Other Updates

The Economic Environment

Entering April, the U.S. economy had posted three consecutive quarters of growth, with first quarter gross domestic product (GDP) rising 2.7 percent from the prior year’s output. The second quarter of 2010 extended this streak to four straight quarters, as most estimates suggest the U.S. economy grew about 3 percent during this period. However, signs of deceleration emerged in May and June due to several factors, including:

• The world’s fastest growing major economy, China, took measures to slow expansion to a more sustainable pace.
• Austerity measures in Greece and other European countries lowered expectations for global economic growth.
• New and existing home sales in the U.S. declined significantly in May, after the expiration of the homebuyer tax credit on April 30.
• The U.S. dollar strengthened, negatively impacting U.S. exports.

Many leading economic indicators continue to be in expansionary territory, but most have flattened or decelerated at the margin in recent weeks.

Hiring of temporary census workers propped employment early in the quarter. Beyond these government hires, the private sector continued to add jobs. Private-sector job creation has been positive for six consecutive months, although the rate of gain has been somewhat disappointing when compared to prior recoveries. The unemployment rate declined to 9.5 percent by the end of the quarter, better than the prior period’s rate of 9.7 percent, but only a slight improvement.

Two short months ago the chance of a “double-dip” recession was considered to be close to zero, but recent deterioration in various economic indicators suggests this may still be a possibility. At this juncture, the data seem more consistent with a “soft patch” in an ongoing recovery, but risks to the growth outlook have risen.

Global economic participation, by reaching consumers who have less debt and a rising standard of living, continues to be important to the growth potential of U.S. companies and our economy. The ability to transition to sustainable growth without the help of government stimulus will be the key determinant of success for the economy as we progress through 2010.

The Stock Market

Stocks posted their first negative quarter of returns since the rebound began in March 2009. After peaking in late April, the market experienced its first official “correction,” dropping by more than 15 percent through the end of the quarter. Concerns over slowing global growth prompted the declines, which occurred across all major categories. Below are index returns for the quarter and year-to-date:

While stocks benefited when investors shifted focus from “seeking shelter” to pursuing superior returns in late 2009 and early 2010, the trend reversed during the second quarter. The initial catalyst for the downward movement in prices was the increased possibility that Greece would default on its debt, potentially causing another credit crisis. However, in May, member countries of the European Union announced a plan to provide monetary backing to Greece and other troubled countries, reducing the chance of “contagion” in the near term. For now, the real issue for stock investors relates to how these debt concerns impact global growth potential, particularly when combined with the slowdown in China. In our view, stock prices have fallen in recent weeks as a means of “recalibrating” to a lower global growth-rate assumption.

International developed-country stocks have led the market lower in 2010, as the center of investment concern has been Europe. As the “flight-to-safety” re-emerged during the quarter, the U.S. dollar strengthened, further reducing returns U.S. investors realized from international stocks. Emerging market stocks have been more resilient, as these countries are generally in better fiscal condition than their developed-country counterparts and also are experiencing a more robust rebound in economic activity. Despite international stock declines year-to-date, the asset class continues to offer significant appeal from the standpoint of both diversification and return potential.

Given the 80 percent rebound in stock prices from March 9, 2009, (S&P 500 low of 676) to April 23, 2010 (S&P 500 high of 1217)1, a correction of 10 percent or more was inevitable at some point. Stock markets rarely move up or down in a straight line. At current levels, the S&P 500 trades at less than 13 times projected 2010 earnings, and actual earnings have exceeded expectations in each of the last two quarters. This represents the most attractive market valuation since spring 2009, as earnings have grown along with stock prices over the past year. So although volatility has definitely returned to the market in recent weeks, reasonable valuation levels and robust earnings momentum should limit further declines.

The Bond Market

One of the most significant surprises for bond investors during the second quarter was the path taken by interest rates. Most of the relevant indicators suggested interest rates were more likely to rise than fall in 2010. However, the same return to risk aversion that negatively affected stock prices in the quarter also served to increase the demand for bonds, driving prices up and yields down. The benchmark 10-year Treasury note yield declined from 3.83 percent at the end of March to 2.95 percent by June 301. The result of this significant downward movement in interest rates was strong total returns for bonds, with the BarCap Aggregate taxable bond index up 5.33 percent for the first six months of the year, and the BarCap Municipal index rising 3.31 percent over the same period. Although the rally in bond prices benefited U.S. Treasuries the most, virtually all other categories also performed well, despite some credit-spread widening. This is in stark contrast to late 2008 and early 2009, when corporate investment-grade and high-yield bonds were falling in price alongside stocks. The credit environment has remained relatively stable recently, allowing bonds to provide the intended diversification benefit to balanced portfolios.

Weakening state and local tax revenues have caused growing concern that municipal bond defaults will rise in the year ahead (albeit from low historical levels, compared to other types of bonds). But while this is a reasonable assumption, in our view this is not likely to evolve into a widespread con­cern for the municipal market, though it will affect specific issuers. Focusing on general obligation (G.O.) bonds, essential services revenue bonds (water, sewer, etc.) and avoiding the geographies most affected by the economic downturn should prove to be beneficial in the current environment.

On the heels of the unexpected decline in interest rates during the second quarter, opportunities for price appreciation are now limited. Therefore, total return expectations for bonds are much more modest going forward.

The Investment Outlook

Entering 2010, the BKD Wealth Advisors Investment Committee made a decision to reduce portfolio risk across most balanced portfolio allocation models, in recognition of the large gains realized during the final 10 months of 2009. This action was not taken in anticipation of significant downward movement in stock prices, but due to the realization market volatility might return in the new year. This incremental shift away from stocks and toward bonds and alternative investments has proven to be productive in terms of managing risk in the current environment.

Given the improvement in the world economy and the stabilization that has occurred in the financial system over the past 18 months, our view is that the current round of market volatility is not likely a precursor to the sort of deep declines experienced in late 2008 and early 2009. Corporate profits have improved greatly over the past three quarters, which should support stock prices.

However, the recent market turmoil highlights the fact that global economic recovery is a process, rather than an event. Given the magnitude of the downturn that ended a little more than a year ago, ripple effects will likely continue in the months ahead. This expectation is reflected in BKD Wealth Advisors’ current portfolio structure, as our team strives to mitigate downside risk while at the same time positioning portfolios to capture the return opportunities that move our clients toward achieving their financial goals.

The process of broadening diversification over the past two years and actions taken to manage risk in 2010 should prove to be beneficial as we progress through the remainder of the year.

1 Source:  Reuters

The views presented in this Market Commentary are those of the Investment Committee of BKD Wealth Advisors, LLC and do not represent any specific investment returns or promises of performance in the future. The comments in this Market Commentary are not to be construed as investment advice or the recommendation to buy or sell any specific investments. Before making changes to your current portfolio, please contact your advisor.