banks failed and required an additional 3.5 billion Euros to shore up their balance sheets. Two of the banks have received substantial government support and the remaining five (Spanish “cajas”) are being forced to consolidate. Economic data released last month were generally positive, though suggestive of a lethargic economy, supporting Federal Reserve Chairman Bernanke’s assessment of a period of “unusual uncertainty”. Residential Housing The residential real estate market continued to soften two months after the home purchase tax credit expired. June housing starts declined 5% after falling more 10% in May while building permits, an indicator of future construction activity, increased 2.1%. Of note, multi-family home construction tumbled 22% in June. New home sales rebounded nicely in June, climbing 24%, after declining 37% in May to a record low and the median home price declined 0.6% year-over-year. Existing home sales declined 5.1% in June while the median home price jumped 1% from a year ago. The S&P/Case-Shiller 20-city home price index showed that prices rose 0.5% in May and the index has increased 4.6% from last year. Spending In its first estimate of Q2 GDP, the government reported that the economy expanded at a 2.4% annualized pace, slightly below expectations of 2.6% and also below the 3.7% (upwardly revised from a 2.7% estimate) pace set in the first quarter. The growth was restrained by a 1.6% increase in consumer spending, which was softer than the 1.9% that was reported in the first quarter. Business spending increased 22% - the fastest pace in 13 years. The Conference Board’s consumer confidence reading dropped in July, falling to 50.4 from 54.3 in June. The gauge of expectations for the next six months tumbled; only 10% of respondents anticipate higher salaries in the next six months. In tandem, the University of Michigan’s final July gauge of consumer sentiment fell to 67.8 from a preliminary reading of 66.5 and June’s final reading of 76.0. U.S. retail sales dropped 0.5% in June, marking the second consecutive monthly decline. Consumer credit dropped by $9.1 billion in May, while revolving debt, such as credit card debt, contracted for the 20th consecutive month as consumers continue to reduce leverage. On the business side, the pace of expansion in the manufacturing sector has abated while business spending remains robust. The ISM Manufacturing index decelerated in June but remained in expansion territory as activity expanded at a reading of 56.2, below May’s reading of 59.7. For July, the Chicago Purchasing Managers Index remained in expansion mode for the 10th straight month, climbing to 62.3. Orders for durable goods sank by 1.0% in June, due to a 26% decrease in aircraft orders. Excluding transportation, orders fell 0.6% following a 1.2% increase in the previous month. Orders for non-defense capital goods excluding aircraft, a proxy for future business investment, grew 0.6% in June after climbing 4.6% in May. Finally, the U.S. trade deficit widened by $42.3 billion in May, as imports rose 2.9% and exports increased 2.4%. Labor Market Although the June Employment Report revealed reduced payrolls and the unemployment rate declined, much of this can be attributed to census worker activity. The unemployment rate fell to 9.5% as many Americans gave up on their job search and non-farm payrolls fell by 125,000, roughly in line with expectations. Initial jobless claims, a leading indicator of the labor market, fell by 11,000 to 457,000 for the week ending July 24th and remain range bound between 440,000 and 480,000. The four-week moving average of initial claims also dropped to 452,500. Inflation Overall price pressures continue to remain well contained, giving the Federal Reserve plenty of room to fine tune monetary policy at its own pace. In fact, markets are increasingly paying attention to the threat of deflation - a prolonged downturn in overall prices. St. Louis Federal Reserve President James Bullard said on July 29th that in the face of a deflationary threat, the Fed should reengage quantitative easing tactics, such as purchasing Treasury securities, to stimulate inflation. The consumer price index fell by 0.1% for a third straight month in June, while core prices, which exclude volatile food and energy prices, were 0.2% higher. In the same period, the producer price index decreased 0.5% while core prices rose 0.1%. Compared to a year earlier, core consumer prices are up 0.9% while core wholesale prices have risen 1.1%. The next FOMC meeting is scheduled for August 10th and in light of subdued economic growth trends and indications of disinflation, market participants currently expect the FOMC to leave the overnight lending rate unchanged until June of 2011.
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